**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**FORM10-QSB**

 

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

 

**Commission File Number 0-33295**

 

**MEDICALCV, INC.**

(Exact Name of Small BusinessIssuer as Specified in Its Charter)

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

 

**9725South Robert Trail**

**InverGrove Heights, Minnesota 55077**

**(651)452-3000**

(Address of Principal Executive Offices andIssuer’s

Telephone Number, includingArea Code)

 

 

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

 

Yes  ý  No  o

 

As of August 31, 2004, the issuer had outstanding 10,730,833shares of common stock.  This number includes 1,500,000 units, eachconsisting of one share of common stock and one redeemable Class A Warrant,sold in the issuer’s initial public offering.

 

Transitional Small Business Disclosure Format (check one)  oYes   ý No

 

 

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TABLE OF CONTENTS

 
| PART I            | FINANCIAL  INFORMATION |                                                                                                                                       |
|-------------------|------------------------|--------------------------------------------------------------------------------------------------------------------------------------------|
|              |                   |                                                                                                                                       |   |
|              | ITEM 1                 | Financial  Statements                                                                                                                      |   |
|              |                   | Consolidated  Balance Sheet at July 31, 2004 (unaudited) and April 30, 2004                                                      |   |
|              |                   | Consolidated Statement of Operations for  the three month periods ended July 31, 2004 (unaudited) and  July 31, 2003 (unaudited) |   |
|              |                   | Consolidated  Statement of Cash Flows for the three month periods ended July 31, 2004  (unaudited) and July 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 2                 | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                               |   |
|              | ITEM 6                 | Exhibits  and Reports on Form 8-K                                                                                                          |   |
|              |                   |                                                                                                                                       |   |
| SIGNATURES        |                   |
| INDEX TO EXHIBITS |                   |

 

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**PARTI**

 

**ITEM 1****              FinancialStatements**

 

**MEDICALCV, INC.**

 

**ConsolidatedBalance Sheet**

 
| ** **                                                                                                                         | ** ** | **July 31, 2004** | ** ** | **April 30,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------------------|------------|
| ** **                                                                                                                         | ** ** | **(unaudited)**        | ** ** | ** **               | ** ** |
| **ASSETS**                                                                                                                         |       |                   |       |                     |       |
| Current assets:                                                                                                                    |       |                   |       |                     |       |
| Cash and cash equivalents                                                                                                          |       | $                      | 1,159,268  |                     | $          | 659,856 |   |
| Trade and accounts receivable, net                                                                                                 |       | 1,384,156              |       | 1,495,401                |       |
| Inventories                                                                                                                        |       | 2,511,563              |       | 2,518,698                |       |
| Prepaid expenses and other assets                                                                                                  |       | 159,281                |       | 211,816                  |       |
| Total current assets                                                                                                               |       | 5,214,268              |       | 4,885,771                |       |
|                                                                                                                               |       |                   |       |                     |       |
| Property, plant and equipment, net                                                                                                 |       | 1,062,500              |       | 1,135,618                |       |
| Other long term assets                                                                                                             |       | 152,500                |       | —                   |       |
| Deferred financing costs, net                                                                                                      |       | 63,685                 |       | 74,605                   |       |
| Total assets                                                                                                                       |       | $                      | 6,492,953  |                     | $          | 6,095,994 |   |
|                                                                                                                               |       |                   |       |                     |       |
| **LIABILITIES AND SHAREHOLDERS’ DEFICIT**                                                                                     |       |                   |       |                     |       |
| Current liabilities:                                                                                                               |       |                   |       |                     |       |
| Accounts payable                                                                                                                   |       | $                      | 1,307,046  |                     | $          | 1,498,848 |   |
| Short-term debt with related parties                                                                                               |       | 3,443,333              |       | —                   |       |
| Current portion of related party lease  obligations                                                                                |       | 292,099                |       | 288,995                  |       |
| Note payable                                                                                                                       |       | —                 |       | 485,708                  |       |
| Accrued expenses                                                                                                                   |       | 630,363                |       | 266,671                  |       |
| Total current liabilities                                                                                                          |       | 5,672,841              |       | 2,540,222                |       |
| Long-term debt                                                                                                                     |       | —                 |       | 3,443,333                |       |
| Related party lease obligations, less  current portion                                                                             |       | 3,125,393              |       | 3,166,425                |       |
| Total liabilities                                                                                                                  |       | 8,798,234              |       | 9,149,980                |       |
|                                                                                                                               |       |                   |       |                     |       |
| Shareholders’ 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; 10,730,833 and 7,894,356 shares issued and outstanding,  respectively |       | 107,308                |       | 91,899                   |       |
| Additional paid-in capital                                                                                                         |       | 22,155,631             |       | 20,168,133               |       |
| Deferred stock-based compensation                                                                                                  |       | (1,481                 | )          | (1,933                   | )          |
| Accumulated deficit                                                                                                                |       | (24,566,739            | )          | (23,312,085              | )          |
| Total shareholders’ deficit                                                                                                   |       | (2,305,281             | )          | (3,053,986               | )          |
| Total liabilities and shareholders’ deficit                                                                                   |       | $                      | 6,492,953  |                     | $          | 6,095,994 |   |

 

The accompanying notes are an integral partof these financial statements.

