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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, 2004 OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934    Commission file number 0-21982 Diametrics Medical, Inc.     Internal Revenue Service  Employer Identification No. 41-1663185 3050 Centre Pointe Drive, Suite 150, Roseville, Minnesota 55113
(651) 639-8035    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 an accelerated filer (as
defined by Rule 12b-2 of the Act).  Yes  x  No  o As of November 3, 2004, 35,121,739 shares of Common Stock were outstanding.




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Diametrics Medical, Inc. PagePart
I  FINANCIAL INFORMATIONItem 1. Consolidated Financial Statements (unaudited)Consolidated Statements of Operations:Three Months Ended September 30, 2004 and 2003
    
    
    3Nine Months Ended September 30, 2004 and 2003
    
    
    3Consolidated Balance Sheetsas of September 30, 2004 and December 31, 2003
    
    
    4Consolidated
Statements of Cash Flows:Nine Months Ended September 30, 2004 and 2003
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Results of Operations and Financial Condition
    
    
    16Item 3. Quantitative and Qualitative Disclosure About Market Risk
    
    
    21Item 4. Controls and Procedures
    
    
    22Part
II  OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    22Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    22Item 3. Defaults Upon Senior Securities
    
    
    22Item 4. Submission of Matters to a Vote of Security Holders
    
    
    22Item 5. Other Information
    
    
    22Item 6. Exhibits
    
    
    23Signatures
    
    
    24Articles of IncorporationCertificate of Designations of Series F Convertible Preferred StockCertification of the CEO Pursuant to Section 302Certification of the CFO Pursuant to Section 302Certification of the CEO Pursuant to Section 906Certification of the CFO Pursuant to Section 906
  2




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PART I  FINANCIAL INFORMATION 
 Item 1. Consolidated Financial Statements (unaudited) DIAMETRICS MEDICAL, INC. 
 CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenue:Product revenue
    
    $
    697,443
    
    
    $
    609,595
    
    
    $
    1,992,738
    
    
    $
    2,019,068Other revenue
    
    
    
    
    
    
    200,000
    
    
    
    
    
    
    
    200,000Total revenue
    
    
    697,443
    
    
    
    809,595
    
    
    
    1,992,738
    
    
    
    2,219,068Cost of revenue
    
    
    852,349
    
    
    
    551,746
    
    
    
    2,145,249
    
    
    
    1,798,047Gross profit (loss)
    
    
    (154,906
    )
    
    
    257,849
    
    
    
    (152,511
    )
    
    
    421,021Operating expenses:Research and development
    
    
    415,952
    
    
    
    546,147
    
    
    
    1,321,495
    
    
    
    1,665,561Selling, general and administrative
    
    
    925,785
    
    
    
    1,264,860
    
    
    
    3,566,396
    
    
    
    4,324,425Restructuring and other nonrecurring charges
    
    
    2,018,212
    
    
    
    650,538
    
    
    
    2,018,212
    
    
    
    650,538Total operating expenses
    
    
    3,359,949
    
    
    
    2,461,545
    
    
    
    6,906,103
    
    
    
    6,640,524Operating loss
    
    
    (3,514,855
    )
    
    
    (2,203,696
    )
    
    
    (7,058,614
    )
    
    
    (6,219,503
    )Interest income
    
    
    3,379
    
    
    
    1,252
    
    
    
    10,394
    
    
    
    11,937Interest expense
    
    
    (399,437
    )
    
    
    (401,538
    )
    
    
    (1,333,668
    )
    
    
    (880,776
    )Gain on modification of convertible notes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,500,000Other income (expense), net
    
    
    46,824
    
    
    
    (27,908
    )
    
    
    (11,050
    )
    
    
    (38,854
    )Net loss before discontinued operations
    
    
    (3,864,089
    )
    
    
    (2,631,890
    )
    
    
    (8,392,938
    )
    
    
    (5,627,196
    )Discontinued operations:Loss from discontinued operations
    
    
    
    
    
    
    (949,717
    )
    
    
    
    
    
    
    (2,071,036
    )Gain on sale of discontinued operations
    
    
    
    
    
    
    1,832,059
    
    
    
    557,052
    
    
    
    1,832,059Income (loss) from discontinued operations
    
    
    
    
    
    
    882,342
    
    
    
    557,052
    
    
    
    (238,977
    )Net loss
    
    
    (3,864,089
    )
    
    
    (1,749,548
    )
    
    
    (7,835,886
    )
    
    
    (5,866,173
    )Beneficial conversion featurepreferred stock dividend
    
    
    
    
    
    
    
    
    
    
    (1,733,644
    )
    
    
    (958,962
    )Deemed dividend on preferred stock
    
    
    
    
    
    
    
    
    
    
    (1,050,690
    )
    
    
    Net loss available to common shareholders
    
    $
    (3,864,089
    )
    
    $
    (1,749,548
    )
    
    $
    (10,620,220
    )
    
    $
    (6,825,135
    )Basic and diluted net loss per common share:Net loss from continuing operations
    
    $
    (0.11
    )
    
    $
    (0.10
    )
    
    $
    (0.36
    )
    
    $
    (0.24
    )Discontinued operations:Loss from discontinued operations
    
    
    
    
    
    
    (0.04
    )
    
    
    
    
    
    
    (0.08
    )Gain on sale of discontinued operations
    
    
    
    
    
    
    0.07
    
    
    
    0.02
    
    
    
    0.07Net income (loss) from discontinued operations
    
    
    
    
    
    
    0.03
    
    
    
    0.02
    
    
    
    (0.01
    )Net loss
    
    $
    (0.11
    )
    
    $
    (0.06
    )
    
    $
    (0.34
    )
    
    $
    (0.25
    )Weighted average number of
common shares outstanding
    
    
    34,915,784
    
    
    
    26,984,184
    
    
    
    31,251,142
    
    
    
    27,391,959
 See accompanying notes to consolidated financial statements. 3




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DIAMETRICS MEDICAL, INC. 
 CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
 September 30,
    
    December 31,2004
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    88,472
    
    
    $
    315,176Restricted cash
    
    
    
    
    
    
    720,169Accounts receivable, net
    
    
    261,855
    
    
    
    464,402Inventories
    
    
    152,825
    
    
    
    1,450,824Prepaid expenses and other current assets
    
    
    115,526
    
    
    
    298,167Total current assets
    
    
    618,678
    
    
    
    3,248,738Property and equipment
    
    
    6,874,204
    
    
    
    7,249,524Less accumulated depreciation and amortization
    
    
    (6,757,726
    )
    
    
    (5,390,497
    )116,478
    
    
    
    1,859,027Other
assets
    
    
    53,188
    
    
    
    85,234$
    788,344
    
    
    $
    5,192,999LIABILITIES AND SHAREHOLDERS DEFICITCurrent liabilities:Accounts payable
    
    $
    1,462,559
    
    
    $
    1,097,069Accrued expenses
    
    
    1,127,893
    
    
    
    794,148Deferred credits and revenue
    
    
    34,936
    
    
    
    826,359Capital lease obligations and other borrowings
    
    
    65,306
    
    
    
    169,861Total current liabilities
    
    
    2,690,694
    
    
    
    2,887,437Long-term liabilities:Convertible senior secured fixed rate notes (net of discount of $938,936
and $1,667,858 at September 30, 2004 and December 31, 2003, respectively)
    
    
    6,361,064
    
    
    
    5,632,142Long-term liabilities, excluding current portion
    
    
    24,258
    
    
    
    48,736Accrued retirement plan benefit
    
    
    2,495,260
    
    
    
    2,495,260Total liabilities
    
    
    11,571,276
    
    
    
    11,063,575Shareholders deficit:Preferred stock, $.01 par value: 5,000,000 authorized, 27,500
and 7,500 shares issued and outstanding at September 30, 2004
and December 31, 2003, respectively
    
    
    250
    
    
    
    75Common stock, $.01 par value: 100,000,000 authorized,
35,121,739 and 27,456,209 shares issued and outstanding
at September 30, 2004 and December 31, 2003, respectively
    
    
    351,218
    
    
    
    274,562Additional paid-in capital
    
    
    156,169,795
    
    
    
    150,612,474Accumulated deficit
    
    
    (163,476,931
    )
    
    
    (152,856,593
    )Deferred compensation
    
    
    
    
    
    
    (93,699
    )Accumulated other comprehensive loss
    
    
    (3,827,264
    )
    
    
    (3,807,395
    )Total shareholders deficit
    
    
    (10,782,932
    )
    
    
    (5,870,576
    )$
    788,344
    
    
    $
    5,192,999
 See accompanying notes to
consolidated financial statements. 4




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DIAMETRICS MEDICAL, INC. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 Nine Months EndedSeptember 30,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (7,835,886
    )
    
    $
    (5,866,173
    )Adjustments to reconcile net loss to net cash used in continuing operation
activities:Loss from discontinued operations
    
    
    
    
    
    
    2,071,036Gain on sale of discontinued operations
    
    
    (557,052
    )
    
    
    (1,832,059
    )Depreciation and amortization
    
    
    480,965
    
    
    
