UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) (X) Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended AUGUST 31, 2003 OR ( ) 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 0-19095 SOMANETICS CORPORATION (Exact name of registrant as specified in its charter) MICHIGAN 38-2394784 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1653 EAST MAPLE ROAD, TROY, MICHIGAN 48083-4208 (Address of principal executive offices) (Zip Code) (248) 689-3050 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ---------------- ---------------- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes No X ---------------- ---------------- Number of common shares outstanding at October 1, 2003: 9,158,634 PART I FINANCIAL INFORMATION SOMANETICS CORPORATION BALANCE SHEETS August 31, November 30, 2003 2002 ------------- ------------- (Unaudited) (Audited) ASSETS CURRENT ASSETS: Cash and cash equivalents.......................................... $ 1,905,941 $ 2,381,808 Accounts receivable................................................ 1,400,118 1,227,785 Inventory.......................................................... 1,172,421 1,004,305 Prepaid expenses................................................... 104,398 96,308 ------------- ------------- Total current assets............................................ 4,582,878 4,710,206 ------------- ------------- PROPERTY AND EQUIPMENT (at cost): Machinery and equipment............................................ 2,005,029 1,861,679 Furniture and fixtures............................................. 248,657 241,295 Leasehold improvements............................................. 171,882 171,882 ------------- ------------- Total........................................................... 2,425,568 2,274,856 Less accumulated depreciation and amortization..................... (1,772,307) (1,757,781) ------------- ------------- Net property and equipment...................................... 653,261 517,075 ------------- ------------- OTHER ASSETS: Intangible assets, net............................................. 961,566 921,957 Other.............................................................. 15,000 15,000 ------------- ------------- Total other assets.............................................. 976,566 936,957 ------------- ------------- TOTAL ASSETS........................................................... $ 6,212,705 $ 6,164,238 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable................................................... $ 553,099 $ 470,880 Accrued liabilities................................................ 188,640 192,766 ------------- ------------- Total current liabilities....................................... 741,739 663,646 ------------- ------------- COMMITMENTS AND CONTINGENCIES.......................................... SHAREHOLDERS' EQUITY: Preferred shares; authorized, 1,000,000 shares of $.01 par value; no shares issued or outstanding................................. - - Common shares; authorized, 20,000,000 shares of $.01 par value; issued and outstanding, 9,152,034 shares at August 31, 2003, and 9,077,863 shares at November 30, 2002....................... 91,520 90,779 Additional paid-in capital......................................... 59,290,123 59,071,122 Accumulated deficit................................................ (53,910,677) (53,661,309) ------------- ------------- Total shareholders' equity...................................... 5,470,966 5,500,592 ------------- ------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY............................. $ 6,212,705 $ 6,164,238 ============= ============= See notes to financial statements 2 SOMANETICS CORPORATION STATEMENTS OF OPERATIONS (Unaudited) Three Months Nine Months Ended August 31, Ended August 31, -------------------------- --------------------------- 2003 2002 2003 2002 ----------- ------------ ------------ ------------ NET REVENUES.......................................................... $ 2,303,880 $ 1,432,826 $ 6,458,268 $ 4,684,252 COST OF SALES......................................................... 519,545 409,076 1,530,937 1,445,082 ----------- ----------- ----------- ----------- GROSS MARGIN.......................................................... 1,784,335 1,023,750 4,927,331 3,239,170 ----------- ----------- ----------- ----------- OPERATING EXPENSES: Research, development and engineering............................ 85,435 147,902 328,214 431,344 Selling, general and administrative.............................. 1,628,322 1,267,691 4,867,270 3,968,698 ----------- ----------- ----------- ----------- Total operating expenses.................................... 1,713,757 1,415,593 5,195,484 4,400,042 ----------- ----------- ----------- ----------- OPERATING INCOME (LOSS)............................................... 70,578 (391,843) (268,153) (1,160,872) ----------- ----------- ----------- ----------- OTHER INCOME (EXPENSE): Interest expense................................................. -- -- -- (794) Interest income.................................................. 4,876 14,801 18,785 40,863 ----------- ----------- ----------- ----------- Total other income.......................................... 4,876 14,801 18,785 40,069 ----------- ----------- ----------- ----------- NET INCOME (LOSS)..................................................... $ 75,454 $ (377,042) $ (249,368) $(1,120,803) ----------- ----------- ----------- ----------- NET INCOME (LOSS) PER COMMON SHARE-BASIC AND DILUTED............................................ $ 0.01 $ (0.04) $ (0.03) $ (0.13) ----------- ----------- ----------- ----------- WEIGHTED AVERAGE SHARES OUTSTANDING-BASIC.................................................. 9,101,397 9,077,863 9,086,613 8,909,221 =========== =========== =========== =========== WEIGHTED AVERAGE SHARES OUTSTANDING-DILUTED ............................................... 9,700,387 9,077,863 9,086,613 8,909,221 =========== =========== =========== =========== See notes to financial statements 3 SOMANETICS CORPORATION STATEMENTS OF CASH FLOWS (UNAUDITED) For the Nine Month Periods Ended -------------------------- August 31, August 31, 2003 2002 ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ............................................................ $ (249,368) $(1,120,803) Adjustments to reconcile net loss to net cash used in operations: Depreciation and amortization ................................... 176,619 166,295 Compensation expense for non-employee stock options ............. 7,224 4,352 Changes in assets and liabilities: Accounts receivable (increase) decrease ..................... (172,333) 533,829 Inventory (increase) ........................................ (168,116) (414,135) Prepaid expenses (increase) ................................. (8,090) (42,286) Other assets decrease ....................................... -- 12,078 Accounts payable increase (decrease) ........................ 82,219 (71,177) Accrued liabilities increase (decrease) ..................... (4,126) 28,686 ----------- ----------- Net cash (used in) operations ............................. (335,971) (903,161) ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of property and equipment (net) ......................... (307,620) (246,508) ----------- ----------- Net cash (used in) investing activities ................... (307,620) (246,508) ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common shares ............................. 167,724 3,689,101 ----------- ----------- Net cash provided by financing activities ................. 167,724 3,689,101 ----------- ----------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ......................................................... (475,867) 2,539,432 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ........................................................... 2,381,808 167,873 ----------- ----------- CASH AND CASH EQUIVALENTS, END OF PERIOD ........................................................... $ 1,905,941 $ 2,707,305 =========== =========== Supplemental Disclosure of Non cash investing activities: Issuance of warrants in connection with license acquisition (Note 2) ................................... $ 44,793 See notes to financial statements 4 SOMANETICS CORPORATION NOTES TO FINANCIAL STATEMENTS (UNAUDITED) AUGUST 31, 2003 1. FINANCIAL STATEMENT PRESENTATION We prepared our unaudited interim financial statements pursuant to the Securities and Exchange Commission's rules. Accordingly, they do not include all of the information and footnotes normally included in our annual financial statements prepared in accordance with generally accepted accounting principles. We believe, however, that the disclosures are adequate to make the information presented not misleading. The unaudited interim financial statements in this report reflect all adjustments which are, in our opinion, necessary to a fair statement of the results for the interim periods presented. All of these adjustments that are material are of a normal recurring nature. Our operating results for the nine-month period ended August 31, 2003 do not necessarily indicate the results that you should expect for the year ending November 30, 2003. You should read the unaudited interim financial statements together with the financial statements and related footnotes for the year ended November 30, 2002 included in our Annual Report on Form 10-K for the fiscal year ended November 30, 2002. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Inventory is stated at the lower of cost or market on a first-in, first-out (FIFO) basis. Inventory consists of: August 31, 2003 November 30, 2002 --------------- ----------------- Finished goods................... $ 409,001 $ 410,133 Work in process.................. 282,285 154,816 Purchased components............. 481,135 439,356 --------------- ----------------- Total....................... $ 1,172,421 $ 1,004,305 =============== ================= Intangible Assets consist of patents and trademarks, and license acquisition costs. Patents and trademarks are recorded at cost and are being amortized on the straight-line method over 17 years. The carrying amount and accumulated amortization of these patents and trademarks is as follows: August 31, 2003 November 30, 2002 --------------- ----------------- Patents and trademarks........... 111,733 111,733 Less accumulated amortization.. (79,260) (74,076) --------------- ----------------- Total....................... $ 32,473 $ 37,657 =============== ================= Amortization expense for the three months ended August 31, 2003 and August 31, 2002 was approximately $1,700. Amortization expense for the nine months ended August 31, 2003 and August 31, 2002 was approximately $5,200. Amortization expense for each of the next five fiscal years is expected to be approximately $6,900 per year. License acquisition costs are related to our acquisition of exclusive, worldwide, royalty-bearing licenses to specified rights relating to the CorRestore(TM) System, and related products and accessories. The total carrying amount of these license acquisition costs is as follows: 5 SOMANETICS CORPORATION NOTES TO FINANCIAL STATEMENTS (UNAUDITED) AUGUST 31, 2003 August 31, 2003 November 30, 2002 --------------- ----------------- License acquisition costs........ $ 929,093 $ 884,300 Effective April 25, 2003, in connection with our receipt of CE Mark certification for the CorRestore System, an additional 50,000 warrants to purchase common shares vested for CorRestore LLC and its agent, Wolfe & Company. We estimated the value of these warrants as part of our license acquisition costs using the Black-Scholes valuation model with the following assumptions: expected volatility (the measure by which the stock price has fluctuated or is expected to fluctuate during the period) 64.70%, risk-free interest rate of 2.0%, expected life of 25 months and dividend yield of 0%. License acquisition costs are intangible assets with indefinite lives that are reviewed annually for impairment and whenever events or changes in circumstances indicate that the carrying value of the asset may not be recovered. Stock Options In October 1995, Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," was issued by the Financial Accounting Standards Board. In addition, in December 2002, Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," was issued by the Financial Accounting Standards Board, and amends Statement No. 123. Statement No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, Statement No. 148 amends the disclosure requirements of Statement No. 123 regardless of the accounting method used to account for stock-based compensation. We have chosen to continue to account for stock-based compensation of employees using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. We have also adopted the enhanced disclosure provisions as defined by Statement No. 148 beginning with our fiscal quarter ended February 28, 2003. During the first three quarters of fiscal 2003, we granted 471,000 stock options to our employees and directors, and two of our employees exercised stock options to purchase 74,171 newly-issued common shares. During the first three quarters of fiscal 2002 we granted 509,500 stock options to our employees and directors, and one of our former employees exercised stock options to purchase 2,833 newly-issued common shares. FOR THE NINE MONTHS ENDED AUGUST 31, 2003 2002 ----------- ----------- Net loss ..................................... $ 249,368 $ 1,120,803 Pro-forma net loss, had fair value method been applied ...................................... $ 777,428 $ 1,579,668 Net loss per common share-basic and diluted ...................................... (.03) (.13) Pro-forma net loss per common share-basic and diluted, had fair value method been applied ...................................... (.09) (.18) Stock-based employee compensation included in actual net loss ........................... $ 7,224 $ 4,352 Pro-forma stock-based employee compensation, had fair value method been applied ........... $ 535,284 $ 463,217 6 SOMANETICS CORPORATION NOTES TO FINANCIAL STATEMENTS (UNAUDITED) AUGUST 31, 2003 Net Income (Loss) Per Common Share - basic and diluted is computed using the weighted average number of common shares outstanding during each period. Weighted average shares outstanding - diluted, for the three month period ended August 31, 2003, includes the potential dilution that could occur for common stock issuable under stock options or warrants. Common shares issuable under stock options and warrants have not been included in the computation of the net loss per common share - diluted for the nine months ended August 31, 2003, or for the three or nine month period ended August 31, 2002, because such inclusion would be antidilutive. As of August 31, 2003 and August 31, 2002, we had outstanding warrants and options to purchase common shares of 5,509,502 and 5,163,050, respectively. Accounting Pronouncements During the first quarter of fiscal 2003, we adopted Financial Accounting Standards Board Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." The adoption of this interpretation statement had no impact on our financial statements. 3. ACCRUED LIABILITIES Accrued liabilities consist of the following: August 31, 2003 November 30, 2002 --------------- ----------------- Incentive Compensation ................. $ 108,909 $ 8,000 Sales commissions ...................... 33,147 55,381 Clinical Research ...................... 20,000 21,450 Royalty ................................ 11,934 12,071 Professional fees ...................... 8,000 15,000 Warranty ............................... 6,650 6,400 Insurance .............................. -- 34,464 Training ............................... -- 40,000 --------------- ----------------- Total .............................. $ 188,640 $ 192,766 --------------- ----------------- 4. COMMITMENTS AND CONTINGENCIES We may become subject to products liability claims by patients or physicians, and may become a defendant in products liability or malpractice litigation. We have obtained products liability insurance and an umbrella policy. We might not be able to maintain such insurance or such insurance might not be sufficient to protect us against products liability. 