 

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**MEDICALCV, INC.**

 

**ConsolidatedStatement of Operations**

(unaudited)

 
| ** **                                                     | ** ** | **Three Months Ended July 31,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                     | ** ** | **2004**                             | ** ** | **2003** | ** ** |
|                                                           |       |                                 |       |   |   |
| Net sales                                                      |       | $                                    | 795,503    |   | $ | 900,229 |   |
| Cost of goods sold                                             |       | 422,460                              |       | 497,103 |   |
| Gross profit                                                   |       | 373,043                              |       | 403,126 |   |
| Operating expenses:                                            |       |                                 |       |   |   |
| Sales and marketing                                            |       | 269,436                              |       | 600,738 |   |
| General and administrative                                     |       | 868,785                              |       | 556,923 |   |
| Engineering and regulatory                                     |       | 312,210                              |       | 203,994 |   |
| Total operating expenses                                       |       | 1,450,431                            |       | 1,361,655 |   |
| Loss from operations                                           |       | (1,077,388                           | )          | (958,529 | ) |
| Other (expense) income:                                        |       |                                 |       |   |   |
| Interest expense                                               |       | (180,420                             | )          | (156,246 | ) |
| Interest income                                                |       | 2,840                                |       | 4,993 |   |
| Other (expense) income                                         |       | 312                                  |       | (11,181 | ) |
| Total other expense                                            |       | (177,268                             | )          | (162,434 | ) |
|                                                           |       |                                 |       |   |   |
| Net loss                                                       |       | $                                    | (1,254,656 | ) | $ | (1,120,963 | ) |
| Basic and diluted net loss per share                           |       | $                                    | (.13       | ) | $ | (.14 | ) |
|                                                           |       |                                 |       |   |   |
| Shares used in computing basic and diluted  net loss per share |       | 9,489,670                            |       | 7,894,356 |   |

 

The accompanying notes are an integral partof these financial statements.

 

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**MEDICALCV, INC.**

 

**ConsolidatedStatement of Cash Flows**

(unaudited)

 
| ** **                                                                                  | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                  | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Cash flows from operating activities:                                                       |       |                                 |       |   |   |
| Net loss                                                                                    |       | $                                    | (1,254,656 | ) | $ | (1,120,963 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                |       |                                 |       |   |   |
| Depreciation                                                                                |       | 80,247                               |       | 79,821 |   |
| Provision for doubtful accounts, excluding  return of inventory                             |       | —                               |       | 5,960 |   |
|                                                                                        |       |                                 |       |   |   |
| Provision for inventory obsolescence                                                        |       | 10,250                               |       | — |   |
| Stock-based compensation                                                                    |       | 452                                  |       | 29,526 |   |
| Interest expense associated with warrant  grants and amortization of loan origination costs |       | 14,292                               |       | 114,895 |   |
| Changes in assets and liabilities:                                                          |       |                                 |       |   |   |
| Accounts receivable                                                                         |       | 111,245                              |       | (162,382 | ) |
| Inventories                                                                                 |       | (3,115                               | )          | 71,600 |   |
| Prepaid expenses and other assets                                                           |       | 52,535                               |       | (142,283 | ) |
| Accounts payable                                                                            |       | (191,802                             | )          | (157,199 | ) |
| Accrued expenses                                                                            |       | 363,692                              |       | (317,203 | ) |
| Net cash used in operating activities                                                       |       | (816,858                             | )          | (1,598,228 | ) |
|                                                                                        |       |                                 |       |   |   |
| Cash flows from investing activities:                                                       |       |                                 |       |   |   |
| Purchase of property, plant and equipment                                                   |       | (7,129                               | )          | — |   |
| Purchase of other long-term assets                                                          |       | (152,500                             | )          | — |   |
| Net cash used in investing activities                                                       |       | (159,629                             | )          | — |   |
|                                                                                        |       |                                 |       |   |   |
| Cash flows from financing activities:                                                       |       |                                 |       |   |   |
| Deferred financing costs                                                                    |       | 10,920                               |       | — |   |
| Proceed from the issuance of common stock  and warrants, net of offering costs              |       | 2,002,907                            |       | — |   |
| Proceeds from short-term debt                                                               |       | —                               |       | 1,764,728 |   |
| Principal payments on short-term debt                                                       |       | (500,000                             | )          | — |   |
| Principal payments under capital lease  obligations                                         |       | —                               |       | (13,199 | ) |
| Principal payments under related party  lease obligations                                   |       | (37,928                              | )          | (134,738 | ) |
| Net cash provided by financing activities                                                   |       | 1,475,899                            |       | 1,616,791 |   |
|                                                                                        |       |                                 |       |   |   |
| Net increase in cash and cash equivalents                                                   |       | 499,412                              |       | 18,563 |   |
| Cash and cash equivalents at beginning of  year                                             |       | 659,856                              |       | 184,227 |   |
| Cash and cash equivalents at end of period                                                  |       | $                                    | 1,159,268  |   | $ | 202,790 |   |

 

The accompanying notes are an integral partof these financial statements.

 

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**MEDICALCV, INC.**

 

**Notes****to ConsolidatedFinancial Statements**

 

**(1)****                                 Basisof Financial Statement Presentation**

 

The accompanying unaudited consolidated financial statements includedherein have been prepared by MedicalCV, Inc. (the “Company”) in accordance withaccounting principles generally accepted in the United States of America forinterim financial information and pursuant to the rules and regulations of theSecurities and Exchange Commission.  Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed or omitted pursuant to such rules and regulations. These consolidated interim financial statements should be read in conjunctionwith the consolidated financial statements and the notes thereto included inthe Company’s Annual Report on Form 10-KSB for the fiscal year endedApril 30, 2004.