    553,354Gain on modification of convertible senior secured fixed rate notes
    
    
    
    
    
    
    (1,500,000
    )Accretion of convertible senior secured fixed rate notes
    
    
    724,679
    
    
    
    408,226Expense related to warrant repricings
    
    
    161,191
    
    
    
    Write-down of assets
    
    
    1,435,000
    
    
    
    Stock-based compensation
    
    
    93,699
    
    
    
    300,342Loss on disposal of property and equipment
    
    
    3,723
    
    
    
    Recognition of deferred gain on sale of business
    
    
    (718,924
    )
    
    
    Changes in operating assets and liabilities
(net of effect of operations sold):Accounts receivable
    
    
    202,547
    
    
    
    (42,644
    )Inventories
    
    
    1,297,999
    
    
    
    458,119Prepaid expenses and other current assets
    
    
    182,641
    
    
    
    113,065Accounts payable
    
    
    365,491
    
    
    
    921,424Accrued expenses
    
    
    333,745
    
    
    
    426,311Deferred credits and revenue
    
    
    (72,499
    )
    
    
    824,923Net cash used in continuing operating activities
    
    
    (3,902,681
    )
    
    
    (3,164,076
    )Cash
flows from investing activities:Purchases of property and equipment
    
    
    (239,686
    )
    
    
    (363,941
    )Proceeds from sale of discontinued operations
    
    
    
    
    
    
    4,153,938Release of escrowed proceeds on sale of business
    
    
    720,169
    
    
    
    (724,923
    )Net cash provided by (used in) investing activities
    
    
    480,483
    
    
    
    3,065,074Cash flows from financing activities:Redemption of Preferred Stock
    
    
    (25
    )
    
    
    Principal payments on borrowings and capital leases
    
    
    (124,791
    )
    
    
    (153,243
    )Convertible senior secured fixed rate notes extension costs
    
    
    
    
    
    
    (81,306
    )Net proceeds from the issuance of preferred stock and common stock warrants
    
    
    2,667,957
    
    
    
    1,205,270Net proceeds from the issuance of common stock
    
    
    11,834
    
    
    
    24,487Net cash provided by financing activities
    
    
    2,554,975
    
    
    
    995,208Net cash provided by (used in) discontinued operations
    
    
    557,052
    
    
    
    (749,316
    )Effect of exchange rate changes on cash and cash equivalents
    
    
    83,467
    
    
    
    (49,241
    )Net increase (decrease) in cash and cash equivalents
    
    
    (226,704
    )
    
    
    97,649Cash and cash equivalents at beginning of period
    
    
    315,176
    
    
    
    3,964,791Cash and cash equivalents at end of period
    
    $
    88,472
    
    
    $
    4,062,440Supplemental disclosure of cash flow information:Cash paid during the period for interest
    
    $
    17,950
    
    
    $
    426,059
 Supplemental disclosure of noncash investing and financing activities:  -
    
    As further described in note 2, effective May 28, 2004, the Company completed a $1.5 million
financing through the sale
of 15,000 shares of Series G convertible preferred stock. A beneficial conversion feature embedded
in the preferred stock was
calculated at $1,067,650 and was recorded as a noncash charge to retained earnings and treated as a
reconciling item on the
Statements of Operations to adjust the reported net loss to net loss available to common
shareholders. In connection
with the Series G financing, the Company also issued new warrants to the investors in the Companys
Series E and Series F
preferred stock to purchase an aggregate of 12,241,608 shares of common stock at $.05 per share and
reduced the exercise price
and ceiling exercise price of the warrants previously issued to the Companys Series E and Series F
preferred stock investors,
respectively. The issuance of new warrants to the Series E and Series F investors and the change in the
exercise price terms of the
warrants previously issued to these investors was considered a dividend to the Series E and Series
F preferred stockholders,
requiring a noncash charge to retained earnings aggregating $1,050,690. This charge was also
treated as a reconciling item on
the Statement of Operations to adjust the reported net loss to net loss available to
common shareholders.-
    
    As further described in note 3, effective January 16, 2004, the Company completed a $1.5 million
financing through the sale
of 15,000 shares of Series F convertible preferred stock. A beneficial conversion feature embedded
in the preferred stock was calculated at $665,994 and was recorded as a noncash charge to retained earnings and treated as a
reconciling item on the Statements of Operations to adjust the reported net loss to net loss available to common
shareholders.-
    
    The Company entered into capital lease obligations for equipment of $18,977 during the three months ended March 31,
2003. See accompanying notes to consolidated financial statements. 5




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DIAMETRICS MEDICAL, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2004
(Unaudited)
 (1) UNAUDITED FINANCIAL STATEMENTS The interim consolidated financial statements of Diametrics Medical, Inc. (the
Company) are unaudited and have been prepared by the Company in accordance
with accounting principles generally accepted in the United States of America
for interim financial information, pursuant to the rules and regulations of the
Securities and Exchange Commission. Pursuant to such rules and regulations,
certain financial information and footnote disclosures normally included in the
financial statements have been condensed or omitted. However, in the opinion
of management, the financial statements include all adjustments, consisting of
normal recurring accruals, necessary for a fair presentation of the interim
periods presented. Operating results for these interim periods are not
necessarily indicative of results to be expected for the entire year, due to
seasonal, operating and other factors. Prior-year results of operations for the Companys discontinued intermittent
testing business have been reported as discontinued operations. This
reclassification had no effect on the Companys previously reported
consolidated financial position, net loss or cash flows. The Company has identified certain of its significant accounting policies that
it considers particularly important to the portrayal of the Companys results
of operations and financial position and which may require the application of a
higher level of judgment by the Companys management, and as a result are
subject to an inherent level of uncertainty. These are characterized as
critical accounting policies and address the accounting for and
classification of debt and equity instruments, revenue recognition and accounts
receivable, inventories, foreign currency translation and transactions,
impairment of long-lived assets and retirement plan funding, each more fully
described under Managements Discussion and Analysis of Results of Operations
and Financial Condition in the Companys Annual Report on Form 10-K for the
year ended December 31, 2003. No other changes to the Companys critical
accounting policies have been made during the quarter ended September 30, 2004. These statements should be read in conjunction with the financial statements
and related notes which are part of the Companys Annual Report on Form 10-K
for the year ended December 31, 2003. (2) SERIES G CONVERTIBLE PREFERRED STOCK FINANCING On May 28, 2004, the Company completed a $1.5 million financing through the
sale of 15,000 shares of Series G convertible preferred stock at $100 per
share. The financing was completed in a private placement with the Mercator
Advisory Group and its related funds and BCC Acquisition II, LLC. The Mercator
Advisory Group and its related funds were also the investors in the Companys
Series E and Series F convertible preferred stock issued in May 2003 and
January 2004, respectively. Each share of the Series G preferred stock is
convertible at any time into common stock at 75% of the volume weighted average
trading price of the lowest three inter-day trading prices of the common stock
during the five consecutive trading days preceding the conversion date, with a
maximum exercise price of $.14 per share and a minimum price of $.06 per share.
The Company held a special meeting of its shareholders to request an increase
in its authorized common stock from 100 million shares to 200 million shares on
September 7, 2004. After the shareholders approved that increase, the minimum
exercise price was decreased automatically to $.03 per share pursuant to the
Certificate of Designations of Series G Convertible Preferred Stock, without
further amendment. As part of this financing, the Company issued three-year warrants (Series G
warrants) to the purchasers of the Series G preferred stock. Those warrants
entitle the holders to purchase an aggregate of 1,250,000 shares of the
Companys common stock at the lower of $.11 per share or the average of the
lowest ten inter-day closing prices of the Companys common stock during the
ten trading days preceding the exercise 6




