UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2006

Commission File Number 1-13165

CRYOLIFE, INC.

(Exact name of registrant as specified in its charter)

 

1655 Roberts Boulevard, NW

Kennesaw, Georgia 30144

(Address of principal executive offices)

(zip code)

(770) 419-3355

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES   x   NO   o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (check one):

Large Accelerated filer   o

Accelerated filer   x

Non-accelerated filer   o

 

Indicate by check mark whether the registrant is a shell company (as defined in the Rule 12b-2 of the Exchange Act).

YES   o   NO   x

The number of shares of common stock, par value $0.01 per share, outstanding on November 1, 2006 was 24,899,477.

Part I – FINANCIAL INFORMATION

Item 1. Financial Statements

CRYOLIFE, INC. AND SUBSIDIARIES

SUMMARY CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE DATA)

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2006			2005			2006			2005
		(Unaudited)						(Unaudited)
Revenues:
Products		$	9,687		$	9,129		$	30,308		$	29,102
Human tissue preservation services		10,319			7,329			29,839			22,219
Research grants		12			—			74			—
Total revenues		20,018			16,458			60,221			51,321
Costs and expenses:
Products		1,576			1,940			5,581			6,135
Human tissue preservation services (Including write-downs of $815 for the three months and $1,568 for the nine months ended September 30, 2006 and $626 for the three months and $1,298 for the nine months ended September 30, 2005)		6,954			6,015			20,751			17,984
General, administrative, and marketing		8,549			11,085			30,106			42,726
Research and development		826			894			2,572			2,744
Interest expense		169			77			504			220
Interest income		(94		)	(166		)	(304		)	(408		)
Change in valuation of derivative		44			(412		)	111			372
Other expense, net		4			37			348			212
Total costs and expenses		18,028			19,470			59,669			69,985
Earnings (loss) before income taxes		1,990			(3,012		)	552			(18,664		)
Income tax expense		12			106			137			190
Net income (loss)		$	1,978		$	(3,118	)	$	415		$	(18,854	)
Effect of preferred stock		(243		)	(243		)	(730		)	(533		)
Net income (loss) applicable to common shares		$	1,735		$	(3,361	)	$	(315	)	$	(19,387	)
Income (loss) per common share:
Basic		$	0.07		$	(0.14	)	$	(0.01	)	$	(0.81	)
Diluted		$	0.07		$	(0.14	)	$	(0.01	)	$	(0.81	)
Weighted average common shares outstanding:
Basic		24,847			24,161			24,804			23,839
Diluted		25,118			24,161			24,804			23,839

 

See accompanying notes to summary consolidated financial statements.

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CRYOLIFE, INC. AND SUBSIDIARIES

SUMMARY CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS)

		September 30,			December 31,
		2006			2005
		(Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents		$	4,606		$	6,631
Marketable securities, at market		2,986			4,968
Restricted securities		565			560
Trade receivables, net		11,754			10,153
Other receivables		4,087			1,934
Deferred preservation costs, net		19,509			13,959
Inventories		5,013			4,609
Prepaid expenses and other assets		3,055			2,387
Total current assets		51,575			45,201
Property and equipment, net		22,396			24,375
Patents, net		4,337			4,877
Other long-term assets		2,156			2,356
TOTAL ASSETS		$	80,464		$	76,809
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Accounts payable		$	3,404		$	2,239
Accrued expenses and other current liabilities		8,441			8,578
Accrued compensation		2,014			1,467
Accrued procurement fees		4,203			3,797
Notes payable		826			—
Derivative liability		225			114
Line of credit		4,504			4,530
Current maturities of capital lease obligations		232			554
Total current liabilities		23,849			21,279
Capital lease obligations, less current maturities		135			—
Other long-term liabilities		4,760			4,909
Deferred income taxes		248			—
Total liabilities		28,992			26,188
Shareholders’ Equity:
Preferred stock (325 issued shares in 2006 and 325 in 2005)		3			3
Common stock (25,792 issued shares in 2006 and 25,582 in 2005)		258			256
Additional paid-in capital		114,758			113,507
Retained deficit		(58,884		)	(58,569		)
Accumulated other comprehensive income		88			123
Treasury stock at cost (904 shares in 2006 and 892 in 2005)		(4,751		)	(4,699		)
Total shareholders’ equity		51,472			50,621
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY		$	80,464		$	76,809

 

See accompanying notes to summary consolidated financial statements.

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CRYOLIFE, INC. AND SUBSIDIARIES

SUMMARY CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

		Nine Months Ended
		September 30,
		2006			2005
		(Unaudited)
Net cash from operating activities:
Net income (loss)		$	415		$	(18,854	)
Adjustments to reconcile net income (loss) to net cash from operating activities:
Gain on sale of marketable equity securities		—			(5		)
Loss on sale or disposal of assets		385			146
Depreciation and amortization		3,646			3,816
Provision for doubtful accounts		72			72
Write-down of deferred preservation costs		1,568			1,298
Other non-cash adjustments		102			(138		)
Non-cash compensation		853			166
Change in valuation of derivative		111			372
Changes in operating assets and liabilities:
Receivables		(3,997		)	(754		)
Income taxes		(130		)	66
Deferred preservation costs and inventories		(7,522		)	(5,023		)
Prepaid expenses and other assets		(460		)	(940		)
Accounts payable, accrued expenses, and other liabilities		2,088			4,809
Net cash used in operating activities		(2,869		)	(14,969		)
Net cash from investing activities:
Capital expenditures		(1,409		)	(664		)
Net proceeds from sale of assets		13			—
Other assets		(59		)	(173		)
Purchases of marketable securities		(12,436		)	(21,690		)
Sales and maturities of marketable securities		14,562			18,847
Net cash provided by (used in) investing activities		671			(3,680		)
Net cash from financing activities:
Proceeds from debt issuance		585			3,765
Principal payments of debt		(428		)	(265		)
Payment of obligations under capital leases		(370		)	(582		)
Proceeds from financing of insurance policies		2,349			2,482
Principal payments on short-term notes payable		(1,523		)	(1,613		)
Proceeds from exercise of stock options and issuance of common stock		398			308
Payment of preferred stock dividends		(730		)	(533		)
Proceeds from equity offerings		—			19,098
Purchase of treasury stock		(50		)	—
Net cash provided by financing activities		231			22,660
(Decrease) increase in cash and cash equivalents		(1,967		)	4,011
Effect of exchange rate changes on cash		(58		)	(124		)
Cash and cash equivalents, beginning of period		6,631			4,713
Cash and cash equivalents, end of period		$	4,606		$	8,600

 

See accompanying notes to summary consolidated financial statements.

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CRYOLIFE, INC. AND SUBSIDIARIES

NOTES TO SUMMARY CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 1 – Basis of Presentation

The accompanying unaudited summary consolidated financial statements have been prepared in accordance with (i) accounting principles generally accepted in the United States for interim financial information and (ii) the instructions to Form 10-Q and Rule 10-01 of Regulation S-X of the United States Securities and Exchange Commission (“SEC”).  Accordingly, the statements do not include all of the information and disclosures required by accounting principles generally accepted in the United States for a complete presentation of financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Certain prior year cash flow line items have been reclassified to conform to current year presentation.  Operating results for the nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.  For further information, refer to the consolidated financial statements and notes thereto included in the CryoLife Form 10-K for the year ended December 31, 2005.

