Escalon Medical Corp.
Annual Report 2004

Plain-text annual report

2004 Annual Report ESCALON MEDICAL CORP. LETTER TO SHAREHOLDERS As I look back over the last several years, Escalon Medical has made major strides strategically, operationally, and Ñnancially. We set out to strengthen our franchise, put Ñnancial disciplines in place, maximize our return on investment, drive free cash Öow and support continued innovation. As we began the year, Escalon Medical was structured around three core divisions, Sonomed, Vascular, and Medical/Trek. We have strengthened these businesses through cost-cutting initiatives and by selectively investing in research driven new product initiatives, international expansion and marketing support. In Ñscal 2004, we saw the fruits of our eÅorts with another year of record revenues and net income. Solid performance has enabled us to make excellent strides improving our balance sheet, using free cash Öow to further reduce debt. Our improved Ñnancial soundness and stock price appreciation also helped us to raise over $9.8 million of equity through a private Ñnancing, making us even stronger Ñnancially and better positioned to achieve our goal of sustainable long term growth. This also provided us with the ability to pursue niche acquisitions and, in July 2004, we acquired Drew ScientiÑc. Drew will approximately double the size of our company and will further diversify our product portfolio and add an important new vehicle for growth. Fiscal 2004 Ì Another Record Year Our strategic initiatives and solid operational performance fueled our record results. Net revenue for Ñscal 2004 increased 10.1% to $14.7 million compared to $13.4 million in Ñscal 2003. Product revenue increased 10.3% during the year to $12.3 million. For Ñscal 2004, revenue from Sonomed increased 17.0% to $7.6 million and revenue in the Vascular division increased 10.7% to $3.1 million. Product revenue in our Medical/Trek division declined 3.6% to $1.4 million. Other revenue, which is included in the Medical/Trek business unit, was $2.4 million. This includes royalties from Bausch & Lomb in connection with their sale of Silicone Oil, as well as royalty payments related to the licensing of our intellectual laser properties. Our gross margin was 55.7% of product revenue in Ñscal 2004 compared to 56.3% in the year ago period. The slight decline was primarily related to a higher percentage of international sales at Sonomed and cost increases in the Vascular business. Marketing, general and administrative expenses declined as a percent of sales to 35.4% from 37.7% in Ñscal 2003, due primarily to a reduction in management staÅ. Research and development spending, which is targeted at market speciÑc niche products, was relatively unchanged at $776,496. Net income for Ñscal 2004 increased 60.1% to a record $2.7 million, or $0.64 per diluted share, compared to net income of $1.7 million, or $0.48 per diluted share, for the year ended June 30, 2003. In Ñscal 2004, income from operations was over $3.2 million. When combined with the $9.8 raised from our private equity Ñnancing in March 2004 and cash generated from the exercise of options, we ended the year with $12.6 million in cash and saw shareholders' equity increase by 162% to $23.5 million. We also paid down over $2.3 million in debt, putting us in a much stronger Ñnancial position. Core Businesses Achieve Operational and Financial Stability Back in 1998 we set out to build a more diversiÑed business portfolio to better position Escalon Medical for long-term sustainable growth. We sold our rights to Silicone Oil back to Bausch & Lomb and redeployed the capital into higher growth and higher return opportunities. We acquired Sonomed and the Vascular divisions in 2000 and 1999 respectively and since then have worked diligently to cut costs and reinvest in the businesses. We have operated conservatively and have used the improved cash Öows primarily to pay down debt, strengthening our balance sheet. Today, both divisions are on solid footing and we are pursuing growth through select investment in product-driven research and development, international expansion and increased marketing support. We beneÑted from strong sales of our pachymeter, a device that measures the thickness of the cornea and has become a more widely used piece of equipment for glaucoma screening. During the year we also received FDA marketing clearance for our new B-Scan, the E-Z ScanTM, a diagnostic device to help see inside the eye under diÇcult circumstances, and introduced a new ultrasound bio-microscope, recently trademarked VuMAX. These innovative products round out our portfolio of diagnostic tools, enabling ophthalmologists to have access to both the front and the back of the eye, which is critical given the continued advances in the treatment of ophthalmic disorders. On the strength of our product portfolio, we also continued to pursue international expansion, particularly in Europe and Asia. During Ñscal 2004 we began to beneÑt from the additional sales and marketing resources put in place in Europe. Looking ahead, we believe Asia oÅers the most signiÑcant potential for growth and we are targeting fast growing markets such as China, Taiwan and Korea. Our Vascular division continues to be driven primarily by domestic sales of our PD AccessTM and Smart NeedleTM products, which use Doppler ultrasound technology to diÅerentiate between veins and arteries. During the year, we began a focused product launch of our new Doppler Guided Peripheral IV Needle to select institutions in the Philadelphia and Chicago regions. This product oÅers exciting opportunities to expand beyond the cardiac catheterization labs into oncology, hematology and anesthesia, large market opportunities. We have also increased our Vascular sales force, both in the U.S. and in Europe, and are optimistic that we will achieve a return on this investment. Our third division, Medical/Trek, is primarily an original equipment manufacturer and distributor of a variety of ophthalmic surgical products. Also included in the Medical/Trek division are royalties from Bausch & Lomb's sale of Silicone Oil and royalty payments related to the licensing of our intellectual laser technologies. Fiscal 2005 will be the last year we receive royalty revenue from Bausch & Lomb under our contractual agreement. As a result, revenue from the Medical/Trek division will likely decline over the near term. Drew ScientiÑc Adds New Vehicle for Growth Improvements to our balance sheet over the last several years gave us the Ñnancial Öexibility and the ability to more aggressively pursue diversiÑcation of our business portfolio. In July, we acquired the majority of the shares of Drew ScientiÑc Group PLC through a tender oÅer. Drew provides instrumentation and consumables for the diagnosis and monitoring of medical disorders in the areas of diabetes, cardiovascular diseases and hematology, as well as veterinary hematology and blood chemistry. The acquisition approximately doubles our product revenue base and will add a new vehicle for growth. While Drew has historically lost money, with appropriate capitalization we believe we can add value and grow the business. Our key goal will be to reinvest in their products to reestablish their market position. While we do expect some cost savings due to the combination of two public company entities and will look for eÇciencies in manufacturing and sales, we also are investigating opportunities for some of Escalon's products to be utilized in Drew's veterinary business. Foundation for Sustainable Growth Strategy is in Place As I look out to Ñscal 2005, we are in a much better position to aggressively purse our goal of sustainable long-term growth. We have strengthened our franchise and today have solid growth opportunities in our Sonomed, Vascular and Drew divisions. Financial discipline and debt reduction remains a top priority. By further reducing debt we will have much more Öexibility, both strategically and Ñnancially. We plan to use this Öexibility to leverage our infrastructure to support continued innovation across our product lines, with the ultimate goals being to maximize our return on investment and drive free cash Öow. In addition to focusing on our products, international expansion Ì particularly in Asia and Europe Ì and investing in marketing support will also be key growth drivers and we will continue to explore strategic alliances or small niche acquisitions where they make Ñnancial sense. With the continued support of our customers, employees as well as the new Drew ScientiÑc employees we are well prepared to meet today's challenges and are committed to capitalizing on the opportunities of tomorrow. Sincerely, Richard J. DePiano Chairman and Chief Executive OÇcer October 19, 2004 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K ¥ n ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Ñscal year ended June 30, 2004. TRANSITIONAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transitional period from to . Commission Ñle number 0-20127 ESCALON MEDICAL CORP. (Exact name of Registrant as speciÑed in its charter) Pennsylvania (State or other jurisdiction of incorporation or organization) 33-0272839 (I.R.S. Employer IdentiÑcation Number) 575 East Swedesford Road, Suite 100, Wayne, PA 19087 (Address of principal executive oÇces, including zip code) (610) 688-6830 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, Par Value $0.001 per share Indicate by check mark whether the Registrant (1) has Ñled all reports required to be Ñled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the Registrant was required to Ñle such reports) and (2) has been subject to such Ñling requirements for the last 90 days. Yes ¥ No n Indicate by check mark if disclosure of delinquent Ñlers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in deÑnitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. n Indicate by check mark whether the Registrant is an accelerated Ñler (as deÑned in Rule 12b-2 of the Act). Yes n No ¥ At December 31, 2003, the aggregate market value of the shares of Common Stock held by the Registrant's nonaÇliates was approximately $22,835,416 (based upon the last sales price of Common Stock on the Nasdaq SmallCap Market on such date). At September 20, 2004, 5,915,008 shares of Common Stock were outstanding. Documents Incorporated by Reference Registrant's proxy statement to be Ñled in connection with its 2004 Annual Meeting of Shareholders incorporated by reference in Part III, Items 10, 11, 12, 13 and 14. ESCALON MEDICAL CORP. ANNUAL REPORT ON FORM 10-K For The Fiscal Year Ended June 30, 2004 TABLE OF CONTENTS PART I Item 1. Item 2. Item 3. Item 4. Business ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Properties ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Legal Proceedings ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Submission of Matters to a Vote of Security HoldersÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Selected Financial Data ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Item 6. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 7A. Quantitative and Qualitative Disclosures About Market Risk ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Financial Statements and Supplementary Data ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Item 9. Disclosure ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Item 9A. Controls and Procedures ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Item 9B. Other Information ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ PART III Item 10. Directors and Executive OÇcers of the Registrant ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Item 11. Executive CompensationÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Security Ownership of Certain BeneÑcial Owners and Management and Related Item 12. Stockholder Matters ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Item 13. Certain Relationships and Related Transactions ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Principal Accountants Fees and Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Item 14. PART IV Page 2 15 15 16 16 17 18 30 30 30 30 31 31 31 31 31 31 Item 15. Exhibits and Financial Statement Schedules ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 32 1 Item 1. Business Company Overview PART I Escalon Medical Corp. (""Escalon'' or the ""Company'') was incorporated in California in 1987 as Intelligent Surgical Lasers, Inc. The Company's present name was adopted in August 1996. Escalon reincorporated in Delaware in November 1999, and then reincorporated in Pennsylvania in November 2001. Within this document, the ""Company'' collectively shall mean Escalon and its wholly owned subsidiaries: Sonomed, Inc. (""Sonomed''), Sonomed EMS, Srl. (""Sonomed EMS''), Escalon Vascular Access, Inc. (""Vascular''), Escalon Digital Vision, Inc. (""EMI'') and Escalon Pharmaceutical, Inc. (""Pharmaceutical''). The Company operates in the healthcare market, specializing in the development, manufacture, marketing and distribution of ophthalmic medical devices, pharmaceuticals and vascular access devices. The Company and its products are subject to regulation and inspection by the United States Food and Drug Administration (""FDA''). The FDA requires extensive testing of new products prior to sale and has jurisdiction over the safety, eÇcacy and manufacturing of products, as well as product labeling and marketing. The Company's Internet address is www.escalonmed.com. In February 1996, the Company acquired substantially all of the assets and certain liabilities of Escalon Ophthalmics, Inc. (""EOI''), a developer and distributor of ophthalmic surgical products. Prior to this acquisition, the Company devoted substantially all of its resources to the research and development of ultrafast laser systems designed for the treatment of ophthalmic disorders. As a result of the EOI acquisition, Escalon changed its market focus and is no longer developing laser technology. In October 1997, the Company licensed its intellectual laser property to Intralase Corp. (""IntraLase''), in return for an equity interest and future royalties on sales of products relating to the laser technology. IntraLase undertook the responsibility for funding and developing the laser technology through to commercialization. IntraLase began selling products related to the laser technology during Ñscal 2002. The Company is in dispute with Intralase over royalty payments owed to the Company. See Item 3 Ì Litigation, for further information. To further diversify its product portfolio, in January 1999, the Company's Vascular subsidiary acquired the vascular access product line from Endologix, Inc. (""Endologix''), formerly Radiance Medical Systems, Inc. Vascular's products use Doppler technology to aid medical personnel in locating arteries and veins in diÇcult circumstances. Currently, this product line is concentrated in the cardiac catheterization market. In January 2000, the Company purchased Sonomed, a privately held manufacturer of ophthalmic ultrasound diagnostic equipment. In April 2000, EMI formed a joint venture, Escalon Medical Imaging, LLC with Megavision, Inc. (""Megavision''), a privately held company, to develop and market a camera back for ophthalmic photography. The Company terminated its joint venture with Megavision and commenced operations within its EMI business unit on January 1, 2002. As of July 23, 2004, Escalon acquired approximately 67% of the outstanding ordinary shares of Drew ScientiÑc Group PLC (""Drew''), a United Kingdom company, pursuant to the Company's exchange oÅer for all of the outstanding ordinary shares of Drew, and since that date has acquired approximately 92% of the Drew shares. Escalon expects to acquire the remaining outstanding Drew shares pursuant to procedures under United Kingdom laws and regulations within the next Ñscal year. Drew is a diagnostics company specializing in the design, manufacture and distribution of analytical systems for laboratory testing worldwide. Drew is focused on providing instrumentation and consumables for the diagnosis and monitoring of medical disorders in the areas of diabetes, cardiovascular diseases and hematology. In addition, Drew supplies other diagnostic systems, which perform blood component tests. Escalon expects to operate Drew as wholly owned separate business segment. Sonomed Business Sonomed develops, manufactures and markets Ultrasound systems for diagnostic or biometric applica- tions in ophthalmology. The systems are of three types: A-Scans, B-Scans and pachymeters. 2 A-Scans The A-Scan provides information about the internal structure of the eye by sending a beam of ultrasound along a Ñxed axis through the eye and displaying the various echoes reÖected from the surfaces intersected by the beam. The principal echoes occur at the cornea, both surfaces of the lens and the retina. The system displays the position and magnitudes of the echoes on an electronic display. The A-Scan also includes software for measuring distances within the eye. This information is primarily used to calculate lens power for implants. B-Scans The B-Scan is primarily a diagnostic tool, which supplies information to physicians where the media within the eye are cloudy or opaque. Whereas physicians normally use light, which cannot pass through such media, the ultrasound beam is capable of passing through the opacity and displaying an image of the internal structures of the eye. Unlike the A-Scan, the B-Scan transducer is not in a Ñxed position; it swings through a 60 degree sector to provide a two dimensional image of the eye. Pachymeters The pachymeter uses the same principles as the A-Scan, but the system is tailored to measure the thickness of the cornea. With the advent of refractive surgery (where the cornea is actually cut and reshaped) this measurement has become critical. Surgeons must know the precise thickness of the cornea so as to set the blade to make a cut of approximately 20% of the thickness of the cornea. Vascular Business Vascular develops, manufactures and markets vascular access products. These products are Doppler- guided vascular access assemblies used to locate desired vessels for access. Primary specialty groups that use the device are cardiac catheterization labs and interventional radiology. The Company's vascular products include the PD AccessTM and SmartNeedleTM lines of monitors, Doppler-guided bare needles and Doppler- guided infusion needles. PD AccessTM and SmartneedleTM Monitors, needles and catheter Products These patented devices detect blood Öow using Doppler ultrasound technology and diÅerentiate between a venous and arterial vessel. The devices utilize a miniature Doppler ultrasound probe that is positioned within the lumen of a vascular access needle. When a Doppler-guided needle pierces the skin of a patient, the probe and monitor can determine if the user is approaching an artery or vein, guiding them to a successful access. Medical/Trek Business Medical/Trek develops, manufactures and distributes ophthalmic surgical products under the Escalon Medical Corp. and/or Trek Medical Products names. Vitreoretinal ophthalmic surgeons primarily utilize the products. The following is a summary of the business's key product lines: Adatosil» 5000 Silicone Oil (""Silicone Oil'') Silicone Oil is a specialty product used in worst-case detached retina surgery as a mechanical aid in the reattachment procedure. The Company distributed Silicone Oil until August 13, 1999, at which time the license and distribution rights for the product were sold to Bausch & Lomb Surgical, Inc. The license and distribution rights were sold for $2.1 million and additional cash consideration based on future sales to be received through August 2005 (See Note 10 of the Notes to Consolidated Financial Statements for additional details). 3 Ispan Intraocular Gases The Company distributes two intraocular gas products, C(3)F(8) and SF(6), which are used by vitreoretinal surgeons as a temporary tamponade in detached retina surgery. Under a non-exclusive distribu- tion agreement with Scott Medical Products (""Scott''), Escalon distributes packages of Scott gases in canisters containing 25 grams or less of gas. Along with the intraocular gases, the Company manufactures and distributes a patented disposable universal gas kit, which delivers the gas from the canister to the patient. Viscous Fluid Transfer Systems Escalon markets viscous Öuid transfer systems and related disposable syringe products, which aid surgeons in the process of injecting and extracting Silicone Oil. Adjustable pressures and vacuums provided by the equipment allow surgeons to manipulate the Öow of Silicone Oil during surgery. Fiber Optic Light Sources Light source and Ñber optic products are widely used by vitreoretinal surgeons during surgery. The Company oÅers surgeons a complete line of light sources along with a variety of Ñber optic probes and illuminated tissue manipulators. EMI Business EMI markets a CFA (Color/Fluorescein Angiography) digital imaging system, designed speciÑcally for ophthalmology. This diagnostic tool, ideal for use in detecting retinal problems in diabetic and elderly patients, provides a high-resolution image, far superior to conventional Ñlm in image quality, processing and capture. The instant image display provides users with the necessary clinical information so laser treatment can be performed while the patient is still in the oÇce. CFA Camera Back The images furnished by the CFA camera system provide a very high level of detail. The camera back is being marketed to medical institutions, educational institutions and ophthalmologists for the use in connection with the diagnosis of retinal disorders. Pharmaceutical Business The Company obtained the license and distribution rights for Povidone-Iodine 2.5% solution from Harbor-UCLA Medical Center. Povidone-Iodine 2.5% solution is a broad-spectrum anti-microbial intended to prevent ophthalmia neonatorum in newborns. The product required further development before achieving FDA approval. Having exhausted all partnering possibilities, during Ñscal 2003 the Company decided that further expenditures on this project were not in the shareholders' best interest and the project was abandoned. The decision resulted in the Company's taking a charge of $196,000, which included the write-oÅ of the remaining net book value of the license and distribution rights subject to normal amortization. Drew Business Drew is a diagnostics company specializing in the design, manufacture and distribution of analytical systems for laboratory testing worldwide. Drew is focused on providing instrumentation and consumables for the diagnosis and monitoring of medical disorders in the areas of diabetes, cardiovascular diseases and hematology. In addition, Drew supplies other diagnostic systems, which perform blood component tests. Diabetic Testing The DS5 instrument, dispenser and associated reagent kit measure long term glucose control in diabetic patients. The system's small size and ease of use make it ideal for main laboratory, clinic or satellite laboratory settings. The Hb-Gold instrument and associated reagent kit provides for the in vitro measurement of certain genetic diseases of the blood. In the United States, this instrument is available for research only. 4 Hematology Drew oÅers a broad array of equipment for use in the Ñeld of human and veterinary hematology. Drew's Excell and HC product lines are for use in the Ñeld of human hematology, whereas the Hemavet product line is for use in the veterinary Ñeld. Research and Development Escalon conducts medical device and vascular access product development at its New Berlin, Wisconsin facility located near Milwaukee. The development of ultrasound ophthalmic equipment is performed at the Company's Lake Success, New York facility located on Long Island. The Company sponsored research and development expenditures for the Ñscal years ended June 30, 2004, 2003 and 2002 were $776,496, $780,333 and $554,760, respectively. Manufacturing and Distribution Escalon leases 13,500 square feet of space in New Berlin, Wisconsin, near Milwaukee, for its surgical products and vascular access operations. The facility is currently used for engineering, product design and development, manufacturing and product assembly. The Company subcontracts component manufacture, assembly and sterilization to various vendors. The New Berlin manufacturing facility includes a class 10,000 clean room. A class 10,000 clean room is a controlled environment for producing devices while avoiding any signiÑcant contaminants. The cleanliness provided by the clean room exceeds the requirements of the FDA. All of the Company's ophthalmic surgical products and vascular access products are distributed from its Wisconsin facility. The Company designs, develops and services its ultrasound ophthalmic products at its facility in Lake Success, New York. The Company relocated its New York operations to a new 11,000 facility in September 2004. The Company pursued and achieved ISO9001 certiÑcation at both of its manufacturing facilities for all medical and ultrasound devices produced. ISO9001 requires an implemented quality system that applies to product design. These certiÑcations can be obtained only after a complete audit of a company's quality system by an independent outside auditor. These certiÑcations require that these facilities undergo periodic reexamination. European Community (""CE'') certiÑcation has been obtained for disposable delivery systems, Ñber optic light probes, vascular access products and certain ultrasound models. The manufacture, testing and marketing of each of the Company's products entails the risk of product liability. Product liability insurance is carried by Escalon to cover primary risk. Additionally, Drew leases an aggregate of 69,000 square feet of space at its facilities in the United Kingdom, Connecticut and Texas. These sites are currently used for engineering, product design and development, manufacturing and product assembly. Governmental Regulations Escalon's products are subject to stringent ongoing regulation by the FDA and similar health authorities, and if the FDA's approvals or clearances of the Company's products are restricted or revoked the Company could face delays that would impair the Company's ability to generate funds from operations. The FDA and similar health authorities in foreign countries extensively regulate Escalon's activity. The Company must obtain either 510(K) clearances or pre-market approvals and new drug application approvals prior to marketing a product in the United States. Foreign regulation also requires that Escalon obtain other approvals from foreign government agencies prior to the sale of products in those countries. Also, Escalon may be required to obtain FDA clearance or approval before exporting a product or device that has not received FDA marketing clearance or approval. Escalon has received the necessary FDA clearances and approvals for all products that the Company currently markets. Any restrictions on or revocation of the FDA approvals and clearances that the Company has obtained, however, would prevent the continued marketing of the impacted products and other devices. The restrictions or revocations could result from the discovery of previously unknown problems with the product. Consequently, the FDA revocation would impair the Company's ability to generate funds from operations. 