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date. The Company also issued
three-year warrants to the Mercator Advisory Group and its related funds that invested in the Companys
Series E and Series F preferred stock to purchase an aggregate of 12,241,608
shares of common stock at $.05 per share. Additionally, in connection with the Series G financing, the holders of the
Companys Convertible Senior Secured Fixed Rate Notes agreed to defer until
December 31, 2004 the Companys obligation to make interest payments previously
due on June 30, 2004 (including interest payments originally due on December
31, 2003 and March 31, 2004, payment of which was deferred until June 30, 2004)
and September 30, 2004. In exchange for the deferral of interest payments, the
exercise price on the note holders common stock warrants was reduced from $.34
per share to $.09 per share. Finally, in connection with the Series G
financing, the exercise price of the outstanding common stock warrants issued
as part of the Series E preferred stock financing was reduced from $.35 per
share to $.11 per share, and the ceiling price for the exercise of the common
stock warrants issued as part of the Series F preferred stock financing was
reduced from $.35 per share to $.11 per share. The Series G financing effectively replaced the unfunded second tranche of the
Series F preferred stock financing arranged in January 2004. As expected, the
first $1.5 million tranche of financing generated in January 2004 under the
Series F preferred stock agreement and other available funds had been
substantially consumed by operations by the time the Series G financing was
completed. This additional financing was necessary to help meet near-term
funding requirements for support of the Companys operations as the Company
continued to pursue longer-term financing in order to sustain the development
of its continuous monitoring business and explore additional applications of
its technology. Accounting for these transactions required a review of several criteria,
including assessment of the treatment of the conversion feature associated with
the Series G preferred stock, an assessment of the classification as debt or
equity of the warrants issued in connection with the Series G preferred stock
financing, an assessment of the impact of the changes in the exercise and
ceiling exercise prices, as applicable, of the common stock warrants previously
issued to the note holders and the Series E and Series F preferred stock
investors and an assessment of the treatment of the fair value associated with
the new warrants issued to the Series E and Series F preferred stock investors. The application of the provisions of EITF 98-5, Accounting for Convertible
Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Ratios, and EITF 00-27, Application of Issue 98-5 to Certain
Convertible Instruments resulted in the calculation of an embedded beneficial
conversion feature in the Series G preferred stock, which is required to be
treated as a deemed dividend to preferred shareholders. The Company allocated
the net investor proceeds of $1,445,000 from the issuance of the Series G
convertible preferred stock to the preferred stock and Series G warrants based
upon their relative fair values. The fair value allocated to the Series G
warrants of $68,205 was recorded as equity. The fair value allocated to the
preferred stock of $1,376,795 was used to calculate the value of the beneficial
conversion feature of $1,067,650. The $1,067,650 was charged to retained
earnings with the offsetting credit to additional paid-in-capital. The Company
treated the beneficial conversion feature of $1,067,650 as a reconciling item
on the statement of operations to adjust its reported net loss to net loss
available to common shareholders, which is used in the numerator in the loss
per share calculation for the nine months ended September 30, 2004. The Company classified the warrants issued in connection with the Series G
preferred stock financing as equity rather than debt based upon an assessment
of the Companys contractual obligations for registration of the related common
shares issuable upon exercise of the warrants as provided under EITF 00-19
Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Companys Own Stock. As further discussed in note 5, the
reduction in the exercise price of the note holders warrants from $.34 to $.09
increased the fair value of those warrants by an estimated $70,517, which was
recorded in the second quarter 2004 as a charge to interest expense with an
offsetting credit to additional paid-in capital. The issuance of new warrants
to the Series E and Series F investors and the reduction in the exercise price
or ceiling exercise price, as applicable, of the warrants previously issued to
these investors resulted in a deemed dividend on the Series E and Series F
preferred stock, requiring a charge to retained earnings and an offsetting
credit to additional paid-in capital aggregating $1,050,690. Similar to the
beneficial conversion feature on the Series G preferred stock, this amount was
charged to retained earnings, with an offsetting 7




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credit to additional paid-in-capital, and was treated as a reconciling item on the statement of operations
to adjust the reported net loss to net loss available to common shareholders,
which is used in the numerator in the loss per share calculation for
the nine
months ended September 30, 2004. (3) SERIES F CONVERTIBLE PREFERRED STOCK FINANCING On January 16, 2004, the Company completed the sale in a private placement of
15,000 shares of Series F convertible preferred stock at a price of $100 per
share, resulting in aggregate gross proceeds to the Company of $1.5 million.
Each share of preferred stock is convertible at any time into common stock at
75% of the volume weighted average trading price of the lowest three inter-day
trading prices of the common stock for the five consecutive trading days
preceding the conversion date, but at an exercise price of no more than $.25
per share and no less than $.20 per share. In accordance with the terms of the
Series F preferred stock agreement, the floor conversion price was reduced to
$.15 per share effective June 30, 2004, due to the Companys inability to
achieve a six-month cash flow projection through that date. Five-year warrants
were also issued to purchase an aggregate of 6,000,000 shares of the Companys
common stock at the lower of $.35 per share or the average of the lowest ten
inter-day closing prices of the Companys common stock on the Over-the-Counter
Bulletin Board during the 10 trading days immediately preceding the exercise
date. As discussed in note 2, the ceiling exercise price on the Series F
warrants was reduced from $.35 to $.11 per share in connection with the Series
G preferred stock financing transaction completed in May 2004. Proceeds from
the Series F interim financing were used to help meet the Companys short-term
funding requirements for support of its operations. Accounting for this transaction falls primarily under EITF 98-5, Accounting
for Convertible Securities with Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios, and EITF 00-27, Application of Issue 98-5 to
Certain Convertible Instruments. The Company allocated the net investor
proceeds of $1,350,000 from the issuance of the Series F convertible preferred
stock to the preferred stock and associated warrants based upon their estimated
relative fair values. The resulting fair value allocations of $665,994 and
$684,006 for the preferred stock and warrants, respectively, were recorded as
equity in the first quarter 2004. The beneficial conversion feature embedded
in the preferred stock was calculated at $665,994 and was limited to the fair
value allocated to the preferred stock. The beneficial conversion feature of
$665,994 was treated as a deemed dividend to preferred shareholders, and was
charged to retained earnings, with the offsetting credit to additional
paid-in-capital. Additionally, the Company treated the beneficial conversion
feature of $665,994 as a reconciling item on the statement of operations to
adjust its reported net loss to net loss available to common shareholders,
which is used in the numerator in the loss per share calculation for the
nine months ended September 30, 2004. The Company classified the warrants issued in
connection with the Series F preferred stock financing as equity rather than
debt based upon an assessment of the Companys contractual obligations for
registration of the related common shares issuable upon exercise of the
warrants as provided under EITF 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Companys Own Stock. (4) DISCONTINUED OPERATIONS On September 29, 2003, the Company completed the sale of substantially all of
the assets used in the Companys intermittent testing business to International
Technidyne Corporation (ITC), a wholly owned subsidiary of Thoratec
Corporation, for approximately $5.2 million in cash and the assumption of
certain liabilities, including trade payables of approximately $583,000. Of
the $5.2 million cash payment, $758,000 was placed in escrow and restricted
from the Companys use for 180 days to cover excess trade payables assumed by
ITC, any shortfall in collected receivables or any indemnification claims. The
carrying value of assets sold to ITC approximated $3 million, and ITC assumed
liabilities of the intermittent testing business totaling $669,000. As
prescribed by SFAS No. 144, Accounting for the Impairment of Long-lived
Assets, the Company began reporting the results of operations of the
intermittent testing business as discontinued operations effective with the
quarter ended September 30, 2003, for all periods presented. Upon completion
of the sale transaction in September 2003, the Company recorded a gain on the
sale of the intermittent testing business of $1.8 million. In late March 2004,
sale proceeds remaining in escrow and deferred for 8




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recognition were released to
the Company, amounting to approximately $713,000. After deducting transaction costs of
$156,000, an additional gain on the sale of discontinued operations was
recognized in the first quarter 2004 of approximately $557,000. (5) CONVERTIBLE SENIOR SECURED FIXED RATE NOTES Effective April 7, 2003, the Company completed the renegotiation of the terms
of its $7.3 million Convertible Senior Secured Fixed Rate Notes due August 4,
2003, to extend repayment of the notes to August 4, 2005. In exchange for the
extension of repayment, the Company agreed to reduce the conversion price for
$6.9 million principal value of the notes from $8.40 to $3.51 per share, and to
use 50% of the net proceeds in excess of $10 million received prior to August
4, 2005 from the issuance of any equity securities to pay down the principal
value of the notes. In addition, the Company issued the note holders
five-year warrants for 4,255,837 shares of its common stock at an exercise
price of $.94 per share. This transaction requires accounting treatment
prescribed under EITF 96-19, Debtors Accounting for a Modification or Exchange
of Debt Instruments. As such, the modified notes and associated warrants were
recorded in the second quarter 2003 as debt and equity, respectively, at their
respective individual fair values of $5 million and $800,000. The $7.3 million
carrying value of the original notes was retired, and the residual amount of
$1.5 million was recorded in the second quarter 2003 in other income as a gain
on modification of the notes. The Company will accrete the initial $5 million
carrying value of the modified notes to their redemption value of $7.3 million
over the remaining term of the notes using the effective interest method at an
effective interest rate of approximately 17%. This will result in the
recording of $2.3 million of additional interest expense over the remaining
term of the notes, of which $252,895 and $728,921 was recorded in the three and
nine months ended September 30, 2004, respectively, compared to $215,013 and
$408,226 for the three and nine months ended September 30, 2003. In January 2004, the note holders agreed to further amend the Note Purchase
Agreement effective December 30, 2003 to defer the timing of interest payments
due for the fourth quarter 2003 and the first quarter 2004, amounting to
approximately $256,000, to June 30, 2004, and to reduce the exercise price of
the warrants from $.94 per share to $.34 per share. In connection with the
Series G preferred stock financing completed in May 2004, the note holders
agreed to again amend the Note Purchase Agreement to defer until December 31,
2004 the Companys obligation to make interest payments previously due on June
30, 2004 (including the deferred interest payments described above) and
September 30, 2004, amounting to approximately $640,000. In exchange for the
deferral of interest payments, the exercise price on the note holders common
stock warrants was further reduced from $.34 per share to $.09 per share. The
first and second quarter reductions in the exercise price of the warrants
resulted in an increase in the fair value of the warrants of $90,674 and
$70,517, respectively. These amounts were recorded as a charge to interest
expense with an offsetting credit to additional paid-in capital in the
respective quarter. The Company evaluated the appropriate accounting treatment
for the modification of the terms of the convertible notes and associated
warrants and determined that the provisions of SFAS No. 15, Accounting for
Debtors and Creditors for Troubled Debt Restructurings, and EITF 96-19,
Debtors Accounting for a Modification or Exchange of Debt Instruments, were
not applicable. (6) SUBSEQUENT EVENT On October 14, 2004, the Company announced that it had initiated a
restructuring of all its domestic and international operations. As a result of
the restructuring, the Company has ceased manufacturing and support of its only
current products, the Trend Care line of continuous blood and tissue monitoring
systems. The Company is completing certain batches of production in process
and is offering its customers the opportunity to purchase those products, when
complete, as well as all products in inventory at the time the restructuring
was announced. Virtually all employees were terminated in early November 2004. The Company is pursuing additional financing to allow it to develop additional
applications for its technology. If additional funds are not obtained, the
Company will have no alternative but to cease all operations in the near
future. 9




