** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**FORM 10-QSB**

 

 

| **ý** |   | **QUARTERLY REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE  QUARTERLY PERIOD ENDED JANUARY 31, 2004** |
|------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                              |
| **o**      |   | **TRANSITION REPORT UNDER SECTION 13  OR 15(d) OF THE EXCHANGE ACT**                                                                         |

 

**Commission File Number 0-33295**

 

**MEDICALCV, INC.**

(Exact Name of Small Business Issuer as Specified in Its Charter)

 

| **Minnesota**                                                   |   | **41-1717208**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or Other Jurisdiction  of Incorporation or Organization) |   | (I.R.S. Employer  Identification No.) |

 

| **9725 South  Robert Trail  Inver Grove Heights, Minnesota 55077  (651) 452-3000** |
|------------------------------------------------------------------------------------|
| (Address of Principal Executive Offices and Issuer’s  Telephone Number)       |

 

Checkwhether the issuer:  (1) filed allreports required to be filed by Section 13 or 15(d) of the Exchange Actduring the past 12 months (or such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yesý  No o

 

As of March 22, 2004, the issuer had outstanding 8,369,933 shares ofcommon stock.  This number includes1,500,000 units, each consisting of one share of common stock and oneredeemable Class A Warrant, sold in the issuer’s initial public offering.

 

TransitionalSmall Business Disclosure Format (check one) o Yes  ý No

 

 

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**TABLE OFCONTENTS**

 
| PART I             | FINANCIAL INFORMATION |                                                                                                                                                      |
|--------------------|-----------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|
|               |                  |                                                                                                                                                      |   |
|               | ITEM 1                | Financial Statements                                                                                                                                      |   |
|               |                  | Consolidated Balance Sheet  at January 31, 2004 (unaudited) and April 30, 2003                                                                  |   |
|               |                  | Consolidated  Statement of Operations for the three and nine-month periods ended  January 31, 2004 (unaudited) and January 31, 2003 (unaudited) |   |
|               |                  | Consolidated  Statement of Cash Flows for the nine-month periods ended January 31,  2004 (unaudited) and January 31, 2003 (unaudited)           |   |
|               |                  | Notes to  Consolidated Financial Statements                                                                                                               |   |
|               | ITEM  2               | Management’s  Discussion and Analysis or Plan of Operation                                                                                           |   |
|               | ITEM 3                | Controls and Procedures                                                                                                                                   |   |
|               |                  |                                                                                                                                                      |   |
| PART  II           | OTHER  INFORMATION    |                                                                                                                                                      |
|               |                  |                                                                                                                                                      |   |
|               | ITEM  1               | Legal  Proceedings                                                                                                                                        |   |
|               | ITEM 2                | Changes in Securities                                                                                                                                     |   |
|               | ITEM 3                | Defaults upon  Senior Securities                                                                                                                          |   |
|               | ITEM  4               | Submission  of Matters to a Vote of Security Holders                                                                                                      |   |
|               | ITEM  5               | Other  Information                                                                                                                                        |   |
|               | ITEM 6                | Exhibits and  Reports on Form 8-K                                                                                                                         |   |
|               |                  |                                                                                                                                                      |   |
| SIGNATURES         |                  |                                                                                                                                                      |   |
| INDEX TO  EXHIBITS |                  |                                                                                                                                                      |

 

2

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**PART I**

**ITEM 1****       ****FINANCIALSTATEMENTS**

**MEDICALCV, INC.**

**Consolidated Balance Sheet**

 
|                                                                                                                              |   | **January 31,  2004** |      | **April 30,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|-----------|--------------------------|--------|
|                                                                                                                              |   | **(unaudited)**            |      |                     |   |
| **ASSETS**                                                                                                                        |   |                       |      |                     |   |
| Current assets:                                                                                                                   |   |                       |      |                     |   |
| Cash and cash equivalents                                                                                                         |   | $                          | 151,164   |                     | $      | 184,227 |   |
| Trade and accounts receivable, net                                                                                                |   | 1,367,848                  |      | 1,472,995                |   |
| Inventories                                                                                                                       |   | 2,845,808                  |      | 2,782,613                |   |
| Prepaid expenses and other assets                                                                                                 |   | 130,797                    |      | 183,856                  |   |
| Total current assets                                                                                                              |   | 4,495,617                  |      | 4,623,691                |   |
|                                                                                                                              |   |                       |      |                     |   |
| Property, plant and equipment, net                                                                                                |   | 1,138,740                  |      | 1,368,240                |   |
| Deferred financing costs, net                                                                                                     |   | 164,236                    |      | 62,989                   |   |
| Total assets                                                                                                                      |   | $                          | 5,798,593 |                     | $      | 6,054,920 |   |
|                                                                                                                              |   |                       |      |                     |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY  (DEFICIT)**                                                                          |   |                       |      |                     |   |
| Current liabilities:                                                                                                              |   |                       |      |                     |   |
| Short-term debt with related parties                                                                                              |   | $                          | 2,068,530 |                     | $      | 943,333 |   |
| Current portion of long-term debt                                                                                                 |   | 1,530,970                  |      |                     |   |
| Current portion of related party lease  obligations                                                                               |   | 241,228                    |      | 273,843                  |   |
| Current portion of capital lease  obligations                                                                                     |   | 2,658                      |      | 42,069                   |   |
| Accounts payable                                                                                                                  |   | 1,252,954                  |      | 895,405                  |   |
| Accrued expenses                                                                                                                  |   | 323,995                    |      | 813,539                  |   |
| Total current liabilities                                                                                                         |   | 5,420,335                  |      | 2,968,189                |   |
| Long –term debt, less current portion                                                                                        |   | 262,068                    |      |                     |   |
| Related party lease obligations, less  current portion                                                                            |   | 2,994,161                  |      | 3,472,661                |   |
| Total liabilities                                                                                                                 |   | 8,679,564                  |      | 6,440,850                |   |
|                                                                                                                              |   |                       |      |                     |   |
| Shareholders’ equity (deficit):                                                                                              |   |                       |      |                     |   |
| Preferred stock, $.01 par value; 5,000,000  shares authorized; no shares issued and outstanding                                   |   |                       |      |                     |   |
| Common stock; $.01 par value; 95,000,000  shares authorized; 7,995,070 and 7,843,834 shares issued and outstanding,  respectively |   | 79,951                     |      | 78,438                   |   |
| Additional paid-in capital                                                                                                        |   | 17,812,482                 |      | 16,613,337               |   |
| Deferred stock-based compensation                                                                                                 |   | (2,385                     | )         | (4,610                   | )      |
| Accumulated deficit                                                                                                               |   | (20,768,019                | )         | (17,073,095              | )      |
| Total shareholders’ equity (deficit)                                                                                         |   | (2,877,971                 | )         | (385,930                 | )      |
| Total liabilities and shareholders’ deficit                                                                                  |   | $                          | 5,798,593 |                     | $      | 6,054,920 |   |

 

The accompanying notes are an integralpart of these financial statements.

 

3

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**MEDICALCV,INC.**

 