The Company expects that the following will continue to have an adverse impact on earnings and cash flows during 2006:

·                  The anticipated lower preservation services revenues as compared to preservation revenues prior to the August 13, 2002 U.S. Food and Drug Administration (“FDA”) Order, subsequent FDA activities, and related events (discussed in Note 2),

·                  The high cost of human tissue preservation services as a percent of revenue, as compared to the period prior to the FDA Order, as a result of lower tissue processing volumes and changes in processing methods, which have increased the cost of processing human tissue and decreased yields of implantable tissue per donor,

·                  An expected use of cash related to the defense and resolution of lawsuits and claims, and

·                  The legal and professional costs related to ongoing FDA compliance.

The Company believes the following should continue to have a favorable impact on cash flow from operations during the remainder of 2006, although there can be no assurance that these events will occur as and when currently anticipated:

·                  Expected increases in product revenues over levels experienced in 2005 due to increases in BioGlue® Surgical Adhesive (“BioGlue”) list prices implemented in January and July 2006,

·                  Expected increases in preservation service revenues over levels experienced in 2005 for cardiovascular, vascular, and orthopaedic tissues due to fee increases implemented in January and July 2006, to reflect the higher cost of processing these tissues,

·                  Anticipated improvements in yields of implantable tissues per donor over the levels experienced in 2005 through process changes and process directives,

·                  Expected increases in procurement of human tissues for processing over the levels experienced in 2005, and

·                  Anticipated decreases in cash payments related to the defense and resolution of lawsuits and claims from the levels seen in 2003 through 2005.

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The Company believes that the Company’s existing cash, cash equivalents, marketable securities, and availability under the Credit Agreement (as defined in Note 6) will enable the Company to meet its liquidity needs through at least September 30, 2007.

The Company’s long term liquidity and capital requirements will depend upon numerous factors, including:

·                  The success of the Company’s strategic plan to enhance shareholder value, resulting from the conclusion of its strategic review with the assistance of Piper Jaffray & Co.,

·                  The success of BioGlue and other products using related technology,

·                  The Company’s ability to increase the level of tissue procurement and demand for its tissue preservation services,

·                  The Company’s ability to reestablish sufficient margins on its tissue preservation services, in the face of increased processing costs, by improving yields and increasing prices,

·                  The Company’s spending levels on its research and development activities, including research studies, to develop and support its service and product pipeline,

·                  The timing and cost of resolving product liability lawsuits and other claims (see Note 13), and

·                  To a lesser degree, the Company’s success at resolving the issues with the FDA regarding processing of human tissue using the SynerGraft® technology (see Note 2).

If the Company is unable to address these issues and continues to experience negative operating cash flows, the Company anticipates that it may require additional financing or seek to raise additional funds through bank facilities, debt or equity offerings, or other sources of capital to meet liquidity and capital requirements beyond September 30, 2007.  Additional funds may not be available when needed or on terms acceptable to the Company, which could have a material adverse effect on the Company’s business, financial condition, results of operations, and cash flows.

Note 2 – FDA Order on Human Tissue Preservation and Other FDA Correspondence and Notices

FDA Order

On August 13, 2002 the Company received an order from the Atlanta district office of the FDA regarding the non-valved cardiac, vascular, and orthopaedic tissues processed by the Company since October 3, 2001 (the “FDA Order”).  Pursuant to the FDA Order, the Company placed non-valved cardiac, vascular, and orthopaedic tissue subject to the FDA Order (i.e. processed since October 3, 2001) on quality assurance quarantine and recalled the portion of those tissues that had been distributed but not implanted.  In addition the Company ceased processing non-valved cardiac, vascular, and orthopaedic tissues.

The FDA allowed non-valved cardiac and vascular tissues covered by the recall to be distributed beginning in late September 2002, subject to specified conditions.  The Company changed its processing procedures and took other actions intended to address the FDA’s concerns, and now processes non-valved cardiac, vascular, and orthopaedic tissues.

Other FDA Correspondence and Notices

July 2005 483

An FDA Form 483 Notice of Observations (“483”) was issued in August 2005 in connection with the FDA inspections of the Company’s facilities in July 2005 (“July 2005 483”).  The Company responded to the July 2005 483 in August 2005, in September 2005, and in October 2005.  In April 2006 the FDA responded on the adequacy of the Company’s responses.  The Company responded to the FDA in June 2006.  In response to the July 2005 483 the

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Company has implemented new and revised existing systems and procedures.  The FDA may require the Company to implement additional corrective actions, perform additional validation testing, or supply additional information related to the inspections, and has the authority to take other actions, which may be more burdensome.  The Company has cooperated and will continue to cooperate with the FDA to review process improvements and address any outstanding observations.

SynerGraft

On February 20, 2003 the Company received a letter from the FDA stating that a 510(k) premarket notification should be filed for the Company’s SynerGraft processed human cardiac tissues (“CryoValve® SG”) and that premarket approval marketing authorization should be obtained for the Company’s SynerGraft processed human vascular tissues (“CryoVein® SG”) when marketed or labeled as an arteriovenous (“A-V”) access graft.  The agency’s position is that use of the SynerGraft technology in the processing of allograft heart valves represents a modification to the Company’s legally marketed CryoValve allograft and that vascular allografts labeled for use as A-V access grafts are medical devices that require premarket approval.

On November 3, 2003 the Company filed a 510(k) premarket notification with the FDA for the CryoValve SG.  On February 4, 2004 the Company received a letter from the FDA requesting additional information.  On August 24, 2004 the Company submitted an amendment to its original 510(k) submission providing clarification and additional information.  The FDA requested further additional information in November 2004.  On June 8, 2005 CryoLife responded to some of these additional requests.  CryoLife also has initiated an appeal of other requests through administrative procedures.  The FDA requested further additional information in January 2006.  Since March 2006 the Company has had discussions with the FDA to address the outstanding requests for additional information and seek clearance for the CryoValve SG pulmonary valve.  On July 21, 2006 the Company submitted an amendment to its 510(k) application addressing information requested by the FDA.  The Company is currently undertaking further clinical and preclinical evaluations in response to requests by the FDA that will be included in an additional 510(k) amendment.  The FDA may still require that additional studies be undertaken.  Clearance of the 510(k) premarket notification with the FDA will be required before the Company can resume distribution of SynerGraft processed CryoValve SG.

On December 8, 2003 the Company received a letter from the FDA stating that it was the agency’s position that cardiovascular tissues processed with the SynerGraft technology should be regulated as medical devices.  On September 14, 2004 the Company met with the FDA to discuss the data to be used to support a formal Request for Designation (“RFD”) filing for SynerGraft processed non-valved cardiac and vascular tissue, including the CryoVein SG.  An RFD submission establishes the regulatory status of the tissue.  The Company submitted the RFD on October 5, 2004.  The FDA affirmed its original decision in letters received in December 2004.  That decision was subject to an administrative appeal.  On October 20, 2005 CryoLife was informed that the FDA had denied the appeal and that CryoLife will be unable to distribute CryoVein tissues with the SynerGraft technology until further submissions and FDA approvals are granted.  The Company is evaluating whether it will file and seek approvals for CryoVein SG or discontinue the CryoVein SG.