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It is unlikely that future product development activities would require many of
the existing assets and the Company has therefore recorded a restructuring
charge in the quarter ended September 30, 2004 to reduce property and equipment
and inventory that it does not expect to sell to estimated realizable values.
The Company also expects to implement some formal plan of discontinuing
operations of its United Kingdom subsidiary which will impact the amounts of
recorded liabilities in addition to the impairment of assets previously noted.
No adjustments have been made to those liabilities pending final resolution of
this matter. The financial statements have otherwise been prepared on a going-concern basis
which contemplates realization of assets, as adjusted, and satisfaction of
liabilities and commitments in the normal course of business. The
report of the Companys independent auditors pertaining to the
Companys consolidated financial statements for the year ended
December 31, 2003 contained an explanatory paragraph expressing
substantial doubt about the Companys ability to continue as a going
concern as a result of recurring losses and negative cash flows. Failure to
obtain additional funding during November 2004 would likely result in
discontinuing business as a going-concern. (7) LIQUIDITY The Company incurred a consolidated net loss of $7,835,886 for the nine months
ended September 30, 2004, preceded by a consolidated net loss of $8,479,145
(including net losses from continuing operations of $8,240,168) for the year
ended December 31, 2003, and has incurred net losses since inception. The net
loss for the 2004 year-to-date period is net of a $557,000 gain recognized upon
the release in late March 2004 of escrowed proceeds from the Companys sale of
its intermittent testing business effective September 29, 2003. The Companys aggregate cash balance (including the impact of restricted cash)
decreased by approximately $946,873 during the nine months ended September 30,
2004 to $88,472. Primarily impacting the reduction in cash during the first
half of 2004 was a net loss from operations excluding noncash items of $7.8
million, partially offset by net proceeds of $2.7 million from the issuance
during the first and second quarters of Series F and Series G convertible
preferred stock, respectively, and the receipt of escrowed proceeds of
approximately $.7 million from the sale of the Companys intermittent testing
business. As discussed in Discontinued Operations under note 4 to the consolidated
financial statements, on September 29, 2003, the Company completed the sale of
substantially all of the assets used in the operation of the Companys
intermittent testing business to ITC. Gross proceeds received at closing
amounted to $4,420,000, of which approximately $389,000 was used to pay accrued
interest due on the Companys Convertible Senior Secured Fixed Rate Notes.
Proceeds from the sale also included approximately $758,000 placed in escrow by
ITC and restricted from the Companys use for 180 days to cover excess trade
payables assumed by ITC, any shortfall in collected receivables or any
indemnification claims. In late March 2004, sales proceeds remaining in escrow
were released to the Company, amounting to $713,000. Effective upon the sale of
the Companys intermittent testing business, the holders of the Companys
Series E preferred stock elected to exercise their option to put back to the
Company 50% of their original $1.5 million investment plus a return of 1% per
month. As a result, in October 2003, the Company redeemed $750,000 in value of
the Series E preferred stock, with cash payments of $790,250 including accrued
interest. Additionally, the Company made payments of approximately $600,000
after the completion of the sale transaction for accrued retention bonuses
earned by employees and accrued vacation pay for employees transferring to ITC
or leaving the Company. Also, as part of changes made to reduce the cost
structure of the Companys continuing operations, the Company made payments
after the closing of the sale for severance and related costs of approximately
$659,000. As more fully discussed under note 3 to the consolidated financial statements,
on January 16, 2004, the Company completed the sale in a private placement of
15,000 shares of Series F convertible preferred stock at a price of $100 per
share, resulting in aggregate gross proceeds to the Company of $1.5 million.
Five-year warrants were also issued to purchase an aggregate of 6,000,000
shares of the Companys common stock at the lower of $.35 per share or a
defined average trading price preceding exercise, providing a potential source
of future funding. 10




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Proceeds from this financing were used
to help meet the Companys short-term funding requirements for support of its
operations, as the Company continued to pursue longer-term financing. In late
April 2004, the Company received shareholder approval to increase its number of
authorized shares of common stock by 40 million shares to 100 million shares,
enhancing the Companys ability to pursue additional equity financing. In conjunction with the sale of Series F preferred stock in January 2004,
holders of the Companys Convertible Senior Secured Fixed Rate Notes agreed to
amend the Note Purchase Agreement effective December 30, 2003 to defer the
timing of interest payments due for the fourth quarter 2003 and the first
quarter 2004, amounting to approximately $256,000, to June 30, 2004, and to
reduce the exercise price on their outstanding warrants from $.94 per share to
$.34 per share. The reduction in the exercise price resulted in an increase in
the fair value of the warrants of $90,674, which was recorded as a noncash
charge to other expense with an offsetting credit to additional paid-in-capital
in the first quarter 2004. As noted below, the convertible notes and common
stock warrants were further modified in May 2004. On May 28, 2004, the Company completed a $1.5 million financing through the
sale of 15,000 shares of Series G convertible preferred stock at $100 per
share. The financing was completed in a private placement with the Mercator
Advisory Group and its related funds and BCC Acquisition II, LLC. The Mercator
Advisory Group and its related funds were also the investors in the Companys
Series E and Series F convertible preferred stock issued in May 2003 and
January 2004, respectively. Each share of the Series G preferred stock is
convertible at any time into common stock at 75% of the volume weighted average
trading price of the lowest three inter-day trading prices of the common stock
during the five consecutive trading days preceding the conversion date, with a
maximum exercise price of $.14 per share and a minimum price of $.06 per share.
The Company held a special meeting of its shareholders in September 2004 to
request an increase in its authorized common stock from 100 million shares to
200 million shares. The shareholders approved that increase. The minimum
exercise price was decreased automatically to $.03 per share pursuant to the
Certificate of Designations of Series G Convertible Preferred Stock, without
further amendment. As part of this financing, the Company issued three-year warrants (Series G
warrants) to the purchasers of the Series G preferred stock. Those warrants
entitle the holders to purchase an aggregate of 1,250,000 shares of the
Companys common stock at the lower of $.11 per share or a defined average
trading price preceding the exercise date. The Company also issued three-year
warrants to the Mercator Advisory Group and its related funds that invested in
the Companys Series E and Series F preferred stock to purchase an aggregate of
12,241,608 shares of common stock at $.05 per share. The issuance of new
warrants to the Series E and Series F investors was considered a dividend to
those preferred stockholders, and required a noncash charge to retained
earnings in the second quarter 2004 for the fair value of the warrants of
$1,035,684. Additionally, in connection with the Series G financing, the holders of the
Companys convertible notes agreed to defer until December 31, 2004 the
Companys obligation to make interest payments previously due on June 30, 2004
(including interest payments originally due on December 31, 2003 and March 31,
2004, payment of which was deferred until June 30, 2004) and September 30,
2004. In exchange for the deferral of interest payments, the exercise price on
the note holders common stock warrants was reduced from $.34 per share to $.09
per share. Finally, in connection with the Series G financing, the exercise
price of the outstanding common stock warrants issued as part of the Series E
preferred stock financing was reduced from $.35 per share to $.11 per share,
and the ceiling price for the exercise of the common stock warrants issued as
part of the Series F preferred stock financing was reduced from $.35 per share
to $.11 per share. The reduction in the exercise price of the note holders
warrants resulted in an increase in the fair value of the warrants of $70,517,
which was recorded as a noncash charge to interest expense with an offsetting
credit to additional paid-in-capital in the second quarter 2004. The change in
the exercise price terms of the Series E and Series F warrants was considered a
dividend to the Series E and Series F preferred stockholders, and required a
noncash charge to retained earnings in the second quarter 2004 for $15,006,
representing the increase in the fair value of the warrants. 11