**ConsolidatedStatement of Operations**

**(unaudited)**

 
|                                                                            |   | **Three  Months Ended January 31,** |       | **Nine  Months Ended January 31,** |   |
|---------------------------------------------------------------------------------|--------|------------------------------------------|------------|-----------------------------------------|--------|
|                                                                            |   | **2004**                                 |       | **2003  Restated  (Note 11)**           |   | **2004** |   | **2003  Restated  (Note 11)** |   |
|                                                                            |   |                                     |
| Net sales                                                                       |   | $                                        | 836,733    |                                    | $      | 719,395 |   | $ | 2,544,494 |   | $ | 1,787,443 |   |
| Cost of goods sold                                                              |   | 481,144                                  |       | 423,312                                 |   | 1,404,436 |   | 1,384,838 |   |
| Gross profit                                                                    |   | 355,589                                  |       | 296,083                                 |   | 1,140,058 |   | 402,605 |   |
| Operating expenses:                                                             |   |                                     |       |                                    |   |   |   |   |   |
| Sales and marketing                                                             |   | 396,297                                  |       | 596,316                                 |   | 1,502,308 |   | 1,829,113 |   |
| General and administrative                                                      |   | 649,552                                  |       | 544,964                                 |   | 1,830,617 |   | 1,544,333 |   |
| Engineering and regulatory                                                      |   | 279,537                                  |       | 198,050                                 |   | 684,219 |   | 699,721 |   |
| Total operating expenses                                                        |   | 1,325,386                                |       | 1,339,330                               |   | 4,017,145 |   | 4,073,167 |   |
| Loss from operations                                                            |   | (969,797                                 | )          | (1,043,247                              | )      | (2,877,087 | ) | (3,670,562 | ) |
| Other (expense) income:                                                         |   |                                     |       |                                    |   |   |   |   |   |
| Interest expense                                                                |   | (368,863                                 | )          | (46,379                                 | )      | (828,119 | ) | (124,002 | ) |
| Interest income                                                                 |   |                                     |       | 43                                      |   | 4,993 |   | 12,704 |   |
| Other income                                                                    |   | 10,609                                   |       | 6,367                                   |   | 6,038 |   | 32,451 |   |
| Total other expense                                                             |   | (358,254                                 | )          | (39,969                                 | )      | (817,088 | ) | (78,847 | ) |
|                                                                            |   |                                     |       |                                    |   |   |   |   |   |
| Net loss                                                                        |   | $                                        | (1,328,051 | )                                       | $      | (1,083,216 | ) | $ | (3,694,925 | ) | $ | (3,749,409 | ) |
| Basic and diluted net loss per share                                            |   | $                                        | (.15       | )                                       | $      | (.14 | ) | $ | (.42 | ) | $ | (.48 | ) |
|                                                                            |   |                                     |       |                                    |   |   |   |   |   |
| Weighted average shares used in computing  basic and diluted net loss per share |   | 8,737,214                                |       | 7,843,834                               |   | 8,737,214 |   | 7,843,834 |   |

 

The accompanying notes are an integral partof these financial statements.

 

4

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**MEDICALCV,INC.**

 

**ConsolidatedStatement of Cash Flows**

(unaudited)

 
|                                                                                                        |   | **Nine  Months Ended January 31,** |       |
|-------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|------------|
|                                                                                                        |   | **2004**                                |       | **2003** |   |
| Cash flows from operating activities:                                                                       |   |                                    |       |   |   |
| Net loss                                                                                                    |   | $                                       | (3,694,924 | ) | $ | (3,749,409 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                                |   |                                    |       |   |   |
| Depreciation                                                                                                |   | 236,352                                 |       | 256,465 |   |
| Provision for doubtful accounts, excluding  return of inventory in 2003                                     |   | (33,451                                 | )          | 47,132 |   |
| Return of inventory                                                                                         |   |                                    |       | (92,000 | ) |
| Provision for inventory obsolescence                                                                        |   |                                    |       | 116,027 |   |
| Warrant expense related to purchase of  technology                                                          |   | 31,280                                  |       | 12,361 |   |
| Stock-based compensation                                                                                    |   | 178,417                                 |       | 16,145 |   |
| Interest expense related to issued warrants  and amortization of loan origination costs                     |   | 630,909                                 |       |   |   |
| Changes in assets and liabilities:                                                                          |   |                                    |       |   |   |
| Accounts receivable                                                                                         |   | 138,598                                 |       | 99,171 |   |
| Inventories                                                                                                 |   | (63,195                                 | )          | (536,179 | ) |
| Prepaid expenses and other assets                                                                           |   | 53,059                                  |       | (52,200 | ) |
| Accounts payable                                                                                            |   | 357,549                                 |       | 507,406 |   |
| Accrued expenses                                                                                            |   | (489,544                                | )          | 140,583 |   |
| Deferred financing costs                                                                                    |   | (201,424                                | )          |   |   |
| Net cash used in operating activities                                                                       |   | (2,865,374                              | )          | (3,125,074 | ) |
|                                                                                                        |   |                                    |       |   |   |
| Cash flows from investing activities:                                                                       |   |                                    |       |   |   |
| Purchase of property, plant and equipment                                                                   |   | (6,852                                  | )          | (97,768 | ) |
| Net cash used in investing activities                                                                       |   | (6,852                                  | )          | (97,768 | ) |
|                                                                                                        |   |                                    |       |   |   |
| Cash flows from financing activities:                                                                       |   |                                    |       |   |   |
| Borrowings under term debt arrangements                                                                     |   | 3,293,038                               |       | 735,505 |   |
| Principal payments on other long-term debt                                                                  |   |                                    |       | (38,557 | ) |
| Issuance of common shares                                                                                   |   | 96,950                                  |       |   |   |
| Principal payments under capital lease  obligations                                                         |   | (42,069                                 | )          | (46,967 | ) |
| Principal payments under related party  lease obligations                                                   |   | (508,456                                | )          |   |   |
| Net cash provided by financing activities                                                                   |   | 2,839,163                               |       | 649,981 |   |
|                                                                                                        |   |                                    |       |   |   |
| Net decrease in cash and cash equivalents                                                                   |   | (33,063                                 | )          | (2,572,861 | ) |
| Cash and cash equivalents at beginning of  year                                                             |   | 184,227                                 |       | 2,781,675 |   |
| Cash and cash equivalents at end of period                                                                  |   | $                                       | 151,164    |   | $ | 208,814 |   |
|                                                                                                        |   |                                    |       |   |   |
| Non-cash investing and financing activities                                                                 |   |                                    |       |   |   |
| Discount on convertible subordinated bridge  notes related to warrants granted in connection with the notes |   | 896,536                                 |       |   |   |

 

The accompanying notes are an integral part of these financialstatements.

 

5

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**MEDICALCV, INC.**

 

**Notes toConsolidated Financial Statements**

 

**(1)****                                ****Basis of Financial Statement Presentation**

 

Theaccompanying unaudited consolidated financial statements included herein havebeen prepared by MedicalCV, Inc. (the “Company”) in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial information and pursuant to the rules and regulations of theSecurities and Exchange Commission. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America have been condensed oromitted pursuant to such rules and regulations.  These consolidated interim financial statements should be read inconjunction with the consolidated financial statements and the notes theretoincluded in the Company’s Annual Report on Form 10-KSB for the fiscal yearended April 30, 2003.

 

Theconsolidated balance sheet as of January 31, 2004, the consolidatedstatement of operations for the three and nine months ended January 31,2004 and 2003, and the consolidated statement of cash flows for the nine monthsended January 31, 2004 and 2003 include, in the opinion of management, alladjustments, consisting solely of normal recurring adjustments, necessary for afair presentation of the financial results for the respective interim periodsand are not necessarily indicative of results of operations to be expected forthe entire fiscal year ending April 30, 2004.

 

**(2)****                                 GoingConcern**

 

The Company’s unaudited consolidated financial statements for thequarter ended January 31, 2004, have been prepared on a going concernbasis, which contemplates the realization of assets and settlement ofliabilities and commitments in the normal course of business.  The Companyhas sustained losses and negative cash flows from operations in recent yearsand expects these conditions to continue for the foreseeable future.  AtJanuary 31, 2004, the Company had an accumulated deficit of $20,768,019and had insufficient funds to finance its working capital and capitalexpenditure needs.  These matters raisesubstantial doubt about the Company’s ability to continue as a goingconcern.  The Company iscurrently seeking other sources of financing to fund its operations and workingcapital requirements.  If the Company isunable to obtain additional funds beginning in April 2004, it will berequired to significantly revise its business plans and drastically reduceoperating expenditures such that it may not be able to develop or enhance itsproducts including the atrial fibrillation technology currently underdevelopment, gain market share in the United States for the Omnicarbon® heartvalve or respond to competitive pressures or unanticipated requirements, whichcould seriously harm its business, financial position and results ofoperations.  These financial statementsdo not include any adjustments that might result from the outcome of thisuncertainty.

 

The Company is subject to risks and uncertainties common to medicaltechnology-based companies, including rapid technological change, dependence onone principal product, new product development and acceptance, regulatoryimpacts on product marketing approval and reimbursement, actions ofcompetitors, dependence on key personnel and United States market penetration.

 

**(3)****                                ****Stock-based Compensation**

 

TheCompany accounts for stock-based employee compensation arrangements inaccordance with the provisions of Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations, and complies with the disclosure provisions of SFASNo. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148“Accounting for Stock-Based Compensation-Transition and Disclosure, anamendment of FASB Statement No. 123.”