In 2003 the Company suspended the use of the SynerGraft technology in the processing of allograft tissue and the distribution of tissues on hand previously processed with the SynerGraft technology until the regulatory issues associated with these tissues are resolved.  Additionally, the Company discontinued labeling its vascular grafts for use as A-V access grafts.  Until such time as the issues surrounding SynerGraft are resolved, the Company is employing its traditional processing methods on these tissues.  As of September 30, 2006 the Company had no deferred preservation costs related to SynerGraft processed tissues on its Summary Consolidated Balance Sheets.

Note 3 – Cash Equivalents and Marketable Securities

The Company maintains cash equivalents and investments in several large, well-capitalized financial institutions, and the Company’s policy excludes investment in any securities rated less than “investment-grade” by national rating services.  Management determines the appropriate classification of its marketable securities at the time of purchase and reevaluates such designations quarterly.

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Debt securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity.  Held-to-maturity securities are stated at amortized cost.  Trading securities are securities that are acquired principally for the purpose of generating a profit from short-term fluctuations in price.  Trading securities are stated at their fair values, with the realized and unrealized gains and losses, interest, and dividends included in investment income.  Debt securities not classified as held-to-maturity or trading and marketable equity securities not classified as trading are classified as available-for-sale.  Available-for-sale securities are stated at their fair values, with the unrealized gains and losses, net of applicable taxes, reported in a separate component of shareholders’ equity.  Interest, dividends, realized gains and losses, and declines in value judged to be other than temporary are included in investment income.  The cost of securities sold is based on the specific identification method.

As of September 30, 2006 $3.0 million of marketable securities were designated as available-for-sale and $565,000 were designated as held-to-maturity.  As of December 31, 2005 $5.0 million of marketable securities were designated as available-for-sale and $560,000 were designated as held-to-maturity.  The held-to-maturity securities were designated as such due to a contractual commitment to hold the securities as pledged collateral relating to one of the Company’s product liability insurance policies, and, therefore, they are reported as restricted securities on the September 30, 2006 and December 31, 2005 Summary Consolidated Balance Sheets.

The following is a summary of cash equivalents and marketable securities (in thousands):

					Unrealized			Estimated
					Holding			Market
September 30, 2006		Cost Basis			Gains (Losses)			Value
Cash equivalents:
Money market funds		$	3,837		$	—		$	3,837
Marketable securities:
Government entity sponsored debt securities		$	2,985		$	1		$	2,986
Total marketable securities		$	2,985		$	1		$	2,986
Restricted securities:
Government entity sponsored debt securities		$	565		$	—		$	565

 

					Unrealized			Estimated
					Holding			Market
December 31, 2005		Cost Basis			Gains (Losses)			Value
Cash equivalents:
Money market funds		$	5,595		$	—		$	5,595
Marketable securities:
Government entity sponsored debt securities		$	2,980		$	(2	)	$	2,978
US Treasury debt securities		1,990			—			1,990
Total marketable securities		$	4,970		$	(2	)	$	4,968
Restricted securities:
Government entity sponsored debt securities		$	560		$	—		$	560

 

There were no gross realized gains or losses on sales of available-for-sale securities for both the three and nine months ended September 30, 2006 and 2005.  Differences between cost and market listed above, consisting of a net unrealized holding gain of $1,000 less deferred taxes of zero at September 30, 2006, and a net unrealized holding loss of $2,000 less deferred taxes of zero at December 31, 2005, are included as a separate component of other comprehensive income in the shareholders’ equity section of the Summary Consolidated Balance Sheets.

At September 30, 2006 and December 31, 2005 all of the Company’s marketable securities had a maturity date within 90 days.

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Note 4 – Inventories

Inventories are comprised of the following (in thousands):

		September 30,			December 31,
		2006			2005
		(Unaudited)
Raw materials		$	2,935		$	3,083
Work-in-process		374			415
Finished goods		1,704			1,111
Total inventories		$	5,013		$	4,609

 

Note 5 – Income Taxes

Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and tax return purposes.  The Company generated deferred tax assets beginning in 2002 primarily as a result of write-downs of deferred preservation costs, accruals for product liability claims, and operating losses.  These write-downs, accruals, and losses reflect reductions in revenues and additional professional fees, as a result of the FDA Order, subsequent FDA activities, and related events.  The Company assesses the recoverability of its deferred tax assets, on an annual basis and on an interim basis, as necessary, when the Company experiences changes that could materially affect its determination of the recoverability of its deferred tax assets.  Management provides a valuation allowance when, as a result of this analysis, management believes it is more likely than not that its deferred tax assets will not be realized.  In assessing the recoverability of its deferred tax assets at December 31, 2005 the Company reviewed its historical operating results, including the reasons for its operating losses, uncertainties regarding projected future operating results, and the uncertainty of the outcome of litigation.  Based on the results of this analysis, at December 31, 2005 the Company determined that it was more likely than not that the Company’s deferred tax assets would not be realized.  Therefore, as of December 31, 2005 the Company had a total of $26.4 million in valuation allowances against deferred tax assets and a net deferred tax asset balance of zero.

Based on the Company’s results of operations for the nine months ended September 30, 2006, the Company does not expect to generate material deferred tax assets or utilize material amounts of its net operating loss carryforwards during the year ended December 31, 2006.  For the nine months ended September 30, 2006 the Company did not experience any changes that would materially affect the Company’s prior determination of the recoverability of its deferred tax assets.  As of September 30, 2006 the Company had a total of $26.4 million in valuation allowances against deferred tax assets and a net deferred tax liability of $248,000 related to taxes in a foreign jurisdiction.  The realizability of the Company’s deferred tax assets could be limited in future periods as mandated by Internal Revenue Service Section 382.

As of September 30, 2006 the Company had income tax receivables related to federal income tax losses from the years ended December 31, 2005 and 2004 that can be carried back to prior years to offset income taxes paid and should result in approximately $453,000 in refunds to the Company during 2006.