5. COMMON STOCK Effective January 23, 2003, we granted 10-year options under the 1997 Stock Option Plan to purchase 11,500 common shares, to two of our employees at an exercise price of $1.70 per share (the closing sale price of the common shares as of the date of grant). In February 2003, one of our employees exercised stock options to purchase 2,500 newly-issued common shares. 7 SOMANETICS CORPORATION NOTES TO FINANCIAL STATEMENTS (UNAUDITED) AUGUST 31, 2003 Effective March 24, 2003, we granted 10-year options under the 1997 Stock Option Plan to purchase 10,000 common shares, to one of our employees at an exercise price of $1.76 per share (the closing sale price of the common shares as of the date of grant). On April 10, 2003, our shareholders approved an amendment to the Somanetics Corporation 1997 Stock Option Plan to increase the number of common shares reserved for issuance pursuant to the exercise of options granted under the 1997 Plan by 450,000 shares, from 2,110,000 to 2,560,000 shares. In addition, effective April 10, 2003, we granted to five of our directors, who are not officers or employees, 10-year options under the 1997 Stock Option Plan to purchase an aggregate of 17,500 common shares at an exercise price of $2.80 per share (the closing sale price of the common shares as of the date of grant). In August 2003, one of our employees exercised stock options to purchase 71,671 newly-issued common shares. In addition, effective August 13, 2003, we granted 10-year options under the 1997 Stock Option Plan to purchase 432,000 common shares, to 16 of our key employees (including officers) at an exercise price of $3.89 per share (the closing sale price of the common shares as of the date of grant). 6. SEGMENT INFORMATION We operate our business in one reportable segment, the development, manufacture and marketing of medical devices. Each of our two product lines have similar characteristics, customers, distribution and marketing strategies, and are subject to similar regulatory requirements. In addition, in making operating and strategic decisions, our management evaluates net revenues based on the worldwide net revenues of each major product line, and profitability on an enterprise-wide basis due to shared costs. Approximately 91% of our net revenues in the first three quarters of fiscal 2003 were derived from our INVOS Cerebral Oximeter product line, compared to 97% of our net revenues in the first three quarters of fiscal 2002. 7. NOTES PAYABLE - BANK LINE OF CREDIT As of April 24, 2003, we amended our Loan and Security Agreement with Crestmark Bank. Pursuant to the amendment, we paid a $5,000 renewal commitment fee to continue our lending relationship for the remainder of 2003. We must negotiate a new lending relationship if we would like to continue the lending relationship into 2004. Pursuant to the amendment, we also agreed to give the bank at least 30 days advance notice of any intended draw on our line of credit. 8 SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AUGUST 31, 2003 Some of the statements in this report are forward-looking statements. These forward-looking statements include statements relating to our performance in this Management's Discussion and Analysis of Financial Condition and Results of Operations. Forward-looking statements include statements regarding the intent, belief or current expectations of us or our officers, including statements preceded by, followed by or including forward-looking terminology such as "may," "will," "should," "believe," "expect," "anticipate," "estimate," "continue," "predict" or similar expressions, with respect to various matters. Our actual results might differ materially from those projected in the forward-looking statements depending on various important factors. These important factors include our history of losses, our current dependence on the Cerebral Oximeter and SomaSensor, the challenges associated with developing new products, the uncertainty of acceptance of our products by the medical community, the lengthy sales cycle for our products, competition in our markets, our dependence on our distributors, and the other factors discussed under the caption "Risk Factors" and elsewhere in our Registration Statement on Form S-1 (file no. 333-74788) effective January 11, 2002 and elsewhere in this report, all of which constitute cautionary statements identifying important factors with respect to the forward-looking statements, including risks and uncertainties, that could cause actual results to differ materially from those in the forward-looking statements. All forward-looking statements in this report are based on information available to us on the date of this report. We do not undertake to update any forward-looking statements that may be made by us or on our behalf in this report or otherwise. RESULTS OF OPERATIONS OVERVIEW We develop, manufacture and market the INVOS Cerebral Oximeter, the only non-invasive patient monitoring system commercially available in the United States that continuously measures changes in the blood oxygen level in the brain. We also develop and market the CorRestore System for use in cardiac repair and reconstruction, including heart surgeries called surgical ventricular restoration, or SVR. During fiscal 2002 and the first three quarters of fiscal 2003, our primary activities consisted of sales and marketing of the Cerebral Oximeter, the related disposable SomaSensor, and the CorRestore System. We derive our revenues from sales of Cerebral Oximeters and SomaSensors to our distributors, and from sales of Cerebral Oximeters, SomaSensors and CorRestore Systems to hospitals in the United States through our direct sales employees and independent sales representatives. We offer to our customers a no-cap sales program whereby we ship the Cerebral Oximeter to the customer at no charge, in exchange for the customer agreeing to purchase at a premium a minimum monthly quantity of SomaSensors. Payment terms are generally net 30 days for United States sales and net 60 days or longer for international sales. Our primary expenses, excluding the cost of our products, are selling, general and administrative and research, development and engineering. 