5 The FDA and comparable agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon the manufacturing and marketing of pharmaceutical and medical device equipment and related disposables, including the obligation to adhere the FDA's Good Manufacturing Practice regulations. Compliance with these regulations requires time-consuming detailed validation of manufacturing and quality control processes, FDA periodic inspections and other procedures. If the FDA Ñnds any deÑciencies in the validation processes, for example, the FDA may impose restrictions on marketing the speciÑc products until such deÑciencies are corrected. Escalon has received CE approval on several of the Company's products that allows the Company to sell the products in the countries comprising the European community. In addition to the CE mark, however, some foreign countries may require separate individual foreign regulatory clearances. Escalon cannot assure you that the Company will be able to obtain regulatory clearances for other products in the United States or foreign markets. The process for obtaining regulatory clearances and approvals and underlying clinical studies for any new products or devices and for multiple indications for existing products is lengthy and requires substantial commitments of our Ñnancial resources and our management's time and eÅort. Any delay in obtaining clearances or approvals or any changes in existing regulatory requirements would materially adversely aÅect the Company's business. Escalon's failure to comply with the applicable regulations would subject the Company to Ñnes, delays or suspensions of approvals or clearances, seizures or recalls of products, operating restrictions, injunctions or civil or criminal penalties, which would adversely aÅect the Company's business, Ñnancial condition and results of operations. Marketing and Sales The Medical/Trek business unit sells its ophthalmic devices and instruments products directly to end users through internal sales and marketing employees located at the Company's Wisconsin facility. Sales are primarily to teaching institutions, key hospitals and eye surgery centers focusing primarily on physicians and operating room personnel performing vitreoretinal surgery. Vascular business unit products are marketed domestically through internal sales and marketing employees located in Pennsylvania, Illinois, California and at its Wisconsin facility, as well as through Ñve independent distributors and sales representatives located in Florida, Missouri, Ohio, Washington and Germany managed by the Company's sales team. The Sonomed product line is sold through internal sales employees located at the Company's New York facility, as well as an independent sales representative in Europe, to a large network of distributors and directly to medical institutions both domestically and abroad. The EMI product line is sold through independent sales representatives. The Drew business unit sells its products through internal sales and marketing employees as well as through a large network of distributors. Service and Support Escalon maintains a full-service program for all products sold. Limited warranties are given on all products against defects and performance. Product repairs are made at the Wisconsin facility for surgical devices and vascular access products and EMI devices. Sonomed's products are serviced at the New York facility. Drew's products are serviced at its Connecticut facility. Third Party Reimbursement It is expected that physicians and hospitals will purchase the Company's ophthalmic products and that they in turn will bill various third party payers for health care services provided to their patients. These payers include Medicare, Medicaid and private insurers. Government agencies generally reimburse health care providers at a Ñxed rate based on the procedure performed. Third party payers may deny reimbursement if they determine that a procedure performed using any one of the Company's products was unnecessary, inappropriate, not cost-eÅective, experimental or used for a non-approved indication. 6 Patents, Trademarks and Licenses The pharmaceutical and medical device communities place considerable importance on obtaining patent and trade secret protection for new technologies, products and processes for the purpose of strengthening the Company's position in the market place and protecting the Company's economic interests. The Company's policy is to protect its technology by aggressively obtaining patent protection for all of its developments and products, both in the United States and in selected countries outside the United States. It is the Company's policy to Ñle for patent protection in those foreign countries in which the Company believes such protection is necessary to protect its economic interests. Twenty-one United States issued patents, and nineteen patents issued abroad cover the Company's surgical products and pharmaceutical technology. With respect to the Company's ultrafast laser technology (licensed to Intralase Corp.), sixteen patents have been issued in the United States and eleven overseas. Vascular access products are covered by eighteen patents, which provide protection in the United States, Europe, Japan and other countries overseas. The Company intends to vigorously defend its patents if the need arises. Drew has approximately sixty patents related to its technology. While in the aggregate the Company's patents are of material importance to its business taken as a whole, the patents, trademarks and license that are the most critical to the Company's ability to generate revenues are as follows: ‚ The Escalon trademark is due for renewal on January 19, 2013, and the Company intends to renew the trademark. The Sonomed trademark is due for renewal on April 16, 2006 and the Company intends to renew the trademark. ‚ In the Vascular business unit, the Company has two patents that are of material importance. The Ñrst patent is the apparatus for the cannulation of blood vessels. This patent will expire on February 23, 2011. The second patent is also an apparatus for the cannulation of blood vessels. This patent will expire on January 11, 2009. ‚ The Company licensed its ultrafast laser systems to Intralase Corp. The material patents will expire between 2008 and 2014. Under the terms of the ultrafast laser systems license, in exchange for the use of the Company's licensed laser patents, Escalon will receive a 2.5% royalty on future product sales that are based on the licensed laser patents, subject to deductions for royalties payable to third parties up to a maximum of 50% of royalties otherwise due and payable to the Company and a 1.5% royalty on product sales that are not based on the licensed laser patents. The Company receives a minimum annual license fee of $15,000 per year during the term of the license that is oÅset against the royalty payments. The license was dated October 23, 1997, and was amended and restated in October 2000 and expires upon the latest to occur of the following events: 1. the last to expire of the licensed patents; 2. ten years from the eÅective date of the amended and restated agreement; or 3. the Ñfth anniversary date of the date of the Ñrst commercial sale. The material termination provisions of the license are as follows: 1. the default in payment of any royalty; 2. the default in the making of any required report; 3. making of any false report; 4. the commission of any material breach of any covenant or promise under the license agreement; or 5. the termination of the license by the licensee at any time after 90 days notice. If the licensee were to terminate it would not be permitted to utilize the licensed technology necessary to manufacture its current products. 7 The duration of the Company's patents, trademarks and licenses vary through 2020. See Item 3 Ì Litigation, for further information regarding the licensing of Escalon intellectual property to Intralase. Competition There are numerous direct and indirect competitors of the Company in the United States and abroad. These companies include ophthalmic-oriented companies that market a broad portfolio of products including prescription ophthalmic pharmaceuticals, ophthalmic devices, consumer products (such as contact lens cleaning solution) and other eye care products; large integrated pharmaceutical companies that market a limited number of ophthalmic pharmaceuticals in addition to many other pharmaceuticals; and smaller specialty pharmaceutical and biotechnology companies that are engaged in the development and commerciali- zation of prescription ophthalmic pharmaceuticals and products and, to some extent, drug delivery systems. The Company's competitors for medical devices and ophthalmic pharmaceuticals include, but are not limited to, Bausch & Lomb, Inc., Alcon Laboratories, Inc., Paradigm Medical, Inc., Quantel, Inc. and Accutome, Inc. Several large companies dominate the ophthalmic market, with the balance of the industry being highly fragmented. The Company believes that these large companies capture approximately 85% of the overall ophthalmic market. The balance of the market is comprised of smaller companies ranging from start-up entities to established market players. The ophthalmic market in general is intensely competitive, with each company eager to expand its market share. The Company's strategy is to compete primarily on the basis of technological innovation to which it has proprietary rights. The Company believes, therefore, that its success will depend in large part on protecting its intellectual property through patents and other governmental regulations. The Company recognizes that there are other innovative companies that may develop competitive strategies. Sonomed designs and manufactures ophthalmic ultrasound products: A-Scans, pachymeters and B- Scans. The A-Scans and pachymeters furnish internal measurements of the eye and B-Scans provide an image of the rear of the eye. The principal competitors are Alcon Laboratories, Quantel, Inc. and Accutome, Inc. Management believes that the Company is in a market leadership position. Sonomed has had a leading presence in the industry for over thirty years. Management believes that this has helped the Company build a reputation as a long-standing operation that provides a quality product, which has enabled the Company to establish eÅective distribution coverage within the United States market. The Company seeks to preserve its position in the market through continued product enhancement. Various competitors oÅering similar products at a lower price could threaten Sonomed's market position. The development of laser technologies for ophthalmic biometrics and imaging may also diminish the Company's market position. This equipment can be used instead of ultrasound equipment in most, but not all, patients. Such equipment, however, is more expensive. The Medical/Trek business sells a broad range of ophthalmic surgical products. The more signiÑcant products are ISPAN» gases and delivery systems. Medical/Trek also manufactures various ophthalmic surgical products for major ophthalmic companies to be sold under their name. To remain competitive, the Company needs to maintain a low cost operation. There are numerous other companies that can provide this manufacturing service. There are a variety of other devices that directly compete with Sonomed's ultrasound products and the camera back marketed by EMI. The vascular access product line is comprised of disposable devices, and currently it has no direct competition. However, a signiÑcantly higher priced non-disposable device that facilitates vascular access is currently being marketed. Vascular produces the only device that can be accommodated within a standard needle for assisting medical practitioners in gaining access to a vessel in the human vascular system. There are no similar devices in the market that enable medical practitioners in gaining access using their normal procedures. The only similar product utilizes a separate ultrasound monitor, but no disposables are utilized. When using the competing device, medical practitioners need to look at the monitor while advancing the 8 needle into the patient. The perceived disadvantage of the Company's vascular product is that its retail price is substantially greater than the cost of a traditional needle. Human Resources As of June 30, 2004, the Company employed 63 full-time employees and one part-time employee. Thirty- four of the Company's employees are employed in manufacturing, 15 are employed in general and administrative positions, 10 are employed in sales and marketing and Ñve are employed in research and development. Escalon's employees are not covered by a collective bargaining agreement, and the Company considers its relationship with its employees to be good. As of July 23, 2004, Drew employed approximately 90 employees. Cautionary Factors That May AÅect Future Results Certain statements contained in, or incorporated by reference in, this Annual Report on Form 10-K, are forward-looking statements, made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, which provide current expectations or forecasts of future events. Such statements can be identiÑed by the use of terminology such as ""anticipate,'' ""believe,'' ""could,'' ""estimate,'' ""expect,'' ""forecast,'' ""intend,'' ""may,'' ""plan,'' ""possible,'' ""protect,'' ""should,'' ""will'' and similar words or expressions. The Company's forward-looking statements include certain information relating to general business strategy, growth strategies, Ñnancial results, liquidity, product development, the introduction of new products, the potential markets and uses for the Company's products, the Company's regulatory Ñlings with the FDA, the development of joint venture opportunities, the eÅect of competition on the structure of the markets in which the Company competes and defending the Company in litigation matters. One must carefully consider forward-looking statements and consider forward-looking statements and understand that such statements involve a variety of risks and uncertainties, known and unknown, and may be aÅected by assumptions that fail to materialize as anticipated. Consequently, no forward-looking statement can be guaranteed, and actual results may vary materially. It is not possible to foresee or identify all factors aÅecting the Company's forward- looking statements, and one therefore should not consider the following list of such factors to be an exhaustive statement of all risks, uncertainties or potentially inaccurate assumptions. The Company undertakes no obligation to update any forward-looking statement. Although it is not possible to create a comprehensive list of all factors that may cause actual results to diÅer from our forward-looking statements, the most important factors include, without limitation, the following: The company's products are subject to stringent ongoing regulation by the FDA and similar health authorities, and if the FDA's approvals or clearances of the company's products are restricted or revoked the company could face delays that would impair the company's ability to generate funds from operations. The FDA and similar health authorities in foreign countries extensively regulate Escalon's activity. The Company must obtain either 510(K) clearances or pre-market approvals and new drug application approvals prior to marketing a product in the United States. Foreign regulation also requires that Escalon obtain other approvals from foreign government agencies prior to the sale of products in those countries. Also, Escalon may be required to obtain FDA approval before exporting a product or device that has not received FDA marketing clearance or approval. Escalon has received the necessary FDA approvals for all products that the Company currently markets. Any restrictions on or revocation of the FDA approvals and clearances that the Company has obtained, however, would prevent the continued marketing of the impacted products and other devices. The restrictions or revocations could result from the discovery of previously unknown problems with the product. Conse- quently, the FDA revocation would impair the Company's ability to generate funds from operations. The FDA and comparable agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon the manufacturing and marketing of pharmaceutical and medical device equipment and related disposables, including the obligation to adhere the FDA's Good Manufacturing Practice regulations. Compliance with these regulations requires time-consuming detailed validation of 9 manufacturing and quality control processes, FDA periodic inspections and other procedures. If the FDA Ñnds any deÑciencies in the validation processes, for example, the FDA may impose restrictions on marketing the speciÑc products until such deÑciencies are corrected. Escalon has received CE approval on several of the Company's products that allows the Company to sell the products in the countries comprising the European community. In addition to the CE mark, however, some foreign countries may require separate individual foreign regulatory clearances. Escalon cannot assure you that the Company will be able to obtain regulatory clearances for other products in the United States or foreign markets. The process for obtaining regulatory clearances and approvals and underlying clinical studies for any new products or devices and for multiple indications for existing products is lengthy and will require substantial commitments of Escalon's Ñnancial resources and Escalon's management's time and eÅort. Any delay in obtaining clearances or approvals or any changes in existing regulatory requirements would materially adversely aÅect the Company's business. Escalon's failure to comply with the applicable regulations would subject the Company to Ñnes, delays or suspensions of approvals or clearances, seizures or recalls of products, operating restrictions, injunctions or civil or criminal penalties, which would adversely aÅect the Company's business, Ñnancial condition and results of operations. Failure of the market to accept the Company's products could adversely impact the Company's business and Ñnancial condition. The Company's business and Ñnancial condition will depend upon the market acceptance of the Company's products. The Company cannot assure that the Company's products will achieve market acceptance. Market acceptance depends upon a number of factors: ‚ the price of the products; ‚ the receipt of regulatory approvals for multiple indications; ‚ the establishment and demonstration of the clinical safety and eÇcacy of the Company's products; and ‚ the advantages of the Company's products over those marketed by the Company's competitors. Any failure to achieve signiÑcant market acceptance of the Company's products will have a material adverse eÅect on the Company's business. The success of competitive products could have an adverse eÅect on the Company's business. The Company faces intense competition in the medical device and pharmaceutical markets, which are characterized by rapidly changing technology, short product life cycles, cyclical oversupply and rapid price erosion. Many of the Company's competitors have substantially greater Ñnancial, technical, marketing, distribution and other resources. The Company's strategy is to compete primarily on the basis of technological innovation, reliability, quality and price of the Company's products. Without timely introductions of new products and enhancements, the Company's products will become technologically obsolete over time, in which case the Company's revenues and operating results would suÅer. The success of the Company's new product oÅerings will depend on several factors, including the Company's ability to: ‚ properly identify customer needs; ‚ innovate and develop new technologies, services and applications; ‚ establish adequate product distribution coverage; ‚ obtain and maintain required regulatory approvals from the FDA and other regulatory agencies; ‚ protect the Company's intellectual property; ‚ successfully commercialize new technologies in a timely manner; 10 ‚ manufacture and deliver the Company's products in suÇcient volumes on time; ‚ diÅerentiate the Company's oÅerings from the oÅerings of the Company's competitors; ‚ price the Company's products competitively; ‚ anticipate competitors' announcements of new products, services or technological innovations; and ‚ general market and economic conditions. The Company cannot assure that the Company will be able to compete eÅectively in this competitive environment. The Company's products employ proprietary technology, and this technology may infringe on the intellectual property rights of third parties. The Company holds several United States and foreign patents for the Company's products. Other parties, however, hold patents relating to similar products and technologies. The Company believes that the Company is not infringing on any patents held by others. However, if patents held by others were adjudged valid and interpreted broadly in an adversarial proceeding, the court or agency could deem them to cover one or more aspects of the Company's products or procedures. Any claims for patent infringements or claims by the Company for patent enforcement would consume time, result in costly litigation, divert technical and management personnel or require the Company to develop non-infringing technology or enter into royalty or licensing agreements. The Company cannot be certain that the Company will not be subject to one or more claims for patent infringement, that the Company would prevail in any such action or that the Company's patents will aÅord protection against competitors with similar technology. If a court determines that any of the Company's products, including the Company's products used for the cannulation of blood vessels used in the Company's vascular business segment, infringes, directly or indirectly, on a patent in a particular market, the court may enjoin the Company from making, using or selling the product. Furthermore, the Company may be required to pay damages or obtain a royalty-bearing license, if available, on acceptable terms. The Company will no longer receive revenue from the sale of silicone oil by Bausch & Lomb subsequent to August 13, 2005. The Company realized 13.18% and 13.90% of its net revenue during the Ñscal years ended June 30, 2004 and 2003, respectively, from Bausch & Lomb's sales of Silicone Oil. The Company is entitled to receive this revenue from Bausch & Lomb, in varying amounts, through August 2005. The agreement with Bausch & Lomb, which commenced on August 13, 2000, is structured so that the Company receives consideration from Bausch & Lomb based on its adjusted gross proÑt from its sales of Silicone Oil on a quarterly basis. The consideration is subject to a factor, which steps down according to the following schedule: From 8/13/00 to 8/12/01 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ From 8/13/01 to 8/12/02 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ From 8/13/02 to 8/12/03 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ From 8/13/03 to 8/13/04 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ From 8/13/04 to 8/12/05 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 100% 82% 72% 64% 45% The revenue associated with the sale of Silicone Oil by Bausch & Lomb has no associated expenses and consequently provides a gross margin of 100%. Any signiÑcant reduction in this revenue can have a signiÑcant negative impact on gross margin. Any signiÑcant decrease in Silicone Oil revenue received by the Company would have an impact on the Company's Ñnancial position, results of operations and cash Öows and the Company's stock price could be negatively impacted. 