Note 6 – Debt

On February 8, 2005 CryoLife and its subsidiaries entered into a credit agreement with Wells Fargo Foothill, Inc. as lender (the “Credit Agreement”).  The Credit Agreement provides for a revolving credit facility in an aggregate amount equal to the lesser of $15.0 million (including a letter of credit subfacility of up to an aggregate of $2.0 million) or a borrowing base determined in accordance with the terms of the Credit Agreement.  Generally, the borrowing base is 20% of the appraised value of the business of CryoLife, reduced by specified lender reserves.  The Credit Agreement places limitations on the amount that the Company may borrow, and includes various affirmative and negative covenants, including financial covenants such as a requirement that CryoLife either (i) maintain quarterly a minimum aggregate borrowing availability under the Credit Agreement, less certain payables incurred outside the Company’s

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historical practices, plus unrestricted cash and cash equivalents, as defined (“Availability”), of at least $12.5 million or (ii) achieve as of each quarter end a minimum level of earnings before extraordinary gains, interest, taxes, depreciation, and amortization (“EBITDA”), BioGlue gross margins of at least 70% for the preceding twelve months, as well as Availability of at least $5.0 million.  While the Company currently expects that its aggregate borrowing capacity under the Credit Agreement will equal $15.0 million, there can be no assurance that the capacity will remain at this level.  The Credit Agreement also includes customary conditions on incurring new indebtedness and limitations on cash dividends.  Cash dividends on any class of capital stock are prohibited, provided that cash dividends on preferred stock may be paid so long as the Company maintains $7.5 million, in the aggregate, of cash, cash equivalents, and borrowing capacity, as defined.  There is no restriction on the payment of stock dividends.  Commitment fees are paid based on the unused portion of the facility.  The Credit Agreement expires on February 7, 2008, at which time the outstanding principal balance will be due.  Due to the terms of the Credit Agreement and due to the net losses and negative cash flows experienced by the Company since the FDA Order, the Company has classified amounts due under the Credit Agreement as short-term debt on the September, 2006 and December 31, 2005 Summary Consolidated Balance Sheets in accordance with the provisions of FASB Technical Bulletin No. 79-3 (As Amended).

Amounts borrowed under the Credit Agreement are secured by substantially all of the tangible and intangible assets of CryoLife and its subsidiaries and bear interest at the bank’s prime rate plus 1%, which was 9.25% as of September 30, 2006.  As of September 30, 2006 the outstanding balance of the Credit Agreement was $4.5 million and the remaining borrowing availability was $10.5 million.

The Company routinely enters into agreements to finance insurance premiums for periods not to exceed the terms of the related insurance policies.  In the quarter ended June 30, 2005 the Company entered into two agreements to finance approximately $1.7 million and $761,000 in insurance premiums associated with the yearly renewal of certain Company insurance policies.  The amounts financed accrued interest at 4.98% and 5.01%, respectively, and were payable in equal monthly payments over a nine month period and an eight month period, respectively.  As of September 30, 2006 the outstanding balance under the agreements was zero.

In the second quarter of 2006 the Company entered into two agreements to finance approximately $1.6 million and $715,000 in insurance premiums associated with the yearly renewal of certain of the Company’s insurance policies.  The amounts financed accrue interest at 6.71% and 6.7%, respectively, and are payable in equal monthly payments over a nine month and an eight month period, respectively.  As of September 30, 2006 the aggregate outstanding balance under the agreements was $826,000.

In September 2006 the Company’s European subsidiary obtained a pre-approved credit facility with a bank in the United Kingdom for the financing of vehicles.  This credit facility pre-approves the Company to enter into leases to finance vehicles, for which terms and interest rates are set for each individual lease agreement.  The Company has accounted for the leases entered into under this credit facility as operating leases.  The credit facility allows the Company to have a total exposure on outstanding leases, as defined by the bank, of £180,000 (or approximately $339,000 as of September 30, 2006).  Per the bank, the Company had a total exposure of approximately £105,000 or $198,000 as of September 30, 2006, and the Company’s total payment obligations related to these outstanding leases was $123,000 as of September 30, 2006.

Note 7 – Convertible Preferred Stock

On December 17, 2004 the Company announced that it had filed a shelf registration statement on Form S-3 with the SEC covering the sale from time to time of up to $50 million of its common stock, preferred stock, depositary shares, or any combination of these securities for its own account in one or more offerings.

On March 18 and April 19, 2005 the Company completed a public offering of 417,000 shares of 6% convertible preferred stock (the “Preferred Stock”) at a price to the public of $50.00 per share.  Net proceeds from the offering, after deducting underwriting discounts and offering-related expenses, totaled approximately $19.1 million.

Dividends on the Preferred Stock are cumulative from the date of original issue at the annual rate of 6% of the liquidation preference of the Preferred Stock, payable quarterly on the first day of January, April, July, and October, commencing July 1, 2005.  Any dividends must be declared by the Company’s board of directors and must come

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from funds that are legally available for dividend payments.  On September 7, 2006 the Company declared a dividend of $0.75 per share on its Preferred Stock.  The dividend of approximately $243,000 was paid on October 2, 2006 to shareholders of record on September 22, 2006.

The Preferred Stock is convertible at the option of the holder at any time into the Company’s common stock at a conversion rate of approximately 6.2189 shares of common stock for each share of Preferred Stock, based on an initial conversion price of $8.04 per share of common stock.  The initial conversion price is subject to adjustment in certain events.  The Company reserved 4,600,000 shares of common stock for issuance upon conversion.  Through September 30, 2006 holders had voluntarily converted 92,000 shares of Preferred Stock into 575,000 shares of common stock.

The Company may automatically convert the Preferred Stock into common stock if the closing price of the Company’s common stock has exceeded $12.06, which is 150% of the conversion price of the Preferred Stock, for at least 20 trading days during any 30-day trading period, ending within five trading days prior to notice of automatic conversion.

If the Company elects to automatically convert, or the holder elects to voluntarily convert, some or all of the Preferred Stock into common stock prior to April 1, 2008, the Company will make an additional payment on the Preferred Stock equal to the aggregate amount of dividends that would have been payable on the Preferred Stock through and including April 1, 2008, less any dividends already paid on the Preferred Stock, the “Dividend Make-Whole Payment”.  The Dividend Make-Whole Payment is payable in cash or, at the Company’s option, in shares of the Company’s common stock, or a combination of cash and shares of common stock.  Through September 30, 2006 the Company had issued 119,000 shares of common stock to converting holders in satisfaction of this additional payment.

The Preferred Stock has a liquidation preference of $50.00 per share, plus accrued and unpaid dividends.  The liquidation preference of the Preferred Stock was approximately $16.2 million as of September 30, 2006, before the payment of the October 2006 dividend.

The Company may elect to redeem the Preferred Stock, in whole or in part, at declining redemption prices on or after April 7, 2008.

The Preferred Stock has no maturity date and no voting rights prior to conversion into common stock, except under limited circumstances and as required by law.

Note 8 – Derivative

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), the Company is required to separate and account for the Dividend Make-Whole Payment feature of its Preferred Stock as an embedded derivative, (the “Derivative”).  As an embedded derivative instrument, the Dividend Make-Whole Payment feature must be measured at fair value and reflected as a current liability on the Company’s Summary Consolidated Balance Sheets.  Changes in the fair value of the Derivative are recognized in the line item change in valuation of derivative as a non-operating income/expense on the Company’s Summary Consolidated Statements of Operations.  The Company determined the fair value of the Derivative to be $1.0 million on March 18, 2005, the date of issuance.  The Company determined the fair value of the Derivative related to the issuance of additional Preferred Stock upon exercise of the underwriter’s over allotment option to be $32,000 on April 19, 2005, the date of issuance.  The proceeds from the Preferred Stock as recorded on the Summary Consolidated Balance Sheets were reduced by these amounts, which were allocated to the derivative liability.