9 SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AUGUST 31, 2003 THREE MONTHS ENDED AUGUST 31, 2003 COMPARED TO THREE MONTHS ENDED AUGUST 31, 2002 Our net revenues increased approximately $871,000, or 61%, from $1,432,826 in the three-month period ended August 31, 2002 to $2,303,880 in the three-month period ended August 31, 2003. The increase in net revenues is primarily attributable to: - an increase in United States sales of approximately $549,000, from approximately $1,259,000 in the third quarter of fiscal 2002 to approximately $1,808,000 in the third quarter of fiscal 2003. This increase is primarily due to an increase in sales of the disposable SomaSensor of approximately $498,000, or 46%, and an increase in CorRestore System revenues of approximately $68,000, or 132%, - a 14% increase in the average selling price of SomaSensors in the United States, primarily due to the increase in the suggested retail price of the SomaSensor effective December 1, 2002, the addition of new customers at the higher suggested retail prices, and increased sales of SomaSensors to larger U.S. hospitals at a premium price pursuant to our no-cap sales program, and - an increase in international sales of approximately $321,000, or 185%, from approximately $174,000 in the third quarter of fiscal 2002 to approximately $495,000 in the third quarter of fiscal 2003. This increase is primarily due to increased purchases by Tyco Healthcare. Approximately 21% of our net revenues in the third quarter of fiscal 2003 were export sales, compared to approximately 12% of our net revenues in the third quarter of fiscal 2002. Sales of our products as a percentage of net revenues were as follows: PERCENT OF NET REVENUE THIRD QUARTER OF FISCAL PRODUCT 2003 2002 ------- ---- ---- SomaSensors............................. 73% 82% Cerebral Oximeters...................... 22% 14% CorRestore Systems...................... 5% 4% --- --- Total............................... 100% 100% === === One international distributor accounted for approximately 17% of net revenues for the three months ended August 31, 2003. The Company expects net revenues to be between $9,000,000 and $10,000,000 for fiscal 2003. 10 SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AUGUST 31, 2003 Gross margin as a percentage of net revenues was approximately 77% for the quarter ended August 31, 2003 and approximately 71% for the quarter ended August 31, 2002. The increase in gross margin as a percentage of net revenues is primarily attributable to: - the increase in the average selling price of SomaSensors described above, - sales of our latest model SomaSensor, which is less costly to manufacture than the prior model SomaSensor sold in the third quarter of fiscal 2002, and - sales of our latest model Cerebral Oximeter, which is less costly to manufacture than the prior model Cerebral Oximeter sold in the third quarter of fiscal 2002. These increases in gross margin percentage were partially offset by increased international sales, which have lower gross margins than sales in the United States. Our research, development and engineering expenses decreased approximately $62,000, or 42%, from $147,902 for the three months ended August 31, 2002 to $85,435 for the three months ended August 31, 2003. The decrease is primarily attributable to approximately $39,000 in decreased costs associated with our next generation Cerebral Oximeter launched in 2003, and $28,000 in decreased development costs associated with the CorRestore System. Selling, general and administrative expenses increased approximately $361,000, or 28%, from $1,267,691 for the three months ended August 31, 2002 to $1,628,322 for the three months ended August 31, 2003. The increase in selling, general and administrative expense is primarily attributable to: - a $152,000 increase in commissions paid to our independent sales representatives as a result of increased sales, - an $89,000 increase in salaries, wages, employee sales commissions and related expenses, primarily as a result of an increase in the number of employees, principally sales and marketing (from an average of 28 employees for the third quarter of fiscal 2002 to an average of 29 employees for the third quarter of fiscal 2003), increased salaries and increased employee insurance costs, - a $57,000 increase in trade show, promotional, and selling-related expenses as a result of our increased sales and marketing activities, and - a $43,000 increase in accrued incentive compensation expense, primarily due to our executive officers receiving awards under the 2003 Incentive Compensation Plan after forgoing awards under the 2002 Incentive Compensation Plan. For the three-month period ended August 31, 2003, we realized net income of $.01 per share, compared to a loss per share of $.04 in the same period in fiscal 2002. This is primarily attributable to: - a 61% increase in net revenues, and - a 6% increase in gross margin percentage. We achieved net income despite a 21% increase in operating expenses. 