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The Series G interim financing effectively replaced the unfunded second tranche
of the Series F preferred stock financing arranged in January 2004. As
expected, the first $1.5 million tranche of financing generated in January 2004
under the Series F preferred stock agreement and other available funds had been
substantially consumed by operations by the time the Series G financing was
completed. This additional financing was necessary to help meet short-term
funding requirements for support of the Companys operations. As part of an amendment to the exclusive distribution agreement with Philips
signed in April 2003, the Company was provided an option to purchase from
Philips certain unused inventory of TrendCare instruments previously sold to
Philips. In late 2003, the Company provided a forecast to Philips for the
purchase of approximately $0.6 million of TrendCare instruments over the course
of 2004. The Company has satisfied approximately $41,000 of its instrument
purchase commitment with Philips through June 30, 2004. The Company has advised
Philips it will not meet the remaining amount of its purchase commitment. The terms of the Companys Convertible Senior Secured Fixed Rate Notes require
a lump sum principal payment of $7.3 million in August 2005 to retire the
notes, to the extent the note holders do not elect to exercise the conversion
option prior to that date. The Company does not expect to be able to pay the
full maturity value of the notes. As such, the Company expects to either
renegotiate the terms of the notes to further extend repayment, or encourage
conversion to common stock, or raise additional capital to allow retirement of
the notes when due. In January 2003, the Company received a Nasdaq Staff Determination indicating
that the Company did not comply with the minimum stockholders equity
requirement for continued listing on the Nasdaq National Market and that its
securities were subject to delisting from that market. The Company
subsequently applied and received approval to transfer the listing of its
securities to the Nasdaq SmallCap Market effective February 26, 2003. The
Companys securities were later delisted from the SmallCap Market effective
July 2, 2003, due to its failure to comply with the minimum common stock market
value requirement for continued listing on that market. The Companys common
stock became immediately eligible to trade on the Over-the-Counter Bulletin
Board effective with the open of business on July 2, 2003 under the symbol
DMED. Trading of the Companys common stock through the Over-the-Counter
Bulletin Board may be more difficult because of lower trading volumes,
transaction delays and reduced security analyst and news media coverage of the
Company. These factors could contribute to lower prices and larger spreads in
the bid and ask prices for the Companys common stock. Trading of its common
stock in an over-the-counter market may also attract a different type of
investor in the Companys common stock, which may limit the Companys future
equity funding options. On June 9, 2004, KPMG LLP provided written notice to the Company that they
declined to stand for reappointment and have resigned as auditors and principal
accountants for the year ending December 31, 2004. KPMG LLP informed the
Company that the client-auditor relationship would cease upon completion of the
review by KPMG LLP of the Companys consolidated financial statements as of and
for the three and six-month periods ended June 30, 2004. KPMG LLPs notice
further indicated that in connection with the audits of the consolidated
financial statements of the Company for the two years ended December 31, 2003,
and the subsequent interim period through June 9, 2004, there were no
disagreements with KPMG LLP on any matter of accounting principles or
practices, financial statement disclosure, or auditing scope or procedures,
which disagreements if not resolved to their satisfaction would have caused
them to make reference in connection with their opinion to the subject matter
of the disagreement. The Company has appointed Virchow Krause & Company as its
new auditors and principal accountants, effective early August 2004. (8) NET LOSS PER COMMON SHARE Basic earnings per share (EPS) is calculated by dividing net loss available
to common shareholders by the weighted average common shares 12




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outstanding during
the period. Diluted EPS reflects the potential dilution to basic EPS that could occur upon conversion or exercise of
securities, options, or other such items, to common shares using the treasury
stock method based upon the weighted average fair value of the Companys common
shares during the period. For each period presented, basic and diluted loss
per share amounts are identical, as the effect of potential common shares is
antidilutive. The following is a summary of outstanding securities which have
been excluded from the calculation of diluted EPS because the effect on net
loss per common share would have been antidilutive: September 30,2004
    
    2003Common stock options
    
    
    3,406,106
    
    
    
    4,150,022Common stock warrants
    
    
    21,811,426
    
    
    
    4,999,747Convertible senior secured fixed rate notes
    
    
    2,013,431
    
    
    
    2,013,431Convertible preferred stock  Series E
    
    
    
    
    
    
    2,142,857Convertible preferred stock  Series F
    
    
    6,666,667
    (1)
    
    
    Convertible preferred stock  Series G
    
    
    50,000,000
    (2)
    
    
    
  (1)
    
    Based upon the lowest potential conversion rate of $.15 per
share.(2)
    
    Based upon the lowest potential conversion rate as of
September 30, 2004 of $.03 per share. (9) COMPREHENSIVE LOSS Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (3,864,089
    )
    
    $
    (1,749,548
    )
    
    $
    (7,835,886
    )
    
    $
    (5,886,173
    )Change in cumulative translation adjustment
    
    
    46,695
    
    
    
    (12,228
    )
    
    
    82,664
    
    
    
    30,657Comprehensive loss
    
    $
    (3,817,394
    )
    
    $
    (1,761,776
    )
    
    $
    (7,753,222
    )
    
    $
    (5,855,516
    )
 (10) INVENTORIES September 30,
    
    December 31,2004
    
    2003Raw materials
    
    $
    152,825
    
    
    $
    391,364Work-in-process
    
    
    
    
    
    
    306,272Finished goods
    
    
    
    
    
    
    753,188$
    152,825
    
    
    $
    1,450,824
 (11) STOCK-BASED COMPENSATION As permitted by SFAS No. 123, Accounting for Stock-Based Compensation, the
Company applies the intrinsic-value method prescribed in Accounting Principles
Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, to
account for the issuance of stock incentives to employees and directors. As a
result, no compensation expense related to employees and directors stock
incentives has been recognized in the financial statements as all options
granted under stock incentive plans had an exercise price equal to the market
value of the underlying common stock on the date of grant. Had compensation
costs for the Companys stock incentive plans been determined based on the fair
value of the awards on the date of grant, consistent with the provisions of
SFAS No. 123, the Companys net loss per share would have increased to the pro
forma amounts indicated below: 13




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Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Actual net loss available to common shareholders
    
    $
    (4,491,238
    )
    
    $
    (2,184,966
    )
    
    $
    (6,756,131
    )
    
    $
    (5,075,587
    )Pro forma stock-based compensation expense
    
    
    (214,649
    )
    
    
    (404,869
    )
    
    
    (429,298
    )
    
    
    (774,300
    )Pro forma net loss available to common shareholders
    
    $
    (4,705,887
    )
    
    $
    (2,589,835
    )
    
    $
    (7,185,429
    )
    
    $
    (5,849,887
    )Actual basic and diluted net loss per share
    
    $
    (0.15
    )
    
    $
    (0.08
    )
    
    $
    (0.23
    )
    
    $
    (0.19
    )Pro forma stock-based compensation expense
    
    
    (0.01
    )
    
    
    (0.02
    )
    
    
    (0.01
    )
    
    
    (0.03
    )Pro forma basic and diluted net loss per share
    
    $
    (0.16
    )
    
    $
    (0.10
    )
    
    $
    (0.24
    )
    
    $
    (0.22
    )
 No stock options were granted under the Companys stock option plans during the
three and nine months ended September 30, 2004. The per share weighted average fair
value of stock options granted during the three and nine months ended
September 30,
2003 was $.72, determined using the Black Scholes option-pricing model with the
following assumptions: an expected life of five years and no dividends, an
annualized volatility of 97.5% and a risk-free interest rate of 2.3%. (12) PRODUCT WARRANTY The Company, in general, warrants its new hardware products to be free from
defects in material and workmanship under normal use and service for a period
of eighteen months after date of shipment in the case of distributors, and one
year after date of sale in the case of end-user customers. The Company
warrants its disposable products to be free from defects in material and
workmanship under normal use until its stated expiration date. Under the terms
of these warranties, the Company is obligated to repair or replace the products
it deems to be defective due to material or workmanship. Beginning in the
fourth quarter 2003, the Company established provisions for the estimated cost
of maintaining product warranties for the hardware and disposable products of
its continuing operations based on an estimated average per unit repair or
replacement cost applied to the estimated number of units under warranty. The
estimated average per unit repair or replacement cost reflects historical
warranty incidence over the preceding twelve-month period. Evaluation of the
reserve also includes consideration of other factors, including sales levels
and types of warranty claims received. While warranty claims have not been
material to the Companys consolidated financial statements, the warranty
reserve will be evaluated on an ongoing basis to ensure its adequacy. (13) RELATED PARTY TRANSACTIONS In August 1998, the Company issued Convertible Senior Secured Fixed Rate Notes,
with proceeds aggregating $7,300,000, which were used to retire other debt of
the Company. The investor group was led by BCC Acquisition II LLC. Effective
April 7, 2003, the Company and the note holders completed a modification of the
terms of the notes, including a two-year extension of repayment of the notes to
August 4, 2005 and a reduction in the conversion price for $6,900,000 of the
notes from $8.40 to $3.51 per share. Additionally, the note holders received
five-year warrants for 4,255,837 shares of the Companys common stock, at an
exercise price of $.94 per share, subsequently reduced to $.34 per share and
further reduced to $.09 per share as part of amendments to the Note Purchase
Agreement completed in January 2004 and May 2004, respectively. (14) DEFINED BENEFIT RETIREMENT PLAN FUNDING The Companys U.K. subsidiary sponsors a contributory defined benefit
retirement plan (Retirement Plan) covering all eligible employees. The
Companys funding policy is to contribute into a trust fund at an annual rate
that is intended to remain at a level percentage of total pensionable payroll.
Annual contribution amounts are determined by a qualified actuary and are
intended to adequately fund the Companys 14