 

Forpurposes of the pro forma disclosures below, the estimated fair value of theoptions is amortized to expense over the options’ vesting period.  Had compensation cost for the Company’sstock options been recognized based on the fair value at the grant dateconsistent with the provisions of SFAS No. 123, the Company’s net losswould have been adjusted to the pro forma amounts indicated below:

 

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|                                                          |   | **For the  Periods Ended January 31,** |   |
|---------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                          |   | **Three  Months**                      |   | **Nine  Months** |   |
|                                                          |   | **2004**                               |   | **2003** |   | **2004** |   | **2003** |   |
| Net loss reported                                             |   | $(1,328,051                            | )      | $(1,083,216 | ) | $(3,694,925 | ) | $(3,749,409 | ) |
| Less:  Pro forma stock based  employee compensation cost |   | (119,294                               | )      | (73,536 | ) | (259,954 | ) | (220,607 | ) |
|                                                          |   |                                   |   |   |   |   |   |   |   |
| Net loss – pro forma                                     |   | (1,447,345                             | )      | (1,156,752 | ) | (3,952,879 | ) | (3,970,016 | ) |
|                                                          |   |                                   |   |   |   |   |   |   |   |
| Net loss per common share – basic and  diluted           |   |                                   |   |   |   |   |   |   |   |
| As reported                                                   |   | (.15                                   | )      | (.14 | ) | (.42 | ) | (.48 | ) |
| Pro Forma                                                     |   | (.17                                   | )      | (.15 | ) | (.45 | ) | (.51 | ) |

 

 

**(4)****                                ****Net Loss per Share**

 

Net loss per share is computed under the provisions of SFASNo. 128, “Earnings Per Share.” Basic net loss per common share is computed using net loss and theweighted-average number of shares of common stock outstanding.  Diluted earnings per share reflect thepotential dilution of securities that could share in the earnings of anentity.  Diluted net loss per commonshare does not differ from basic net loss per common share in the three andnine-month periods ended January 31, 2004 and 2003, since the potentiallydilutive shares are anti-dilutive. Potentially dilutive shares excluded from the calculation of diluted netloss per share relate to outstanding stock options and warrants aggregating5,457,731 and 4,028,440 shares of the Company’s common stock atJanuary 31, 2004 and 2003, respectively.

 

**(5)****                                ****Inventories**

 
|            |   | **January 31,  2004** |      | **April 30,  2003** |   |
|-----------------|--------|----------------------------|-----------|--------------------------|--------|
|            |   | **(unaudited)**            |      |                     |   |
| Raw materials   |   | $                          | 268,658   |                     | $      | 377,961 |   |
| Work-in-process |   | 765,913                    |      | 529,668                  |   |
| Finished goods  |   | 1,811,237                  |      | 1,874,984                |   |
|            |   | $                          | 2,845,808 |                     | $      | 2,782,613 |   |

 

**(6)****                                ****Short-term Debt**

 

OnJuly 8, 2003, the Company entered into a $1.0 million term debt agreementwith PKM Properties, LLC (“PKM”), an entity controlled by a principalshareholder, who also serves on the Company’s Board of Directors.  Pursuant to the agreement, the Companyborrowed $764,728 under this bridge financing during the first quarter offiscal year 2003 and borrowed the final draw of $235,272 on August 20,2003.  The debt, which is collateralizedby substantially all of the Company’s assets, bears interest at a rate of 10.0percent per year and matures on May 27, 2004.  In connection with the first quarter borrowings, the Company  issued a warrant to PKM with a ten-year termfor the purchase of 320,178 shares of the Company’s common stock at an exerciseprice of $0.70 per share.  The Companyalso issued a warrant to purchase an additional 60,179 shares of the Company’scommon stock on the same terms in conjunction with the final draw onAugust 20, 2003.  In connectionwith this financing, on July 8, 2003, the Company agreed to extend theterm of 700,000 previously issued warrants from five years to ten years.  The allocated fair value of the warrantsissued prior to July 31, 2003, and the incremental value of the existingwarrants was $383,361, and has been reported as a discount on the borrowingsunder the term debt.  This discount,which is presented as a reduction of the carrying value of the debt on theconsolidated balance sheet, is being amortized as interest expense over theeleven-month term of the debt.  As ofJanuary 31, 2004, the unamortized balance of the discount was$139,404.  In addition, the Companyincurred direct and incremental costs of $65,000 in completing the debtarrangement, which are included in other assets and are being amortized as interestexpenses over the eleven-month term of the debt.

 

InOctober 2003, the Company amended the discretionary line of credit withPKM established in January 2003 to extend the maturity date to May 27,2004, and increase the interest rate to 10.0 percent.  As of January 31, 2004, the Company had borrowed $943,333under this line of credit.

 

In November 2003, the Company amended the one-year $1.0 millionterm debt agreement with PKM, initiated

 

7

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on July 8, 2003, to provide for an additional $500,000 ofborrowings with the same terms as the July 8, 2003 financing.  The Company issued, as additionalconsideration, a ten-year warrant to purchase up to 77,381 shares of commonstock at an exercise price of $1.68 per share with terms and conditions thatinclude weighted-average anti-dilution rights.  The allocated fair value of the newly issued warrant was $63,365and is accounted for as a discount on the borrowings under the term debt.  This discount, which is presented as areduction of the carrying value of the debt on the consolidated balance sheetis being amortized as interest expense over the remaining five month term ofthe debt.  As of January 31, 2004,the unamortized balance of the discount was $31,682.

 

OnJuly 8, 2003, the Company also entered into a $1.0 million term debtagreement with Peter L. Hauser (“Hauser”), a principal shareholder.  The Company borrowed $1.0 million under thisbridge financing during the quarter ended July 31, 2003.  The debt, which is collateralized bysubstantially all of the Company’s assets pursuant to our intercreditoragreement with PKM, bears interest at a rate of 10.0 percent per year and isdue on June 30, 2004.  Inconnection with the term debt, the Company also issued a warrant with aten-year term to purchase up to 380,357 shares of the Company’s common stock atan exercise price of $0.70 per share. The allocated fair value of the newly issued warrant was $281,706 and isaccounted for as a discount on the borrowings under the term debt.  This discount, which is presented as areduction of the carrying value of the debt on the consolidated balance sheetis being amortized as interest expense over the twelve-month term of the debt.  As of January 31, 2004, the unamortizedbalance of the discount was $117,378. In addition, the Company incurred direct and incremental costs of$71,772 in completing the debt arrangement, which are included in other assetsand are being amortized as interest expenses over the twelve-month term of thedebt.

 

InNovember 2003, the Company also entered into a loan agreement and borrowed$500,000 from Draft Co. (“Draft”), pursuant to a note maturing on June 30, 2004, which bears interestat an annual rate of 10.0 percent. Pursuant to a restated intercreditor agreement among PKM, Hauser, andDraft, the loan is collateralized by substantially all of the Company’sassets.  The lender was issued warrantsto purchase up to 90,909 shares of common stock at an exercise price of $1.43per share with other terms comparable to the PKM warrants described above. Theallocated fair value of the newly issued warrants was $100,056 and is accountedfor as a discount on the borrowings under the term debt.  This discount, which is presented as areduction of the carrying value of the debt on the consolidated balance sheetis being amortized as interest expense over the seven-month term of thedebt.  As of January 31, 2004, theunamortized balance of the discount was $68,373.  In addition, the Company incurred direct and incremental  costs of $31,850 in completing the debtarrangement, which are included in other assets and are being amortized asinterest expenses over the term of the debt.

 

**(7)****                                ****Segment Information**

 

The Company views its operations and manages its business as onesegment, the manufacturing and marketing of cardiothoracic surgerydevices.  Factors used to identify theCompany’s single operating segment include the organizational structure of theCompany and the financial information available for evaluation by chiefoperating decision maker.