 

The consolidated balance sheet as of July 31, 2004, theconsolidated statement of operations for the three months ended July 31,2004 and 2003, and the consolidated statement of cash flows for the threemonths ended July 31, 2004 and 2003 include, in the opinion of management,all adjustments, consisting solely of normal recurring adjustments, necessaryfor a fair presentation of the financial results for the respective interimperiods and are not necessarily indicative of results of operations to beexpected for the entire fiscal year ending April 30, 2005.

 

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

 

The Company’s unaudited consolidated financial statements for thequarter ended July 31, 2004, have been prepared on a going concern basis,which contemplates the realization of assets and settlement of liabilities andcommitments in the normal course of business.  The Company has sustainedlosses and negative cash flows from operations in recent years and expectsthese conditions to continue for the foreseeable future.  At July 31,2004, the Company had an accumulated deficit of $24,566,739 and hasinsufficient funds to finance its working capital and capital expenditureneeds.  Accordingly, these matters raise substantial doubt about theCompany’s ability to continue as a going concern.  The Company iscurrently seeking other sources of financing to fund its operations and workingcapital requirements.  If the Company is unable to obtain sources ofadditional funds during fiscal year 2005, it will be required to significantlyrevise its business plans and drastically reduce operating expenditures suchthat it may not be able to develop or enhance its products, gain market share inthe United States or respond to competitive pressures or unanticipatedrequirements, which could seriously harm its business, financial position andresults of operations.  These financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

 

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, actions of competitors,dependence on key personnel and United States market penetration.

 

**(3)****                                 Stock-basedCompensation**

 

The Company accounts for stock-based employee compensation arrangementsin accordance with the provisions of Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees,” and related interpretations andcomplies with the disclosure provisions of SFAS No. 123, “Accounting forStock-Based Compensation” and SFAS No. 148 “Accounting for Stock-BasedCompensation-Transition and Disclosure, an amendment of FASB Statement No.123.”

 

For purposes of the pro forma disclosures below, the estimated fairvalue of the options is amortized to expense over the options’ vestingperiod.  Had compensation cost for the Company’s stock options beenrecognized based on the fair value at the grant date consistent with theprovisions of SFAS No. 123, the Company’s net loss would have beenadjusted to the pro forma amounts indicated below:

 

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| ** **                                                    | ** ** | **For Quarters Ended July 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Net loss reported                                             |       | $                                    | (1,254,656 | ) | $ | (1,120,963 | ) |
| Less:  Pro forma stock based employee  compensation cost |       | (43,501                              | )          | (64,269 | ) |
|                                                          |       |                                 |       |   |   |
| Net loss – pro forma                                     |       | (1,298,157                           | )          | (1,185,232 | ) |
|                                                          |       |                                 |       |   |   |
| Net loss per common share – basic and  diluted           |       |                                 |       |   |   |
| As reported                                                   |       | (.13                                 | )          | (.14 | ) |
| Pro forma                                                     |       | (.14                                 | )          | (.15 | ) |
|                                                               |            |                                      |            |  |  |  |  |

 

**(4)****                                 NetLoss per Share**

 

Net loss per share is computed under the provisions of SFASNo. 128, “Earnings Per Share.” Basic net loss per common share is computedusing net loss and the weighted-average number of shares of common stockoutstanding. Diluted earnings per share reflect the potential dilution ofsecurities that could share in the earnings of an entity. Diluted net loss percommon share does not differ from basic net loss per common share in thethree-month periods ended July 31, 2004 and 2003, since the potentiallydilutive shares are anti-dilutive to net loss per share.  Potentiallydilutive shares excluded from the calculation of diluted net loss per sharerelate to outstanding stock options and warrants for the purchase of 1,761,714and 5,010,975 shares of the Company’s common stock at July 31, 2004 and2003, respectively.

 

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

 

Inventory consists of the following components:

 
| ** **      | ** ** | **July 31, 2004** | ** ** | **April 30, 2004** | ** ** |
|-----------------|------------|------------------------|------------|-------------------------|------------|
| ** **      | ** ** | **(unaudited)**        | ** ** | ** **              | ** ** |
| Raw materials   |       | $                      | 109,343    |                    | $          | 97,074 |   |
| Work-in-process |       | 119,918                |       | 216,324                 |       |
| Finished goods  |       | 2,282,302              |       | 2,205,300               |       |
|            |       | $                      | 2,511,563  |                    | $          | 2,518,698 |   |

 

**(6)****                                 RestructuringCharge**

 

In July 2004, the Company restructured its executive managementteam which resulted in a charge of approximately $214,000, which is included ingeneral and administrative expenses. This charge represents the amount of future severance payments due tothese former executives.  As ofJuly 31, 2004, two members of management affected by the restructuringwere no longer employees of the Company and had no obligation to provide futureservice to the Company.  The Companyexpects to pay all amounts due to these former executives by July 2005.

 

**(7)****                                 Equitysale**

 

On May 21, 2004, the Company closed on the private sale of units, eachconsisting of one share of common stock and one warrant to purchase one shareof common stock.  For a price of $1.47 per unit, the Company issued1,540,900 shares of common stock and 1,540,900 five year warrants for thepurchase of common shares of stock at $1.60 per share.  Gross proceedstotaled $2,265,123.  In connection with this sale, the Company issued tothe agent a five year warrant to purchase 123,272 units at an exercise price of$1.8375 per unit, and the Company paid the agent a cash commission of $181,210,and an expense allowance of $67,954. Additional incidental expenses totaling $13,052 were also incurred underthe transaction.  The warrants underlying the unit warrants issued to theagent are exercisable for a period of five years at an exercise price of$1.8375 per share.