11 SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AUGUST 31, 2003 NINE MONTHS ENDED AUGUST 31, 2003 COMPARED TO NINE MONTHS ENDED AUGUST 31, 2002 Our net revenues increased approximately $1,774,000, or 38%, from $4,684,252 in the nine-month period ended August 31, 2002 to $6,458,268 in the nine-month period ended August 31, 2003. The increase in net revenues is primarily attributable to: - an increase in United States sales of approximately $1,500,000, from approximately $3,772,000 in the first three quarters of fiscal 2002 to approximately $5,272,000 in the first three quarters of fiscal 2003. This increase is primarily due to an increase in sales of the disposable SomaSensor of approximately $1,204,000, or 39%, and an increase in CorRestore System revenues of approximately $426,000, or 289%. This increase was partially offset by a decrease in sales of the Cerebral Oximeter of approximately $129,000, or 25%, primarily as a result of a preference by larger U.S. hospitals to acquire Cerebral Oximeters using our no-cap sales program, - a 13% increase in the average selling price of SomaSensors in the United States, primarily due to the increase in the suggested retail price of the SomaSensor effective December 1, 2002, the addition of new customers at the higher suggested retail prices, and increased sales of SomaSensors to larger U.S. hospitals at a premium price pursuant to our no-cap sales program. This increase was partially offset by increased SomaSensor sales to international distributors, which have lower average selling prices, and - an increase in international sales of approximately $274,000, or 30%, from approximately $912,000 in the first three quarters of fiscal 2002 to approximately $1,186,000 in the first three quarters of fiscal 2003, primarily attributable to increased purchases by Tyco Healthcare. Approximately 18% of our net revenues in the first three quarters of fiscal 2003 were export sales, compared to approximately 19% of our net revenues in the first three quarters of fiscal 2002. Sales of our products as a percentage of net revenues were as follows: PERCENT OF NET REVENUE FIRST THREE QUARTERS OF FISCAL PRODUCT 2003 2002 ------- ---- ---- SomaSensors........................ 74% 74% Cerebral Oximeters................. 17% 23% CorRestore Systems................. 9% 3% --- --- Total.......................... 100% 100% === === One international distributor accounted for approximately 13% of net revenues for the nine months ended August 31, 2003, and approximately 11% of net revenues for the nine months ended August 31, 2002. 12 SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AUGUST 31, 2003 Gross margin as a percentage of net revenues was approximately 76% for the nine months ended August 31, 2003 and approximately 69% for the nine months ended August 31, 2002. The increase in gross margin as a percentage of net revenues is primarily attributable to: - the increase in the average selling price of SomaSensors described above, - sales of our latest model SomaSensor, which is less costly to manufacture than the prior model SomaSensor sold in the first three quarters quarter of fiscal 2002, and - sales of our latest model Cerebral Oximeter, which is less costly to manufacture than the prior model Cerebral Oximeter sold in the first three quarters quarter of fiscal 2002. Our research, development and engineering expenses decreased approximately $103,000, or 24%, from $431,344 for the nine months ended August 31, 2002 to $328,214 for the nine months ended August 31, 2003. The decrease is primarily attributable to approximately $73,000 in decreased costs associated with the development of the CorRestore System, and $39,000 in decreased costs associated with our next generation Cerebral Oximeter launched in 2003. Selling, general and administrative expenses increased approximately $899,000, or 23%, from $3,968,698 for the nine months ended August 31, 2002 to $4,867,270 for the nine months ended August 31, 2003. The increase in selling, general and administrative expense is primarily attributable to: - a $224,000 increase in commissions paid to our independent sales representatives as a result of increased sales, - a $202,000 increase in salaries, wages, employee sales commissions and related expenses, primarily as a result of increased salaries, principally sales and marketing, and increased employee insurance costs, - a $165,000 increase in trade show, promotional, and selling-related expenses as a result of our increased sales and marketing activities, - a $152,000 increase in accrued incentive compensation expense, primarily due to our executive officers receiving awards under the 2003 Incentive Compensation Plan after forgoing awards under the 2002 Incentive Compensation Plan, - an $82,000 increase in customer education expenses for the CorRestore System, - a $43,000 increase in royalty expense as a result of increased sales of the CorRestore System, and - a $37,000 increase in professional service fees primarily as a result of increased investor relations and public relations expenses. These increases were partially offset by a $30,000 decrease in corporate general insurance expenses, primarily as a result of a policy premium refund received in 2003 relating to our 2002 products liability insurance coverage. For the nine-month period ended August 31, 2003, we realized a 78% decrease in our net loss over the same period in fiscal 2002. The decrease is primarily attributable to: - a 38% increase in net revenues, and - a 7% increase in gross margin percentage. The reduction in our net loss was achieved despite a 18% increase in operating expenses. 