 

The following table summarizes net sales by geographic area:

 
|          |   | **Three  Months Ended January 31,** |        | **Nine  Months Ended January 31,** |   |
|---------------|--------|------------------------------------------|-------------|-----------------------------------------|--------|
|          |   | **2004**                                 |        | **2003  Restated  (Note 11)**           |   | **2004** |   | **2003  Restated  (Note 11)** |   |
|          |   |                                     |
| Europe        |   | $                                        | 415,509     |                                    | $      | 405,461 |   | $ | 1,275,597 |   | $ | 948,565 |   |
| South Asia    |   | 92,800                                   |        | 116,350                                 |   | 291,200 |   | 339,640 |   |
| Middle East   |   | 149,070                                  |        | 78,548                                  |   | 403,591 |   | 291,465 |   |
| Far East      |   | 16,090                                   |        | 22,171                                  |   | 69,270 |   | 39,873 |   |
| United States |   | 153,508                                  |        | 85,550                                  |   | 440,308 |   | 148,600 |   |
| Other         |   | 9,756                                    |        | 11,315                                  |   | 64,528 |   | 19,300 |   |
|          |   |                                     |        |                                    |   |   |   |   |   |
| **TOTALS**    |   | **$**                                    | **836,733** | ** **                              | **$**  | **719,395** | ** ** | **$** | **2,544,494** | ** ** | **$** | **1,787,443** | ** ** |

 

8

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**(8)****                                 AtrialFibrillation Technology Purchase Agreement**

 

The Company entered into an agreement with LightWave Ablation Systems,Inc. (“LightWave”) in August 2003 to purchase technology for the treatmentof atrial fibrillation.  Upon closing,the Company issued 15,000 shares of common stock and a warrant to purchase upto 25,000 shares of common stock for $1.46 per share, and made an initialpayment of $10,000 to LightWave for the worldwide technology distributionrights.  The Company is obligated to payLightWave an additional $15,000 in February 2005 and $15,000 inApril 2005, or earlier if the Company achieves certain European and U.S.regulatory approvals.  In addition, theCompany is required to pay up to an additional $510,000 and to issue warrantsto purchase up to an additional 75,000 common shares at $1.46 per share in theevent that the Company meets certain development and sales milestones relatedto the acquired technology.  The Companyhas recorded a research and development charge of $48,930 in the nine-monthperiod ended January 31, 2004, to reflect the fair value of the common sharesissued, the cash issued and issuable and the fair value of the common stock andwarrants issued to LightWave.  AtJanuary 31, 2004, the accrued future cash payments of $30,000 are includedin accrued expenses.

 

**(9)****                                 Returnof Inventory**

 

During the quarter ended July 31, 2002, the Company obtainedinventories from two former international distributors.  The heart valves were sold to thesecustomers during fiscal year 2000 and the first half of fiscal year 2001.  Due to financial difficulties experienced bythese distributors, the Company provided allowances for the remaininguncollected accounts receivable balances in fiscal years 2001 and 2002.  The Company did not anticipate the return ofthese products at the time the uncollectible accounts were established.  Upon obtaining title to the heart valvesfrom these former distributors during the quarter ended July 31, 2002, theCompany increased its inventories and recorded a recovery of its priorprovision for doubtful accounts which reduced its general and administrativecosts for the year ended April 30, 2003 by $92,000 representing the costof the returned inventories. As described in Note 11, the Company hadpreviously reported the return of inventory as a reduction of cost of goodssold and has restated its financial statements for the nine month period endedJanuary 31, 2003 to change the classification to a reduction of generaland administrative expenses.

 

**(10****)****                         ****Subsequent Events**

 

InFebruary 2004, the maturity dates of the $2.5 million short-term debt withPKM and the $1.0 million short-term debt with Hauser were extended toJune 30, 2005.  A warrant topurchase 330,933 was issued to PKM and a warrant to purchase 136,000 shares ofcommon stock was issued to Hauser.  Thewarrants have a ten-year term at an exercise price of $2.00 per share withother terms comparable to the PKM warrants described in Note 6.  The $844,024 fair value of these warrantswill be amortized and charged to interest expense over the seventeen-monthmaturity extension period.

 

InFebruary 2004, the Company raised gross proceeds of $543,700 through theprivate placement of shares of common stock to accredited investors.

 

**(11)****                          ****Restatement**

 

The Company has restated its financialstatements for the the three and nine-month period ended January 31, 2003, tochange the classification of marketing support expenditures, which hadpreviously been reported as sales and marketing expense rather than a reductionin net sales pursuant to application of the Consensus for Emerging Issues TaskForce No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer(Including a Reseller of the Vendor’s Products).”  The effect of this change in classification is to decrease netsales, gross profit and sales and marketing expenses by corresponding amountsfor the three and nine month periods ended January 31, 2003.

 

The Company has also restated its financial statements for the ninemonth period ended January 31, 2003, to change the classification ofincome from inventories returned from two former international distributors,which had previously been reported as a reduction of cost of goods sold ratherthan as a reduction of general and administrative expenses (see Note 9).  The effect of this change in classificationis to increase cost of goods sold, decrease gross profit and decrease generaland administrative expenses by $92,000 for the nine month period endedJanuary 31, 2003.

 

Thechanges in classifications described above had no effect on the Company’s lossfrom operations or net loss, nor any effect on the Company’s consolidatedbalance sheet, statement of changes in stockholders’ equity

 

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(deficit)or statement of cash flows.  The tablebelow summarizes the aggregate effect of these changes in classifications.

 

 
|                       |   | **Periods  Ended January 31, 2003** |    |
|----------------------------|--------|------------------------------------------|---------|
|                       |   | **Three  Months**                        |    | **Nine  Months** |   |
|                       |   | **As  Reported**                         |    | **As  Restated** |   | **As  Reported** |   | **As  Restated** |   |
| Net sales                  |   | $                                        | 867,105 |   | $ | 719,395 |   | $ | 2,111,206 |   | $ | 1,787,443 |   |
| Cost of goods sold         |   | n/a                                      |    | n/a |   | 1,292,838 |   | 1,384,838 |   |
| Gross profit               |   | 443,793                                  |    | 296,083 |   | 818,368 |   | 402,605 |   |
| Operating expenses:        |   |                                     |    |   |   |   |   |   |   |
| Sales and marketing        |   | 744,026                                  |    | 596,316 |   | 2,152,876 |   | 1,829,113 |   |
| General and administrative |   | n/a                                      |    | n/a |   | 1,636,333 |   | 1,544,333 |   |
| Total operating expenses   |   | 1,487,040                                |    | 1,339,330 |   | 4,488,930 |   | 4,073,167 |   |
|                            |        |                                          |         |  |  |  |  |  |  |  |  |  |  |

 

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n/a– not applicable

 

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**ITEM 2****                                                       ****MANAGEMENT’S DISCUSSION ANDANALYSIS OR PLAN OF OPERATION**

 

*The followingdiscussion contains various forward-looking statements within the meaning of**Section 21Eof the Exchange Act.  Although webelieve that, in making any such statement, our expectations are based onreasonable assumptions, any such statement may be influenced by factors thatcould cause actual outcomes and results to be materially different from thoseprojected.  When used in the followingdiscussion, the words “anticipates,”“believes,”“expects,”“intends,”“plans,”“estimates” and similar expressions, as they relate to us or ourmanagement, are intended to identify such forward-looking statements.  These forward-looking statements are subjectto numerous risks and uncertainties that could cause actual results to differmaterially from those anticipated. Factors that could cause actual results to differ materially from thoseanticipated, certain of which are beyond our control, are setforth in this document and in our Annual Report on Form 10-KSB for the fiscalyear ended April 30, 2003, under the caption “Management’s Discussion andAnalysis or Plan of Operation-Cautionary Statement.”*

 

*Our actualresults, performance or achievements could differ materially from thoseexpressed in, or implied by, forward-looking statements.  Accordingly, we cannot be certain that anyof the events anticipated by forward-looking statements will occur or, if anyof them do occur, what impact they will have on us.  We caution you to keep in mind the cautions and risks described**in this document and in our Cautionary Statement and to refrain from attributing undue certainty to anyforward-looking statements, which speak only as of the date of the document inwhich they appear.*

 

**Overview**

 

Our primary objective is to develop and market front-end surgicalsolutions to reduce the incidence and severity of congestive heartfailure.  We develop, market and sellmechanical heart valves known as the Omnicarbon 3000 and 4000 heartvalves.  Our long-range strategy,however, is to achieve profitability by diversifying into high growth marketsin cardiothoracic surgery.  Near-term,we plan to develop and introduce products targeting treatment of atrialfibrillation and heart valve repair.