 

**(8)****                                 SegmentInformation**

 

The Company views its operations and manages its business as onesegment, the manufacturing and marketing of 

 

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cardiothoracic surgery devices.  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 July 31,** | ** ** |
|---------------|------------|--------------------------------------|------------|
| ** **    | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| ** **    | ** ** | **(unaudited)**                      | ** ** |
| Europe        |       | $                                    | 353,316    |   | $ | 446,870 |   |
| South Asia    |       | —                               |       | 76,800 |   |
| Middle East   |       | 257,332                              |       | 142,454 |   |
| Far East      |       | 7,703                                |       | 53,180 |   |
| United States |       | 168,548                              |       | 180,700 |   |
| Other         |       | 8,604                                |       | 225 |   |
| **TOTALS**    |       | $                                    | 795,503    |   | $ | 900,229 |   |

 

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**ITEM 2****              MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLANOF OPERATION**

 

*The following discussion contains variousforward-looking statements within the meaning of Section 21E of theExchange Act.  Although we believe that, in making any such statement, ourexpectations are based on reasonable assumptions, any such statement may beinfluenced by factors that could cause actual outcomes and results to bematerially different from those projected.  When used in the followingdiscussion, the words “anticipates,” “believes,” “expects,” “intends,” “plans,”“estimates” and similar expressions, as they relate to us or our management,are intended to identify such forward-looking statements.  Theseforward-looking statements are subject to numerous risks and uncertainties thatcould cause actual results to differ materially from those anticipated.  Factorsthat could cause actual results to differ materially from those anticipated,certain of which are beyond our control, are set forth in this document and inour Annual Report on Form 10-KSB for the fiscal year ended April 30, 2004,under the caption “Management’s Discussion and Analysis or Plan of Operation —Cautionary Statement.”*

 

*Our actual results, performance orachievements could differ materially from those expressed in, or implied by,forward-looking statements.  Accordingly, we cannot be certain that any ofthe events anticipated by forward-looking statements will occur or, if any ofthem do occur, what impact they will have on us.  We caution you to keepin mind the cautions and risks described in this document and in our CautionaryStatement 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 cardiac products for improvedpatient outcomes by early treatment of cardiac disorders.  Historically,we have developed, marketed and sold mechanical heart valves known as theOmnicarbon® 3000 and 4000 heart valves.  Our long-range strategy, however,is to achieve profitability by diversifying into high growth markets incardiothoracic surgery.  Near-term, we plan to develop and introduceproducts targeting treatment of atrial fibrillation.

 

We currently sell the Omnicarbon 3000 valve in the U.S. and Japan, andthe Omnicarbon 4000 internationally.  The Omnicarbon 3000 is manufacturedusing pyrolytic carbon components manufactured by a third party, with theremaining manufacturing completed by our company.  In contrast, theOmnicarbon 4000 is completely manufactured by us, which includes ourproprietary carbon coating process.  We are seeking an amendment from theU.S. Food and Drug Administration (“FDA”) to the Omnicarbon PMA to use our ownproprietary carbon coating process, which we believe will be obtained by latecalendar year 2004.  Such approval would allow us to sell the Omnicarbon4000 in the U.S., and thereby enable us to significantly decrease themanufacturing cost of the Omnicarbon heart valves sold in the UnitedStates.  We believe our proprietary carbon coating technology, as well asthe excellent record of quality and the established superior clinicalperformance of the Omnicarbon valve versus leading mechanical heart valves,give us a strategic position for worldwide growth.

 

Approximately 36,000 Omnicarbon heart valves have been implantedworldwide.  Sales of heart valves have been primarily to customers inEurope, South Asia, the Middle East and the Far East.  Although we derived43 percent and 48 percent of our net sales in fiscal year 2004 and the firstquarter of fiscal year 2005 from Europe, we have established a U.S. salesorganization, consisting primarily of independent sales representatives who areexperienced in marketing products to cardiothoracic surgeons.  Wecommenced marketing the Omnicarbon 3000 heart valve in the U.S. in late January 2002.

 

To reduce our dependence on sales of heart valves, we have developed astrategy to broaden our product offerings to the cardiothoracic surgeon bydeveloping, acquiring or licensing additional technologies.  InAugust 2003, we acquired a technology platform for the treatment of atrialfibrillation from LightWave Ablation Systems, Inc., a private research-basedcorporation focused on new devices for the treatment of cardiovasculardiseases.  Atrial fibrillation is a common irregular heart rhythm conditionamong the U.S. population and is a significant, worldwide healthcare challenge.

 

Our company was incorporated in Minnesota on March 30, 1992, underthe name CV Dynamics, Inc.  In April 1992, we acquired all of thetangible and intangible assets of Omnicor, 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. Our corporate headquarters is located at 9725 South Robert Trail, Inver Grove 

 

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Heights, MN 55077.