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projected pension liability payable
upon employees retirement, given actuarial assumed rates
of average market and
trust fund investment performance. The Company modified the
Retirement Plan effective August 31, 2003 to close the plan to future accrual
of benefits. Company contributions made subsequent to August 31, 2003 will be
allocated fully to reduce the Retirement Plans liabilities for participant
benefits earned through August 31, 2003, thus helping to secure participants
benefits earned through that date, and reducing the Companys exposure to a
potential future significant funding obligation. Subsequent to the August 31,
2003 modification of the Retirement Plan, the actuarial determined minimum
funding requirement was established at 7,000 British pounds per month (or
approximately $12,700 U.S. dollars based upon January 2004 exchange rates
between the British pound sterling and the U.S. dollar). As disclosed in the
Companys Annual Report on Form 10-K for the year ended December 31, 2003, the
Company was funding the Retirement Plan at this minimum level during 2004. The
Company has discontinued funding the Plan and is exploring options to satisfy
Plan obligations. (15) NEW ACCOUNTING PRONOUNCEMENTS EITF Issue No. 03-01, Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments, addresses both qualitative and
quantitative disclosures required for marketable equity and debt securities
accounted for under Financial Accounting Standards Board (FASB) Statement No.
115, Accounting for Certain Investments in Debt and Equity Securities. The
disclosure requirements are effective for fiscal years ending after December
15, 2003. Additionally, the FASBs Emerging Issues Task Force issued an EITF
Consensus in April 2004 that will require companies carrying debt and equity
securities at amounts higher than the securities fair values to use more
detailed criteria to evaluate whether to record a loss and to disclose
additional information about unrealized losses. The other-than-temporary
impairment accounting guidance under the Consensus is effective for reporting
periods beginning after June 15, 2004 and the disclosure requirements for
annual reporting periods ending after June 15, 2004. EITF Issue No. 03-01 and
its follow-on Consensus guidance is not expected to have a material impact on
the Companys financial statements. In December 2003, the FASB issued revisions to Statement of Financial
Accounting Standards (SFAS) No. 132, Employers Disclosures about Pensions
and Other Postretirement Benefits. These revisions require changes to
existing disclosures as well as new disclosures related to pension and other
postretirement benefits, including disclosures about plan assets, investment
strategy, plan obligations and cash flows. The Company will be required to
adopt the new disclosure requirements of SFAS No. 132 effective with its
financial statements for the year ending December 31, 2004. Certain interim
period disclosure requirements relating to the components of net periodic
benefit cost and contribution information are effective beginning in the first
quarter 2004 and included in note 14. In March 2004, the Emerging Issues Task Force issued EITF 03-06, Participating
Securities and the Two-Class Method Under FASB Statement No. 128, Earnings per
Share. This issue addresses a number of questions regarding the computation
of earnings per share (EPS) by companies that have issued securities other
than common stock that contractually entitle the holder to participate in
dividends and earnings of the company, when, and if, it declares dividends on
its common stock. The issue also provides further guidance in applying the
two-class method of calculating EPS. It clarifies what constitutes a
participating security and how to apply the two-class method of computing EPS
once it is determined that a security is participating, including how to
allocate undistributed earnings to such a security. The Company is evaluating
the impact of the issue; however, it does not expect the issue to impact the
calculation of basic or diluted EPS in 2004, as the Company expects to incur a
net loss for the year ending December 31, 2004, causing all potentially
dilutive securities to be anti-dilutive. (16) CONTRACT TERMINATION COSTS Effective May 31, 2004, the Company terminated the lease on one of its
facilities located in the United Kingdom and incurred an early termination
penalty of 30,000 British pounds sterling. Additionally, the Company vacated a
small facility under lease in Malvern, Pennsylvania effective June 30, 2004.
The Company is responsible for monthly payments under the noncancellable lease
agreement for the Pennsylvania facility through March 2007 and is pursuing a
third-party sublease of the property. The Company reviewed the provisions of
SFAS No. 146, 15




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Accounting for Costs Associated
with Exit or Disposal
Activities to assess its expected liability associated with vacating the
Pennsylvania facility
and terminating the lease on its U.K. facility. In accordance with SFAS No.
146, the Company reduced the value of its remaining contractual commitment on
the Pennsylvania lease by the estimated sublease income that could reasonably
be obtained for the property, based upon feedback from the Companys real
estate broker. As a result, the Company incurred a charge to operating
expenses and established a liability for $42,390 as of June 30, 2004 relating
to the Pennsylvania facility. The early termination penalty on the U.K.
facility remaining unpaid as of June 30, 2004 of approximately $45,000 was
likewise recorded as a charge to operating expenses and established as a
liability as of June 30, 2004. 
 Item 2. Managements Discussion and Analysis of Results of Operations and
Financial Condition The Companys discussion and analysis of results of operations and financial
condition include forward-looking statements, which may include statements
regarding the Companys expectations about future financial performance; the
continuation of historical trends; the sufficiency of its cash balances and
cash generated from operating activities for future liquidity and capital
resource needs; the expected impact of changes in accounting policies on the
Companys results of operations, financial condition or cash flows; anticipated
problems and its plans for future operations; and the economy in general or the
future of the medical device industry, all of which are subject to various
risks and uncertainties. Actual results may differ materially from the
Companys expectations depending on a variety of important factors, including,
but not limited to such factors as the Companys ability to successfully
implement its new business plan; the Companys ability to raise an adequate
level of capital to fund its operations; market demand and pressures on the
pricing for its products; changing market conditions, competition and growth
rates within the medical device industry; changes in accounting policies; risks
associated with operations outside of the U.S.; changing economic conditions
such as general economic slowdown, decreased consumer confidence and the impact
of war on the economy; and other risks and uncertainties, including those
described in Exhibit 99.1 to the Companys Form 10-K filed with the U.S.
Securities and Exchange Commission, with respect to the Companys fiscal year
ended December 31, 2003. When used in this Form 10-Q, and in future filings by
the Company with the Securities and Exchange Commission, in the Companys press
releases, presentations to securities analysts or investors, in oral statements
made by or with the approval of an executive officer of the Company, the words
or phrases believes, may, will, expects, should, continue,
anticipates, intends, will likely result, estimates, projects, or
similar expressions and variations thereof are intended to identify such
forward-looking statements. OVERVIEW The Company experienced significant changes over the past year. The Companys
primary line of business from its inception in 1990 through September 2003 was
the development, manufacture and distribution of intermittent blood testing
products. That line of business, which comprised 66% and 57% of consolidated
revenues for the years ended December 31, 2003 and 2002, respectively, was sold
in late September 2003. In late 1996, the Company acquired a continuous blood
and tissue monitoring business. This business, now known as Diametrics Medical,
Ltd, has operated as a wholly owned subsidiary of the Company, with
manufacturing, research and development and marketing operations located in
High Wycombe, England. The Companys continuous monitoring systems are based on fiber optic sensor
technology which measures color changes optically via light transmitted through
plastic fibers embedded with fluorescent dyes sensitive to chemicals in blood
and tissue. Products include the TrendCare Continuous Blood Gas Monitoring
Systems and the Neurotrend Cerebral Tissue Monitoring System. The TrendCare
systems provide immediate and continuous information on blood gases and
temperature in adult, pediatric and neonatal patients via a fiber optic sensor
placed through an arterial catheter. Neurotrend continuously monitors oxygen,
carbon dioxide, acidity and temperature through sensors placed directly 16