Due to the quarterly revaluation of the derivative liability, the Company recorded other expense of $44,000 and $111,000 for the three and nine months ended September 30, 2006, respectively.  At September 30, 2006 the derivative liability was valued at $225,000.

11

Note 9 – Comprehensive Income (Loss)

The following is a summary of comprehensive income (loss) (in thousands):

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2006			2005			2006			2005
		(Unaudited)						(Unaudited)
Net income (loss)		$	1,978		$	(3,118	)	$	415		$	(18,854	)
Unrealized gain (loss) on investments		1			(13		)	3			(37		)
Translation adjustment		(16		)	20			(38		)	(129		)
Comprehensive income (loss)		$	1,963		$	(3,111	)	$	380		$	(19,020	)

 

The tax effect on the change in unrealized gain (loss) on investments is zero for both the three months ended September 30, 2006 and 2005.  The tax effect on the change in unrealized gain (loss) on investments is zero and $11,000 for the nine months ended September 30, 2006 and 2005, respectively.  The tax effect on the translation adjustment is zero for each period presented.

Components of accumulated other comprehensive income consist of the following, net of tax (in thousands):

		September 30,			December 31,
		2006			2005
		(Unaudited)
Unrealized gain (loss) on investments		$	1		$	(2	)
Translation adjustment		87			125
Total accumulated other comprehensive income		$	88		$	123

 

Note 10 – Income (Loss) per Common Share

The following table sets forth the computation of basic and diluted income (loss) per common share (in thousands, except per share data).  The net income (loss) for the three and nine months ended September 30, 2006 and 2005 is adjusted by the effect of the Company’s cumulative, convertible Preferred Stock to arrive at net income (loss) applicable to common shares in accordance with SFAS No. 128, “Earnings Per Share” (“SFAS 128”).  The Company also considers the effect of its Preferred Stock, as discussed in Note 7, the Derivative, as discussed in Note 8, and common stock options, as discussed in Note 11, in the calculation of diluted weighted-average shares below.

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2006			2005			2006			2005
		(Unaudited)						(Unaudited)
Numerator for basic income (loss) per common share:
Net income (loss)		$	1,978		$	(3,118	)	$	415		$	(18,854	)
Effect of preferred stock a		(243		)	(243		)	(730		)	(533		)
Net income (loss) applicable to common shares		$	1,735		$	(3,361	)	$	(315	)	$	(19,387	)
Denominator for basic income (loss) per common share:
Basic weighted-average shares		24,847			24,161			24,804			23,839
Basic income (loss) per common share		$	0.07		$	(0.14	)	$	(0.01	)	$	(0.81	)

 

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		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2006			2005			2006			2005
		(Unaudited)						(Unaudited)
Numerator for diluted income (loss) per common share:
Net income (loss)		$	1,978		$	(3,118	)	$	415		$	(18,854	)
Effect of preferred stock(b)		(243		)	(243		)	(730		)	(533		)
Effect of stock options (c)		—			—			—			—
Net income (loss) applicable to common shares		$	1,735		$	(3,361	)	$	(315	)	$	(19,387	)
Denominator for diluted income (loss) per common share:
Basic weighted-average shares		24,847			24,161			24,804			23,839
Effect of dilutive convertible preferred stock (b)		—			—			—			—
Effect of dilutive stock options (c)		271			—			—			—
Adjusted weighted-average shares		25,118			24,161			24,804			23,839
Diluted income (loss) per common share		$	0.07		$	(0.14	)	$	(0.01	)	$	(0.81	)

 

(a)          The amount of the accumulated dividend on Preferred Stock reduced the net income applicable to common shares by $243,000 for the three months ended September 30, 2006.  The amount of the accumulated dividend on Preferred Stock offset the Company’s net income and resulted in a net loss applicable to common shares with a total unfavorable effect of $730,000 for the nine months ended September 30, 2006.  The amount of the accumulated dividend on Preferred Stock increased the net loss applicable to common shares by $243,000 and $533,000 for the three and nine months ended September 30, 2005, respectively.

(b)         The amount of the accumulated dividend on Preferred Stock reduced the net income applicable to common shares by $243,000 for the three months ended September 30, 2006.  The amount of the accumulated dividend on Preferred Stock offset the Company’s net income and resulted in a net loss applicable to common shares with a total unfavorable effect of $730,000 for the nine months ended September 30, 2006.  The adjustment for the quarterly revaluation of the derivative liability, would have instead increased the net income applicable to common shareholders by $44,000 and $111,000 for the three and nine months ended September 30, 2006, respectively, and the common shares that would be issued to shareholders upon conversion of the remaining Preferred Stock and in payment of the remaining Dividend Make-Whole Payment would have increased the weighted-average shares by 2.3 million for both the three and nine months ended September 30, 2006.  These adjustments were excluded from the calculation above, as they were anti-dilutive pursuant to the provisions of SFAS 128.

The amount of the accumulated dividend on the Preferred Stock increased the net loss applicable to common shares by $243,000 and $533,000 for the three and nine months ended September 30, 2005, respectively.  The adjustment for the Dividend Make-Whole Payment on preferred shares converted during the period and the quarterly revaluation of the derivative liability would have increased the net loss applicable to common shareholders by $412,000 for the three months ended September 30, 2005 and decreased the net loss applicable to common shareholders by $372,000 for the nine months ended September 30, 2005, and the common shares that would be issued to shareholders upon conversion of the remaining Preferred Stock and in payment of the remaining Dividend Make-Whole Payment would have increased the weighted-average shares by 2.4 million and 1.9 million for the three and nine months ended September 30, 2005, respectively.  These adjustments were excluded from the calculation above, as they were anti-dilutive pursuant to the provisions of SFAS 128.

(c)          Outstanding options to purchase the Company’s common stock resulted in 271,000 additional dilutive common shares for the three months ended September 30, 2006. Outstanding options to purchase the Company’s common stock that would have resulted in 211,000 additional dilutive shares for the nine months ended September 30, 2006 were excluded from the calculation, as they were anti-dilutive pursuant to the provisions of SFAS 128.

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Outstanding options to purchase the Company’s common stock that would have resulted in 387,000 and 382,000 additional dilutive common shares, respectively for the three and nine months ended September 30, 2005, were excluded from the calculation, as these items were anti-dilutive pursuant to the provisions of SFAS 128.

In future periods the basic and diluted earnings (loss) per common share are expected to be affected by the declaration of dividends on Preferred Stock, the conversion of Preferred Stock, fluctuations in the fair value of the Company’s common stock, issuance of additional stock options, and changes in the valuation of the Derivative.

Note 11 – Stock Compensation

In August 2006 the Company’s Board of Directors authorized the grant of stock to its non-employee directors.  The stock grants of 2,500 shares of common stock per non-employee director were valued at a total of $109,000 based on the stock price of $5.47 on the date of grant.  The value of this stock grant will be recorded as director compensation over the 12-month vesting period.  The Company also made cash payments totaling $38,000 to the non-employee directors to partially offset each individual’s income tax liability as a result of the stock grant.  The Company recorded $47,000 in expense related to these stock grants during the third quarter of 2006.