 

**Quarters Ended July 31, 2004 and 2003**

 

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

 

| ** **                 | ** ** | **Three Months Ended July 31,** | ** ** |
|----------------------------|------------|--------------------------------------|------------|
| ** **                 | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(unaudited)**                      | ** ** |
| Net sales                  |       | 100.0                                | %          | 100.0 | % |
| Cost of goods sold         |       | 53.1                                 | %          | 55.2 | % |
|                       |       |                                 |       |   |   |
| Gross profit               |       | 46.9                                 | %          | 44.8 | % |
|                       |       |                                 |       |   |   |
| Operating expenses:        |       |                                 |       |   |   |
|                       |       |                                 |       |   |   |
| Sales and marketing        |       | 33.9                                 | %          | 66.7 | % |
| General and administrative |       | 109.2                                | %          | 61.9 | % |
| Engineering and regulatory |       | 39.2                                 | %          | 22.7 | % |
|                       |       |                                 |       |   |   |
| Total operating expenses   |       | 182.3                                | %          | 151.3 | % |
|                       |       |                                 |       |   |   |
| Loss from operations       |       | (135.4                               | )%         | (106.5 | )% |
|                       |       |                                 |       |   |   |
| Other (expense) income:    |       |                                 |       |   |   |
| Interest expense           |       | (22.7                                | )%         | (17.4 | )% |
| Interest income            |       | 0.4                                  | %          | 0.6 | % |
| Other income               |       | —                               | %          | (1.2 | )% |
|                       |       |                                 |       |   |   |
| Total other expense        |       | (22.3                                | )%         | (18.0 | )% |
|                       |       |                                 |       |   |   |
| Net loss                   |       | (157.7                               | )%         | (124.5 | )% |

 

**Critical Accounting Policies**

 

For discussion of our critical accounting policies and estimates, seeour Annual Report on Form 10-KSB for the fiscal year ended April 30, 2004.

 

**Results of Operations**

 

*Net Sales*.  Netsales in the quarter ended July 31, 2004 decreased 11.6 percent to $795,503from $900,229 in the first quarter of the prior year.  Unit sales decreased 18.2 percent in thequarter ended July 31, 2004, compared to the same period in the previousyear.  The average selling price per unitincreased 8 percent in the quarter ended July 31, 2004, compared to thequarter ended July 31, 2003, as a larger proportion of our sales weregenerated in geographic areas where our prices are typically higher.

 

A 60 percent increase in revenues from sales to customers in the MiddleEast was offset by a 26 percent decrease in revenues from customers in Europeduring the quarter ended July 31, 2004, compared to the quarter endedJuly 31, 2003.  European salesaccounted for 42 percent of sales in the quarter ended July 31, 2004,compared to 50 percent of sales for the quarter ended July 31, 2003.  During the quarter ended July 31, 2004,we changed pricing programs and compensation arrangements with severaldistributors in an attempt to reduce sales and marketing expense.  This resulted in a disruption to our sales todistributors in certain markets. Management believes that these revised arrangements will allow us togenerate revenues at levels comparable to the current quarter.

 

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*Gross Profit.*  Grossprofit as a percentage of net sales increased to 46.9 percent in the quarterended July 31, 2004, from 44.8 percent in the comparable period one yearago.  Gross profit decreased $30,083 from$403,126 for the quarter ended July 31, 2003, to $373,043 for the quarterended July 31, 2004.  While grossprofit declined due to the decline in revenues discussed above, gross profit asa percent of sales increased due to the increase in the average selling priceper unit discussed above.

 

*Sales and Marketing*. Sales and marketing expenses in the quarter ended July 31, 2004, were$269,436 or 33.9 percent of net sales compared to $600,738 or 66.7 percent ofnet sales in the same period last fiscal year.  The decrease in sales andmarketing expenses in the first quarter of fiscal year 2005 compared to thefirst quarter of fiscal year 2004 was primarily attributable to restructuringof the company’s sales and distribution organization and changes to thecompany’s distribution arrangements. Management expects that the level of sales and marketing expenses in theremaining quarters of fiscal year 2005 will be higher than the current quarterbut will remain comparable to the current quarter as a percentage of net sales.

 

*General and Administrative*. General and administrative expenses for the quarter ended July 31, 2004,were $868,785 or 109.2 percent of net sales compared to $556,923 or 61.9percent of net sales in the prior year. Included in the general and administrative expense for the three monthsended July 31, 2004, was $214,000 for severance agreements.  In the quarter ended July 31, 2004,increased legal fees of $39,000 and increased consulting fees of $26,000 werethe other major components of the $311,862 increase of general andadministrative expense over the quarter ended July 31, 2003.

 

*Engineering and Regulatory*. Engineering and regulatory expenses for the quarter ended July 31, 2004,were $312,210 or 39.2 percent of net sales compared to $203,994 or 22.7 percentof net sales in the prior year.  Spendingon our atrial fibrillation technology acquired in August 2003 was $124,000for the first quarter of fiscal year 2005 which drove the increase inengineering and regulatory expenses.

 

*Other (Expense) Income*. Interest expense totaled $180,420 in the quarter ended July 31, 2004,compared to $156,246 in the comparable period last fiscal year.  The increase in interest expense in the firstquarter of fiscal year 2005 was due to an increased amount of borrowings outstandingin the current quarter compared to the prior year quarter.

 

*Income Tax Provision*. In light of our history of operating losses, we have historically recorded avaluation allowance to fully offset our deferred tax assets.  We havecontinued to provide a full valuation allowance through the first quarter offiscal year 2005 due to the inherent uncertainty about our ability to generatethe sufficient taxable income to realize these deferred tax assets.  We have recorded no tax provision in thecurrent period due to net operating losses generated for income tax reportingpurposes.