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in
brain tissue, providing critical information regarding blood supply and oxygen
levels in the brain that can guide clinicians and surgeons in treating patients
with head trauma or those requiring surgery in
the brain. The Company has distributed its Neurotrend cerebral tissue
monitoring system through Codman under an exclusive worldwide distribution
agreement. The Company ended an exclusive distribution arrangement with Philips Medical
Systems in late 2002 and started developing its own sales force and
distribution network. Operations have never produced a significant portion of
the funds required to continue developing the business and external fund
raising efforts have become more difficult. The Companys Board of Directors
therefore concluded that it was not practicable to continue both lines of
business, and in early 2003, started the process which led to the sale of the
intermittent testing business. Management subsequently focused on reinvigorating the continuous monitoring
business. Many of the systems installed during recent years are relatively
inactive. The entire sales and sales support organization in Europe, the
United States and various international markets has worked during 2004 to
increase utilization, and therefore sensor sales, where appropriate.
Management had directed most of its sales and sales support resources to
European markets, where sales opportunities for its continuous monitoring
products appear most promising. New account efforts were focused on the
neonatal market based on the more immediately recognized benefits in caring for
critically ill newborns. Distributor relationships were carefully managed to
focus on approximately ten countries where opportunities appeared greatest.
Finally, the Company has actively explored new applications for its technology. The Company has had the only continuous blood and tissue monitoring systems on
the market, although various companies have previously tried to develop similar
products. Continuous monitoring has not yet become the standard of care, so
much of the Companys sales and marketing efforts were directed toward
education of physicians and clinicians involved in caring for critically ill
patients. The systems sold by the Company consisted of a monitor, a patient
data module, and a calibrator, which can support several monitors. After
systems were installed, revenue was derived from the disposable sensors
required for each use of the system. The Company has not penetrated a
significant portion of either the neonatal market or the critically ill
pediatric and adult market. The sale of the intermittent testing business generated gross cash proceeds of
$5.2 million, including escrowed proceeds released in late March 2004. A
significant portion of the proceeds were required to satisfy commitments for
severance payments, accrued vacation obligations and various other employee
related commitments as well as accrued interest payments and the mandatory
redemption of half of the Companys Series E preferred stock. As a result of
those commitments and the fact that significant management and administrative
expenses continue, the Company was required to draw down the first $1.5 million
tranche of financing under a $3 million Series F convertible preferred stock
agreement completed in January 2004. Additionally, in late May 2004, the
Company completed a $1.5 million private placement under a Series G convertible
preferred stock agreement. This financing effectively replaced the unfunded
second $1.5 million tranche of the Series F preferred stock financing arranged
in January 2004. As expected, the $1.5 million of financing generated in
January 2004 under the Series F preferred stock agreement and other available
funds had been substantially consumed by operations by the time the Series G
financing was completed. This additional financing was necessary to meet
near-term funding requirements for support of the Companys operations. RESULTS OF OPERATIONS Revenue.The Companys total revenue from continuing operations was $697,443
and $1,992,738 for the three and nine months ended September 30, 2004, compared
to $809,595 and $2,219,068 for the same periods in the prior year, a decrease
of 14% and 10% for the three and nine month periods, respectively. The decline in revenue during the third quarter and nine months ended September
30, 2004 was due primarily to a reduction in disposable sensor revenues. This
reduction resulted primarily from the timing of disposable sensor purchases by
two major customers in the prior year, 17




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with a concentration of those purchases
in that years first quarter. Products sold internationally, consisting
primarily of sales in
Europe, comprised approximately 68% and 76% of total product revenue from
continuing operations for the three and nine months ended September 30, 2004,
respectively, compared to 82% and 78% for the respective periods in 2003.
Remaining product revenue in each period was generated in the United States. Cost of Revenue.Cost of revenue totaled $852,349 and $2,145,249, or 122% and
108% of total revenue for the three and nine months ended September 30, 2004,
compared to $551,746 and $1,798,047, or 68% and 81% of total revenue for the
same periods last year. The increase in cost of revenue as a percentage of
total revenue was impacted primarily by reduced sensor production volumes and
lower resulting absorption into inventory of overhead costs in the 2004
periods. Also contributing to the increase was the impact of lower average
selling prices extended on large volume orders. Partially offsetting the impact
of these changes was an increase in average selling prices for sensors, due to
selling direct rather than through exclusive distributors. Operating Expenses.Total operating expenses for the three and nine months
ended September 30, 2004 totaled $3,359,949 and $6,906,103, a 36% and 4%
increase relative to the respective periods last year. The increases in expense
were impacted largely by restructuring and other non-recurring charges. The
reduction in on-going expense reflects the Company reducing expenditures as
operations declined. Research and development expenditures totaled $415,952 and $1,321,495 for the
three and nine months ended September 30, 2004, a 24% and 21% decline relative
to the respective periods last year. Expenditures for the three and nine
months ended September 30, 2004 were reduced by the recognition of $50,430 and
$322,430 of funding from Codman under a development program to optimize
neurotrend sensor characteristics. Funding from Codman included the Companys
costs under the development program for labor, materials, overhead and a profit
margin. Selling, general and administrative expenses totaled $925,785 and $3,566,396
for the three and nine months ended September 30, 2004, compared to $1,264, 860
and $4,324, 425 for the same periods in 2003. The 27% and 18% net reduction in
expenses for the quarterly and year-to-date periods in 2004 was the result of a
reduction in general and administrative expenses of $250,503 and $501,922,
respectively, and a similar decrease in sales and marketing expenses of $88,572
and $256,107, respectively. The reductions were primarily due to cost cutting
in line with the decline of business operations. Restructuring and other non-recurring charges represent impairment charges for
non-saleable inventory and the write-down to estimated net realizable value of
property and equipment associated with operations discontinued in October 2004.
See note 6 to the consolidated financial statements for further information. Other Income (Expense).The three and nine months ended September 30, 2004
include $349,234 and $1,334,324 of net other expense, respectively, compared to
$428,194 of net other expense and $592,307 of net other income for the
comparable periods in 2003. Most of this category represents interest expense. The significant changes between periods in net other income and expense
occurred primarily as a result of the accounting treatment for the modification
of the Companys Convertible Senior Secured Fixed Rate Notes in April 2003,
which resulted in the recognition of a $1.5 million gain during the second
quarter 2003. Further, the modification of the notes required the accretion of
the initial $5 million carrying value of the modified notes to their redemption
value of $7.3 million using the effective interest method over the remaining
term of the notes, resulting in $2.3 million of additional interest expense
over this period. Accordingly, the accretion of the note balance resulted in an
additional charge to interest expense of $252,895 and $728,922 for the three
and nine months ended September 30, 2004, compared to $215,013 and $408,226 for
the comparable periods in 2003. Additionally, as a result of amendments in
January 2004 and May 2004 to the Note Purchase Agreement 18




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which reduced the exercise price of the warrants issued in connection with the April 2003 notes
modification from $.94
to $.34 per share, and from $.34 to $.09 per share, respectively, the Company
recorded charges to interest expense during the nine months ended
September 30, 2004 for $161,191 representing the increase in
the fair value of the warrants stemming from the reductions in the exercise
price. The remaining increase in net other expense occurred as a result of an
increase in realized foreign currency transaction losses. Discontinued Operations.On September 29, 2003, the Company completed the sale
of substantially all of the assets used in the Companys intermittent testing
business to ITC for approximately $5.2 million in cash and the assumption of
certain liabilities, including trade payables of approximately $583,000. Of
the $5.2 million cash payment, $758,000 was placed in escrow and restricted
from the Companys use for 180 days to cover excess trade payables assumed by
ITC, any shortfall in collected receivables or any indemnification claims. As
prescribed by SFAS No. 144, Accounting for the Impairment of Long-lived
Assets, the Company began reporting the results of operations of the
intermittent testing business as discontinued operations effective with the
quarter ended September 30, 2003, for all periods presented. Upon completion
of the sale transaction in September 2003, the Company recorded a gain on the
sale of the intermittent testing business of $1.8 million. In late March 2004,
sale proceeds remaining in escrow and deferred for recognition were released to
the Company, amounting to approximately $713,000. After deducting transaction
costs of $156,000, an additional gain on the sale of discontinued operations
was recognized in the first quarter 2004 of approximately $557,000. The operations of the Companys intermittent testing business, reflected in
discontinued operations, reported a net loss of $949,717 and $2,071,036 for the
three and nine months ended September 30, 2003, respectively. Net Loss / Net Loss Available to Common Shareholders.The Companys reported
consolidated net loss amounts for the three and nine months ended September 30,
2004 of $3,864,089 and $7,835,886 were further adjusted by charges of $0 and
$2,784,334, respectively, for calculated beneficial conversion features on
preferred stock and deemed preferred stock dividends to arrive at net loss
available to common shareholders of $3,864,089 and $10,620,220, respectively.
These amounts are used in the numerator in the loss per share calculation for
each period. Such charges occurred as a result of the required accounting
treatment of the Companys issuance of $1.5 million of Series F convertible
preferred stock and associated warrants in January 2004, followed by the
issuance of $1.5 million of Series G convertible preferred stock and associated
warrants in May 2004, as further discussed in notes 2 and 3 to the consolidated
financial statements. Similarly, the Companys reported consolidated net loss
amounts for the three and nine months ended September 30, 2003 of $1,749,548
and $5,866,173 were further adjusted by a $958,962 charge for a beneficial
conversion feature to arrive at net loss available to common shareholders of 19