In February 2006 the Company’s Board of Directors authorized the grant of stock to recognize the performance of certain Company executives.  The stock grants totaled 34,000 shares of common stock, which were valued at $145,000 based on the stock price of $4.25 on the date of grant.  The Company purchased $50,000 of Company stock from employees, based on the closing price on the New York Stock Exchange on the day the stock was transferred to the Company, to pay employee federal and state withholding taxes related to these stock grants.  The Company recorded $145,000 in compensation expense related to these stock grants during the first quarter of 2006.

The Company has stock option and stock incentive plans that provide for grants of shares to employees and grants of options to employees and directors to purchase shares of the Company’s common stock at exercise prices generally equal to the fair values of such stock at the dates of grant.  The Company maintains a shareholder approved Employee Stock Purchase Plan (the “ESPP”) for the benefit of its employees.  The ESPP allows eligible employees the right to purchase common stock on a quarterly basis at the lower of 85% of the market price at the beginning or end of each three-month offering period.  Pursuant to the adoption of SFAS 123 Revised “Share-Based Payment” (“SFAS 123R”) both the Company’s 15% discount on ESPP stock purchases and the lookback portion of ESPP stock purchases are considered components of stock compensation and must be expensed in the Company’s financial statements.  The lookback portion of the Company’s ESPP constitutes an option and, as such, the expense is determined by performing a valuation as discussed below.

The Company adopted SFAS 123R as amended by SEC Rule 2005-57 “Commission Amends Compliance Dates For FASB Statement No. 123R on Employee Stock Options” for the period beginning October 1, 2005.  SFAS 123R requires companies to recognize the cost of all share-based payments in the financial statements using a fair-value based measurement method.  SFAS 123R applies to new awards and to awards modified, repurchased, or cancelled after the implementation date, as well as to the unvested portion of awards outstanding as of the implementation date.  The Company uses the Black-Scholes model to value its stock option grants under SFAS 123R and expenses the related compensation cost using the straight-line method over the vesting period.  The fair value of the Company’s ESPP options is also determined using the Black-Scholes model and is expensed quarterly at the end of the purchase period, as the option is fully vested at that time.  The fair value of stock options is determined on the grant date using assumptions for the expected term, expected volatility, dividend yield, and the risk free interest rate.  The term assumption is primarily based on the contractual term of the option and historic data related to exercise and post-vesting cancellation history experienced by the Company, adjusted based on management’s expectations of future results.  The expected term is determined separately for options issued to the Company’s directors and to employees.  The Company’s anticipated volatility level is primarily based on the historic volatility of the Company’s common stock, adjusted to remove the effects of certain periods of unusual volatility not expected to recur, and adjusted based on management’s expectations of future volatility, for the life of the option or option group.  The Company’s model includes a zero dividend yield assumption, as the Company has not historically paid nor does it anticipate paying dividends on its common stock.  The risk free interest rate is based on recent U.S. Treasury note

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auction results with a similar life to that of the option.  The Company’s model does not include a discount for post-vesting restrictions, as the Company has not issued awards with such restrictions.  The period expense is then determined based on the valuation of the options, and at that time an estimated forfeiture rate is used to reduce the expense recorded.  The Company’s estimate of pre-vesting forfeitures is primarily based on the recent historical experience of the Company, and is adjusted to reflect actual forfeitures at each vesting date.

The following weighted-average assumptions were used to determine the fair value of options under SFAS 123R:

		Three Months Ended				Nine Months Ended
		September 30, 2006				September 30, 2006
		Stock Options		ESPP Options		Stock Options		ESPP Options
		(Unaudited)				(Unaudited)
Expected dividend yield		0	%	0	%	0	%	0	%
Expected stock price volatility		.650		.315		.650		.441
Risk-free interest rate		5.00	%	4.69	%	4.80	%	4.34	%
Expected life of options		4.0 Years		.24 Years		4.1 Years		.24 Years

 

The Company’s expense for stock options and the Company’s ESPP was approximately $156,000 and $698,000, for the three and nine months ended September 30, 2006, respectively, of which approximately $19,000 and $59,000, respectively, was capitalized into the Company’s deferred preservation and inventory costs.  These amounts were recorded as compensation expense and were subject to the Company’s normal allocation of expenses to inventory and deferred preservation costs.  The Company did not recognize a tax benefit, or a related operating cash outflow and financing cash inflow, related to the additional compensation expense recorded in the three months and nine months ended September 30, 2006, as the Company is currently maintaining a full valuation allowance on its deferred tax assets.  See Note 5 for additional discussions of the Company’s income tax valuation.

As of September 30, 2006 there was approximately $2.3 million in total unrecognized compensation costs related to nonvested share-based compensation arrangements, before considering the effect of expected forfeitures.  This expense is expected to be recognized over a weighted average period of 2.2 years.

In periods prior to October 1, 2005 the Company elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations (“APB 25”) in accounting for its employee stock options.  Under APB 25, because the exercise price of the Company’s employee stock options equaled the market price of the underlying stock on the date of the grant, no compensation expense was recognized.  In accordance with APB 25 the compensation recorded for employee stock grants was equal to the value of the grant on the measurement date, the date of the grant, as determined by the closing price of the Company’s common stock on that date.  Some employee stock grants vested in future periods based on a requirement of continued service to the Company.  For these stock grants the amount of the stock grant was recorded as deferred compensation in the equity section of the Company’s Summary Consolidated Balance Sheets, and was expensed on a straight-line basis over the vesting period.

Pro forma information regarding net loss and loss per share was required by SFAS 123 “Accounting for Stock-Based Compensation” (“SFAS 123”) for options accounted for under ABP 25.  SFAS 123 required that option valuation information be disclosed as if the Company accounted for its employee stock options granted under the fair value method of that statement.  The fair values for these options were estimated at the dates of grant using a Black-Scholes option-pricing model.

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The following weighted-average assumptions were used:

		Three Months Ended		Nine Months Ended
		September 30, 2005		September 30, 2005
		(Unaudited)		(Unaudited)
Expected dividend yield		0	%	0	%
Expected stock price volatility		.340		.519
Risk-free interest rate		3.17	%	3.36	%
Expected life of options		0.3 Years		3.2 Years

 

For purposes of pro forma disclosures, the estimated fair values of the options are amortized to expense over the options’ vesting periods on a ratable basis.  The Company’s pro forma information follows (in thousands, except per share data):

		Three Months Ended						Nine Months Ended
		September 30, 2005						September 30, 2005
		Basic			Diluted			Basic			Diluted
		(Unaudited)						(Unaudited)
Basic net loss applicable to commonshares – as reported		$	(3,361	)	$	(3,361	)	$	(19,387	)	$	(19,387	)
Stock-based employee compensation:
Add expense included in net loss		51			51			166			166
Deduct expense determined under the fair value based method for all awards		(1,634		)	(1,634		)	(3,253		)	(3,253		)
Basic net loss applicable to common shares – pro forma		$	(4,944	)	$	(4,944	)	$	(22,474	)	$	(22,474	)
Basic weighted-average shares		24,161			24,161			23,839			23,839
Basic loss per common share:
As reported		$	(0.14	)	$	(0.14	)	$	(0.81	)	$	(0.81	)
Pro forma		$	(0.20	)	$	(0.20	)	$	(0.94	)	$	(0.94	)

 

Note 12 – Segment Information

The Company has two reportable segments organized according to its products and services: Implantable Medical Devices and Human Tissue Preservation Services.