11 Lack of availability of key system components could result in delays, increased costs or costly redesign of the Company's products. Although some of the parts and components used to manufacture the Company's products are available from multiple sources, the Company currently purchases most of the Company's components from single sources in an eÅort to obtain volume discounts. Lack of availability of any of these parts and components could result in production delays, increased costs, or costly redesign of the Company's products. Any loss of availability of an essential component could result in a material adverse change to our business, Ñnancial condition and results of operations. Some of the Company's suppliers are also subject to the FDA's Good Manufacturing Practice regulations. Failure of these suppliers to comply with these regulations could result in the delay or limitation of the supply of parts or components to the Company, which would adversely aÅect the Company's Ñnancial condition and results of operations. The Company's ability to market and sell the Company's products may be adversely aÅected by limitations on reimbursements by government programs, private insurance plans and other third party payors. The Company's customers bill various third party payors, including government programs and private insurance plans, for the health care services provided to their patients. Third party payors may reimburse the customer, usually at a Ñxed rate based on the procedure performed, or may deny reimbursement if they determine that the use of the Company's products was elective, unnecessary, inappropriate, not cost-eÅective, experimental or used for a non-approved indication. Third party payors may deny reimbursement notwith- standing FDA approval or clearance of a product and may challenge the prices charged for the medical products and services. The Company's ability to sell the Company's products on a proÑtable basis may be adversely impacted by denials of reimbursement or limitations on reimbursement, compared with reimburse- ment available for competitive products and procedures. New legislation that further reduces reimbursements under the capital cost pass-through system utilized in connection with the Medicare program could also adversely aÅect the marketing of the Company's products. Future legislation or changes in government programs may adversely aÅect the market for the Company's products. In the past several years, the federal government and Congress have made proposals to change aspects of the delivery and Ñnancing of health care services. The Company cannot predict what form any future legislation may take or its eÅect on the Company's business. Legislation that sets price limits and utilization controls may adversely aÅect the rate growth of ophthalmic and vascular access product markets. If any future health care legislation were to adversely impact those markets, the Company's product marketing could also suÅer, which would adversely impact the Company's business. The Company may become involved in product liability litigation, which may subject the Company to liability and divert management attention. The testing and marketing of the Company's products for applications in ophthalmology and vascular access, our pharmaceutical products and vascular access products entail an inherent risk of product liability, resulting in claims based upon injuries or alleged injuries associated with a defect in the product's performance. Some of these injuries may not become evident for a number of years. Although the Company is not currently involved in any product liability litigation, the Company may be a party to litigation in the future as a result of an alleged claim. Litigation, regardless of the merits of the claim or outcome, could consume a great deal of the Company's time and money and would divert management time and attention away from the Company's core business. The Company maintains limited product liability insurance coverage of $1,000,000 per occurrence and $2,000,000 in the aggregate, with umbrella policy coverage of up to $5,000,000 in excess of such amounts. A successful product liability claim in excess of any insurance coverage may adversely impact the Company's Ñnancial condition and results of operations. The Company cannot assure you that product liability insurance coverage will continue to be available to the Company in the future on reasonable terms or at all. 12 The Company's international operations could be adversely impacted by changes in laws or policies of foreign governmental agencies and social and economic conditions in the countries in which the Company operates. The Company derives a portion of its revenues from sales outside the United States. Changes in the laws or policies of governmental agencies, as well as social and economic conditions, in the countries in which the Company operates could aÅect the Company's business in these countries and the Company's results of operations. Also, economic factors, including inÖation and Öuctuations in interest rates and foreign currency exchange rates, and competitive factors, such as price competition, business combinations of competitors or a decline in industry sales from continued economic weakness, both in the United States and other countries in which the Company conducts business, could adversely aÅect the Company's results of operations. The Company is dependent on its management and key personnel to succeed. The Company's principal executive oÇcers and technical personnel have extensive experience with the Company's products, the Company's research and development eÅorts, the development of marketing and sales programs and the necessary support services to be provided to the Company's customers. Also, the Company competes with other companies, universities, research entities and other organizations to attract and retain qualiÑed personnel. The loss of the services of any of the Company's executive oÇcers or other technical personnel, or the Company's failure to attract and retain other skilled and experienced personnel, could have a material adverse eÅect on the Company's ability to manufacture, sell and market the Company's products and the Company's ability to maintain or expand its business. Any acquisitions, strategic alliances, joint ventures and divestitures that the Company eÅects could result in Ñnancial results that diÅer from market expectations. In the normal course of business, the Company engages in discussions with third parties regarding possible acquisitions (such as Drew), strategic alliances, joint ventures and divestitures. As a result of any such transactions, the Company's Ñnancial results may diÅer from the investment community's expectations in a given quarter. In addition, acquisitions and alliances may require the Company to integrate a diÅerent Company culture, management team and business infrastructure. The Company may have diÇculty developing, manufacturing and marketing the products of a newly acquired company in a way that enhances the performance of the Company's combined businesses or product lines to realize the value from expected synergies. Depending on the size and complexity of an acquisition, the Company's successful integration of the entity depends on a variety of factors including the retention of key employees and the management of facilities and employees in separate geographical areas. These eÅorts require varying levels of management resources, which may divert the Company's attention from other business operations. The Company recently acquired 94% of Drew. Drew does not have a history of producing positive operating cash Öows and, as a result, at the time of acquisition, was operating under Ñnancial constraints and was under-capitalized and is expected to negatively impact the Company's Ñnancial results in the short term. If the Company does not realize the expected beneÑts or synergies of such transactions, the Company's consolidated Ñnancial position, results of operations and stock price could be negatively impacted. The market price of the Company's stock has historically been volatile, and the Company has not paid cash dividends. The volatility of the Company's Common Stock imposes a greater risk of capital losses on shareholders as compared to less volatile stocks. In addition, such volatility makes it diÇcult to ascribe a stable valuation to a shareholder's holdings of the Company's Common Stock. The following factors have and may continue to have a signiÑcant impact on the market price of the Company's Common Stock: ‚ announcements of technological innovations; ‚ changes in marketing, product pricing and sales strategies or new products by the Company's competitors; 13 ‚ any acquisitions, strategic alliances, joint ventures and divestitures that the Company eÅects; ‚ changes in domestic or foreign governmental regulations or regulatory requirements; and ‚ developments or disputes relating to patent or proprietary rights and public concern as to the safety and eÇcacy of the procedures for which the Company's products are used. Moreover, the possibility exists that the stock market, and in particular the securities of technology companies such as the Company, could experience extreme price and volume Öuctuations unrelated to operating performance. The Company has not paid any cash dividends on its Common Stock and does not anticipate paying any cash dividends in the foreseeable future. The Company's results Öuctuate from quarter to quarter. The Company has experienced quarterly Öuctuations in operating results and anticipates continued Öuctuations in the future. A number of factors contribute to these Öuctuations: ‚ changes in the mix of products sold; ‚ the timing and expense of new product introductions by the Company or its competitors; ‚ Öuctuations in royalty income; ‚ announcements of new strategic relationships by the Company or its competitors; ‚ the cancellation or delays in the purchase of the Company's products; ‚ the gain or loss of signiÑcant customers; ‚ Öuctuations in customer demand for the Company's products; and ‚ competitive pressures on prices at which the Company can sell its products. The Company sets its spending levels in advance of each quarter based, in part, on the Company's expectations of product orders and shipments during that quarter. A shortfall in revenue, therefore, in any particular quarter as compared to the Company's plan could have a material adverse eÅect on the Company's results of operations and cash Öows. Also, the Company's quarterly results could Öuctuate due to general conditions in the healthcare industry or global economy generally, or market volatility unrelated to the Company's business and operating results. The impact of terrorism or acts of war could have a material adverse eÅect on the Company's business. Terrorist acts or acts of war, whether in the United States or abroad, could cause damage or disruption to the Company's operations, its suppliers, channels to market or customers, or could cause costs to increase, or create political or economic instability, any of which could have a material adverse eÅect on the Company's business. The Company's charter documents and Pennsylvania law may inhibit a takeover. Certain provisions of Pennsylvania law and our Bylaws could delay or impede the removal of incumbent directors and could make it more diÇcult for a third party to acquire, or could discourage a third party from attempting to acquire, control of the Company. These provisions could limit the price that certain investors might be willing to pay in the future for shares of the Company's Common Stock. The Company's Board of Directors is divided into three classes, with directors in each class elected for three-year terms. The bylaws impose various procedural and other requirements that could make it more diÇcult for shareholders to eÅect certain corporate actions. The Company's Board of Directors may issue shares of preferred stock without shareholder approval on such terms and conditions, and having such rights, privileges and preferences, as the Board may determine. The rights of the holders of Common Stock will be subject to, and may be adversely aÅected by, the rights of the holders of any preferred stock that may be issued in the future. The Company has no current plans to issue any shares of preferred stock. 14 Item 2. Properties The Company currently leases an aggregate of approximately 24,300 square feet of space for its (i) corporate oÇces in Wayne, Pennsylvania, (ii) manufacturing/warehouse facility in New Berlin, Wisconsin and (iii) manufacturing facility in Lake Success, New York. The corporate oÇces in Pennsylvania cover approximately 3,700 square feet. The Wisconsin lease, covering approximately 13,500 square feet of space expires in April 2007. The New York facility lease, covering approximately 7,100 square feet, expires during Ñscal 2005. The Company has signed a lease to a 10,900 square foot facility, also in Lake Success, to which the New York operations will relocate upon termination of the expiring facility lease. Annual rent under all of the Company's lease arrangements was $386,276 for the year ended June 30, 2004. Drew currently leases and aggregate of 69,000 square feet of space for its (i) administrative oÇce and manufacturing facility in Barrow-on-Furness, United Kingdom, (ii) manufacturing facility in Dallas, Texas and (iii) manufacturing facility in Oxford, Connecticut. The facility in the United Kingdom covers approximately 23,000 square feet and consists of three buildings whose leases expire in August and December 2005 and September 2006. The facility in Texas covering approximately 34,000 square feet; and its lease expires in March 2007. The Connecticut facility consists of two separate areas within the same building. The leases cover approximately 12,000 square feet and expire in January 2007 and 2008. Annual rent under all of Drew's lease arrangements was approximately $390,000 for the year ended March 31, 2004. Item 3. Legal Proceedings On June 10, 2004, Escalon provided notice to Intralase of the Company's intention to terminate the license agreement with Intralase due to deÑciencies in the payment of certain royalties that the Company believes are due under the license agreement. On June 21, 2004, Intralase sought a preliminary injunction and a temporary restraining order with the United States District Court for the Central District of California, Southern District against Escalon to prevent the termination of the license agreement with Intralase. The parties subsequently agreed to stipulate to the temporary restraining order to prevent a termination of the license agreement and, on July 6, 2004, as mutually agreed by Intralase and Escalon, the same district court entered a stipulation and order to delay the requested hearing on the preliminary injunction until November 1, 2004. The Company does not believe that the resolution of these matters has had or is likely to have a material adverse eÅect on the Company's business, Ñnancial condition or future results of operations. Escalon is aware of two lawsuits involving Drew. The Ñrst lawsuit involves the principal shareholders of an entity previously acquired by Drew for the collection of unpaid expenses. A counterclaim was Ñled for breach of intellectual property rights and for breach of the principal shareholders' covenants not to compete. This action was Ñled in the state courts of Connecticut. The second lawsuit was Ñled in the state court of Minnesota, but transferred to the Federal District Court of Minnesota. This action was brought by a distributor against an entity previously acquired by Drew claiming a breach of a marketing and distribution agreement. The district court granted in part and denied in part both defendants' Motion for Summary Judgment and Motion to Dismiss. Both parties have appealed the decision. The Company does not believe that the resolution of these matters has had or is likely to have a material adverse eÅect on the Company's business, Ñnancial condition or future results of operations. Furthermore, Escalon, from time to time is involved in various legal proceedings and disputes that arise in the normal course of business. These matters have included intellectual property disputes, contract disputes, employment disputes and other matters. The Company does not believe that the resolution of any of these matters has had or is likely to have a material adverse eÅect on the Company's business, Ñnancial condition or results of operations. 15 Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Escalon's Common Stock trades on the Nasdaq SmallCap Market under the symbol ""ESMC.'' The Company's Common Stock has traded on the Nasdaq SmallCap Market since June 7, 2000. The Common Stock previously traded on the Nasdaq National Market. The table below sets forth, for the periods indicated, the high and low sales prices as quoted on the Nasdaq Stock Market. Fiscal year ended June 30, 2004 High Low Quarter ended September 30, 2003 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Quarter ended December 31, 2003 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Quarter ended March 31, 2004 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Quarter ended June 30, 2004 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 6.60 $ 8.10 $23.85 $27.49 $3.00 $5.47 $6.33 $8.83 Fiscal year ended June 30, 2003 High Low Quarter ended September 30, 2002 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Quarter ended December 31, 2002 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Quarter ended March 31, 2003 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Quarter ended June 30, 2003 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 2.15 $ 2.06 $ 2.26 $ 4.00 $1.35 $1.52 $0.85 $1.82 As of September 14, 2004, there were 6,551 holders of record of the Company's Common Stock. On September 14, 2004, the closing price of Escalon's Common Stock as reported by the Nasdaq SmallCap Stock Market was $13.71 per share. Escalon has never declared or paid a cash dividend on its Common Stock and presently intends to retain any future earnings to Ñnance future growth and working capital needs. In addition, the Company is party to loan agreements that prohibit Escalon's payment of dividends. 16 Item 6. Selected Financial Data The following selected Ñnancial data are derived from the consolidated Ñnancial statements of the Company. The data should be read in conjunction with ""Managements Discussion and Analysis of Financial Condition and Results of Operations'' included herein in Item 7 and the Ñnancial statements and related notes thereto included herein in Item 8. Statement of Operations Data: Product revenue, netÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other revenue ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total revenueÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Costs and expenses: Cost of goods soldÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Research and development ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Marketing, general and administrative ÏÏÏÏÏÏÏÏÏÏÏÏ Writedown of goodwill, license and distribution rights and patents ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 5,476 776 5,206 Ì Total costs and expenses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 11,458 Income/(loss) from operations ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 3,263 Loss from termination of joint ventureÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Sale of Silicone Oil product line ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Equity in gain/(loss) of unconsolidated joint venture Interest income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Interest expenseÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Income/(loss) before taxes ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Income taxes ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Ì Ì Ì 59 (407) 2,915 173 4,896 780 5,034 196 10,906 2,460 Ì Ì Ì 3 (638) 1,825 112 Net income/(loss) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 2,742 $ 1,713 Basic net income/(loss) per share ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 0.70 Diluted net income/(loss) per share ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 0.64 $ $ 0.51 0.48 2004 For the Years Ended June 30, 2003 2002 2001 (in thousands, except per share amounts) $12,348 2,373 $11,191 2,175 $10,293 1,781 14,721 13,366 12,074 $9,626 2,254 11,880 4,297 492 5,430 4,640 555 5,097 2000 $6,670 Ì 6,670 2,874 984 4,661 418 8,937 Ì Ì 10,292 10,219 1,782 1,661 (2,267) (23) Ì 8 2 (791) 978 Ì 978 0.29 0.29 Ì Ì (19) 2 (1,052) 592 Ì Ì 1,864 (33) 149 (576) (863) Ì $ 592 $ (863) $ 0.18 $(0.27) $ 0.18 $(0.27) $ $ $ Weighted average shares Ì basic used in per share computation ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 3,897 3,365 3,346 3,292 3,242 Weighted average shares Ì diluted used in per share computation ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 4,304 3,573 3,360 3,308 3,242 2004 At June 30, 2002 (in thousands, except per share amounts) 2003 2001 2000 Balance Sheet Data: Cash and cash equivalents ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Working capital/(deÑcit) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Long-term debt, net of current portion ÏÏÏÏÏÏÏ Total liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accumulated deÑcitÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total shareholders' equity ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $12,602 13,966 29,457 2,396 5,996 (34,585) 23,461 $ 298 889 16,890 4,080 7,951 (37,326) 8,939 $ 221 (240) 16,912 5,191 9,719 (39,039) 7,193 $ 81 (3,004) 17,798 4,502 11,691 (40,018) 6,107 $ 177 (3,211) 16,845 4,900 11,430 (40,610) 5,415 Note: No cash dividends were paid in any of the periods presented. 