 

To reduce our dependence on sales of heart valves, we have developed astrategy to broaden our product offerings to the cardiothoracic surgeon bydeveloping, acquiring and licensing additional technologies.  Over the last fiscal year ending inApril 2003, we acquired a new annuloplasty technology for the repair ofthe mitral valve and we licensed an internal mammary artery (“IMA”) retractorto provide better exposure of such artery with reduced trauma to the ribs.  We introduced the IMA AccessTM Retractor inDecember 2002 and expect to introduce the annuloplasty system, followingreceipt of necessary regulatory approvals, mid calendar year 2004.  In August 2003, we acquired atechnology platform for the treatment of atrial fibrillation from LightWaveAblation Systems, Inc., a private research-based corporation focused on newdevices for the treatment of cardiovascular diseases.  Atrial fibrillation is the most common irregular heart rhythmcondition among the U.S. population and is a significant, worldwide healthcarechallenge.

 

Our company was incorporated in Minnesota on March 30, 1992, underthe name CV Dynamics, Inc.  InApril 1992, we acquired all of the tangible and intangible assets ofOmnicor, Inc.  Omnicor resulted from thecorporate and financial restructuring of a predecessor company called MedicalIncorporated, which was organized in 1971 to develop and market theLillehei-Kaster heart valve, licensed from the University of Minnesota.  Our company changed its name to MedicalCV,Inc. in February 2000.  Ourcorporate headquarters is located at 9725 South Robert Trail, Inver GroveHeights, MN 55077.

 

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**Periods EndedJanuary 31, 2004 and 2003**

 

Our operating results,expressed as a percentage of total revenue, were as follows:

 
|                        |   | **Three  Months Ended January 31,** |   | **Nine  Months Ended January 31,** |   |
|-----------------------------|--------|------------------------------------------|--------|-----------------------------------------|--------|
|                        |   | **2004**                                 |   | **2003  Restated(1)**                   |   | **2004** |   | **2003  Restated(1)** |   |
|                        |   |                                     |
| Net sales                   |   | 100.0                                    | %      | 100.0                                   | %      | 100.0 | % | 100.0 | % |
| Cost of goods  sold         |   | 57.5                                     | %      | 58.8                                    | %      | 55.2 | % | 77.5 | % |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Gross profit                |   | 42.5                                     | %      | 41.2                                    | %      | 44.8 | % | 22.5 | % |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Operating  expenses:        |   |                                     |   |                                    |   |   |   |   |   |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Sales and  marketing        |   | 47.4                                     | %      | 82.9                                    | %      | 59.1 | % | 102.3 | % |
| General and  administrative |   | 77.6                                     | %      | 75.8                                    | %      | 71.9 | % | 86.4 | % |
| Engineering  and regulatory |   | 33.4                                     | %      | 27.5                                    | %      | 26.9 | % | 39.2 | % |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Total  operating expenses   |   | 158.4                                    | %      | 186.2                                   | %      | 157.9 | % | 227.9 | % |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Loss from  operations       |   | (115.9                                   | )%     | (145.0                                  | )%     | (113.1 | )% | (205.3 | )% |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Other income  (expense):    |   |                                     |   |                                    |   |   |   |   |   |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Interest  expense           |   | (44.1                                    | )%     | (6.5                                    | )%     | (32.5 | )% | (6.9 | )% |
| Interest  income            |   | —                                   | %      | —                                  | %      | .2 | % | .7 | % |
| Other income                |   | 1.3                                      | %      | .9                                      | %      | .2 | % | 1.8 | % |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Total other  expense        |   | (42.8                                    | )%     | (5.6                                    | )%     | (32.1 | )% | (4.4 | )% |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Net loss                    |   | (158.7                                   | )%     | (150.6                                  | )%     | (145.2 | )% | (209.7 | )% |

 

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(1) — As described in Note11 to our consolidated financial statements, we restated our financialstatements for the three and nine month periods ended January 31, 2003 tochange the classification of certain expenditures previously classified as sales and marketingexpenses to a reduction in net sales and to change the classification of incomefrom inventories returned from two former international distributors previouslyclassified as a reduction of cost of goods sold to a reduction of general andadministrative expenses.

 

**CriticalAccounting Policies**

 

Fordiscussion of critical accounting policies and estimates, see our Annual Reporton Form 10-KSB for the fiscal year ended April 30, 2003.

 

**Results ofOperations**

 

We have restated our financial information to reflect changes inclassification of certain items in the Company’s Statement of Operations thethree and nine month periods ended January 31, 2003.

 

We have changed the classification of certain expenditures previouslyclassified as sales and marketing expenses to a reduction in net sales. Theseexpenditures consist of payments made to international distributors forassistance in marketing our products that are required to be reported as areduction in net sales pursuant to application of the Consensus for EITF Issue01-9 “Accounting for Consideration Given by a Vendor to a Customer (Including aReseller of the Vendor’s Products)”. The changes in these classifications decreased net sales, gross profit,sales and marketing expense and total operating expenses by correspondingamounts.

 

We have also changed the classification of income from inventoriesreturned from two former international distributors, which had previously beenreported as a reduction of cost of goods sold rather than as a reduction ofgeneral and

 

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administrative expenses.  Thechange in classification increased cost of goods sold, decreased gross profitand decreased general and administrative expenses by $92,000 for the nine monthperiod ended January 31, 2003.

 

The changes in classifications had no effect on our loss fromoperations or net loss, nor any effect on the consolidated balance sheet,statement of shareholders’ equity (deficit) or cash flows.  See Note 11 to the Consolidated FinancialStatements.

 

*Net Sales*.  Net sales in the third quarter of fiscal year 2004increased 16 percent to $836,733 from $719,395 in the third quarter of the prior year.  Net sales increased 90 percent in the MiddleEast and 79 percent in the U.S. during the third quarter of fiscal year 2004compared to the same period in the prior year. These increases were partially offset by decreases in South Asia and theFar East.  Sales to our Europeancustomers, which were 50 and 56 percent of total sales in the quarters endedJanuary 31, 2004 and 2003, respectively, were relatively flat.  Unit sales for the quarter ended January 31,2004, increased 26 percent compared to unit sales for the quarter ended January31, 2003.  A larger portion of the unitsales increase was to countries with lower selling prices and, as a result,average selling prices declined 8 percent for the quarter.  Netsales in the nine-month period ended January 31, 2004, increased 42percent to $2,544,494 from $1,787,443 in the same period one year ago.  Net sales in the U.S. increased 196 percentfor the nine months ended January 31, 2004, compared to the same period ayear ago, as a result of our changes in distribution and increased marketingefforts.  U.S. sales for the nine monthsended January 31, 2004, represented 17 percent of sales compared to 8percent of sales for the nine months ended January 31, 2003.  For the nine-month period ended January 31,2004, sales to our European customers increased 34 percent compared to the sameperiod a year ago.  The percentageincrease for the nine months ended January 31, 2004, is affected by thefact that our largest customer did not purchase any valves in the secondquarter ended October 31, 2002. Unit sales for the nine months ended January 31, 2004, increased 28percent compared to unit sales for the nine months ended January 31, 2003.  Average selling prices increased for thenine months ended January 31, 2004, compared to the nine months ended January31, 2003.

 

The vast majority of our sales are denominated in U.S. dollars.  Fluctuations in foreign currency exchangerates have not resulted in significant losses or gains on outstanding tradeaccounts receivable.  All of ourdistributors are required to pay for products in U.S. dollars, other than ourJapanese distributor, which pays in Japanese yen, and one European customer, which paysin euros.

 

*Gross Profit.*  Gross profit as a percentage of net sales increased to 42.5 percent in the third quarterof fiscal year 2004 from 41.2 percent in the third quarter of the prior year. Fiscal year-to-date gross profit margins in 2004 were 44.8 percentcompared to 22.5 percent in the same nine month period last fiscal year.   The gross profit on valves we sell inthe U.S. is higher than in other geographic regions as we sell directly tohospitals and selling prices in the U.S. are generally higher due in part togovernment regulations and reimbursement. Selling price for heart valves vary significantly around the world.  Our gross profit is subject to fluctuationsas the geographic mix of sales fluctuates. Our strategy is to obtainFDA approval of our proprietary pyrolytic carbon manufacturing process in order to market theOmnicarbon 4000 in the U.S.  Due to itslower manufacturing cost, we believe the Omnicarbon 4000 will generatesignificantly higher gross profit margins when sold in the U.S. than theOmnicarbon 3000 heart valve.