The Implantable Medical Devices segment includes external revenue from product sales of BioGlue and bioprosthetic devices, including stentless porcine heart valves and SynerGraft processed bovine vascular grafts.  The Human Tissue Preservation Services segment includes external services revenue from cryopreservation of cardiac, vascular, and orthopaedic allograft tissues.  There are no intersegment revenues.

The primary measure of segment performance, as viewed by the Company’s management, is segment gross margin, or net external revenues less cost of products and preservation services.  The Company does not segregate assets by segment, therefore, asset information is excluded from the segment disclosures below.

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The following table summarizes revenues, cost of products and preservation services, and gross margins for the Company’s operating segments (in thousands):

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2006			2005			2006			2005
		(Unaudited)						(Unaudited)
Revenue:
Implantable medical devices		$	9,687		$	9,129		$	30,308		$	29,102
Human tissue preservation services		10,319			7,329			29,839			22,219
All other (a)		12			—			74			—
		20,018			16,458			60,221			51,321
Cost of Products and Preservation Services:
Implantable medical devices		1,576			1,940			5,581			6,135
Human tissue preservation services		6,954			6,015			20,751			17,984
All other (a)		—			—			—			—
		8,530			7,955			26,332			24,119
Gross Margin:
Implantable medical devices		8,111			7,189			24,727			22,967
Human tissue preservation services		3,365			1,314			9,088			4,235
All other (a)		12			—			74			—
		$	11,488		$	8,503		$	33,889		$	27,202

 

(a)                 The “All other” designation includes grant revenue.

The following table summarizes net revenues by product (in thousands):

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2006			2005			2006			2005
		(Unaudited)						(Unaudited)
Products:
BioGlue		$	9,444		$	8,917		$	29,534		$	28,340
Bioprosthetic devices		243			212			774			762
Total products		9,687			9,129			30,308			29,102
Human tissue preservation services:
Cardiovascular tissue		4,189			3,139			11,550			10,407
Vascular tissue		4,468			2,825			13,066			8,281
Orthopaedic tissue		1,662			1,365			5,223			3,531
Total preservation services		10,319			7,329			29,839			22,219
Research grants		12			—			74			—
		$	20,018		$	16,458		$	60,221		$	51,321

 

Note 13 – Commitments and Contingencies

Product Liability Claims

In the normal course of business as a medical device and services company, the Company has product liability complaints filed against it.  As of November 1, 2006 the Company was aware of four pending product liability lawsuits.  The lawsuits are currently in the pre-discovery or discovery stages.  Of these lawsuits, two allege product liability claims arising out of the Company’s orthopaedic tissue services and two allege product liability claims arising out of the Company’s allograft heart valve tissue services.

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Two of the outstanding product liability lawsuits against the Company are not covered by insurance policies, as the claimed loss date was prior to the effective coverage date for the insurance policy.  Additional uninsured claims may be filed in the future.  Other product liability claims have been asserted against the Company that have not resulted in lawsuits as of November 1, 2006.  The Company is monitoring these claims.

The Company performed an analysis as of September 30, 2006 of the settled but unpaid claims and the four pending product liability lawsuits based on settlement negotiations to date and advice from counsel.  As of September 30, 2006 the Company had accrued a total of approximately $414,000 for settled but unpaid claims and pending product liability lawsuits.  The $414,000 accrual is included as a component of accrued expenses and other current liabilities on the September 30, 2006 Summary Consolidated Balance Sheet.  This amount represents the Company’s estimate of the probable loss related to settled but unpaid claims and one of the four pending product liability lawsuits.  The Company has not recorded an accrual for the remaining three product liability claims or any asserted lawsuits that have not resulted in a lawsuit because management has concluded that either a loss is remote or that, although a loss is reasonably possible or probable, a reasonable estimate of that loss or the range of losses cannot be made at this time.  As of December 31, 2005 the Company had accrued a total of approximately $1.5 million for settled but unpaid claims and pending product liability lawsuits and recorded $244,000 representing amounts to be recovered from the Company’s insurance carriers.  The $1.5 million accrual is included as a component of accrued expenses and other current liabilities on the December 31, 2005 Summary Consolidated Balance Sheet.

If the Company is unable to settle one or more of the product liability lawsuits in which the Company is a defendant, and if any such lawsuit should be tried with a substantial verdict rendered in favor of the plaintiff(s), there can be no assurance that such verdict(s) would not exceed the Company’s available liquid assets.  Additionally, the Company does not have a reasonable method for estimating the amount of compensatory or punitive damages that could be assessed by a trial jury with respect to any lawsuit that it is unable to settle prior to trial, and the Company’s product liability insurance policies do not include coverage for any punitive damages.  Failure by the Company to resolve the outstanding product liability claims within its ability to pay would have a material adverse effect on the financial position, results of operations, and cash flows of the Company.

On April 1, 2006 the Company bound coverage for the 2006/2007 insurance policy year.  This policy is a four-year claims-made insurance policy, i.e. claims incurred during the period April 1, 2003 through March 31, 2007 and reported during the period April 1, 2006 through March 31, 2007 are covered by this policy.  Claims incurred prior to April 1, 2003 that have not been reported are uninsured.

The Company maintains claims-made insurance policies to mitigate its financial exposure to product liability claims.  Claims-made insurance policies generally cover only those asserted claims and incidents that are reported to the insurance carrier while the policy is in effect.  Thus, a claims-made policy does not generally represent a transfer of risk for claims and incidents that have been incurred but not reported to the insurance carrier during the policy period.  The Company periodically evaluates its exposure to unreported product liability claims and records accruals as necessary for the estimated cost of unreported claims related to services performed and products used.  In July 2006 the Company retained an independent actuarial firm to prepare revised estimates of the unreported claims as of June 30, 2006 and December 31, 2006.  The independent firm estimated the unreported product loss liability using a frequency-severity approach, whereby projected losses were calculated by multiplying the estimated number of claims by the estimated average cost per claim.  The estimated claims were calculated based on the reported claim development method and the Bornhuetter-Ferguson method using a blend of the Company’s historical claim experience and industry data.  The estimated cost per claim was calculated using a lognormal claims model blending the Company’s historical average cost per claim with industry claims data.  The independent actuarial firm used a number of assumptions in order to estimate the unreported product loss liability, including:

·                  A ceiling of $5.0 million was selected for actuarial purposes in determining the liability per claim given the uncertainty in projecting claim losses in excess of $5.0 million,

·                  The future claim reporting lag time would be a blend of the Company’s experiences and industry data,

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·                  The frequency of unreported claims for accident years 2001 through 2006 would be lower than the Company’s experience since the 2002/2003 policy year, but higher than the Company’s historical claim frequency prior to the 2002/2003 policy year,

·                  The average cost per claim would be lower than the Company’s experience since the 2002/2003 policy year, but higher than the Company’s historical cost per claim prior to the 2002/2003 policy year,

·                  The average cost per BioGlue claim would be consistent with the Company’s overall historical exposures until adequate historical data is available on this product line, and

·                  The number of BioGlue claims per million dollars of BioGlue revenue would be 35% lower than non-BioGlue claims per million dollars of revenue.  The 35% factor was selected based on BioGlue claims experience to-date and consultation with the actuary.