 

**Liquidity and Capital Resources**

 

Cash and cash equivalents increased to $1,159,268 at July 31,2004, from $659,856 at April 30, 2004.  This increase in cash andcash equivalents of $499,412 was due to the following:

 

| Net cash used in operating activities     |   | $         | (816,858 | )      |
|-------------------------------------------|--------|-----------|----------|--------|
| Net cash used in investing activities     |   | (159,629  | )        |
| Net cash provided by financing activities |   | 1,475,899 |     |
| Net increase                              |   | $         | 499,412  |   |

 

Net cash used in operating activities decreased $781,370 to $816,858 inthe quarter ended July 31, 2004, from $1,598,228 in the quarter endedJuly 31, 2003.  The use of cash in operations in the first quarter ofboth fiscal year 2005 and fiscal year 2004 was primarily due to net losses of$1,254,656 and $1,120,963, respectively.  The decrease in the use of cashin operations in the first quarter of fiscal year 2005 relative to 2004 was dueprincipally to increases in accrued expenses and a decrease in prepaidexpenses, versus an decrease in inventories in the first quarter of fiscal year2004.  The increases in accrued expenses were attributable to when we paidcertain costs.

 

Net cash used in investing activities was $159,629 in the quarter endedJuly 31,2004. The increase was attributable to a purchase of equipment tobe used in the clinical studies for the atrial fibrillation product.

 

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Net cash provided by financing activities was $1,475,899 in the quarterended July 31, 2004, and consisted of net proceeds from the issuance ofcommon stock and warrants totaling $2,002,907, offset by payments of short-termdebt of $500,000 and principal payments on the related party lease obligationof $37,928.  Net cash provided byfinancing activities was $1,616,791 in the quarter ended July 31, 2003,and consisted of proceeds from short-term debt of $1,764,738, offset byprincipal payments on capital leases of $13,199, and principal payments onrelated parties lease.

 

Throughout fiscal year 2004 and in the first quarter of fiscal year2005, we entered into a number of financing transactions to provide fundsnecessary to meet our working capital and capital expenditure needs and to meetother obligations.  These financing activities consisted of the following:

 

•                  InJanuary 2003, we established a discretionary line of credit withPKM.  As of July 31 and April 30, 2004, we had borrowed $943,333and $943,333, under this line of credit.  This line of credit, as amended,requires the payment of interest at a rate of 10 percent per year, matures on June 30,2005, and is collateralized by substantially all of our assets.

 

•                  InApril 2003, we also completed a transaction in which our corporateheadquarters, manufacturing facility and surrounding land were sold to PKM in asale-leaseback transaction.  Simultaneous with the sale, we entered into alease with PKM to lease back the facility and a portion of the land.

 

•                  InJuly 2003, we established a $1.0 million term debt with PKM.  Thisterm debt, which was amended in November 2003 to provide for an additional$500,000 of borrowing, requires the payment of interest at a rate of 10 percentper year, matures on June 30, 2005, and is collateralized by substantiallyall of our assets.

 

•                  In asimultaneous July 2003 transaction, we entered into a loan agreement andborrowed $1.0 million from Peter L. Hauser pursuant to the terms of asubordinated note with an interest rate of 10 percent per year.  Pursuantto an intercreditor agreement with PKM, the loan is collateralized bysubstantially all of our assets. This loan, as amended, matures onJune 30, 2005.

 

•                  We also borrowed$500,000 in November 2003 from Draft Co., under a note that matured onJune 30, 2004, which had an interest at a rate of 10 percent peryear.  The Draft loan was collateralized by substantially all our assetspursuant to a restated intercreditor agreement among PKM, Hauser, and Draft.This note was repaid on June 30, 2004.

 

•                  InApril 2004, we issued a short-term promissory note to PKM in the principalamount of $150,000.  The note required the payment of interest at a rateof 10 percent per year.  This note was repaid during April 2004.

 

•                  In February,April and May, 2004, we conducted a private placement to accreditedinvestors of units, each unit consisting of one share of common stock and onecommon stock purchase warrant to purchase one share of common stock. In this placement, we sold 2,730,763 units for aggregate gross proceeds of$4,014,222. During fiscal year 2004 we received gross proceeds from thisprivate placement of $1,749,099. The five-year warrants sold with the commonstock are exercisable to purchase an aggregate of 2,730,763 shares of commonstock at an exercise price of $1.60 per share.  In connection with suchplacement, we issued our agent a five-year warrant to purchase 123,272 units atan exercise price of $1.8375 per unit, paid our agent cash commissions of$181,210 and paid our agent an expense allowance of $67,954.  Inconnection with such placement, we issued our finder a five-year warrant topurchase 190,378 units at an exercise price of $1.8375 per unit, paid ourfinder a finder’s fee of $140,928 and reimbursed our finder for expenses of$4,163.  The warrants underlying the unit warrants issued to the agent andthe finder are exercisable for a period of five-years at an exercise price of$1.8375 per share.

 

Even with the net proceeds from our recently completed privateplacement, we anticipate that we will need to raise additional capital inOctober 2004.  In addition, the report of our independent registeredpublic accounting firm for fiscal year 2004 includes an explanatory paragraphexpressing doubt about our ability to continue as a going concern.

 

We expect that our operating losses and negative operating cash flowwill continue through fiscal year 2005 as we continue adding staff to supportthe development and launch of our atrial fibrillation technology.  Weanticipate that our sales and marketing and general and administrative expenseswill continue to constitute a material use of our cash resources.  Theactual amounts and timing of our capital expenditures will vary significantlydepending upon progress 

 

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on our product development projects, the speed at which we are able toexpand our distribution capability in domestic and international markets andthe availability of financing.