 

*Sales andMarketing*.  Sales and marketingexpenses in the thirdquarter of fiscal year 2004 were $396,297 or 47.4 percent of net sales compared to $596,310 or 82.9 percent of net sales in the third quarter of the prior year.  For the nine-month periodended January 31, 2004, sales and marketing expenses totaled $1,502,309 or59.1 percent of net sales, compared to $1,829,113 or 102.3 percent of net salesin the same period last fiscal year. Sales and marketing expense as a percent of sales decreased for thethree and nine-month periods ended January 31, 2004, due to the increasein sales and the decline in expense for the comparative periods.  Thedecrease in spendingrelated to amore focused Omnicarbon marketingeffort in the U.S. and international markets.  The reduction in sales and marketingexpenses can be directly attributable to three areas: salaries, travel andconsulting expenses which decreased 27 percent, 44 percent and 49 percentrespectively for the quarter ended January 31,2004, compared to the quarterended January 31, 2003.  We downsizedour sales management group which resulted in lower travel expense and salaryexpense.  We also reduced our use ofoutside consultants.  Our overall marketing strategy is to promote the clinicalresults of the Omnicarbon heart valve and the technical strengths of ourcompany in designing and manufacturing mechanical heart valves.

 

*General andAdministrative*.  General andadministrative expenses for the third quarter of fiscal year 2004 were $649,552 or 77.6 percent of net sales, compared to $544,964 or 75.8 percent of net sales in the same period oneyear ago.  For the nine-month periodended January 31, 2004, general and administrative expenses totaled$1,830,617 or 71.9 percent of net sales, compared to $1,544,333 or 86.4 percentof net sales in the same period last year. The increasesfor the quarter andyear-to-date periods were primarily attributable tocertain non-cash, stock-based incentives associated with strengthening the executive managementstaff and board of directors. Expenses associated with these activities totaled $79,998 and $178,417for the respective three and nine-month periods ended January 31, 2004.

 

*Engineering andRegulatory*.  Engineering andregulatory expenses for the thirdquarterof fiscalyear 2004 were $279,537 or 33.4 percent of net sales compared to $198,050 or 27.5 percent of net sales in the third quarter ofthe prior fiscal year. For the nine-month period ended January 31, 2004,engineering and regulatory expenses totaled $684,219 or 26.9 percent

 

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ofnet sales, compared to $699,721 or 39.2 percent of net sales in the same periodlast year.  A major portion of theincrease in Engineering and Regulatory expenses for the quarter endedJanuary 31, 2004, as compared to the same quarter in the previous year,was related to spending on the atrial fibrillation project using the technologyacquired in August 2003 from LightWave Ablation Systems, Inc.  Spending on this project represented 16percent of total engineering and regulatory expense for quarter ended January31, 2004.  For the nine months endedJanuary 31, 2003, engineering and regulatory expenses includednon-recurring expenses associated with the purchase of the Northrup UniversalHeart Valve Repair SystemTM and the IMA AccessTM Retractor Device.

 

*Other (Expense)Income*.  Interest expense totaled$368,863 in the quarter ended January 31, 2004, compared to $46,379 in the third quarter of the prior fiscal year. Fiscalyear-to-date interest expense was $828,119, compared to $124,002 in the sameperiod one year ago.  The increases ininterest expense in the third-quarter and year-to-date periods were attributedto higher financing costs associated with the additional short-term debtobtained in fiscal year 2004 and the related-party propertysale-leaseback.  Expenses related to theissuance of warrants related to debt financing totaled $288,428 and $521,732for the respective three and nine-month periods ended January 31, 2004.

 

*Income TaxProvision*.  In light of ourhistory of operating losses, we recorded a valuation allowance to fully offsetour deferred tax assets in fiscal year 2000. We have continued to provide a full valuation allowance through the third quarter of fiscal year 2004 due to the current uncertainty aboutgenerating the future taxableincome necessary to realize our deferred tax assets. We have recordedno tax provision in the current period due to net operating losses generatedfor income tax reporting purposes.

 

*Loss fromOperations*.  As of January 31, 2004, we had an accumulated deficit of $20,768,019. We have incurred losses in each of the last six fiscal years.  Since 1994, we have invested in developing abileaflet heart valve, a proprietary pyrolytic carbon coating process andobtaining premarket approval from the FDA to market our heart valves in the U.S.  Ourstrategy has been to invest in technology to better position ourselvescompetitively once FDA premarket approval was obtained.  We expect to continue togenerate operating losses intofiscal year 2005 because ofanticipated spending necessary to market our heart valves in the U.S., to establish and maintain a strong marketing organizationfor domestic and foreign markets and our continuing investment inresearch and development in order to introduce new products for thecardiothoracic surgeon.

 

**Liquidity and Capital Resources**

 

Cash and cash equivalents decreasedto $151,164 at January 31, 2004, from $184,227 at April 30, 2003.  Thisdecrease in cash and cash equivalents of$33,063 was due to the following:

 
| Net cash used in operating activities     |   | $         | (2,865,374 | ) |
|-------------------------------------------|--------|-----------|------------|---|
| Net cash used in investing activities     |   | (6,852    | )          |
| Net cash provided by financing activities |   | 2,839,163 |       |
| Net decrease                              |   | $         | (33,063    | ) |

 

Net cash used in operating activities decreased$259,700 to $2,865,374 in the nine-month periodended January 31, 2004, from $3,125,074 in the nine-month period ended January 31, 2003. The use of cash in operations in the nine-month periods of both fiscalyears 2004 and 2003 was primarily due to net losses of $3,694,924 and$3,749,409, respectively.

 

Net cashused in investing activities was$6,852 in the nine-month period ended January 31, 2004.  Net cash used in investing activities was$97,768 in the nine-month period ended January 31, 2003.  Inboth periods, the cash was used for capital expenditures.  Management anticipates total capital expendituresin fiscal year 2004 to be no greater than $200,000.

 

Net cash provided by financing activities was $2,839,163 in the nine months ended January 31,2004, and consisted of short-term borrowings from related partiesof $2.0 million, partially offset by principal payments of $42,069, and$508,456 of payments on related-party lease obligations.  Inthe nine-month period ended January 31, 2003, net cash provided byfinancing activities was $649,981 consisting of short-term borrowing fromnon-related parties of $735,505 offset by principal payments of $85,524.

 

Throughoutfiscal year 2003 and in the first nine months of fiscal year 2004, we enteredinto a number of financing transactions to provide funds necessary to meet ourworking capital and capital expenditure needs and to meet otherobligations.  These financing activitiesconsisted of the following:

 

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InDecember 2002, we received a $60,000 unsecured advance from an executiveofficer.  Principal and interest on thisadvance was repaid in April 2003.

 

InJanuary 2003, we established a line of credit with PKM Properties, LLC(“PKM”), an entity controlled by Paul K. Miller.  Mr. Miller is a member of our board of directors and is thelargest beneficial owner of our securities. The line of credit, as amended, bears interest at 10.0 percent.  The line of credit is currentlycollateralized by a security interest in substantially all of our assets.  This line of credit was amended and matureson May 27, 2004.  In connection with theline of credit, we also issued a warrant to PKM, originally with a five-yearterm, to purchase 350,000 shares of our common stock at an exercise price of$0.596 per share.  The allocated fairvalue of the warrants was $128,995.  Thisdiscount was completely amortized to interest expense as of July 31,2003.  The amount outstanding under thisshort-term debt with related party at January 31, 2004 was $943,333.

 

OnApril 4, 2003, we sold our corporate headquarters, manufacturing facilityand surrounding land in Inver Grove Heights, Minnesota to PKM.  In connection with the transaction, wereceived total consideration of $3.84 million consisting of (i) $1.0 million incash, (ii) PKM’s assumption of our $2.5 million outstanding indebtedness toAssociated Bank which eliminated our indebtedness to Associated Bank, and (iii)PKM’s assumption of our promissory note with Dakota Electric Association andland special assessments payable to Dakota County aggregating $336,105.  We relied on a fair market value appraisalof the property in determining the amount of such consideration.  Also in connection with the transaction, weissued a warrant to PKM, originally with a five-year term, to purchase 350,000shares of our common stock at an exercise price of $0.625 per share.  This warrant had an allocated fair value of$89,602.