17 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis should be read together with the consolidated Ñnancial statements and notes thereto and other Ñnancial information contained elsewhere in this Form 10-K and the discussion under ""Cautionary Factors that May AÅect Future Results'' included in Part I of this Form 10-K. Escalon operates primarily in four reportable business segments: Sonomed, Vascular, Medical/Trek and EMI. Sonomed develops, manufactures and markets ultrasound systems used for diagnostic or biometric applications in ophthalmology. Vascular develops, manufactures and markets vascular access products. Medical/Trek develops, manufactures and distributes ophthalmic surgical products under the Escalon Medical Corp. and/or Trek Medical Products names. EMI manufactures and markets a digital camera system for ophthalmic fundus photography. For a more complete description of these businesses and their products, see Item 1 Ì Business. Executive Overview Ì Fiscal Years Ended June 30, 2004 and 2003 The following highlights are discussed in further detail within this Form 10-K. The reader is encouraged to read this Form 10-K in its entirety to gain a more complete understanding of factors aÅecting Company performance and Ñnancial condition. ‚ The Company completed a $10,400,000 million private placement of Common Stock and Common Stock purchase warrants on March 17, 2004. The net proceeds to the Company of $9.8 million have enabled the Company to strengthen its balance sheet and provide additional working capital for general corporate purposes. ‚ Product revenue, up 10.34% from last year, beneÑted from increased domestic demand for the Company's pachymeter product as well as increased market penetration in Europe. ‚ Other revenue, up 9.12% from last year, was received primarily from Bausch & Lomb in connection with the Silicone Oil product line. The contract for this revenue expires in August 2005. ‚ Operating expenses increased by 2.89% driven primarily by the Company's continuing eÅorts to strengthen its sales channels domestically and overseas oÅset by reductions of certain administrative costs. ‚ Interest expense decreased 36.31% primarily due to reduced debt levels. Subsequent Event On July 23, 2004, the Company announced that holders of approximately 67% of the outstanding ordinary shares of Drew accepted the Company's exchange oÅer for the outstanding shares of Drew. As of September 22, 2004, Escalon had issued 897,886 common shares to Drew shareholders pursuant to the exchange oÅer for approximately 94% of the outstanding ordinary shares of Drew. Drew, based in the United Kingdom, with additional manufacturing operations in Dallas, Texas and Oxford, Connecticut specializes in the design, manufacture, sale and distribution of analytical systems for laboratory testing worldwide. Drew provides instrumentation and consumables for the diagnosis and monitoring of medical disorders in the areas of diabetes, cardiovascular diseases and hematology, as well as veterinary hematology and blood chemistry. 18 Results of Operations Fiscal Year Ended June 30, 2004 Compared to Fiscal Year Ended June 30, 2003 The following table presents consolidated product revenues by business segment as well as identifying trends in business segment product revenues for the Ñscal years ended June 30, 2004 and 2003. 2004 Fiscal Years Ended June 30, 2003 (in thousands) % change Product revenue: Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Vascular ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ EMI ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 7,596 3,055 1,448 249 $ 6,495 2,761 1,502 433 16.95% 10.65% ¿3.60% ¿42.49% $12,348 $11,191 10.34% Product revenue increased $1,157,000, or 10.34%, to $12,348,000 in Ñscal 2004 as compared to $11,191,000 in Ñscal 2003. Product revenue in the Sonomed business unit increased $1,101,000, or 16.95%, to $7,596,000. The increase is attributed to a $336,000 increase in the domestic market, a $324,000 increase in the Middle East, a $297,000 increase in Europe and a $261,000 increase in Latin America oÅset by a $93,000 decrease in Asia and the PaciÑc Rim. The increase in the domestic market primarily relates to increased demand for the Company's pachymeter product. The domestic market for pachymeters expanded due to enhanced techniques in glaucoma screening performed by optometrists. Historically, the typical optometrist has not been a user of the pachymeter. Domestic demand for the pachymeter returned to historic levels in the fourth quarter of Ñscal 2004. The increases in the Middle East and Europe are the result of additional sales and marketing resources and management attention to developing these markets whereas the increase in Latin America is a result of recovering economies in South American countries. Product revenue in the Vascular business unit increased $294,000, or 10.65%, to $3,055,000. The increase primarily relates to increased usage in the domestic marketplace. Product revenue in the Medical/Trek business unit decreased $54,000, or 3.60%, to $1,448,000. The decrease primarily relates to decreased market demand for Medical/Trek's products. Product revenue in the EMI business unit decreased $184,000, or 42.49%, to $249,000. Other revenue, which is included in the Medical/Trek business unit, increased $198,000, or 9.10%, to $2,373,000 in Ñscal 2004 as compared to $2,175,000 in Ñscal 2003. The increase relates to both a $116,000 increase in royalty payments received from Intralase related to the licensing of the Company's intellectual laser technology and a $83,000 increase in revenue received from Bausch & Lomb in connection with its sales of Silicone Oil. The Company's contract with Bausch & Lomb calls for annual step-downs in the calculation of Silicone Oil revenue to be received by the Company. The step-downs occur during the Ñrst quarter of each Ñscal year through the remainder of the contract, which ends in August 2005. For the Ñscal year ended June 30, 2004, the step-down caused a $250,000 decrease in Silicone Oil revenue that the Company would have otherwise received had the step-down not occurred. The oÅsetting $333,000 increase in Silicone Oil revenue is due to market demand for the product. The Company does not have any further knowledge as to what factors have aÅected Bausch & Lomb's sales of Silicone Oil. See the Notes to Consolidated Financial Statements for a description of the step-down provisions under the contract with Bausch & Lomb. 19 The following table presents consolidated cost of goods sold by reportable business segment and as a percentage of related segment product revenue for the Ñscal years ended June 30, 2004 and 2003. Cost of goods sold: Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Vascular ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ EMIÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Fiscal Years Ended June 30, 2003 2004 Dollars % Dollars % $3,076 1,381 911 108 40.49% $2,524 45.20% 1,195 961 62.91% 216 43.37% 38.86% 43.28% 63.98% 49.88% $5,476 44.35% $4,896 43.75% Cost of goods totaled $5,476,000, or 44.35%, of product revenue for the Ñscal year ended June 30, 2004 as compared to $4,896,000, or 43.75%, of product revenue for the Ñscal year ended June 30, 2004. Cost of goods sold in the Sonomed business unit was $3,076,000, or 40.49% of product revenue for the Ñscal year ended June 30, 2004 as compared to $2,524,000, or 38.86%, of product revenue for the Ñscal year ended June 30, 2003. The slight increase in cost of goods sold as a percentage of product revenue was primarily caused by an increase in international sales. Sonomed generally sells its products to international customers at lower price levels. Cost of goods sold in the Vascular business unit was $1,381,000, or 45.20%, or product revenue for the Ñscal year ended June 30, 2004 as compared to $1,195,000, or 43.28%, of product revenue for the Ñscal year ended June 30, 2003. The Company began manufacturing its Doppler-Guided Peripheral I.V. product in the latter part of Ñscal 2004. This product has higher manufacturing costs than the remainder of the Vascular product line. Cost of goods sold in the Medical/Trek business unit totaled $911,000, or 62.91%, of product revenue for the Ñscal year ended June 30, 2004 as compared to $961,000, or 63.98% of product revenue for the Ñscal year ended June 30, 2003. Fluctuations in Medical/Trek cost of goods sold results from product mix changes, which were primarily controlled by market demand. Cost of goods sold in the EMI business unit was $108,000, or 43.37%, of product revenue for the Ñscal year ended June 30, 2004 as compared to $216,000, or 49.88% of product revenue for the same period last Ñscal year. The following table presents consolidated marketing, general and administrative expenses as well as identifying trends in business segment marketing, general and administrative expenses for the Ñscal years ended June 30, 2004 and 2003. Fiscal Years Ended June 30, 2003 % Change 2004 Marketing, general and administrative expenses: Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ VascularÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ EMI ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $1,196 1,353 2,427 230 $1,281 1,205 2,294 254 ¿6.64% 12.28% 5.80% ¿9.45% $5,206 $5,034 3.42% Marketing, general and administrative expenses increased $172,000, or 3.42%, for the Ñscal year ended June 30, 2004 as compared to the Ñscal year ended June 30, 2003. In the Sonomed business unit, marketing, general and administrative expenses decreased $85,000, or 6.64%, to $1,196,000. Salaries and other personnel- related expenses decreased $134,000, primarily the result of head count changes. Commission expense decreased $35,000 as a result of changes in the commission structure with an international distributor. OÅsetting these decreases was an $84,000 increase in consulting expense, which increased as a result of the Company's marketing eÅorts in the international markets. In the Vascular business unit, marketing, general and administrative expenses increased $148,000, or 12.28%, to $1,353,000. Salaries and other personnel- related expenses increased $155,000, primarily the result of increases in headcount. Consulting expenses 20 increased $55,000 as a result of marketing eÅorts in the international markets. Sales and marketing travel- related expenses also increased $68,000. The Company agreed to pay royalties for a Ñve-year period following the acquisition of the vascular access division of Endologix. That Ñve-year period ended in December 2003. This resulted in a $122,000 decrease in royalty expense. In the Medical/Trek business unit, marketing, general and administrative expenses increased $133,000, or 5.80%, to $2,427,000. Accrued compensation increased $108,000. Payroll taxes increased $86,000 primarily due to the exercise of employee stock options. Deprecia- tion and amortization expense decreased $32,000 primarily due to the abandonment of the Company's license and distribution rights to Povidone Iodine 2.5% in March 2003 and consulting expense decreased $14,000 as the Company incurred expenses in Ñscal 2003 related to the Company's search for alternate debt Ñnancing. In the EMI business unit, marketing, general and administrative expenses decreased $24,000, or 9.45%, to $230,000. Research and development expenses decreased $4,000, or 0.51%, to $776,000 for the Ñscal year ended June 30, 2004 as compared to the Ñscal year ended June 30, 2003. Increases in consulting expenses incurred in connection with product development were oÅset by reduced headcount. Several years ago, the Company began seeking a corporate partner to fund commercialization of the Povidone Iodine 2.5% product line. The Company obtained the license and distribution rights to the product from Harbor UCLA Medical Center. Having exhausted all partnering possibilities, during Ñscal 2003, management decided that further expenditures on this project were not in the shareholders' best interest, and the project was abandoned. This decision resulted in the Company taking a charge of $195,000, which included the write-oÅ of remaining net book value of the license and distribution rights subsequent to normal amortization. Interest income was $59,000 and $3,000 for the Ñscal years ended June 30, 2004 and 2003, respectively. The increase relates to increased average cash balances in the current Ñscal year. Interest expense was $407,000 and $638,000 for the Ñscal years ended June 30, 2004 and 2003, respectively. The decrease relates to reduced total debt levels and lower interest rates. Income tax expense was $173,000 and $112,000 for the Ñscal years ended June 30, 2004 and 2003, respectively. The Company began incurring income tax expense in Ñscal 2003 due to the exhausting of certain state net operating loss carryforwards. Fiscal Year Ended June 30, 2003 Compared to Fiscal Year Ended June 30, 2002 The following table presents consolidated product revenues by business segment as well as identifying trends in business segment product revenues for the Ñscal years ended June 30, 2003 and 2002. 2003 Fiscal Years Ended June 30, 2002 (in thousands) % Change Product revenue: Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ VascularÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ EMI ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 6,495 2,761 1,502 433 $ 6,071 2,634 1,321 267 6.98% 4.82% 13.70% 62.17% $11,191 $10,293 8.72% Product revenue increased $898,000, or 8.72%, to $11,191,000 in Ñscal 2003 as compared to $10,293,000 in Ñscal 2002. Product revenue in the Sonomed business unit increased $424,000, or 6.98%, to $6,495,000. The increase is attributed to $476,000 increase in the domestic market as well as a $101,000 increase in Asia and the PaciÑc Rim. The surge in the domestic market primarily relates to increased demand for the Company's pachymeter product. The usage of pachymeters began to include glaucoma screening, opening a new market for the product. The increase in Asia and the PaciÑc Rim relate primarily to the Company's successful 21 strategy of increased penetration of those geographic areas. Conversely, Sonomed experienced a $77,000 decrease in revenue in Latin America as well as a $60,000 decrease in the Middle East. Management believes that the weak economy in Latin America and the turmoil in the Middle East led to these decreases. Product revenue in the Vascular business unit increased $127,000, or 4.82% in Ñscal 2003, to $2,761,000. The increase related primarily to increased usage in the marketplace. During Ñscal 2001, the Company identiÑed certain underperforming distributors within its Vascular business unit and terminated its relationship with them. Subsequent to terminating these distributors, the Company began direct selling in the territories once covered by the distributors. Management believes that revenue in the territories once covered by the distributors remained stable or increased in Ñscal 2002, as revenue in the Vascular business unit increase 24.42% for the Ñscal year ended June 30, 2002 as compared to the Ñscal year ended June 30, 2001. During the Ñscal year ended June 30, 2003, revenue continued to build upon this increased base. Product revenue in the Medical/ Trek business unit increased $181,000, or 13.70%, to $1,502,000. OEM revenue from Bausch & Lomb increased $229,000. Product revenue in the EMI business unit increased $166,000. The Company terminated its joint venture and commenced operations within the EMI business unit on January 1, 2002, and therefore, during the Ñrst six months of Ñscal 2002, these revenues were recognized within the joint venture. Other revenue, which is included in the Medical/Trek business unit, increased $394,000, or 22.12%, to $2,175,000 for the Ñscal year ended June 30, 2003 as compared to $1,781,000 for the Ñscal year ended June 30, 2002. The increase primarily related to a $289,000 increase in royalty payments received from Intralase related to the licensing of Escalon's intellectual laser technology. Escalon licensed the technology to Intralase in October 1997. These royalty payments commenced during the fourth quarter of Ñscal 2002 when Intralase began selling products related to Escalon's intellectual laser property. The remaining $105,000 increase in other revenue during Ñscal 2003 related to revenue earned from Bausch & Lomb in connection with Silicone Oil. The Company's contract with Bausch & Lomb calls for annual step-downs in the calculation of Silicone Oil revenue to be received by Escalon. These step-downs occur during the Ñrst quarter of each Ñscal year through the remainder of the contract. For the Ñscal year ended June 30, 2003, the step-down caused a $259,000 decrease in Silicone Oil revenue that Escalon would have otherwise received had the step- down not occurred. The oÅsetting $364,000 increase in Silicone Oil revenue is due to increase in the market demand for the product. Escalon does not have any knowledge as to what factors have aÅected Bausch & Lomb's sales of Silicone Oil. See Note 10 of the Notes to Consolidated Financial Statements for a description of the step-down provisions under the contract with Bausch & Lomb. The following table presents consolidated cost of goods sold by reportable business segment and as a percentage of related segment product revenue for the Ñscal years ended June 30, 2003 and 2002. Cost of goods sold: Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Vascular ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ EMIÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Fiscal Years Ended June 30, 2002 2003 Dollars % Dollars % $2,524 1,195 961 216 38.86% $2,704 988 43.28% 838 63.98% 110 49.88% 44.54% 37.51% 63.44% 41.20% $4,896 43.75% $4,640 45.08% Cost of goods sold totaled $4,896,000, or 43.75% of product revenue during Ñscal 2003, as compared to $4,640,000, or 45.08% of product revenue. Cost of goods sold in the Sonomed business unit totaled $2,524,000, or 38.86% of net revenue, for the Ñscal year ended June 30, 2003 as compared to $2,704,000, or 44.54% of product revenue, for the Ñscal year ended June 30, 2002. Sonomed experienced a signiÑcant shift in product mix with the increase in demand for the pachymeter product, which has higher margins than much of the remainder of the Sonomed product line. Cost of goods sold in the Vascular business unit totaled $1,195,000, or 43.28% of product revenue, for the Ñscal year ended June 30, 2003, as compared to $988,000, or 37.51% of product revenue, for the Ñscal year ended June 30, 2002. Vascular's margins were adversely aÅected by several 22 factors including product mix, having experienced an increase in sales of over-the-needle catheter (""ONC'') product line, which has lower margins than the remainder of the Vascular product line due to smaller-scale production; lower price per unit, having experienced an increase in sales to distributors to whom the Company discounts its products; and quality issues that led to the Company writing oÅ $52,000 of inventory in the fourth quarter of Ñscal 2003. Cost of goods sold in the Medical/Trek business unit totaled $961,000, or 26.14% of net revenue, for the Ñscal year ended June 30, 2003, as compared to $838,000, or 27.01% of net revenue, for the Ñscal year ended June 30, 2002. When other revenue is excluded (no costs are associated with these revenue streams), cost of goods sold, as a percentage of product revenue, was 63.98% and 63.44% for the Ñscal years ended June 30, 2003 and 2002, respectively. Fluctuations in Medical/Trek cost of goods sold resulted from product mix changes, which were primarily controlled by market demand. Cost of goods sold in the EMI business unit was $216,000, or 49.88% of net revenue, for the Ñscal year ended June 30, 2003, as compared to $110,000, or 41.20% of net revenue, for the Ñscal year ended June 30, 2002. During the Ñrst six months of Ñscal 2002, these expenses were incurred within the joint venture. The following table presents consolidated marketing, general and administrative expenses as well as identifying trends in business segment marketing, general and administrative expenses for the Ñscal years ended June 30, 2003 and 2002. Fiscal Years Ended June 30, 2002 % Change 2003 Marketing, general and administrative expenses: Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ VascularÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ EMI ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $1,281 1,205 2,294 254 $1,441 999 2,528 129 ¿11.10% 20.62% ¿9.26% 96.90% $5,034 $5,097 ¿1.24% Marketing, general and administrative expenses decreased $63,000, or 1.24%, for the Ñscal year ended June 30, 2003, as compared to the Ñscal year ended June 30, 2002. In the Sonomed business unit, marketing, general and administrative expenses decreased $160,000, or 11.10%. Salaries and other personnel-related expenses decreased $201,000, primarily as a result of reduced headcount. Bad debts decreased $55,000, primarily due to the Company reserving for speciÑc international accounts in the Ñscal year ended June 30, 2002, which did not reoccur in the Ñscal year ended June 30, 2003. OÅsetting these decreases were an increase in consulting expense of $60,000, which increased as a result of the Company's eÅorts in the international markets and an increase in commissions of $35,000. In the Vascular business unit, marketing, general and administrative expenses increased $206,000, or 20.62%, for the Ñscal year ended June 30, 2003, as compared to the Ñscal year ended June 30, 2002. Salaries and other personnel-related expenses increased $89,000, primarily as a result of increases in headcount. Travel and sales meeting expenses increased by a combined $36,000, and samples expense increased by $21,000. Also contributing to the increase, the Company began allocating from the Medical/Trek business unit certain overhead expenses related to the Wisconsin facility to the Vascular business unit during Ñscal 2003. In the Medical/Trek business unit, marketing, general and administrative expenses decreased $234,000, or 9.26%, for the Ñscal year ended June 30, 2003 as compared to the Ñscal year ended June 30, 2002. Legal and accounting fees decrease $110,000. Legal fees were unusually high during the Ñscal year ended June 30, 2002 due to required Ñlings with the SEC related to the reincorporation into Pennsylvania and the issuance of Escalon Common Stock shares to Endologix, Inc. Salaries and other personnel-related expenses decreased $16,000, primarily the result of reduced headcount. Also contributing to the decrease, the Company began allocating from the Medical/Trek business unit certain overhead expenses related to the Wisconsin facility to the Vascular business unit during Ñscal 2003. OÅsetting these decreases was a $77,000 increase in insurance expense. The increase primarily relates to premium increases being instituted by the insurance industry in general as well as to an audit of prior year premiums in which the insurance company discovered that they undercharged premiums by $22,000. The undercharge was corrected in the Ñrst quarter of Ñscal 2003. In the EMI business unit, marketing, general and administrative expenses increased $125,000. The Company terminated its joint venture and commenced operations within its 23 EMI business unit on January 1, 2002, and therefore, during the six months of the Ñscal 2002, these expenses were incurred within the joint venture. Research and development expenses increased $225,000, or 40.54%, for the Ñscal year ended June 30, 2003 as compared to Ñscal 2002. The increase primarily relates to consulting expenses incurred in connection with product development. The Company redesigns its products every few years, as technology changes, to remain competitive in the market place. Several years ago, Escalon began seeking a corporate partner to fund commercialization of the Povidone Iodine 2.5% product line. The Company obtained the license and distribution rights to the product from Harbor-UCLA Medical Center. Having exhausted all partnering possibilities, the Company decided that further expenditures on this project were not in the shareholders' best interest, and the project was abandoned. This decision resulted in the Company taking an expense of $196,000 during the Ñscal year ended June 30, 2003, which included the write-oÅ of the remaining net book value of the license and distribution rights. On December 18, 2000, the Company announced that it received 510(K) clearance to begin marketing its high-end digital camera system for ophthalmologists known as the CFA Digital Imaging System. As a result of the approval, the Company began marketing the system through its joint venture with Megavision. Escalon terminated its joint venture with Megavision and commenced operations within the Company's EMI business unit on January 1, 2002. Escalon recognized a gain of $8,000 related to the operations of the joint venture and a $23,000 loss related to the termination of the joint venture during the Ñscal year ended June 30, 2002. Interest income remained relatively unchanged for the Ñscal year ended June 30, 2003 as compared to the Ñscal year ended June 30, 2002, $3,000 and $2,000, respectively. Interest expense decreased $153,000, to $638,000, for the Ñscal year ended June 30, 2003 as compared to the same period in Ñscal 2002 primarily due to reduced total debt levels and lower interest rates. There is no provision for federal income taxes for the periods presented as a result of utilization of net operating loss carryforwards and related changes in the deferred tax valuation allowances. Income taxes of $112,000 were incurred during the Ñscal year ended June 30, 2003 due to Wisconsin state net operating losses being exhausted. 