The Company believes that these assumptions provide a reasonable basis for the calculation of the unreported product liability loss, but the accuracy of the actuarial firm’s estimates is limited by the general uncertainty that exists for any estimate of future activity due to uncertainties surrounding the assumptions used and due to Company specific conditions, including the FDA Order, the Company’s recent levels of litigation activity, the Company’s low volume of pre-FDA Order historical claims, and the scarcity of industry data directly relevant to the Company’s business activities.  Due to these factors, actual results may differ significantly from the assumptions used and amounts accrued.

Based on the actuarial valuation performed in July 2006 as of June 30, 2006 and December 31, 2006, the Company estimated that its liability for unreported product liability claims was $6.7 million and would be $7.5 million as of December 31, 2006.  In accordance with Emerging Issues Task Force Issue 03-8, the Company has accrued a prorated amount of $7.1 million, representing the Company’s best estimate of the total liability for unreported product liability claims related to services performed and products sold prior to September 30, 2006.  The $7.1 million balance is included as a component of accrued expenses and other current liabilities of $3.6 million and other long-term liabilities of $3.5 million on the September 30, 2006 Summary Consolidated Balance Sheet.  Further analysis indicated that the liability could be estimated to be as high as $13.0 million, after including a reasonable margin for statistical fluctuations calculated based on actuarial simulation techniques.  Based on the actuarial valuation, the Company estimated that as of September 30, 2006, $2.5 million of the accrual for unreported liability claims would be recoverable under the Company’s insurance policies.  The $2.5 million insurance recoverable is included as a component of other receivables of $1.2 million and other long-term assets of $1.3 million on the September 30, 2006 Summary Consolidated Balance Sheet.  These amounts represent management’s estimate of the probable losses and anticipated recoveries for unreported product liability claims related to services performed and products sold prior to September 30, 2006.  Actual results may differ from this estimate.

As of December 31, 2005 the Company accrued $7.5 million for unreported product liability claims and recorded a receivable of $2.5 million for unreported liability claims estimated to be recoverable under the Company’s insurance policies.  The $7.5 million balance is included as a component of accrued expenses and other current liabilities of $3.8 million and other long-term liabilities of $3.7 million on the December 31, 2005 Summary Consolidated Balance Sheet.  The $2.5 million insurance recoverable is included as a component of other receivables of $1.1 million and other long-term assets of $1.4 million on the December 31, 2005 Summary Consolidated Balance Sheet.

Insurance Coverage Dispute

In September 2006 the Company settled an insurance coverage dispute with a former insurance carrier for $2.0 million, net of associated legal fees.  The dispute involved losses stemming from approximately $11.25 million paid in 2005 by the Company.  No party admitted any liability as part of the September settlement. The $2.0 million is included as a component of general, administrative, and marketing expenses on the Summary Consolidated Statements of Operations and other receivables on the Summary Consolidated Balance Sheet as of September 30, 2006.  The net proceeds of $2.0 million were received in October 2006.

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SEC Investigation

On August 19, 2002 the Company issued a press release announcing that on August 17, 2002, the Company received a letter from the Atlanta District Office of the SEC inquiring about certain matters relating to the Company’s August 14, 2002 announcement of the FDA Order.  The SEC notified the Company in July 2003 that the inquiry became a formal investigation in June 2003.  CryoLife cooperated with this investigation both before and after the issuance of the formal order of investigation in June 2003 and intends to continue doing so.  CryoLife voluntarily reported the names of six employees and former employees to the SEC in December 2002 after discovering they had apparently sold CryoLife shares on August 14, 2002, before trading was halted pending CryoLife’s press release reporting the FDA Order.  These individuals were not and are not executive officers of CryoLife.  The formal order of investigation indicates that the SEC’s scope includes whether, during 2002, among other things, CryoLife or others may have traded while in possession of material nonpublic information, made (or caused to be made) false or misleading statements or omissions in press releases and SEC filings, and failed to maintain accurate records and adequate controls.  The investigation could also encompass matters not specifically identified in the formal order.  On September 15, 2005 the SEC announced that it had commenced proceedings in federal district court against certain of the above-referenced former and current employees (and certain of their spouses) for alleged illegal insider trading arising out of their August 14, 2002 trading activities.  Those proceedings resulted in settlements with the SEC.  As of the date hereof, the SEC has had no discussions with CryoLife as to whether the SEC will seek relief against CryoLife, or the nature of any relief that may be sought.  At present, CryoLife is unable to predict the ultimate focus or outcome of the investigation, or when it will be completed.  An unfavorable outcome could have a material adverse effect on CryoLife’s reputation, business, financial position, results of operations, and cash flows.

Note 14 – New Accounting Pronouncements

The Company will be required to adopt Financial Accounting Standards Board (“FASB”) Interpretation No. 48 “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“Interpretation 48”) for the fiscal year beginning January 1, 2007.  Interpretation 48 establishes a threshold for recognizing tax benefits if they are “more-likely-than-not” to be upheld upon review by the appropriate taxing authority and the requirement that companies recognize the maximum amount of tax benefit that has a “greater than 50 percent likelihood” of ultimately being realized.  The cumulative effect of adoption of this interpretation will be reported as an adjustment to the opening balance of retained earnings.  The Company is in the process of evaluating the impact of Interpretation 48 on its results of operations and financial position.

The Company will be required to adopt FASB Statement of Financial Accounting Standards (“SFAS”) No. 157 “Fair Value Measurements” (“SFAS 157”) for the fiscal year beginning January 1, 2008.  SFAS 157 provides a single definition of fair value and a hierarchical framework for measuring it, as well as establishing additional disclosure requirements about the use of fair value to measure assets and liabilities.  The Company is in the process of evaluating the impact of SFAS 157 on its results of operations and financial position.

The Company will be required to adopt Staff Accounting Bulletin (“SAB”) No. 108, codified as SAB Topic 1.N, “Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”) for the year ended December 31, 2006.  SAB 108 requires the use of both a balance sheet approach and an income statement approach when quantifying and evaluating the materiality of a misstatement.  Adjustment to the financial statements is required if either approach results in quantifying a misstatement that is material.  The adoption of SAB 108 will not have an impact on the Company’s results of operations and financial position.

Note 15 – Subsequent Events

In October 2006 CryoLife announced that it had signed a licensing and distribution agreement with BioForm Medical, Inc. (“BioForm”), for the development and commercialization of BioGlue for use in cosmetic and plastic surgery indications.  The agreement calls for BioForm to fund the development and regulatory approval process for commercializing BioGlue for use in cosmetic and plastic surgery indications in the United States, Canada, and the

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European Community.  Under the terms of the agreement, CryoLife will receive an initial fee from BioForm, as well as a milestone payment upon achievement of FDA approval.

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