 

Ofthe net cash proceeds, $300,000 plus interest was applied to our indebtednessto PKM pursuant to the line of credit agreement described above.

 

Simultaneouswith the sale of the facility, we entered into a lease with PKM to lease backthe facility and a portion of the land. The lease has a ten-year initial term with options for us to extend thelease up to ten additional years.  Undercertain conditions, we also have an option to purchase the building at the endof the initial ten-year term at the fair value at that time.

 

Dueto our continued involvement with the property, including the ability to buyback the property at a future date, the transaction is accounted for as a financingof the property sold and leased back. Accordingly, the net book value of the facility and land sold to PKMwith a net book value of $759,146 continues to be presented as part of ourproperty, plant and equipment balance. The related-party lease obligation of $3,528,430 at January 31,2004, represents the minimum amounts due PKM for the initial ten-year termdiscounted at 4.4 percent and additional payments to be paid to PKM for theDakota Electric Association and Dakota County obligations assumed by PKM.

 

OnJuly 8, 2003, under the terms of a term debt transaction, we established aone-year $1.0 million term debt with PKM. The line, which requires the payment of interest at a rate of 10.0percent per year, matures on May 27, 2004, and is collateralized bysubstantially all of our assets.  Asadditional consideration for the financing, we issued to PKM two ten-yearwarrants for the purchase of an aggregate of 380,357 shares of our common stockat an exercise price of $0.70 per share with terms and conditions that includeweighted-average anti-dilution rights. We agreed to extend the term of 700,000 previously issued warrants fromfive years to ten years.  The allocatedfair value of the warrants issued prior to July 31, 2003, and theincremental value of the existing warrants was $383,361, and was accounted foras a discount on the borrowings under the bridge debt.  This discount, which is presented as areduction of the carrying value of the debt on the consolidated balance sheet,is being amortized as interest expense over the eleven-month term of thedebt.  We also agreed to modify thesewarrants to conform to the terms of the warrants issued as part of this bridgedebt financing.

 

Ina simultaneous transaction, we entered into a loan agreement and borrowed $1.0million from Peter L. Hauser (“Hauser”) pursuant to a one-year subordinatednote with an interest rate of 10.0 percent per year.  Pursuant to an intercreditor agreement with PKM, the loan iscollateralized by substantially all of our assets.  We issued to Hauser a ten-year warrant for the purchase of380,357 shares of our common stock on terms comparable to the PKM warrantsdescribed above.  As a result of the transaction,Hauser became the beneficial owner of approximately 10.3 percent of oursecurities.

 

InNovember 2003, we amended the one-year $1.0 million term debt with PKMinitiated on July 8, 2003, to provide for an additional $500,000 ofborrowing under the same terms.  Weissued, as additional consideration, a ten-year warrant to purchase 77,381shares of our common stock at an exercise price of $1.68 per share with termsand conditions that include weighted-average anti-dilution rights.

 

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InNovember 2003, we also entered into a loan agreement and borrowed $500,000from Draft Co. (“Draft”), an unrelated third party, pursuant to a note maturingJune 30, 2004, which bears interest at a rate of 10.0 percent peryear.  The loan is collateralized bysubstantially all of our assets pursuant to a restated intercreditor agreementamong PKM, Hauser and Draft.  We issuedto Draft warrants to purchase a total of 90,909 shares of our common stock atan exercise price of $1.43 per share with terms and conditions comparable tothe PKM warrants described above.

 

We expect that our operating losses and negative operating cashflow will continue intofiscal year 2005 as we continue increasing our corporate staff to supportthe development and launch of our atrial fibrillation technologyand heart valve repair products,and add marketing programs domestically and internationally to build awarenessof and create demand for our Omnicarbon heart valves.  Weanticipate that our sales and marketing and general and administrative expenseswill continue to constitute a material use of our cash resources.  The actual amounts and timing of our capitalexpenditures will vary significantly depending upon the speed at which we are able to expandour distribution capability in domestic and international markets and theavailability of financing.

 

Our capital requirements may varydepending upon the timing and the success of the implementation of our businessplan,regulatory,technological and competitive developments, or if:

 

•                  increased sales levels of our core productsand new products are not achieved;

 

•                  operating losses exceed our projections;

 

•                  ourmanufacturing and development costs or estimates prove to beinaccurate;

 

•                  we determine toacquire, license or develop additionaltechnologies;

 

•                  we experiencesubstantial difficulty ingaining U.S. market acceptance ordelays in obtaining FDA clearance of our proprietary carbon coating process forheart valves sold inthe U.S. market.

 

Ourability to continue as a going concern depends upon our ability to obtain additionaldebt and/or equity financing early in calendar year 2004.  We are currently seeking to raise between $3,000,000 and $5,000,000 of additional equity or debt financingto fund our operations and working capital requirements for the next 9 to 12months.  We also anticipate that we willneed to raise additional capital later in calendar year 2004.  Weexpect to face substantial difficulty in raising funds in the current marketenvironment, and we cannot provide any assurance that suchadditional financing will be available on terms acceptable to us or atall.  In addition, we will need toobtain additional capital prior to the maturity of our $500,000 debt with Drafton June 30, 2004, or otherwise extend or restructure this debt to continueoperations.

 

Theterms of any equity financing are expected to be highly dilutive to ourexisting security holders.  Thedelisting of our securities from the Nasdaq SmallCap Market that occurred inMarch 2003 will negatively affect our ability to raise capital.  Ifwe are unable to obtain adequate financing on acceptable terms, we will be unable tocontinue operations.  Unless the level of U.S. market acceptance ofour heart valves increases and the FDA approves our pyrolytic carbon process,we anticipate that we will continue to depend upon cash provided by financingactivities to address our working capital requirements.  By broadening our portfolio ofcardiothoracic surgery products, we hope to reduce our dependence on sales ofheart valves and reduce our reliance upon financing transactions, which may notbe available to us.  We cannot, however,assure you that our efforts to diversify our product offerings will:

 

•               be attainable;

 

•               be profitable;

 

•               reduce our reliance upon financingtransactions; or

 

•               enable us to continue operations.

 

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**Commitments andContingent Liabilities**

 

*Snia S.p.A. Carbomedics (formerlySulzer Carbomedics).* In July 1998, we enteredinto a three-year supply agreement with Snia S.p.A. Carbomedics, the source of certain raw materialcomponents used tomanufacture our Omnicarbon 3000 heart valves. The supply agreement was extended for an additional two years in March 2001. The agreement provided that we purchase a minimum number of raw material unitseach calendar year through December 2003.  Under theterms of the agreement, we were required to compensate Snia S.p.A.Carbomedics for any purchaseshortfalls up to a maximum of $200,000 per year.  We didnot meet the minimumpurchase requirements for the past four calendar years.  Asa result, we expensed $51,986 in the quarter endedJanuary 31, 2004, and $83,613 in the quarter endedJanuary 31, 2003, related tothese purchase shortfalls. For the first nine months of fiscal year 2004, we expensed $137,967compared to $113,738 during the first nine months of fiscal year 2003.  Thesecharges were reflected in cost of goods sold. Future purchase shortfalls could adversely affect our ongoingrelationship with Snia S.p.A. Carbomedics.

 

*Related Party LeaseObligation. *On April 4, 2003, we sold our corporateheadquarters, manufacturing facility and surrounding land in Inver GroveHeights, Minnesota, to PKM.  Inconnection with the transaction, we received total consideration of $3.84million consisting of (i) $1.0 million in cash, (ii) PKM’s assumption of our$2.5 million outstanding indebtedness to Associated Bank which eliminated ourindebtedness to Associated Bank, and (iii) PKM’s assumption of our promissorynote with Dakota Electric Association and land special assessments payable toDakota County aggregating $336,105.

 

Wesimultaneously leased back our facility pursuant to a ten-year lease, withoptions to renew and an option to repurchase the facility.  We will continue to utilize the facility as wedid prior to the sale-leaseback transaction, with no change in operations.