13 SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AUGUST 31, 2003 LIQUIDITY AND CAPITAL RESOURCES Net cash used in operations during the nine-month period ended August 31, 2003 was approximately $336,000. Cash was used primarily to: - fund our net loss, primarily selling, general and administrative expenses and research, development and engineering expenses, totaling approximately $73,000, before depreciation and amortization expense, - increase accounts receivable by approximately $172,000, primarily because of higher third quarter 2003 sales than fourth quarter 2002 sales, and - increase inventories by approximately $168,000, primarily as a result of the acquisition of components associated with our SomaSensor and Cerebral Oximeter due to increased sales. These uses of cash were partially offset by an increase in accounts payable of approximately $82,000, primarily due to increased purchases of inventories. We expect our working capital requirements to increase if sales increase. Capital expenditures in the first nine months of fiscal 2003 were approximately $308,000. These expenditures were primarily for Cerebral Oximeter demonstration units and no-cap sales units. We expect our capital expenditures for fiscal 2003 to be approximately $400,000. We have a Loan and Security Agreement with Crestmark Bank for a working capital line of credit for up to $750,000, collateralized by all of our assets. Under the agreement, Crestmark Bank may, but is not obligated to, lend us amounts we request from time to time, up to $750,000, if no default exists. The loans are limited by a borrowing base based on qualifying accounts receivable and lender reserves. The loan is payable on demand, and our collections of our receivables are directed to Crestmark Bank in payment of any outstanding balance of the loan. The principal amount outstanding bears interest, payable monthly, at the prime rate (4.00% as of September 30, 2003) plus 2% plus a 2.4% service fee. As of September 30, 2003, we had no outstanding principal loan balance and approximately $750,000 was available for borrowing, at Crestmark's discretion, under the facility. Effective April 24, 2003, we amended our Loan and Security Agreement with Crestmark Bank. Pursuant to the amendment, we paid a $5,000 renewal commitment fee to continue our lending relationship for the remainder of 2003. We must negotiate a new lending relationship if we would like to continue the lending relationship into 2004. Pursuant to the amendment, we also agreed to give the bank at least 30 days advance notice of any intended draw on our line of credit. As of August 31, 2003, we had working capital of $3,841,139, cash and cash equivalents of $1,905,941, total current liabilities of $741,739 and shareholder's equity of $5,470,966. We had an accumulated deficit of $53,910,677 through August 31, 2003. We believe that the cash and cash equivalents on hand at August 31, 2003, together with the estimated net borrowings available under the Crestmark Bank Loan and Security Agreement, will be adequate to satisfy our operating and capital requirements for more than the next twelve months. 14 SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AUGUST 31, 2003 The estimated length of time current cash, cash equivalents and available borrowings will sustain our operations is based on estimates and assumptions we have made. These estimates and assumptions are subject to change as a result of actual experience. Actual capital requirements necessary to market the Cerebral Oximeter and SomaSensor, to develop and market the CorRestore System, to undertake other product development activities, and for working capital might be substantially greater than current estimates. CRITICAL ACCOUNTING POLICIES We believe our most significant accounting policies relate to the recording of an intangible asset for license acquisition costs related to our acquisition of exclusive, worldwide, royalty-bearing licenses to specified rights relating to the CorRestore System and related products and accessories, and our accounting treatment of stock options issued to employees. In fiscal years 2000, 2001 and 2003, we recorded an intangible asset related to our acquisition of exclusive, worldwide, royalty-bearing licenses to specified rights relating to the CorRestore System and related products and accessories. License acquisition costs included our estimate of the fair value of ten-year vested stock options to purchase common shares granted to one of our directors in connection with negotiating and assisting us in completing the transaction, and our estimate of the fair value of the vested portion of five-year warrants to purchase common shares issued in the transaction. We estimated the value of the stock options to purchase common shares and the warrants to purchase common shares using the Black-Scholes valuation model. The Black-Scholes valuation model