 

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Our capital requirements may vary depending upon the timing and thesuccess of the implementation of our business plan, regulatory, technologicaland competitive developments, or if:

 

•                  increased saleslevels of our core products and new products are not achieved;

 

•                  operating lossesexceed our projections;

 

•                  ourmanufacturing and development costs or estimates prove to be inaccurate;

 

•                  we determine toacquire, license or develop additional technologies; or

 

•                  we continue toexperience substantial difficulty in gaining U.S. market acceptance or delaysin obtaining FDA clearance of our proprietary carbon coating process for heartvalves sold in the U.S. market.

 

By broadening our portfolio of cardiothoracic surgery products, we hopeto reduce our dependence on sales of heart valves and reduce our reliance uponfinancing transactions, which may not be available to us.  We cannot, however,assure you that our efforts to diversify our product offerings will:

 

•                  be attainable;

 

•                  be profitable;

 

•                  reduce ourreliance upon financing transactions; or

 

•                  enable us tocontinue operations.

 

Our ability to continue as a going concern depends upon our ability toobtain additional debt and/or equity financing in October 2004.  Wewill be seeking a minimum of $3,000,000 to fund our operations and workingcapital requirements through April 2005.  We cannot provide anyassurances, however, that such additional financing will be available on termsacceptable to us or at all.  We will need to obtain additional capitalprior to the maturity date of our line of credit with PKM and our term debtwith PKM and Hauser, all of which is due on June 30, 2005, unless theterms are otherwise extended or restructured to continue operations.  We cannot provide any assurances, however,that we will be able to extend or restructure our debt on terms acceptable tous or at all.

 

We expect to face substantial difficulty in raising funds in thecurrent market environment and we have no commitments at this time to providethe required financing.  If we obtain the foregoing financing, we believewe will have sufficient capital resources to operate and fund the growth of ourbusiness for the remainder of fiscal year 2005.

 

The amount of capital needed for fiscal year 2006 is difficult toestimate and will be dependent on our efforts to reduce losses in our heartvalve operations, the introduction of our open-heart atrial fibrillationproduct and development costs on our minimally invasive atrial fibrillationproducts.

 

We cannot assure you that we will be able to raise sufficientadditional capital on terms that we consider acceptable, or at all.  Theterms of any equity financing are expected to be highly dilutive to ourexisting security holders.  The delisting of our securities from theNasdaq SmallCap Market that occurred in March 2003 will negatively affectour ability to raise capital.  If we are unable to obtain adequate financingon acceptable terms, we will be unable to continue operations.

 

**Commitments and Contingent Liabilities**

 

*Related Party Lease Obligation*. On April 4, 2003, we sold our corporate headquarters, manufacturingfacility and surrounding land in Inver Grove Heights, Minnesota, to PKM. In connection 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.

 

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We simultaneously leased back our facility pursuant to a ten-yearlease, with options to renew and an option to repurchase the facility.  Wecontinue to utilize the facility as we did prior to the financing transaction,with no change in operations.

 

*Clinical Studies*. We entered into agreements with several large non-U.S. hospitals to conductclinical studies regarding certain aspects of our Omnicarbon heart valve’sclinical performance.  The agreements run through fiscal year 2006. In general, recipients of clinical study payments are required to purchase ourproducts in order to complete their studies and collect and submit dataaccording to a study protocol.

 

*Deferred compensation.*As part of the management restructuring, weare obligated to make severance payments to two former officers totaling  $213,626 during fiscal year 2005.

 

*Atrial Fibrillation Technology PurchaseAgreement*.  We entered into an agreement withLightWave Ablation Systems, Inc. (“LightWave”) in August 2003 to purchasetechnology for the treatment of atrial fibrillation.  We issued 15,000shares of common stock and a warrant to purchase 25,000 shares of common stock,and made an initial payment of $10,000 to LightWave for the worldwidetechnology distribution rights.  In April 2004, we paid $15,000coincident with the filing of a 510(k) application with the FDA pertaining toan application of the LightWave technology.  Pursuant to terms of theagreement, additional cash payments will be made and warrants to purchaseshares of our common stock may be issued to LightWave in the event that we meetcertain development and marketing milestones, including obtaining a CE Mark,receipt of 510(k) clearance, and issuance of a U.S. Patent.  Upon thefirst commercial sale in the U.S. or Europe utilizing the purchased technology,a payment of $125,000 will be due and an additional $385,000 will be due whencumulative gross sales of disposable products utilizing the purchasedtechnology reach $1,500,000.  In addition, for a period of 10 years measuredfrom the first commercial sale utilizing the purchased technology, we will makea payment totaling 2 to 6 percent of net sales of disposable products. Following the first commercial sale utilizing the purchased technology, thetiming of which is indeterminable, minimum payments under this provision wouldtotal $2,325,000 over nine years.

 

*Debt with Related Parties*. We entered into agreements with PKM and Hauser in July andNovember of 2003 to provide $2.5 million of bridge financing.  Wepreviously established a line of credit in January 2003 with PKM and haveentered into various other financing transactions with PKM as described above.