24 Liquidity and Capital Resources In recent years, Escalon's principal source of liquidity generally has been net cash provided by operating activities. The Company, however, completed a private placement of its Common Stock during the Ñscal year ended June 30, 2004 that signiÑcantly aÅected the Company's liquidity. Additionally, stock options were exercised during the Ñscal year ended June 30, 2004 providing the Company with additional cash. Changes in Escalon's overall liquidity and capital resources from continuing operations during Ñscal 2004 are reÖected in the following table: Current Assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Less: Current Liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ June 30, 2004 June 30, 2003 (dollars are in thousands) 4,759 $ 17,566 3,870 3,600 $ Working CapitalÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Current Ratio ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Notes Payable and Current Maturities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Long-Term Debt ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 13,966 4.9 to 1 1,872 2,396 $ Total Debt ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total Equity ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 4,268 23,461 $ 889 1.2 to 1 2,485 4,080 $ $ 6,565 8,939 Total Capital ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total Debt to Total Capital ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 27,729 $ 15,504 15.39% 42.34% Working Capital Position Working capital increased $13,077,000 as of June 30, 2004 and the current ratio increased to 4.9 to 1 when compared with June 30, 2003. Current assets increased by $12,807,000 primarily due to the issuance of Common Stock totaling $11,780,000. Current liabilities decreased by $270,000 as a result of several oÅsetting factors that included the following: ‚ A $725,000 decrease in the Escalon's outstanding line of credit as the Company used cash from operations to pay down its debt. ‚ A $201,000 increase in accrued compensation (incentive, payroll and vacation). ‚ A $112,000 increase in current portion of long-term debt primarily due to the step-up of principal payments due on the Company's term debt. Cash Flows from Operating Activities Net cash provided by operating activities increased $992,000 to $3,163,000, for the Ñscal year ended June 30, 2004 as compared to the Ñscal year ended June 30, 2003. Apart from year-over-year increased net proÑtability of $1,029,000, the following are the primary oÅsetting factors aÅecting the increase in net cash provided by operating activities: ‚ The Company held overall inventory levels relatively constant as compared to Ñscal 2003 when the Company increased overall inventory levels to be more quickly responsive to customer orders. ‚ Accounts receivable in the Sonomed and Vascular business unit increased in proportion to increased volume in those business units whereas in Medical/Trek and EMI, accounts receivable were lower than Ñscal 2003. 25 Cash Flows from Investing and Financing Activities The Company had substantial expenditures related to the Drew acquisition that are classiÑed as other current assets until the transaction is Ñnalized. Otherwise, cash Öows used in investing activities related solely to the purchase of Ñxed assets for the Ñscal year ended June 30, 2004 and 2003, and remained largely unchanged. Any necessary capital expenditures have generally been funded out of cash from operations, and the Company is not aware of any factors that would cause historical capital expenditure levels not to be indicative of capital expenditures in the future and, accordingly, does not believe that it will have to commit material resources to capital investment for the foreseeable future. Cash Öows from Ñnancing activities were $9,440,000 for the Ñscal year ended June 30, 2004. Cash Öows from Ñnancing activities primarily related to proceeds from a private placement of Common Stock and Common Stock warrants as well as proceeds from the issuance of Common Stock through the exercise of stock options. On March 17, 2004, the Company completed a private placement of Common Stock resulting in net proceeds of $9,788,000 and, during the Ñscal year ended June 30, 2004, issued Common Stock related to the exercise of stock options resulting in proceeds to the Company of $1,992,000. This was oÅset by repayments of the Company's term debt and line of credit. The Company paid down its line of credit by $725,000 and paid down its term debt by $1,615,000. The Company utilized cash from operations to pay down its term loan and line of credit. Cash Öows used in Ñnancing activities were $2,017,000 during the Ñscal year ended June 30, 2003. During the Ñscal year ended June 30, 2003, cash Öows used in Ñnancing activities primarily related to repayments of the Company's term debt and line of credit. The Company paid down its term debt and line of credit by $1,761,000 and $275,000, respectively. The reduction in repayments of term debt relates to a reduction in required principal payments that resulted from the Company's renegotiating its debt in February 2003. Management believes that cash on hand, cash generated from operations and cash available from the line of credit ($1,750,000 as of June 30, 2004) should be suÇcient to satisfy the Company's (including Drew) working capital, debt service, capital expenditures and research and development costs for the foreseeable future. Forward-looking Statement about SigniÑcant Items Likely to AÅect Liquidity As of July 23, 2004, Escalon acquired 67.03% of the outstanding ordinary shares of Drew, pursuant to the Company's exchange oÅer for all of the outstanding ordinary shares of Drew; and since that date has acquired approximately 94% of the Drew shares. Escalon expects to acquire the remaining outstanding Drew shares pursuant to procedures under United Kingdom laws and regulations. Drew does not have a history of producing positive operating cash Öows and, as a result, at the time of acquisition, was operating under Ñnancial constraints and was under-capitalized and is expected to negatively impact the Company's Ñnancial results in the short term. As of September 23, 2004, Escalon loaned $1,550,000 to Drew. The funds have been primarily used to procure components to build up inventory to support the manufacturing process. As Drew is integrated into the Company, management will be working to reverse the situation, while at the same time strengthening Drew's market position. Escalon realized 13.18% and 13.90% of its net revenue during the Ñscal years ended June 30, 2004 and 2003, respectively, from Bausch & Lomb's sale of Silicone Oil. Silicone Oil revenue is based on sales of the product by Bausch & Lomb multiplied by a contractual factor that reduces on an annual basis due to a contractual step-down provision. While the Company does not expect total Silicone Oil revenue to decline rapidly during the remainder of the contract, any such decrease would have an impact on the Company's Ñnancial position, results of operations and cash Öows and the Company's stock price could be negatively impacted. The Company is entitled to receive this revenue from Bausch & Lomb, in varying amounts, through August 2005, when all revenues will cease. See the Notes to Consolidated Financial Statements for a description of the step-down provisions under the contract with Bausch & Lomb. The Company issued 120,000 Common Stock purchase warrants in connection with the private placement on March 17, 2004. The warrants are exercisable 181 days from the placement date at $15.60 per 26 share and expire Ñve years from the placement date. If all 120,000 warrants were to be exercised, it would provide gross proceeds to the Company of $1,872,000. Escalon cannot assure, however, that the warrant exercise price will be less than the market price of the Company's Common Stock when the warrants are exercisable or that even if the exercise price is less than the market price that any of the warrants will be exercised. See the notes to Consolidated Financial Statements for a description of the private placement of the Company's Common Stock and Common Stock purchase warrants. Pursuant to the successful exchange oÅer for all of the outstanding shares of Drew, Escalon is required to provide the historical Ñnancial information of the acquired business required by Rule 3-05 of Regulation S-X. Furthermore, pursuant to Item 7(a)(4) of Form 8-K, the required historical Ñnancial information is also required to be Ñled as soon as practicable within the time prescribed under such Item. To date, Escalon has experienced diÇculties in providing the required Ñnancial information due to circumstances concerning the presentation of United Kingdom Ñnancial statements. Therefore, in the event that Escalon does not Ñle the Ñnancial information required by Article 11 of Regulation S-X or Item 7(b)(2) of Form 8-K, Escalon will not be in compliance with the reporting requirements under the Securities Exchange Act of 1934 rules. Consequently, Escalon's ability to raise additional capital pursuant to registration statements may be limited. Escalon intends to provide the required Ñnancial information. If, however, Escalon is unable to timely report the required Ñnancial information due to the aforementioned issues, Escalon intends to Ñle such Ñnancial information as soon as practicable. Debt History On December 23, 2002, a lender acquired the Company's bank debt, which consisted of term debt of $5,850,000 and $1,475,000 outstanding on a $2,000,000 available line of credit. On February 13, 2003, the Company entered into an Amended Agreement with the lender. The primary amendments of the Amended Loan Agreement were to reduce the quarterly principal payments, extend the term of the repayments and to alter the covenants of the original bank agreement. As of June 30, 2004, the amount outstanding under the term loan and line of credit were $3,896,019 and $250,000, respectively. At June 30, 2004, the interest rates applicable to the term loan and line of credit were 5.75% and 5.50%, respectively. The lender's prime rate at June 30, 2004 was 4.00%. The $3,896,000 term loan balance includes a $2,396,000 balloon payment that is due on September 1, 2005. As of June 30, 2004, $1,750,000 was available on the line of credit. The Company paid $100,000 in Ñnance fees on January 14, 2000, when this debt was originally incurred. The Ñnance fees are being amortized over the life of the loans using the eÅective interest method. On January 21, 1999, the Company's Vascular subsidiary and Endologix entered into an Assets Sale and Purchase Agreement. Pursuant to this agreement, the Company acquired for cash the assets of Endologix's vascular access business in exchange for cash and also agreed to pay royalties to Endologix based on future sales of the vascular access business for a period of Ñve years following the closing of the sale, with a guaranteed minimum royalty of $300,000 per year. On February 1, 2001, the parties amended the agreement to eliminate any future royalty payments to Endologix. Pursuant to the amendment, the Company paid $17,558 in cash to Endologix, delivered a short-term note in the amount of $64,884 that was satisÑed in January 2002 and a note in the amount of $717,558, payable in 11 quarterly installments that commenced on April 15, 2002 and issued 50,000 shares of the Company's Common Stock to Endologix. As of June 30, 2004, the amount outstanding under the Endologix term loan was $130,461 and the interest rate applicable to the loan was 5.00%. Escalon Common Stock The Company's Common Stock is currently listed on the Nasdaq SmallCap Market. In order to continue to be listed on the Nasdaq SmallCap Market, the following requirements must be met: ‚ Stockholders' equity of $2,500,000 or market value of listed securities of $35,000,000 or net income from continuing operations (in the latest Ñscal year or two of the last three Ñscal years) of $500,000; 27 ‚ 500,000 publicly held shares; ‚ $1,000,000 market value of publicly held shares; ‚ A minimum bid price of $1; ‚ 300 round lot shareholders; ‚ Two market makers; and ‚ Compliance with corporate governance standards. As of June 30, 2004, Escalon complied with these requirements. Critical Accounting Policies The preparation of Ñnancial statements requires management to make estimates and assumptions that aÅect amounts reported therein. The most signiÑcant of those involve the application of SFAS No. 142, discussed further in the Notes to the Consolidated Financial Statements included in this Form 10-K. The Ñnancial statements are prepared in conformity with accounting principles generally accepted in the United States of America, and, as such, include amounts based on informed estimates and judgments of management. For example, estimates are used in determining valuation allowances for uncollectible receivables, obsolete inventory, sales returns and rebates, deferred income taxes and purchased intangible assets. Actual results achieved in the future could diÅer from current estimates. The Company used what it believes are reasonable assumptions and, where applicable, established valuation techniques in making its estimates. Revenue Recognition The Company recognizes revenue from the sale of its products at the time of shipment, when title and risk of loss transfer. The Company provides products to its distributors at agreed wholesale prices and to the balance of its customers at set retail prices. Distributors can receive discounts for accepting high volume shipments. The discounts are reÖected immediately in the net invoice price, which is the basis for revenue recognition. No further material discounts or sales incentives are given. The Company's considerations for recognizing revenue upon shipment of product to a distributor are based on the following: ‚ Persuasive evidence that an arrangement (purchase order and sales invoice) exists between a willing buyer (distributor) and the Company that outlines the terms of the sale (company information, quantity of goods, purchase price and payment terms). The buyer (distributor) does not have an immediate right of return. ‚ Shipping terms are ex-factory shipping point. At this point the buyer (distributor) takes title to the goods and is responsible for all risks and rewards of ownership, including insuring the goods as necessary. ‚ The Company's price to the buyer (distributor) is Ñxed and determinable as speciÑcally outlined on the sales invoice. The sales arrangement does not have customer cancellation or termination clauses. ‚ The buyer (distributor) places a purchase order with the Company; the terms of the sale are cash, COD or credit. Customer credit is determined based on the Company's policy and procedures related to the buyer's (distributor's) creditworthiness. Based on this determination, the Company believes that collectibility is reasonably assured. Escalon assesses collectibility based on credit worthiness of the customer and past transaction history. The Company performs ongoing credit evaluations of its customers and does not require collateral from its customers. For many of Escalon's international customers, the Company requires an irrevocable letter of credit to be issued by the customer before the purchase order is accepted. 28 Valuation of Intangible Assets Escalon annually evaluates for impairment its intangible assets and goodwill in accordance with SFAS No. 142, ""Goodwill and Other Intangible Assets,'' or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. These intangible assets include goodwill, trademarks and trade names. Factors the Company considers important that could trigger an impairment review include signiÑcant under-performance relative to historical or projected future operating results or signiÑcant negative industry or economic trends. If these criteria indicate that the value of the intangible asset may be impaired, an evaluation of the recoverability of the net carrying value of the asset is made. If this evaluation indicates that the intangible asset is not recoverable, the net carrying value of the related intangible asset will be reduced to fair value. Any such impairment charge could be signiÑcant and could have a material adverse eÅect on the Company's Ñnancial statements if and when an impairment charge is recorded. No impairment losses were recorded for goodwill, trademarks and trade names during any of the periods presented based on these evaluations. Taxes Estimates of full year taxable income of the various legal entities and jurisdictions are used in the tax rate calculation. Management uses judgment in estimating what the Company's income will be for the year. Since judgment is involved, there is risk that the tax rate may signiÑcantly increase or decrease in any period. In determining income (loss) for Ñnancial statement purposes, management must make certain estimates and judgments. These estimates and judgments occur in the calculation of certain tax liabilities and in the determination of the recoverability of certain of the deferred tax assets, which arise from temporary diÅerences between the tax and Ñnancial statement recognition of revenue and expense. SFAS 109 also requires that the deferred tax assets be reduced by a valuation allowance, if based on the weight of available evidence, it is more likely than not that all or some portion of the recorded deferred tax assets will not be realized in future periods. In evaluating the Escalon's ability to recover the Company's deferred tax assets management considers all available positive and negative evidence including the Company's past operating results, the existence of cumulative losses, and near term forecasts of future taxable income, management develops assumptions which require signiÑcant judgment about the near term forecasts of future taxable income which are consistent with the plans and estimates management is using to manage the underlying businesses. Through June 30, 2004, the Escalon has recorded a full valuation allowance against the Company's net operating losses due to the uncertainty of their realization as a result of the Company's earnings history, cumulative historical losses, the number of years the Company's operating losses and tax credits can be carried forward, the existence of taxable temporary diÅerences, and near-term earnings expectations. The amount of the valuation allowance could decrease if facts and circumstances change that materially increase taxable income prior to the expiration of the loss carryforwards. Any reduction would reduce (increase) the income tax expense (beneÑt) in the period such determination is made by the Company. OÅ-Balance Sheet Arrangements and Contractual Obligations Escalon did not have any oÅ-balance sheet arrangements as of and for the Ñscal years ended June 30, 2004 and 2003. The following table presents the Company's contractual obligations as of June 30, 2004: Total Long-term debt ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Operating lease obligations ÏÏÏÏÏÏÏÏ Purchase obligations ÏÏÏÏÏÏÏÏÏÏÏÏÏ 4,276,000 2,508,229 1,050,000 Less than 1 Year 1,880,000 440,779 1,050,000 1-3 Years 3-5 Years 2,396,000 850,463 Ì Ì 566,512 Ì More than 5 Years Ì 650,475 Ì 7,834,229 3,370,779 3,246,463 566,512 650,475 29 Item 7A. Quantitative and Qualitative Disclosure About Market Risk Interest Rate Risk The table below provides information about Escalon's Ñnancial instruments, consisting primarily of debt obligations that are sensitive to changes in interest rates. For debt obligations, the table represents principal cash Öows and related interest rates by expected maturity dates. Interest rates are based on the prime rate at June 30, 2004 plus 1.75% on the term loan, the prime rate plus 1.50% on the line of credit and the prime rate plus 1.00% on the Endologix note. Long-Term Debt ClassiÑed as Current as of June 30, 2004 2005 2006 Thereafter Total Term loanÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Interest rate ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Line of credit ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Interest rate ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Endologix note ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Interest rate ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Deferred Ñnance fees ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $1,500,000 5.75% 250,000 5.50% 130,000 5.00% (9,000) $2,396,000 5.75% Ì Ì Ì Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $1,871,000 $2,396,000 $Ì $Ì $3,896,000 Ì Ì Ì $Ì Ì Ì Ì $Ì 250,000 130,000 (9,000) $4,267,000 Exchange Rate Risk During the Ñscal years ended June 30, 2004 and 2003, approximately 21.58% and 18.12%, respectively, of Escalon's consolidated net revenue was derived from international sales. Prior to the acquisition of Drew, the price of all product sold overseas was denominated in United States Dollars and consequently the Company incurred no exchange rate risk on revenue. The Company's Sonomed business unit began incurring marketing expenses in the European market during the second quarter of Ñscal 2003, the majority of which are transacted in Euros. These expenses were $129,000 and $92,000 for the Ñscal years ended June 30, 2004 and 2003, respectively. The Company's Vascular business began incurring marketing expenses in the European market during the second quarter of Ñscal 2004, the majority of which are transacted Euros. These expenses were $90,000 for the Ñscal year ended June 30, 2004. Additionally, the Company acquired the majority of Drew on July 23, 2004. Drew has a facility in the United Kingdom, and therefore transacts a portion of its operations in United Kingdom pounds. Consequently, the Company may begin to experience Öuctuations, beneÑcial or adverse, in the valuation of the currencies in which the Company transacts its business, namely the United States Dollar, the United Kingdom Pound and the Euro. Item 8. Financial Statements and Supplementary Data The Ñnancial statements of the Company are Ñled under this Item 8, beginning on page F-2 of this report. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures (a) Evaluation of Disclosure Controls and Procedures The Company's management, with the participation of the Company's Chief Executive oÇcer and the Senior Vice President of Finance, has evaluated the eÅectiveness of the Company's disclosure controls and procedures (as such term is deÑned in Rule 13a-15(e) and 15(d)-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive OÇcer and Senior Vice President of Finance have concluded that, as of the end of such period, the Company's disclosure controls and procedures are eÅective in recording, processing, summarizing and reporting, on a 30 timely basis, information required to be disclosed by the Company in reports that it Ñles or submits under the Exchange Act. (b) Internal Control Over Financial Reporting There have not been any changes in the Company's internal control over Ñnancial reporting (as such term is deÑned in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth Ñscal quarter ended June 30, 2004 that have materially aÅected, or are reasonably likely to materially aÅect, the Company's internal control over Ñnancial reporting. A control system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. Item 9B. Other Information None. Item 10. Directors and Executive OÇcers of the Registrant PART III The information required by this Item 10 is incorporated by reference to the Company's proxy statement for the Company's 2004 Annual Meeting of Shareholders to be Ñled with the Securities and Exchange Commission. Item 11. Executive Compensation The information required by this Item 11 is incorporated by reference to the Company's proxy statement for the Company's 2003 Annual Meeting of Shareholders to be Ñled with the Securities and Exchange Commission. Item 12. Security Ownership of Certain BeneÑcial Owners and Management and Related Shareholder Matters The information required by this Item 12 is incorporated by reference to the Company's proxy statement for the Company's 2004 Annual Meeting of Shareholders to be Ñled with the Securities and Exchange Commission. Item 13. Certain Relationships and Related Transactions None. Item 14. Principal Accountant Fees and Services The information required by this Item 14 is incorporated by reference to the Company's proxy statement for the Company's 2004 Annual Meeting of Shareholders to be Ñled with the Securities and Exchange Commission. 31 PART IV Item 15. Exhibits and Financial Statement Schedules Consolidated Financial Statements See index to Consolidated Financial Statements on page F-1. Consolidated Financial Statement Schedules All schedules have been omitted because they are not applicable, or not required, or the information is shown in the Ñnancial statements or notes thereto. 32 Exhibits The following is a list of exhibits Ñled as part of this Annual Report on Form 10-K where so indicated by footnote, exhibits, which were previously Ñled, are incorporated by reference. For exhibits incorporated by reference, the location of the exhibit in the previous Ñling is indicated parenthetically, followed by the footnote reference to the previous Ñling. 3.1 3.2 4.5 4.6 4.7 4.8 4.9 4.10 4.11 10.6 10.7 10.9 10.13 10.15 10.16 10.17 10.18 10.20 10.21 10.22 10.23 10.24 10.29 10.30 10.31 (a) Restated Articles of Incorporation of Registrant.(8) (b) Agreement and Plan of Merger dated as of September 28, 2001 between Escalon Pennsylvania, Inc. and Escalon Medical Corp.(8) Bylaws of Registrant.(8) (a) Warrant Agreement between Registrant and U.S. Stock Transfer Corporation.(1) (b) Amendment to Warrant Agreement between the Registrant and U.S. Stock Transfer Corporation.(2) (c) Amendment to Warrant Agreement between the Registrant and American Stock Transfer Corporation.(3) Securities Purchase Agreement, dated as of December 31, 1997 by and among the Registrant and Combination.(4) Registration Rights Agreement, dated as of December 31, 1997 by and among the Registrant and Combination.(4) Warrant to Purchase Common Stock issued December 31, 1997 to David Stefansky.(4) Warrant to Purchase Common Stock issued December 31, 1997 to Combination.(4) Warrant to Purchase Common Stock issued December 31, 1997 to Richard Rosenblum.(4) Warrant to Purchase Common Stock issued December 31, 1997 to Trautman, Kramer & Company.(4) Employment Agreement between the Registrant and Richard J. DePiano dated May 12, 1998.(6)** Non-Exclusive Distributorship Agreement between Registrant and Scott Medical Products dated October 12, 2000.(9) Assets Sale and Purchase Agreement between the Registrant and Endologix, Inc. dated January 21, 1999.(5) Supply Agreement between the Registrant and Bausch & Lomb Surgical, Inc. dated August 13, 1999.(5) Registrant's Amendment and Supplement Agreement and Release between the Registrant and Endologix, Inc. dated February 28, 2001.(10) 2003 Amendment to Loan Agreement.(12) Allonge to the Amended and Restated Term/Time Note.(12) Allonge to the Amended and Restated Line of Credit Note.(12) PNC Bank, N.A. Letter Agreement dated November 16, 2001.(11) PNC Bank, N.A. Amended and Restated Committed Line of Credit Note dated November 16, 2001.(11) PNC Bank, N.A. Amended and Restated Time Note dated November 16, 2001.(11) PNC Bank, N.A. Pledge Agreement dated November 16, 2001.(11) PNC Bank, N.A. Amended and Restated Security Agreement dated November 16, 2001.(11) Registrant's Amended and Restated 1999 Equity Incentive Plan.(13) Securities Purchase Agreement dated as of March 16, 2004 (the ""Securities Purchase Agreement'') between the Company and the Purchasers signatory thereto.(14) Registration Rights Agreement dated as of March 16, 2004 between the Company and the Purchasers signatory thereto.(14) 33 10.32 10.33 21 23.1 31.1 31.2 32.1 32.2 Form of Warrant to Purchase Common Stock issued to each Purchaser under the Securities Purchase Agreement.(14) Manufacturing Supply and Distribution Agreement between Sonomed, Inc. and Ophthalmic Technologies, Inc. dated as of March 11, 2004.(15) Subsidiaries.(11) Consent of Parente Randolph, LLC, independent Registered Public Accounting Firm.(*) CertiÑcation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Ì Richard J. DePiano(*) CertiÑcation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Ì Harry M. Rimmer(*) CertiÑcation pursuant to Section 1350 of Title 18 of the United States Code Ì Richard J. DePiano.(*) CertiÑcation pursuant to Section 1350 of Title 18 of the United States Code Ì Harry M. Rimmer.(*) * Filed Herewith. ** Management contract of compensatory plan (1) Filed as an exhibit to Pre-EÅective Amendment No. 2 to the Company's Registration Statement on Form S-1 dated November 9, 1993 (Registration No. 33-69360). (2) Filed as an exhibit to the Company's Form 10-K for the year ended June 30, 1994. (3) Filed as an exhibit to the Company's Form 10-K for the year ended June 30, 1995. (4) Filed as an exhibit to the Company's Registration Statement on Form S-3 dated January 20, 1998 (Registration No. 333-44513). (5) Filed as an exhibit to the Company's Form 10-K for the year ended June 30, 1999. (6) Filed as an exhibit to the Company's 8-K/A, dated March 31, 2000. (7) Filed as an exhibit to the Company's Registration Statement on Form S-8 dated February 25, 2000 (Registration No. 333-31138). (8) Filed as an exhibit to the Company's Proxy Statement on Schedule 14A, as Ñled by the Company with the SEC on September 21, 2001. (9) Filed as an exhibit to the Company's Form 10-K for the year ended June 30, 2001. (10) Filed as an exhibit to the Company's Form 10-Q for the quarter ended March 31, 2001. (11) Filed as an exhibit to the Company's Form 10-K/A for the year ended June 30, 2002. (12) Filed as an exhibit to the Company's Form 10-Q for the quarter ended December 31, 2002. (13) Filed as an exhibit to the Company's Form 10-Q for the quarter ended December 31, 2003. (14) Filed as an exhibit to the Company's Registration Statement on Form S-3 dated April 8, 2004 (Registration No. 333-114332). (15) Filed as an exhibit to the Company's Form 10-Q for the quarter ended March 31, 2004. 34 Pursuant to the requirements of Section 13 or 15(d) 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. SIGNATURES ESCALON MEDICAL CORP. (Registrant) By: /s/ RICHARD J. DEPIANO Richard J. DePiano Chairman and Chief Executive OÇcer Dated: September 28, 2004 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. By: /s/ RICHARD J. DEPIANO Richard J. DePiano Chairman and Chief Executive OÇcer (Principal Executive OÇcer) and Director September 28, 2004 By: /s/ HARRY M. RIMMER Harry M. Rimmer Senior Vice President Ì Finance (Principal Financial OÇcer) September 28, 2004 By: /s/ ANTHONY COPPOLA Director September 28, 2004 Anthony Coppola By: /s/ JAY L. FEDERMAN, M.D. Jay L. Federman, M.D. Director September 28, 2004 By: /s/ WILLIAM L.G. KWAN Director September 28, 2004 William L.G. Kwan By: /s/ LISA NAPOLITANO Director September 28, 2004 Lisa Napolitano By: /s/ JEFFREY F. O'DONNELL JeÅrey F. O'Donnell Director September 28, 2004 35 ESCALON MEDICAL CORP. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ F-2 Consolidated Balance Sheet at June 30, 2004 and 2003 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ F-3 Consolidated Statement of Income for the years ended June 30, 2004, 2003 and 2002ÏÏÏÏÏÏÏÏÏÏÏÏÏ F-4 F-5 Consolidated Statement of Shareholders' Equity for the years ended June 30, 2004, 2003 and 2002 Consolidated Statement of Cash Flows for the years ended June 30, 2004, 2003 and 2002 ÏÏÏÏÏÏÏÏÏ F-6 Notes to Consolidated Financial Statements ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ F-7 Page F-1 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Escalon Medical Corp. Wayne, Pennsylvania: We have audited the accompanying consolidated balance sheet of Escalon Medical Corp. and subsidiar- ies (the ""Company'') as of June 30, 2004 and 2003, and the related consolidated statements of income, shareholders' equity and cash Öows for each of the three years in the period ended June 30, 2004. These Ñnancial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these Ñnancial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the Ñnancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the Ñnancial statements. An audit also includes assessing the accounting principles used and signiÑcant estimates made by management, as well as evaluating the overall Ñnancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated Ñnancial statements referred to above present fairly, in all material respects, the Ñnancial position of Escalon Medical Corp. and subsidiaries as of June 30, 2004 and 2003, and the results of their operations and cash Öows for each of the three years in the period ended June 30, 2004 in conformity with accounting principles generally accepted in the United States of America. PARENTE RANDOLPH, LLC Philadelphia, Pennsylvania September 10, 2004, except for Note 13, as to which the date is September 22, 2004 F-2 ESCALON MEDICAL CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET June 30, 2004 June 30, 2003 Current assets: ASSETS Cash and cash equivalents ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accounts receivable, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Inventory, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Note receivable ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other current assetsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 12,601,971 2,492,689 1,781,592 150,000 539,508 $ Total current assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 17,565,760 Long-term note receivable ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Furniture and equipment, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Goodwill ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Trademarks and trade names, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ License and distribution rights, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Patents, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Ì 409,187 10,591,795 616,906 Ì 172,078 101,389 298,390 2,364,370 1,785,480 Ì 310,420 4,758,660 150,000 516,686 10,591,795 616,906 13,138 182,811 60,235 Total assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 29,457,115 $ 16,890,231 Current liabilities: LIABILITIES AND SHAREHOLDERS' EQUITY Line of credit ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Current portion of long-term debt ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accounts payable ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accrued compensation ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other current liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ Total current liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Long-term debt, net of current portion ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 250,000 1,621,687 499,242 908,568 320,930 3,600,427 2,396,019 Total liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 5,996,446 $ 975,000 1,510,344 454,711 708,231 222,036 3,870,322 4,080,461 7,950,783 Shareholders' equity: Preferred stock, $0.001 par value; 2,000,000 shares authorized; no shares issuedÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Common stock, $0.001 par value; 35,000,000 shares authorized; 5,017,122 and 3,365,359 shares issued and outstanding at June 30, 2004 and 2003 respectively ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Common stock warrants ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Additional paid-in capital ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accumulated deÑcitÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Ì Ì 5,018 1,601,346 56,438,903 (34,584,598) 3,365 Ì 46,262,411 (37,326,328) Total shareholders' equity ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 23,460,669 8,939,448 Total liabilities and shareholders' equity ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 29,457,115 $ 16,890,231 See notes to consolidated Ñnancial statements F-3 ESCALON MEDICAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME For the Years Ended June 30, 2003 2002 2004 Product revenue ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other revenueÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $12,347,922 2,372,845 $11,191,493 2,174,537 $10,293,051 1,780,881 Revenues, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 14,720,767 13,366,030 12,073,932 Costs and expenses: Cost of goods sold ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Research and development ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Marketing, general and administrativeÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Write-down of Povidone Iodine license and distribution rights ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 5,475,703 776,496 5,206,067 4,895,574 780,333 5,033,852 4,640,325 554,760 5,096,994 Ì 195,950 Ì Total costs and expenses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 11,458,266 10,905,709 10,292,079 Income from operations ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 3,262,501 2,460,321 1,781,853 Other income and expenses: Loss from termination of joint venture ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Equity in income of unconsolidated joint venture ÏÏÏÏÏÏÏÏÏ Interest incomeÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Interest expense ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Ì Ì 59,072 (406,543) Ì Ì 2,813 (638,345) (23,434) 8,848 2,347 (790,757) Total other income and expenses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (347,471) (635,532) (802,996) Income before income taxes ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Income taxes ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2,915,030 173,300 1,824,789 112,412 Net income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 2,741,730 $ 1,712,377 Basic net income per share ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Diluted net income per share ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ $ 0.704 0.637 $ $ 0.509 0.479 978,857 Ì 978,857 0.293 0.291 $ $ $ Weighted average shares Ì basicÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 3,896,951 3,365,359 3,345,851 Weighted average shares Ì diluted ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 4,304,375 3,573,192 3,360,492 See notes to consolidated Ñnancial statements F-4 ESCALON MEDICAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS EQUITY For the Years Ended June 30, 2004, 2003 AND 2002 Common Stock Shares Amount Common Stock Warrants Additional Paid-In Capital Accumulated DeÑcit Total Shareholders' Equity Balance at June 30, 2001 ÏÏÏÏ Exercise of stock options ÏÏÏÏ Net income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 3,292,184 53,667 Ì $3,292 54 Ì $ Ì $46,121,519 107,191 Ì Ì Ì $(40,017,562) $ 6,107,249 107,245 978,857 Ì 978,857 Balance at June 30, 2002 ÏÏÏÏ Common stock issued in connection with acquisition of trade name ÏÏÏÏÏÏÏÏÏÏÏ Exercise of stock options ÏÏÏÏ Net income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Balance at June 30, 2003 ÏÏÏÏ Private placement oÅering ÏÏÏ Exercise of stock options ÏÏÏÏ Treasury stock retirement ÏÏÏ Net income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 3,345,851 3,346 Ì 46,228,710 (39,038,705) 7,193,351 10,000 9,508 Ì 3,365,359 800,000 856,412 (4,649) Ì 10 9 Ì 3,365 800 857 (4) Ì 15,090 Ì 18,611 Ì Ì Ì Ì 46,262,411 8,185,772 2,021,075 (30,355) Ì 1,601,346 Ì Ì Ì Ì Ì 1,712,377 (37,326,328) Ì Ì Ì 2,741,730 15,100 18,620 1,712,377 8,939,448 9,787,918 2,021,932 (30,359) 2,741,730 Balance at June 30, 2004 ÏÏÏÏ 5,017,122 $5,018 $1,601,346 $56,438,903 $(34,584,598) $23,460,669 See notes to consolidated Ñnancial statements F-5 ESCALON MEDICAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS Cash Flows from Operating Activities: Net income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Adjustments to reconcile net income to net cash provided by in operating activities: Depreciation and amortization ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Loss from termination of joint venture ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Equity in net income of unconsolidated joint venture ÏÏÏÏÏÏ Write-down of license and distribution rights ÏÏÏÏÏÏÏÏÏÏÏÏÏ Disposal of furniture and equipment ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Change in operating assets and liabilities: Accounts receivable, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Inventory, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other current and long-term assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accounts payable, accrued and other liabilities ÏÏÏÏÏÏÏÏÏ 2004 Years Ended June 30, 2003 2002 $ 2,741,730 $ 1,712,377 978,857 241,453 Ì Ì Ì Ì 310,315 Ì Ì 195,950 927 (128,319) 3,888 (39,228) 343,762 (270,493) (213,413) 242,007 193,246 215,165 23,434 (8,848) Ì Ì 350,546 116,479 194,545 159,012 Net cash provided by operating activities ÏÏÏÏÏÏÏÏÏÏÏÏ 3,163,286 2,170,916 2,029,190 Cash Flows from Investing Activities: Acquisition costs Ì Drew ScientiÑc ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Proceeds from unconsolidated joint venture ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Payment for license and distribution rightsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Purchase of Ñxed assetsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Net cash (used in)/provided by investing activities ÏÏÏ Cash Flows from Financing Activities: Line of credit borrowing ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Line of credit repaymentÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Principal payments on term loans ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Issuance of common stock Ì private placement ÏÏÏÏÏÏÏÏÏÏÏÏ Issuance of common stock Ì stock options ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Payment of Ñnancing fees ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (231,014) Ì Ì (68,274) (299,288) Ì Ì Ì (76,040) (76,040) Ì 204,247 (25,000) (96,054) 83,193 153,981 (878,981) (1,614,908) 9,787,918 1,991,573 Ì 775,000 (1,050,000) (1,760,932) Ì 18,620 Ì 1,350,000 (1,726,009) (1,630,117) Ì 107,245 (73,506) Net cash provided by (used in) Ñnancing activities ÏÏÏ 9,439,583 (2,017,312) (1,972,387) Net increase in cash and cash equivalents ÏÏÏÏÏÏÏÏÏÏÏ Cash and cash equivalents, beginning of yearÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 12,303,581 298,390 Cash and cash equivalents, end of yearÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $12,601,971 Supplemental Schedule of Cash Flow Information: Interest paid ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Income taxes paid ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Issuance of Common Stock for EMS trade name ÏÏÏÏÏÏÏÏÏÏÏ Restructure of line of credit to long-term debtÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Transfer of title to assets in settlement of due from joint venture Accounts receivable ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Inventory ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Fixed assetsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ $ $ $ $ $ $ 77,564 220,826 298,390 544,155 112,412 $ $ $ Ì $ 15,100 Ì $ 3,000,000 139,996 80,830 220,826 793,005 Ì Ì Ì $ $ $ $ $ 338,155 173,300 Ì $ Ì $ Ì $ Ì $ 126,947 Ì $ 188,725 Ì $ 62,253 See notes to consolidated Ñnancial statements F-6 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Organization and Description of Business Escalon Medical Corp. (""Escalon'') was incorporated in California in 1987 as Intelligent Surgical Lasers, Inc. The Company's present name was adopted in August 1996. Escalon reincorporated in Delaware in November 1999, and then reincorporated in Pennsylvania in November 2001. Within this document, the ""Company'' collectively shall mean Escalon and its wholly owned subsidiaries: Sonomed, Inc. (""Sonomed''), Sonomed EMS, Srl. (""Sonomed EMS''), Escalon Vascular Access, Inc. (""Vascular''), Escalon Digital Vision, Inc. (""EMI'') and Escalon Pharmaceutical, Inc. (""Pharmaceutical''). The Company operates in the healthcare market, specializing in the development, manufacture, marketing and distribution of ophthalmic medical devices, pharmaceuticals and vascular access devices. The Company and its products are subject to regulation and inspection by the United States Food and Drug Administration (""FDA''). The FDA requires extensive testing of new products prior to sale and has jurisdiction over the safety, eÇcacy and manufacturing of products, as well as product labeling and marketing. In February 1996, the Company acquired substantially all of the assets and certain liabilities of Escalon Ophthalmics, Inc. (""EOI''), a developer and distributor of ophthalmic surgical products. Prior to this acquisition, the Company devoted substantially all of its resources to the research and development of ultrafast laser systems designed for the treatment of ophthalmic disorders. As a result of the EOI acquisition, Escalon changed its market focus and is no longer developing laser technology. In October 1997, the Company licensed its intellectual laser property to Intralase Corp. (""IntraLase''), in return for an equity interest and future royalties on sales of products relating to the laser technology. IntraLase undertook the responsibility for funding and developing the laser technology through to commercialization. IntraLase began selling products related to the laser technology during Ñscal 2002, and in June 2004 announced the Ñling of its Registration Statement for the initial public oÅering of its common stock. To further diversify its product portfolio, in January 1999, the Company's Vascular subsidiary acquired the vascular access product line from Endologix, Inc. (""Endologix''), formerly Radiance Medical Systems, Inc. Vascular's products use Doppler technology to aid medical personnel in locating