requires the following assumptions: expected life period of the security, expected volatility of our stock price during the period, risk-free interest rate, and dividend yield. Given the assumptions inherent in the Black-Scholes valuation model, it would have been possible to calculate a different value for our intangible asset by changing one or more of the valuation model variables or by using a different valuation model. However, we believe that the model is appropriate, that the judgments and assumptions that we made at the time of valuation were also appropriate, and that the reported results would not have been materially different had one or more of the variables been different or had a different valuation model been used. We have adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." This statement establishes accounting and reporting standards for goodwill and other intangible assets. The effect of adopting this Statement has been to discontinue amortizing our license acquisition costs related to our acquisition of exclusive, worldwide, royalty-bearing licenses to specified rights relating to the CorRestore System and related products and accessories described above because we believe these licenses have an indefinite life. Therefore, no amortization expense has been recorded related to these license acquisition costs since December 1, 2001, the date we adopted Statement No. 142. 15 SOMANETICS CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AUGUST 31, 2003 In October 1995, Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," was issued by the Financial Accounting Standards Board. In addition, in December 2002, Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," was issued by the Financial Accounting Standards Board, and amends Statement No. 123. We have chosen to continue to account for stock-based compensation of employees using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, compensation costs for stock options granted to employees are measured as the excess, if any, of the market price of our stock at the date of the grant over the amount an employee must pay to acquire the stock. No compensation expense has been charged against income for stock option grants to employees because our stock option grants are priced at the market value as of the date of grant. During the first three quarters of fiscal 2003, we granted 471,000 stock options to our employees and directors. Had we recognized compensation expense for stock options granted to employees in the first nine months of fiscal 2003, using the fair value method of accounting based on the fair value of the options on the grant date using the Black-Scholes valuation model, our net loss, on a pro forma basis, would have increased by approximately $528,000, or $.06 per common share. Had we recognized compensation expense for our stock options granted to employees in the first nine months of fiscal 2002, using the fair value method of accounting based on the fair value of the options on the grant date using the Black-Scholes valuation model, our net loss, on a pro forma basis, would have increased by approximately $459,000, or $.05 per common share. 16 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. 17 ITEM 4. CONTROLS AND PROCEDURES Our management has evaluated, with the participation of our principal executive and principal financial officers, the effectiveness of our disclosure controls and procedures as of August 31, 2003, and, based on their evaluation, our principal executive and principal financial officers have concluded that these controls and procedures are effective as of August 31, 2003. There was no change in our internal control over financial reporting identified in connection with such evaluation that occurred during our fiscal quarter ended August 31, 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. 18 PART II OTHER INFORMATION Item 5. Other Information Effective April 10, 2003, at our annual board meeting following our Annual Meeting of Shareholders, Mr. Robert R. Henry, Mr. Daniel S. Follis and Dr. James I. Ausman were elected as members of the Audit Committee. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 31.1 Certifications of Chief Executive Officer Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certifications of Chief Financial Officer Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K No reports on Form 8-K were filed by us during the quarter for which this report is filed. We furnished a Current Report on Form 8-K on June 20, 2003, reporting under Item 9 the information required by Item 12 - Results of Operations and Financial Condition in connection with our press release regarding second quarter 2003 results. No financial statements were filed, although we furnished the financial information included in the press release furnished with the Form 8-K. 19 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. Somanetics Corporation ---------------------------------------- (Registrant) Date: October 1, 2003 By: /s/ William M. Iacona --------------- ------------------------------------ William M. Iacona Vice President, Finance, Controller, and Treasurer (Duly Authorized and Principal Financial Officer) 20 EXHIBIT INDEX Exhibit Description ------- ----------- 31.1 Certifications of Chief Executive Officer Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certifications of Chief Financial Officer Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 21