 

*ClinicalStudies. *We entered intoagreements with several large non-U.S. hospitals toconduct clinical studies regarding certain aspects of our Omnicarbon heartvalve’s clinicalperformance.  The agreements run through fiscal year 2006.  In general, recipients of clinical studypayments are required to purchase our products in order to complete their studies.

 

*Consulting*.  Weentered into an employment separation agreement with an officer inSeptember 2003, which provides for consulting services throughApril 2004.

 

*Short-Term Debt with RelatedParties.*  We entered into an agreement with PKM andanother shareholder in early July to provide $2.0 million of bridgefinancing.  We previously established aline of credit in January 2003 with PKM. As noted above, PKM is an entity controlled by a principal shareholder,who also serves on our board of directors.

 

*Atrial Fibrillation Technology Purchase Agreement. *We entered into an agreement with LightWave Ablation Systems, Inc.(“LightWave”) in August 2003 to purchase technology for the treatment ofatrial fibrillation.  We issued 15,000shares of common stock and made an initial payment of $10,000 to LightWave forthe worldwide technology distribution rights. Pursuant to terms of the agreement, additional cash payments may be madeand warrants to purchase shares of our common stock may be issued to LightWavein the event that we meet certain development and marketing milestones, includingobtaining a CE Mark, completion of a FDA 510(k) filing and the company meetingcertain revenue milestones.

 
|                                               |   | **Payments Due By Period** |      |
|----------------------------------------------------|--------|----------------------------|-----------|
| **Summary of Contractual****Obligations**          |   | **TOTAL**                  |      | **Less than****OneYear** |   | **Two to Three****Years** |   | **Four or More****Years** |   |
| Snia  S.p.A. Carbomedics                           |   | $                          | 171,301   |   | $ | 171,301 |   | $ |   |   | $ |   |   |
| Related Party Lease Obligation(1)                  |   | 3,509,100                  |      | 360,000 |   | 828,000 |   | 2,321,100 |   |
| Clinical Studies                                   |   | 10,100                     |      | 10,100 |   |   |   |   |   |
| Consulting                                         |   | 17,308                     |      | 17,308 |   |   |   |   |   |
| Atrial Fibrillation Technology Purchase  Agreement |   | 30,000                     |      |   |   | 30,000 |   |   |   |
| Short-Term Debt with Related Party                 |   | 2,443,333                  |      | 2,443,333 |   |   |   |   |   |
| Other Short-Term Debt                              |   | 500,000                    |      | 500,000 |   |   |   |   |   |
| TOTAL CONTRACTUAL  OBLIGATIONS                     |   | $                          | 6,681,142 |   | $ | 3,502,042 |   | $ | 858,000 |   | $ | 2,321,100 |   |

 

----

(1)                                  Future paymentsinclude interest due.

 

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**Qualitative andQuantitative Disclosures about Market Risk**

 

We develop our products in the U.S. and market our productsglobally.  Because we continue to deriveour revenue primarily from sources outside of the U.S., our financial resultscould be affected by many factors, such as changes in currency exchange ratesor weak economic conditions in foreign markets.  Substantially all of our sales are denominated in U.S.dollars.  A strengthening of the U.S.dollar could make our products less competitive in foreign markets.  We do not currently participate in anycurrency hedging activities to mitigate this risk.  We assess the need to use financial instruments to hedge ourexchange rate exposure on an ongoing basis.  Inaddition, we continually evaluate selling prices and billing currencies tomonitor our exchange rate exposure.  Our interest income and expenses aresensitive to changes in the general level of U.S. interest rates. Based on the current nature and levels of our investments and debt,however, we believe that we currently have no material market risk exposure.

 

Our general investing policy is to limit market and credit riskand the risk of principal loss.  Allliquid investments with original maturities of three months or less areconsidered to be cash equivalents.

 

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**ITEM 3****                          ****CONTROLS AND PROCEDURES**

 

Wemaintain a system of disclosure controls and procedures that is designed to providereasonable assurance that information, which is required to be disclosed, isaccumulated and communicated to management timely.  As of the end of the period covered by this report, we carriedout an evaluation under the supervision and with the participation of ourmanagement, including our Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of our disclosure controls andprocedures pursuant to Exchange Act Rule 13a-15.  In connection with its review of our financial statements for thequarter ended January 31, 2004, PricewaterhouseCoopers LLP informed ouraudit committee that there was a material weakness in our internalcontrols.  Specifically, PricewaterhouseCoopersLLP identified a significant deficiency in the design and operation of internalcontrols relating to documenting and reporting international distributionmarketing expenditures and related reimbursement.  We initiated procedures and reporting to document and supportcustomer marketing expenses to remedy this deficiency in the future.  Except for that deficiency, based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective in timely alertingthem to material information relating to our company required to be disclosedin our periodic filings with the SEC.

 

Duringour most recent fiscal quarter, there has been no change in our internalcontrol over financial reporting (as defined in Rule 13a-15(f) or 15d-15(f)under the Exchange Act) that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

 

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**PART II     OTHERINFORMATION**

ITEM 1        Legal Proceedings

 

Asof March 22, 2004, we were not a party to any material litigation.

 

ITEM 2        Changes in Securities

 

(a)          Not applicable.

 

(b)         Not applicable.

 

(c)            On November 13, 2003, we issued to PKMProperties, LLC, an entity controlled by Paul K. Miller, a member of our boardof directors and the largest beneficial owner of our securities, a ten-yearwarrant to purchase 77,381 shares of our common stock at an exercise price of$1.68 per share.  We issued this warrantin consideration of amendment to the one-year $1.0 million term debtarrangement with PKM, which provided for an additional $500,000 of borrowings.

 

OnNovember 24, 2003, we issued to Draft Co., an unrelated third party,ten-year warrants to purchase 90,909 shares of our common stock at an exerciseprice of $1.43 per share.  We issuedthis warrant in consideration of a loan agreement to borrow $500,000,pursuant to a note maturing June 30,2004, which bears interest at a rate of 10.0 percent per year.

 

The foregoing issuances were made in reliance upon the exemptionprovided in Section 4(2) of the Securities Act.  Such securities are restricted as to sale or transfer, unlessregistered under the Securities Act, and the certificate representing suchsecurities contains a restrictive legend preventing sale, transfer or otherdisposition, unless registered under the Securities Act.  In addition, the recipients of suchsecurities received material information concerning our company, including, butnot limited to, our reports on Form 10-KSB and Form 10-QSB, as filed with theSecurities and Exchange Commission.  Nounderwriting commissions or discounts were paid with respect to the issuance ofsuch securities.

 

 (d)         Not applicable.

 

ITEM 3        Defaults upon Senior Securities

 

Notapplicable.

 

ITEM 4        Submission of Matters to a Vote of SecurityHolders

 

None.

 

ITEM 5        Other Information

 

Notapplicable.

 

ITEM 6        Exhibits and Reports on Form 8-K

 

(a)         Exhibits

 

SeeIndex to Exhibits.

 

(b)        Reports on Form 8-K

 

OnDecember 9, 2003, the registrant furnished a Current Report on Form 8-K(under Item 12) regarding its release of material non-public informationrelating to its results of operations for the fiscal period endedOctober 31, 2003.

 

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**SIGNATURES**

 

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
|                            | MedicalCV,  Inc. |
|---------------------------------|------------------|
|                            |             |   |
|                            |             |   |
| Date:  March 22, 2004 | By               | /s/  Blair P. Mowery |   |
|                            |             | Blair  P. Mowery |
|                            |             | President  and Chief Executive Officer |
|                            |             |   |
| Date:  March 22, 2004 | By               | /s/  John H. Jungbauer |   |
|                            |             | John  H. Jungbauer |
|                            |             | Chief  Financial Officer |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** |   | **Description**                                                                                                                         |
|---------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |   | Warrant  Agreement to purchase 77,381 shares of common stock issued by the Registrant  to PKM Properties, LLC, dated November 13, 2003. |
| 31.1                |   | Chief  Executive Officer Certification pursuant to Rule 13a-14.                                                                         |
| 31.2                |   | Chief  Financial Officer Certification pursuant to Rule 13a-14.                                                                         |
| 32.1                |   | Chief  Executive Officer Certification pursuant to 18 U.S.C. Section 1350.                                                         |
| 32.2                |   | Chief  Financial Officer Certification pursuant to 18 U.S.C. Section 1350.                                                         |

 

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