arteries and veins in diÇcult circumstances. Currently, this product line is concentrated in the cardiac catheterization market. In January 2000, the Company purchased Sonomed, a privately held manufacturer of ophthalmic ultrasound diagnostic equipment. In April 2000, EMI formed a joint venture, Escalon Medical Imaging, LLC with Megavision, Inc. (""Megavision''), a privately held company, to develop and market a camera back for ophthalmic photography. The Company terminated its joint venture with Megavision and commenced operations within its EMI business unit on January 1, 2002. (2) SigniÑcant Accounting Policies Principles of Consolidation The consolidated Ñnancial statements included the accounts of the Company and its wholly owned subsidiaries, Sonomed, Vascular, Pharmaceutical, EMI and Sonomed EMS. All intercompany accounts and transactions have been eliminated. Use of Estimates The preparation of Ñnancial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that aÅect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the Ñnancial statements and reported amounts of revenue and expenses during the reported period. Actual results could diÅer from those estimates. F-7 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) Cash and Cash Equivalents For the purposes of reporting cash Öows, the Company considers all cash accounts, which are not subject to withdrawal restrictions or penalties, and highly liquid investments with original maturities of 90 days or less to be cash and cash equivalents. Fair Value of Financial Instruments The carrying amounts for cash and cash equivalents, accounts receivable, line of credit, accounts payable and accrued liabilities approximate their fair value because of their short-term maturity. The carrying amounts of long-term debt approximate fair value since the Company's interest rates approximate current interest rates. The carrying amount and estimated fair values of the Company's Ñnancial instruments at June 30, 2004 and 2003 are as follows: Cash and cash equivalents ÏÏÏÏÏÏÏÏÏÏÏ Accounts receivable ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Line of credit ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accounts payable ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accrued liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Long-term debt ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Revenue Recognition June 30, 2004 June 30, 2003 Carrying Amount $12,601,971 $ 2,492,689 250,000 $ $ 499,242 $ 1,229,498 $ 4,017,706 Fair Value $12,601,971 $ 2,492,689 250,000 $ $ 499,242 $ 1,229,498 $ 4,017,706 Carrying Amount $ 298,390 $2,364,370 $ 975,000 $ 454,711 $ 930,267 $ 590,805 Fair Value $ 298,390 $2,364,370 $ 975,000 $ 454,711 $ 930,267 $5,590,805 The Company recognizes revenue from the sale of its products at the time of shipment, when title and risk of loss transfer. The Company provides products to its distributors at agreed wholesale prices and to the balance of its customers at set retail prices. Distributors can receive discounts for accepting high volume shipments. The discounts are reÖected immediately in the net invoice price, which is the basis for revenue recognition. No further material discounts or sales incentives are given. The Company's considerations for recognizing revenue upon shipment of product to a distributor are based on the following: ‚ Persuasive evidence that an arrangement (purchase order and sales invoice) exists between a willing buyer (distributor) and the Company that outlines the terms of the sale (company information, quantity of goods, purchase price and payment terms). The buyer (distributor) does not have an immediate right of return. ‚ Shipping terms are ex-factory shipping point. At this point the buyer (distributor) takes title to the goods and is responsible for all risks and rewards of ownership, including insuring the goods as necessary. ‚ The Company's price to the buyer (distributor) is Ñxed and determinable as speciÑcally outlined on the sales invoice. The sales arrangement does not have customer cancellation or termination clauses. ‚ The buyer (distributor) places a purchase order with the Company; the terms of the sale are cash, COD or credit. Customer credit is determined based on the Company's policy and procedures related to the buyer's (distributor's) creditworthiness. Based on this determination, the Company believes that collectibility is reasonably assured. F-8 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) With respect to additional consideration related to the sale of Silicone Oil by Bausch & Lomb and the licensing of the Company's intellectual laser technology, revenue is recognized upon notiÑcation from the other parties of amount earned or upon receipt of royalty payments. Provision has been made for estimated sales returns based on historical experience. Shipping and Handling Revenues and Costs Shipping and handling revenues are included in product revenue and the related costs are included in cost of goods sold. Inventories Raw materials/work in process and Ñnished goods are recorded at lower of cost (Ñrst-in, Ñrst-out) or market. The composition of inventories is as follows: Raw materials/Work in process ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Finished goods ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $1,419,606 367,111 $1,374,184 475,316 Valuation allowance ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (5,125) (64,020) Total inventory ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $1,781,592 $1,785,480 1,786,717 1,849,500 June 30, 2004 2003 Accounts Receivable Accounts receivable are recorded at net realizable value. The Company performs ongoing credit evaluations of customers' Ñnancial condition and does not require collateral for accounts receivable arising in the normal course of business. The Company maintains allowances for potential credit losses based on the Company's historical losses and upon periodic review of individual balances. Accounts are written oÅ when they are determined to be uncollectible based on management's assessment of individual accounts. Credit losses, when realized, have been within the range of management's expectations. Allowance for doubtful accounts was $121,212 and $261,351 at June 30, 2004 and 2003, respectively. Furniture and Equipment Furniture and equipment is recorded at cost. Depreciation is recorded using the straight-line method over the economic useful life of the related assets, which are estimated to be over three to ten years. Depreciation for the years ended June 30, 2004, 2003 and 2002 was $175,773, $183,804 and $163,807, respectively. Furniture and equipment consist of the following at: Equipment ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Furniture and Ñxtures ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Leasehold improvements ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $1,169,504 62,168 113,081 $1,127,444 53,934 95,101 June 30, 2004 2003 Less: Accumulated depreciation and amortizationÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 1,344,753 (935,566) 1,276,479 (759,793) $ 409,187 $ 516,686 F-9 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) Long-lived Assets Management assesses the recoverability of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable from its future undiscounted cash Öows. If it is determined that an impairment has occurred, an impairment loss is recognized for the amount by which the carrying amount of the asset exceeds it estimated fair value. Intangible Assets The Company follows Statement of Financial Accounting Standards No. 142 (""SFAS 142''), ""Goodwill and Other Intangible Assets,'' which discontinues the amortization of goodwill and identiÑable intangible assets that have indeÑnite lives. In accordance with SFAS 142, these assets are tested for impairment on an annual basis. Stock-based Compensation The Company reports stock-based compensation through the disclosure-only requirements of Statement of Financial Accounting Standards No. 123 (""SFAS 123''), ""Accounting for Stock-Based Compensation,'' as amended by Statement of Financial Accounting Standards No. 148 (""SFAS 148''), ""Accounting for Stock- Based Compensation Ì Transition and Disclosure Ì an Amendment to FASB No. 123.'' Compensation expense for options is measured using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, ""Accounting for Stock Issued to Employees'' (""APB 25''). Under APB 25, because the exercise price of the Company's employee stock options is generally equal to the market price of the underlying stock on the date of grant, no compensation expense is recognized. SFAS 123 establishes an alternate method of expense recognition for stock-based compensation awards based on fair values. The following table illustrates the eÅect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123. Net Income, as reported ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax eÅects ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Year Ended June 30, 2003 2004 2002 $2,741,730 $1,712,377 $978,857 (406,357) (145,110) (188,883) Pro forma net incomeÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $2,335,373 $1,567,267 $789,974 Earnings per share: Basic Ì as reported ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Basic Ì pro forma ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Diluted Ì as reportedÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Diluted Ì pro formaÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ $ $ $ 0.704 0.599 0.637 0.543 $ $ $ $ 0.509 0.466 0.479 0.439 $ $ $ $ 0.293 0.236 0.291 0.235 The Company has followed the guidelines of SFAS 123 to establish the valuation of its stock options. The fair value of these equity awards was estimated at the date of grant using the Black-Scholes option pricing method. For the purposes of pro forma disclosures, the estimated fair value of the equity awards is amortized to expense over the options' vesting period. For the purposes of applying SFAS No. 123, the estimated per share value of the options granted during the Ñscal years ended June 30, 2004, 2003 and 2002 was $6.94, $0.84 and $1.09, respectively. The fair value was estimated using the following assumptions: dividend yield of 0.0%; volatility ranging between 0.60 and 2.51; risk-free interest ranging between 4.00% and 4.25%; and expected F-10 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) lives of 10 years. The volatility assumption is based on the volatility seen in the Company's stock over the last Ñve years. This assumption was made according to the guidance of SFAS 123. There is no reason to believe that future volatility will compare with the historical volatility. Because the Company's stock options have characteristics signiÑcantly diÅerent from those of traded options, and because changes in the subjective input assumptions can materially aÅect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the value of its options. Research and Development All research and development costs are charged to operations as incurred. Advertising Costs Advertising costs are charged to operations as incurred. Advertising expense for the three years ended June 30, 2004, 2003 and 2002 was $35,439, $25,466 and $37,959, respectively. Net Income Per Share The Company follows Financial Accounting Standard Board Statement No. 128, ""Earnings Per Share,'' in presenting basic and diluted earnings per share. The following table sets forth the computation of basic and diluted earnings per share: Year Ended June 30, 2003 2004 2002 Numerator: Numerator for basic and diluted earnings per share: Net income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $2,741,730 $1,712,377 $ 978,857 Denominator: Denominator for basic earnings per share Ì weighted average sharesÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ EÅect of dilutive securities: 3,896,951 3,365,359 3,345,851 Stock options and warrants ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 407,424 207,833 14,641 Denominator for diluted earnings per share Ì weighted average and assumed conversion ÏÏÏÏÏÏÏÏ 4,304,375 3,573,192 3,360,492 Basic earnings per share ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Diluted earnings per share ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ $ 0.704 0.637 $ $ 0.509 0.479 $ $ 0.293 0.291 As of June 30, 2004, 120,000 warrants to purchase shares of Escalon Common Stock were outstanding. These warrants were excluded from the calculation of diluted earnings per share as the exercise price of the warrants exceeded the average share price of the Company's common stock for the year ended June 30, 2004, thus making the warrants antidilutive. See Note 13 for common shares issued to Drew ScientiÑc Group, PLC Shareholders. Income Taxes The Company accounts for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on the diÅerence between the Ñnancial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in eÅect in the years when those temporary diÅerences are F-11 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) expected to reverse. The eÅect on deferred taxes of a change in tax rates, should a change occur, is recognized in income in the period that include the enactment date. (3) Intangible Assets Acquired License and Distribution Rights In connection with the acquisition of assets of EOI assets (see Company overview in Part I of this Form 10-K), a portion of the purchase price was allocated to certain license and distribution agreements. This cost allocation was based on an evaluation by management, with such costs being amortized over an eight-year period (which terminated in January 2004) using the straight-line method. Additionally, Escalon's decision to abandon Povidone Iodine caused the Company to write-oÅ $195,950 relating to license and distribution rights in March 2003. Accumulated amortization of license and distribution rights was $180,182 and $167,044 at June 30, 2004 and 2003, respectively. Amortization expense for the years ended June 30, 2004, 2003 and 2002 was $13,138, $37,900 and $40,625, respectively. Patents It is the Company's practice to seek patent protection on processes and products in various countries. Patent application costs are capitalized and amortized over their estimated useful lives, not exceeding 17 years, on a straight-line basis from the date the related patents are issued. Costs associated with patents no longer being pursued are expensed. Accumulated patent amortization was $122,139 and $111,406 at June 30, 2004 and 2003, respectively. Amortization expense for the years ended June 30, 2004, 2003 and 2002 was $10,733, $10,733 and $10,733, respectively. Goodwill, Trademarks and Trade Names Goodwill, trademarks and trade names represent intangible assets obtained from the EOI, Endologix and Sonomed acquisitions. Goodwill represents the excess of purchase price over the fair market value of net assets acquired. In accordance with SFAS 142, eÅective July 1, 2001, Escalon discontinued the amortization of goodwill and identiÑable intangible assets that have indeÑnite lives. Intangible assets that have Ñnite lives will continue to be amortized over their useful lives. Management evaluated the carrying value of goodwill and its identiÑable intangible assets that have indeÑnite lives during each of the Ñscal year subsequent to July 1, 2001. Management concluded that the carrying value of goodwill and identiÑable intangible assets did not exceed their fair values and therefore were not impaired. Management made this conclusion after evaluating the discounted cash Öow of each of its business units. In accordance with SFAS 142, these intangible assets will continue to be assessed on an annual basis. F-12 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) The following table presents intangible assets by business unit as of June 30, 2004 and 2003: Gross Carrying Amount Impairment Adjusted Gross Carrying Amount Accumulated Amortization Net Carrying Value Goodwill Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Vascular ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Sonomed EMS ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $10,547,488 1,149,813 272,786 Ì Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $11,970,087 Unamortized Intangible Assets Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Vascular ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Sonomed EMS ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Gross Carrying Amount $665,000 Ì Ì 15,100 Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $680,100 $Ì Ì Ì Ì $Ì $10,547,488 1,149,813 272,786 Ì $(1,021,938) (208,595) (147,759) Ì $ 9,525,550 941,218 125,027 Ì $11,970,087 $(1,378,292) $10,591,795 Adjusted Gross Carrying Amount Impairment Accumulated Amortization Net Carrying Value $Ì Ì Ì Ì $Ì $665,000 Ì Ì 15,100 $(63,194) Ì Ì Ì $601,806 Ì Ì 15,100 $680,100 $(63,194) $616,906 The following table presents intangible assets by business unit as of June 30, 2004: Gross Carrying Amount Impairment Adjusted Gross Carrying Amount Accumulated Amortization Net Carrying Value Amortized Intangible Assets Patents Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Vascular (pending issuance)ÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Sonomed EMS ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ Ì 36,916 257,301 Ì Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $294,217 License and Distribution Rights Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Vascular ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Sonomed EMS ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ Ì Ì 180,182 Ì Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $180,182 $Ì Ì Ì Ì $Ì $Ì Ì Ì Ì $Ì $ Ì $ 36,916 257,301 Ì Ì $ Ì (122,139) Ì Ì 36,916 135,162 Ì $294,217 $(122,139) $172,078 $ Ì $ Ì 180,182 Ì Ì $ Ì (180,182) Ì $180,182 $(180,182) $ Ì Ì Ì Ì Ì F-13 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) The following table presents intangible assets by business unit as of June 30, 2003: Gross Carrying Amount Impairment Adjusted Gross Carrying Amount Accumulated Amortization Net Carrying Value Amortized Intangible Assets Patents Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Vascular (pending issuance)ÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Sonomed EMS ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ Ì 36,916 257,301 Ì Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $294,217 License and Distribution Rights Sonomed ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Vascular ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Medical/Trek ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Sonomed EMS ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ Ì Ì 180,182 Ì Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $180,182 $Ì Ì Ì Ì $Ì $Ì Ì Ì Ì $Ì $ Ì $ 36,916 257,301 Ì Ì $ Ì (111,406) Ì Ì 36,916 145,895 Ì $294,217 $(111,406) $182,811 $ Ì $ Ì 180,182 Ì Ì $ Ì (167,044) Ì Ì Ì 13,138 Ì $180,182 $(167,044) $ 13,138 Amortization expense, relating entirely to patents, is estimated to be $10,733 per year for each of the next Ñve Ñscal years. (4) Note Receivable Escalon entered into an agreement with an individual who was involved in the development of the Company's OcuÑt SR» drug delivery system. The Company holds a note receivable from the individual in the amount of $150,000 that is due in May 2005. (5) Line of Credit and Long-Term Debt On December 23, 2002, a privately held fund (the ""lender'') acquired the Company's bank debt, which consisted of outstanding term debt of $5,850,000 and $1,475,000 outstanding on a $2,000,000 line of credit. On February 13, 2003, the Company entered into an Amended Loan Agreement with the lender. The primary amendments of the Amended Loan Agreement were to reduce quarterly principal payments, extend the term of the repayments and to alter the covenants of the original loan agreement. As of June 30, 2004, the amount outstanding under the term loan and line of credit were $3,896,019 and $250,000, respectively. At June 30, 2004, the variable interest rates applicable to the term loan and line of credit were 5.75% and 5.50%, respectively. The lender's prime rate at June 30, 2004 was 4.00%. The $3,896,019 term loan balance includes a $2,396,000 balloon payment that is due on September 1, 2005. The Company paid $100,000 in Ñnance fees on January 14, 2000, when this debt was originally incurred. The Ñnance fees are being amortized over the life of the loans using the eÅective interest method. On January 21, 1999, the Company's Vascular subsidiary and Endologix entered into an Assets Sale and Purchase Agreement. Pursuant to this agreement, the Company acquired for cash the assets of Endologix's vascular access business in exchange for cash and also agreed to pay royalties to Endologix based on future sales of the vascular access business for a period of Ñve years following the closing of the sale, with a guaranteed minimum royalty of $300,000 per year. On February 1, 2001, the parties amended the agreement to eliminate any future royalty payments to Endologix. Pursuant to the amendment, the Company paid F-14 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) $17,558 in cash to Endologix, delivered a short-term note in the amount of $64,884 that was satisÑed in January 2002, a note in the amount of $717,558, payable in 11 quarterly installments that commenced on April 15, 2002 and the Company issued 50,000 shares of its Common Stock to Endologix. As of June 30, 2004, the amount outstanding under the Endologix term loan was $130,461 and the interest rate applicable to the loan was 5.00%. The following table illustrates future principal amortization through June 2006 under each of the Company's loan agreements as of June 30, 2004: Year Ending June 30, Private Group Term Loan Endologix Term Loan Deferred Finance Fees Total 2005 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2006 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $1,500,000 2,396,000 $130,000 Ì $(9,000) Ì $1,621,000 2,396,000 $3,896,000 $130,000 $(9,000) $4,017,000 (6) Capital Stock Transactions Stock Option Plans As of June 30, 2004, Escalon had in eÅect seven employee stock option plans which provide for incentive and non-qualiÑed stock options. After accounting for shares issued upon exercise of options, a total of 866,035 shares of the Company's Common Stock remain available for issuance as of June 30, 2004. Under the terms of the plans, options may not be granted for less than the fair market value of the Common Stock at the date of grant. Vesting generally occurs ratably over Ñve years and is exercisable over a period no longer than 10 years after the grant date. As of June 30, 2004, options to purchase 618,706 shares of the Company's Common Stock were outstanding, 419,152 were exercisable and 247,329 were reserved for future grants. The following is a summary of Escalon's stock option activity and related information for the Ñscal years ended June 30, 2004, 2003 and 2002: 2004 2003 2002 Common Stock Options Weighted Average Exercise Price Common Stock Options Weighted Average Price Exercise Common Stock Options Weighted Average Price Exercise Outstanding at beginning of year Granted ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Exercised ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ ForfeitedÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 1,313,367 166,200 (856,412) (4,449) Outstanding at end of year ÏÏÏÏÏ Exercisable at end of year ÏÏÏÏÏÏ 618,706 419,152 $2.301 $6.940 $2.361 $1.684 $3.395 1,153,458 172,750 (9,508) (3,333) 1,313,367 1,125,796 $2.385 $1.450 $1.958 $1.601 $2.301 1,090,000 171,750 (53,667) (54,625) 1,153,458 976,765 $2.301 $2.674 $1.998 $2.008 $2.385 Weighted average fair value of options granted during year ÏÏÏ $6.940 $0.840 $1.090 F-15 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) The following table summarizes information about stock options outstanding at June 30, 2004: Range of Exercise Prices 1.45 to 2.18 2.19 to 3.29 3.30 to 4.95 4.96 to 6.94 Number Outstanding at June 30, 2004 154,731 297,925 25,000 141,050 Weighted Average Remaining Contractual Life (Years) 6.49 5.92 5.75 9.42 Sale of Common