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$1,749,548 and $6,825,135, respectively. The charge in 2003 occurred as a
result of the required accounting
treatment of the Companys issuance of $1.5 million of Series E convertible
preferred stock and associated warrants in May 2003. LIQUIDITY AND CAPITAL RESOURCES On October 14, 2004, the Company announced that it had initiated a
restructuring of all its domestic and international operations. As a result
of the restructuring, the Company has ceased manufacturing and support of its
only current products, the Trend Care line of continuous blood and tissue
monitoring systems. The Company is completing certain batches of production in
process and is offering its customers the opportunity to purchase those
products, when complete, as well as all products in inventory at the time the
restructuring was announced. Virtually all employees were terminated in early
November 2004. The Company has depleted virtually all of its available cash and is pursuing
additional financing to allow it to develop additional applications for its
technology. If additional funds are not obtained, the Company will have no
alternative but to cease all operations
in the near future. It is unlikely that future product development activities would require many of
the existing assets and the Company has therefore recorded a restructuring
charge in the quarter ended September 30, 2004 to reduce property and equipment
and inventory that it does not expect to sell to estimated realizable values.
The Company also expects to implement some formal plan of discontinuing
operations of its United Kingdom subsidiary which will impact the amounts of
recorded liabilities in addition to the impairment of assets previously noted.
No adjustments have been made to those liabilities pending final resolution of
this matter. The financial statements have otherwise been prepared on a going-concern basis
which contemplates realization of assets, as adjusted, and satisfaction of
liabilities and commitments in the normal course of business. Failure to
obtain additional funding during November 2004 would likely result in
discontinuing business as a going-concern. In either event, it is
unlikely that the Company will be able to certify its compliance with
Section 404 of the Sarbanes-Oxley Act of 2002 by
December 31, 2004. The Companys aggregate cash balance (including the impact of restricted cash)
decreased by approximately $947,000 during the nine months ended September 30,
2004 to $88,472. Primarily impacting the reduction in cash during the first
half of 2004 was a net loss from operations excluding noncash items of $7.8
million, partially offset by net proceeds of $2.7 million from the issuance
during the first and second quarters of Series F and Series G convertible
preferred stock, respectively, and the receipt of escrowed proceeds of
approximately $.7 million from the sale of the Companys intermittent testing
business. Analysis of Changes in Cash Flows From Continuing Operations.Net cash used in
continuing operating activities totaled $3,902,681 for the nine months ended
September 30, 2004, compared to $3,164,076 for the same period in 2003. This
was primarily the result of consolidated net losses from continuing operations
each period adjusted by noncash items, amounting to $7.8 million and $5.6
million in 2004 and 2003, respectively. Net cash provided by investing activities totaled $480,483 for the nine months
ended September 30, 2004, compared to net cash provided in investing
activities of $3,065,074 for the nine months ended September 30, 2003.
Primarily impacting investing activities during the 2004 period was the receipt
in March 2004 of escrowed proceeds approximating $720,000 from the Companys
sale of its intermittent testing business. Purchases of property and equipment
partially offset the 2004 net increase in cash provided by investing activities
and comprised the full use of cash during the same period in 2003. Net cash provided by financing activities totaled $2,554,975 and $995,208 for
the nine months ended September 30, 2004 and 2003, respectively. Financing
activities in the current period were primarily impacted by the Companys
receipt in January 2004 and May 2004 of combined net proceeds of approximately
$2.7 million in connection with the completion of its Series F and Series G
convertible 20




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preferred stock financings. This was partially offset by principal
payments on capital lease obligations.
Financing activities in the prior years period stemmed primarily from the
Companys receipt in May 2003 of net proceeds of $1.2 million in connection
with the completion of a Series E convertible preferred stock financing. This
was partially offset by principal payments on borrowings and capital leases and
payment of debt extension costs related to the modification of the Companys
convertible notes. At September 30, 2004, the Company had U.S. tax net operating loss and research
and development tax credit carryforwards for income tax purposes of
approximately $132 million and $1.5 million, respectively. Pursuant to the Tax
Reform Act of 1986, use of a portion of the Companys net operating loss
carryforwards are limited due to a change in ownership. If not used, these
net operating loss carryforwards begin to expire in 2005 ($500,000) and at
increasing amounts between 2006 and 2023 ($31.6 million between 2006 and 2009,
and $98.2 million thereafter). The Companys foreign subsidiary also has a net
operating loss carryforward of approximately $57.5 million, which can be
carried forward indefinitely, subject to review by the governmental taxing
authority. Analysis of Changes in Cash Flows From Discontinued Operations.Net cash
provided by discontinued operations totaled $557,052 for the nine months ended
September 30, 2004, while net cash used in discontinued operations totaled
$749,316 for the same period in 2003. Activity in the current period
represents the release to the Company in late March 2004 of $713,000 of
proceeds remaining in escrow from the sale of the intermittent testing
business, reduced by $156,000 of related transaction costs. The use of cash
during the prior years period primarily reflects the net loss before noncash
items generated by the intermittent testing business during the period,
partially offset by improvements in working capital. 
 Item 3. Quantitative and Qualitative Disclosure About Market Risk The Company is exposed to market risk from foreign exchange rate fluctuations
of the British pound sterling to the U.S. dollar as the financial position and
operating results of the Companys U.K. subsidiary, DML, are translated into
U.S. dollars for consolidation. The Companys exposure to foreign exchange
rate fluctuations also arises from transferring funds to its U.K. subsidiary in
British pounds sterling. From November 1999 through October 2002, most of the
Companys sales were made to the Companys two global distribution partners,
Philips and Codman, with sales denominated in U.S. dollars, thereby
significantly mitigating the risk of exchange rate fluctuations on trade
receivables. With the termination of the exclusive agreement with Philips, the
Company established a direct sales force in the United States, the United
Kingdom and Germany, as well as nonexclusive third-party distributors in
various other countries. All sales made from the Companys U.S. operations are
denominated in U.S. dollars and, with the exception of sales to end-user
customers in Germany (which are denominated in euros), all sales made from DML
are denominated in British pounds sterling. The Company is currently
reassessing its risk of exchange rate fluctuations on trade receivables due to
changing distribution relationships and methods precipitated by the termination
of the Companys exclusive agreement with Philips. The Company is also exposed to both market and interest rate risk in the
actuarial valuation of its subsidiarys defined benefit retirement plan. The
Retirement Plans projected benefit obligation exceeded the fair value of plan
assets by approximately $3 million at the December 31, 2002 valuation date,
reflecting a $1.6 million and $2 million increase in the plans underfunded
status relative to December 31, 2001 and 2000, respectively. This occurred due
to an environment of weaker investment performance in the global markets over
the prior two to three years (which negatively affected the value of Retirement
Plan assets), and to a lesser extent, lower prevailing interest rates (which
drove the use of a lower discount rate to calculate the projected benefit
obligation, thereby increasing the amount of this obligation at December 31,
2002). While the underfunded status of the Companys Retirement Plan has
improved as of the most recent valuation date of December 31, 2003 to
approximately $2.5 million, and is expected to continue to improve over time as
a result of actuarial assumed improvements in future average market (and trust
fund) performance, the inability of the trust fund investments to perform at or
near these average projected rates of return over the employees remaining
service lives could result in a significant future funding obligation of the
Company. To help 21




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manage this exposure, the Company modified the Retirement
Plan effective August 31, 2003 to close
the plan to future accrual of benefits. The Retirement Plan continues to
exist; however, the liabilities of the Retirement Plan were frozen effective
August 31, 2003. The Company has discontinued funding the Plan
and is exploring options to satisfy plan obligations. 
 Item 4. Controls and Procedures (a) Evaluation of disclosure controls and procedures. Under the supervision and with the participation of management, including the
Companys Chief Executive Officer and Chief Financial Officer, the Company
evaluated the effectiveness of the design and operation of its disclosure
controls and procedures (as defined in Rule 13a-15(e) under the Securities
Exchange Act of 1934 (the Exchange Act)). Based upon that evaluation, the
Chief Executive Officer and Chief Financial Officer concluded that, as of the
end of the period covered by this report, the Companys disclosure controls and
procedures were effective in timely alerting them to the material information
relating to the Company (or its consolidated subsidiary) required to be
included in the reports the Company files or submits under the Exchange Act. (b) Changes in internal controls over financial reporting. During the quarter ended September 30, 2004, there has been no change in the
Companys internal control over financial reporting (as defined in Rule
13a-15(f) under the Exchange Act) that has materially affected, or is
reasonably likely to materially affect, its internal control over financial
reporting. 
 PART II - OTHER INFORMATION 
 Item 1. Legal Proceedings None 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities None 
 Item 3. Defaults Upon Senior Securities None 
 Item 4. Submission of Matters to a Vote of Security Holders A special meeting of the Companys shareholders was held on September 30,
2004. At the meeting, the shareholders voted to approve an amendment to the
Companys Amended and Restated Articles of Incorporation to increase the
number of shares of all classes of stock from 105,000,000 to 205,000,000,
and to increase the number of authorized shares of Common Stock, par value
$.01 per share, from 100,000,000 to 200,000,000. This amendment was
approved as follows: 24,914,627 votes For, 689,675 votes Against and
42,318 votes Abstained. Additionally, the Companys
shareholders voted to approve an amendment to the Companys
Certificate of Designations of Series F Convertible Preferred Stock
to clarify the relative priority of such stock in the event of a
liquidation. 
 Item 5. Other Information None 22




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Item 6. Exhibits Exhibit
    
    
    
    MethodNo.
    
    
    
    of Filing3.1
    
    Articles of Incorporation of the Company (as amended)
    
    Filed herewith4.1
    
    Certificate of Designations of Series F Convertible
Preferred Stock of the Company, as amended
    
    Filed herewith31.1
    
    Certification of the Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
    
    Filed herewith31.2
    
    Certification of the Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
    
    Filed herewith32.1
    
    Certification of the Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
    
    Filed herewith32.2
    
    Certification of the Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
    
    Filed herewith
   23




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DIAMETRICS MEDICAL, INC. 
 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. DIAMETRICS MEDICAL, INC.By:
    
    /s/ W. Glen WinchellW. Glen WinchellSenior Vice Presidentand Chief Financial Officer(and Duly Authorized Officer)
 Dated:  November 9, 2004 24