 

The following table summarizes our contractual obligation as ofJuly 31, 2004:

 
| ** **                                            | ** ** | **Payments Due By Period** | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|
| **Summary  of Contractual   Obligations**             | ** ** | **TOTAL**                  | ** ** | **Less than One Year** | ** ** | **Two to Three  Years** | ** ** | **Four or More  Years** | ** ** |
| Related Party Lease Obligation(1)                     |       | $                          | 3,713,134  |   | $ | 384,000 |   | $ | 768,000 |   | $ | 2,561,134 |   |
| Clinical Studies                                      |       | 10,300                     |       | 10,300 |   |   |   |   |   |
| Deferred compensation                                 |       | 213,626                    |       | 213,626 |   |   |   |   |   |
| Atrial Fibrillation Technology Purchase  Agreement(2) |       | 15,000                     |       | 15,000 |   |   |   |   |   |
| Debt with Related Parties                             |       | 3,443,333                  |       | 3,443,333 |   |   |   |   |   |
| TOTAL CONTRACTUAL OBLIGATIONS                         |       | $                          | 7,395,393  |   | $ | 4,066,258 |   | $ | 768,000 |   | $ | 2,561,134 |   |

 

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(1)                                  Futurepayments include interest due.

(2)                                  Excludespayments that are contingent upon achievement of future development and salesmilestones, as described above.

 

**Qualitative and Quantitative Disclosuresabout Market Risk**

 

We develop our products in the U.S. and market our productsglobally.  Because we continue to derive our revenue primarily fromsources outside of the U.S., our financial results could be affected by manyfactors, such as changes in currency exchange rates or weak economic conditionsin foreign markets.  Substantially all of our sales are denominated inU.S. dollars.  A strengthening of the U.S. dollar could make our productsless competitive in foreign markets.  We do 

 

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not currently participate in any currency hedging activities tomitigate this risk.  We intend to assess the need to use financialinstruments to hedge our exchange rate exposure on an ongoing basis.  Ourinterest income and expenses are sensitive to changes in the general level ofU.S. interest rates, particularly since our investments are in short-terminstruments and our long-term debt and revolving line of credit requireinterest payments calculated at variable rates.  Based on the currentnature and levels of our investments and debt, however, we believe that wecurrently have no material market risk exposure.

 

Our general investing policy is to limit market and credit risk and therisk of principal loss.  All liquid investments with original maturitiesof three months or less are considered to be cash equivalents.

 

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

 

We maintain a system of disclosure controls and procedures that isdesigned to provide reasonable assurance that information, which is required tobe disclosed, is accumulated and communicated to management timely.  As ofthe end of the period covered by this report, we carried out an evaluationunder the supervision and with the participation of our management, including ourChief Executive Officer and Chief Financial Officer, of the effectiveness ofthe design and operation of our disclosure controls and procedures pursuant toExchange Act Rule 13a-15.  Based uponthat evaluation, our Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures are effective in timelyalerting them to material information relating to our company required to bedisclosed in our periodic filings with the SEC.

 

During our most recent fiscal quarter, there has been no change in ourinternal control over financial reporting (as defined in Rule 13a-15(f) or15d-15(f) under the Exchange Act) that has materially affected, or isreasonably likely to materially affect, our internal control over financial reporting.

 

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**PARTII**

 

**OTHER INFORMATION**

 

**ITEM2              Unregistered Sales of Equity Securities and Use of Proceeds**

 

(a)                                  OnMay 21, 2004, the Company closed on the private sale of units, each consistingof one share of common stock and one warrant to purchase one share of commonstock.  For a price of $1.47 per unit, the Company issued 1,540,900 sharesof common stock and 1,540,900 five year warrants for the purchase of commonshares of stock at $1.60 per share.  Gross proceeds totaled$2,265,123.  In connection with this sale, the Company issued to the agenta five year warrant to purchase 123,272 units at an exercise price of $1.8375per unit, and the Company paid the agent a cash commission of $181,210, and anexpense allowance of $67,954.  The warrants underlying the unit warrantsissued to the agent are exercisable for a period of five years at an exerciseprice of $1.8375 per share.

 

The foregoing issuance was made in reliance upon the exemption providedin Section 4(2) of the Securities Act.  Such securities arerestricted as to sale or transfer, unless registered under the Securities Act,and the certificate representing such securities contains a restrictive legendpreventing sale, transfer or other disposition, unless registered under theSecurities Act.  In addition, the recipients of such securities receivedmaterial information concerning our company, including, but not limited to, ourreports on Form 10-KSB and Form 10-QSB, as filed with the Securities andExchange Commission.  Except as disclosedabove, no underwriting commissions or discounts were paid with respect to theissuance of such securities.

 

**ITEM 6****              Exhibitsand Reports on Form 8-K**

 

(a)  Exhibits

 

See Index to Exhibits.

 

(b)  Reportson Form 8-K

 

No reports on Form 8-K were filed during the quarter for which thisreport is filed.

 

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**SIGNATURES**

 

In accordance with the requirements of the Exchange Act, the registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                                | MedicalCV, Inc. |
|-------------------------------------|-----------------|
|                                |            |   |
| Date:  September 14, 2004 | By              | /s/ Marc P. Flores |   |
|                                |            | Marc P. Flores |
|                                |            | President and Chief Executive Officer |
|                                |            |   |
|                                | By              | /s/ John H. Jungbauer |   |
|                                |            | John H. Jungbauer |
|                                |            | Chief Financial Officer |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit********Number** | ** ** | **Description**                                                                 |
|---------------------------|------------|---------------------------------------------------------------------------------|
| 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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