Stock and Warrants Weighted Average Exercise Price $1.80 $2.47 $4.31 $6.94 Number Exercisable at June 30, 2004 92,825 262,119 21,250 42,958 Weighted Average Exercise Price $1.97 $2.44 $4.31 $6.94 On March 17, 2004, the Company completed a $10,400,000 private placement of Common Stock and Common Stock purchase warrants to accredited and institutional investors. The Company sold 800,000 shares of its Common Stock at $13.00 per share. The investors also received warrants to purchase an additional 120,000 shares of Common Stock at an exercise price of $15.60 per share. The warrants cannot be exercised for 181 days from the private placement date and expire on September 13, 2009, if not exercised. The securities were sold pursuant to the exemptions from registration of Rule 506 of Regulation D and Section 4(2) under the Securities Act of 1933. The Company has subsequently Ñled a registration statement with the Securities and Exchange Commission, declared eÅective on April 20, 2004, to register all of the Common Stock issued in conjunction with this private placement and Common Stock purchasable upon exercise of the warrants. The net proceeds to the Company from the oÅering, after costs associated with the oÅering, of $9,787,908, have been allocated among Common Stock and warrants based on their relative fair values. The Company used the Black-Sholes pricing model to determine the fair value of the warrants to be $1,601,346. (7) Income Taxes The provision for income taxes for the years ended June 30, 2004, 2003 and 2002 consist of the following: 2004 2003 2002 Current income tax provision Federal ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ State ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 30,748 142,552 173,300 $ Ì $ 112,412 112,412 Ì Ì Ì Deferred income tax provision (beneÑt) Federal ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ State ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Change in valuation allowance ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 342,915 (363,580) 20,665 3,070,701 722,518 (3,793,219) (324,875) 76,441 248,434 Income tax expense ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 173,300 $ 112,412 $ Ì Ì Ì Ì F-16 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) Income taxes as a percentage of income for the years ended June 30, 2004, 2003 and 2002 diÅers from the statutory federal income tax rate due to the following: 2004 2003 2002 Statutory federal income tax rate ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ State income taxes, net of federal income tax impact ÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Change in valuation allowance ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 34.0% 4.9% 34.0% 34.0% (6.2)% 6.2% (34.0)% (34.0)% (27.8)% 0.0% 0.0% 1.1% EÅective income tax rate ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 6.0% 6.2% 0.0% As of June 30, 2004, the Company had deferred income tax assets of $13,197,238. The deferred income tax assets have been reduced by a $13,197,238 valuation allowance. The valuation allowance is based on uncertainty with respect to the ultimate realization of net operating loss carryforwards. The components of the net deferred tax income tax assets and liabilities as of June 30, 2004 and 2003 are as follows: Deferred income tax assets: 2004 2003 Net operating loss carryforward ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Stock options ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ General business credit ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Allowance for doubtful accounts ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accrued vacation ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Inventory reserve ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Warranty reserve ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 11,513,579 1,999,931 450,199 50,909 78,626 2,153 8,163 $ 12,988,019 Ì 562,000 109,767 66,482 26,888 14,913 Total deferred income tax assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Valuation allowance ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 14,103,560 (13,197,238) 13,768,069 (13,217,903) 906,322 550,166 Deferred income tax liabilities: Accelerated depreciation ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accelerated amortizationÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (43,538) (862,784) (43,596) (506,570) Total deferred income tax liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (906,322) (550,166) $ Ì $ Ì As of June 30, 2004, the Company had a valuation allowance of $13,197,238, which primarily relates to the federal net operating loss carryforwards. The valuation allowance is a result of management evaluating its estimates of the net operating losses available to the Company as they relate to the results of operations of acquired businesses subsequent to their being acquired by Escalon. The Company evaluates a variety of factors in determining the amount of the valuation allowance, including the Company's earnings history, the number of years the Company's operating loss and tax credits can be carried forward, the existence of taxable temporary diÅerences, and near term earnings expectations. Future reversal of the valuation allowance will be recognized either when the beneÑt is realized or when it has been determined that it is more likely than not that the beneÑt will be realized through future earnings. Any tax beneÑts related to stock options that may be recognized in the future through reduction of the associated valuation allowance will be recorded as additional paid-in capital. The Company has available federal and state net operating loss carryforwards of approximately F-17 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) $33,423,000 and $1,550,000, respectively, of which $22,263,000 and $1,399,000, respectively, will expire over the next Ñve years and $11,160,000 and $151,000 respectively, will expire in years six through 20. The Company continues to monitor the realization of its deferred tax assets based on changes in circumstances, for example, recurring periods of income for tax purposes following historical periods of cumulative losses or changes in tax laws or regulations. Escalon's income tax provision and management's assessment of the realizability of the Company's deferred tax assets involve signiÑcant judgments and estimates. If taxable income expectations change, in the near term the Company may be required to reduce the valuation allowance which would result in a material beneÑt to the Company results of operations in the period in which the beneÑt is determined by the Company. (8) Commitments and Contingencies Commitments Escalon leases its manufacturing, research and corporate oÇce facilities and certain equipment under non-cancelable operating lease arrangements. The Company has also entered into an agreement whereby the Company is obligated to purchase a contracted minimum amount of product from the other party to the agreement. The future minimum payments to be paid under these arrangements as of June 30, 2004 are as follows: Year Ending June 30, Lease Obligations Purchase Commitment 2005 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2006 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2007 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2008 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2009 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Thereafter ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 440,779 418,217 432,246 302,571 263,941 650,475 $1,050,000 Ì Ì Ì Ì Ì Total $1,490,779 418,217 432,246 302,571 263,941 650,475 Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $2,508,229 $1,050,000 $3,558,229 Rent expense charged to operations during the years ended June 30, 2004, 2003 and 2002 was $386,276, $360,484 and $338,540, respectively. Contingencies On June 10, 2004, Escalon provided notice to Intralase of the Company's intention to terminate the license agreement with Intralase due to deÑciencies in the payment of certain royalties that the Company believes are due under the license agreement. On June 21, 2004, Intralase sought a preliminary injunction and a temporary restraining order with the United States District Court for the Central District of California, Southern District against Escalon to prevent the termination of the license agreement with Intralase. The parties subsequently agreed to stipulate to the temporary restraining order to prevent a termination of the license agreement and, on July 6, 2004, as mutually agreed by Intralase and Escalon, the same district court entered a stipulation and order to delay the requested hearing on the preliminary injunction until November 1, 2004. The Company does not believe that the resolution of these matters has had or is likely to have a material adverse eÅect on the Company's business, Ñnancial condition or future results of operations. Furthermore, Escalon, from time to time is involved in various legal proceedings and disputes that arise in the normal course of business. These matters have included intellectual property disputes, contract disputes, employment disputes and other matters. The Company does not believe that the resolution of any of these F-18 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) matters has had or is likely to have a material adverse eÅect on the Company's business, Ñnancial condition or results of operations. (9) Retirement Plans Escalon adopted a 401(k) retirement plan eÅective January 1, 1994. Escalon employees become eligible for the plan commencing on the date of employment. Company contributions are discretionary and no contributions have been made since the plan's inception. On January 14, 2000, Escalon acquired Sonomed. Sonomed adopted a 401(k) retirement plan eÅective on January 1, 1993. This plan has continued subsequent to the acquisition and is available only to Sonomed employees. Escalon's contribution for the Ñscal years ended June 30, 2004, 2003 and 2002 was $27,703, $37,287 and $40,906, respectively. (10) Sale of Silicone Oil Product Line, Licensing of Laser Technology and Other Revenue Sale of Silicone Oil In the Ñrst quarter of Ñscal 2000, Escalon received $2,117,000 from the sale to Bausch & Lomb of its license and distribution rights for the Silicone Oil product line. This sale resulted in a $1,864,000 gain after writing oÅ the remaining net book value of license and distribution rights associated with that product line. The Company will continue to receive additional consideration based on future sales of Silicone Oil through August 2005. The agreement with Bausch & Lomb, which commenced on August 13, 2000, is structured so that the Company receives consideration from Bausch & Lomb based on its adjusted gross proÑt from its sales of Silicone Oil on a quarterly basis. The consideration is subject to a factor, which steps down according to the following schedule: From 8/13/00 to 8/12/01 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ From 8/13/01 to 8/12/02 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ From 8/13/02 to 8/12/03 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ From 8/13/03 to 8/12/04 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ From 8/13/04 to 8/12/05 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 100% 82% 72% 64% 45% Licensing of Laser Technology In October 1997, Escalon licensed its intellectual laser properties to Intralase in exchange for an equity interest in Intralase. The material terms of the license are that in exchange for licensing the Company's laser patents, which expire in 2014, the Company will receive a 2.5% royalty on product sales that are based on the licensed laser patents, subject to deductions for royalties payable to third parties up to a maximum of 50% of royalties otherwise due and payable to the Company, and a 1.5% royalty on product sales that are not based on the licensed laser patents. The Company receives a minimum annual license fee of $15,000 per year during the remaining term of the license. The minimum annual license fee is oÅset against the royalty payments. The license was dated October 23, 1997, was amended and restated in October 2000 and expires on the latest of the following events: ‚ The last to expire of the laser patents; ‚ ten years from the eÅective date of the amended and restated agreement; or ‚ the Ñfth anniversary date of the Ñrst commercial sale. F-19 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) The material termination provisions of the license are as follows: ‚ The Company has the right to terminate if the licensee defaults in the payment of any royalty; ‚ The Company has the right to terminate if the licensee defaults in the making of any required report; ‚ The Company has the right to terminate if the licensee makes any false report; ‚ The Company has the right to terminate if the licensee commits any material breach of any covenant or promise under the license agreement; or ‚ The licensee has the right to terminate after 90 days notice (if the licensee were to terminate, the licensee would not be permitted to utilize the licensed technology necessary to manufacture its core products). Also contributed to the venture were the Company's laser inventory, equipment and related furniture having a net book value of $-0-. In December 1999, Intralase received its Ñrst 510(k) approval from the FDA. Intralase began selling its products in calendar 2002. Other Revenue Other revenue includes quarterly payments from Bausch & Lomb in connection with the sale of the Silicone Oil product line as well as royalty payments received from Intralase related to the licensing of the Company's intellectual laser technology. For the Ñscal years ended June 30, 2004, 2003 and 2002, Silicone Oil revenue totaled $1,941,000, $1,858,000 and $1,754,000, respectively, and laser technology revenues totaled $432,000, $316,000 and $27,000, respectively. At June 30, 2004 and 2003, accounts receivable related to other revenue was $459,000 and $511,000, respectively. F-20 2 0 0 2 l a t o T 3 0 0 2 4 0 0 2 2 0 0 2 I M E 3 0 0 2 4 0 0 2 2 0 0 2 3 0 0 2 4 0 0 2 2 0 0 2 3 0 0 2 4 0 0 2 2 0 0 2 3 0 0 2 4 0 0 2 k e r T / l a c i d e M r a l u c s a V d e m o n o S , 0 3 e n u J d e d n E s r a e Y Ì ) s d n a s u o h t n I ( s n o i t a r e p O f o s t n e m e t a t S l a t n e m g e S S E I R A I D I S B U S D N A . 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AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) The Company operates in the healthcare market, specializing in the development, manufacture, marketing and distribution of ophthalmic medical devices, pharmaceuticals and vascular access devices. The business segments reported above are the segments for which separate Ñnancial information is available and for which operating results are evaluated regularly by executive management in deciding how to allocate resources and assessing performance. The accounting policies of the business segments are the same as those described in the summary of signiÑcant accounting policies. For the purpose of this illustration, corporate expenses, which principally consist of executive management and administrative support functions, are allocated across the business segments primarily based on each segment's product revenue. These expenses are otherwise included in the Medical/Trek business unit. During the Ñscal year ended June 30, 2004, Sonomed derived its revenue from the sale of A-Scans, B-Scans and pachymeters. These products are used for diagnostic or biometric applications in ophthalmology. Vascular derived its revenue from the sale of PD AccessTM and SmartNeedleTM monitors, needles and catheter products. These products are used by medical personnel to assist in gaining access to arteries and veins in diÇcult cases. Medical/Trek derived its revenue from the sale of ISPANTM gas products, various disposable ophthalmic surgical products, revenue derived from Bausch & Lomb's sale of Silicone Oil and from royalty revenue related to Intralase's licensing of the Company's intellectual laser technology. EMI derived its revenue from the sale of the CFA digital imaging system and related products. During the Ñscal years ended June 30, 2004 and 2003, there was one entity, Bausch & Lomb, from whom Escalon derived greater than 10 percent of consolidated net revenue. Revenue from Bausch & Lomb was $2,622,000, or 17.81% of consolidated net revenue during the year ended June 30, 2004, and was $2,525,000, or 18.89% of consolidated net revenue during the year ended June 30, 2003. This revenue is recorded in the Medical/Trek business unit. Of the external revenue reported above, $2,941,000, $194,000, $42,000 and $-0- were derived internationally in Sonomed, Vascular, Medical/Trek and EMI, respectively during the Ñscal year ended June 30, 2004; and $2,175,000, $170,000, $45,000 and $32,000 were derived internationally in Sonomed, Vascular, Medical/Trek and EMI, respectively during the Ñscal year ended June 30, 2003. (12) Quarterly Data Year Ended June 30, 2004 Total revenueÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Gross proÑt ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Net income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Basic net income per share(a) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Diluted net income per share(a) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2003 Total revenueÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Gross proÑt ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Net income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Basic net income per share(a) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Diluted net income per share(a) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ First Quarter Second Quarter Third Quarter (Unaudited) Fourth Quarter Full Year $3,412 2,199 623 $0.185 $0.154 $3,008 1,929 258 $0.077 $0.076 $3,757 2,507 821 $0.243 $0.196 $3,268 1,989 348 $0.103 $0.103 $3,613 2,248 739 $0.192 $0.172 $3,386 2,208 455 $0.136 $0.133 $3,939 2,291 559 $0.111 $0.103 $3,704 2,344 651 $0.194 $0.182 $14,721 9,245 2,742 $ 0.704 $ 0.637 $13,366 8,470 1,712 $ 0.509 $ 0.479 (a) Each quarterly amount is based on separate calculations of weighted average shares outstanding. F-22 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued) (13) Subsequent Event Ì Acquisition of the Majority of Shares of Drew ScientiÑc Group PLC As of July 23, 2004, Escalon acquired 67.03% of the outstanding ordinary shares of Drew ScientiÑc Group PLC (""Drew''), a United Kingdom company with manufacturing operations in Connecticut and Texas, pursuant to the Company's exchange oÅer for all of the outstanding ordinary shares of Drew; and through September 22, 2004, has acquired approximately 94% of the Drew shares. Escalon expects to acquire the remaining outstanding Drew shares pursuant to procedures under United Kingdom laws and regulations. The Company oÅered 900,000 shares of Escalon Common Stock in exchange for all of the ordinary shares of Drew; as of September 22, 2004, the Company had issued 897,886 common shares to Drew Shareholders. The Company will determine its purchase price upon acquisition of all of the outstanding shares of Drew; the per share price will be based on an average market price for the period two days before and after July 23, 2004. Due to the fact that the Company has not yet acquired all of the outstanding shares of Drew, the purchase price allocation has not been Ñnalized. The results of operations of Drew will be included in the consolidated results of the combined Company from July 24, 2004 forward. Escalon, in March 2004, had raised approximately $9,788,000 in a private placement oÅering (Note 6), thereby providing the Company with Öexibility to invest in a broader range of expansion opportunities; Escalon management view the Drew acquisition a such an opportunity, since approximately 70% of Drew's sales are derived in the United States. Drew is a diagnostics company specializing in the design, manufacture and distribution of analytical systems for laboratory testing worldwide. Drew is focused on providing instrumentation and consumables for the diagnosis and monitoring of medical disorders in the areas of diabetes, cardiovascular diseases and hematology. In addition, Drew supplies other diagnostic systems, which perform other blood component tests. Escalon expects to operate and report Drew as a separate business segment. Escalon is aware of two lawsuits involving Drew. The Ñrst lawsuit involves the principal shareholders of an entity previously acquired by Drew for the collection of unpaid expenses. A counterclaim was Ñled for breach of intellectual property rights and for breach of the principal shareholders' covenants not to compete. This action was Ñled in the state courts of Connecticut. The second lawsuit was Ñled in the state court of Minnesota, but transferred to the Federal District Court of Minnesota. This action was brought by a distributor against an entity previously acquired by Drew claiming a breach of a marketing and distribution agreement. The district court granted in part and denied in part both defendants' Motion for Summary Judgment and Motion to Dismiss. Both parties have appealed the decision. The Company does not believe that the resolution of these matters has had or is likely to have a material adverse eÅect on the Company's business, Ñnancial condition or future results of operations. F-23 INVESTOR INFORMATION DIRECTORS AND OFFICERS DIRECTORS CORPORATE OFFICERS Richard J. DePiano Chairman and Chief Executive OÇcer Harry M. Rimmer Secretary and Senior Vice President Finance Richard J. DePiano Chairman and Chief Executive OÇcer Escalon Medical Corp. Jay L. Federman, M.D. Ophthalmics Subspecialty Consultants Narberth, Pennsylvania JeÅrey F. O'Donnell PhotoMedex Montgomeryville, Pennsylvania William L. G. Kwan Fort Worth, Texas Anthony J. Coppola Town of Historic Smithville, LLC Smithville, New Jersey Lisa A. Napolitano Global Tax Management Newtown Square, Pennsylvania TRANSFER AGENT AND REGISTRAR American Stock Transfer and Trust Company Brooklyn, New York (800) 937-5449 ANNUAL MEETING December 1, 2004, 9:00 am Duane Morris LLP 42nd Floor One Liberty Place Philadelphia, Pennsylvania FORM 10-K The Form 10-K, contained herein, for the Company's Ñscal year ended June 30, 2004, is not accompanied by the exhibits, which were Ñled with the Securities and Exchange Commission. The Company will furnish any exhibits to those shareholders who request the same upon payment to the Company of its reasonable expenses in furnishing such exhibits. Requests for any such exhibits should be made in writing to the Company's Secretary at its corporate oÇce. CORPORATE OFFICE Headquarters Escalon Medical Corp. 575 East Swedesford Road Suite 100 Wayne, Pennsylvania 19087 (610) 688-6830 Manufacturing Operations Escalon Medical Corp. 2440 South 179th Street New Berlin, WI 53146 (262) 821-9182 Sonomed, Inc. 1979 Marcus Avenue Suite C105 Lake Success, NY 11042 (516) 354-0900 Drew ScientiÑc Group PLC Sowerby Woods Industrial Estate Park Road Barrow in Furness Cumbria LA14 4QR United Kingdom 1229 432089 4230 Shilling Way Dallas, TX 75237 (214) 210-4900 353 Christian Street Oxford, CT 06478 (203) 267-7022 STOCK LISTING Nasdaq Small Cap Market System Trading Symbol: ESMC INDEPENDENT AUDITORS Parente Randolph, LLC Philadelphia, Pennsylvania GENERAL COUNSEL Duane Morris LLP Philadelphia, Pennsylvania The Company has adopted a code of ethics which can be viewed at www.escalonmed.com This report includes forward-looking statements about the Company's future growth, product development, regulatory Ñlings, potential joint venture arrangements, potential markets and competitive position. Any such statements are subject to risks and uncertainties that could cause the actual results to vary materially. Such risks are discussed in the Company's report on Form 10-K for its 2004 Ñscal year. SAFE HARBOR STATEMENT Escalon Medical Corp. 575 East Swedesford Road Suite 100 Wayne, PA 19087 Voice: 610.688.6830 Fax: 610.688.3641 www.escalonmed.com 

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