**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 
| **ý**                                             | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
|                                                   | ** ** | ** **                                                                                    |
| **For the  quarterly period ended September 30, 2004** |
| ** **                                             |
| **OR**                                                 |
|                                                   | ** ** | ** **                                                                                    |
| **o**                                                  | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from          to          **

 

**CommissionFile Number**

**0-22233**

 

**ENDOCARDIAL SOLUTIONS, INC.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                     | ** ** | **41-1724963**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **1350  Energy Lane, Suite 110,  St. Paul, MN**                  | ** ** | **55108**                             |
| (Address of principal  executive offices)                        |       | (Zip Code)                            |

 

**(651)523-6900**

(Registrant’s telephonenumber, including area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes ý    No o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theAct). Yes ý    No o

 

As of November 4, 2004 thenumber of shares outstanding of the registrant’s common stock, par value $.01per share, was 22,147,151.

 

 

 

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**INDEX**

 

**EndocardialSolutions, Inc.**

 
| **PART I. FINANCIAL  INFORMATION**                                                                   |
|------------------------------------------------------------------------------------------------------|
| Item 1. Financial  Statements                                                                        |
| Consolidated Balance  Sheets—September 30, 2004 and December 31, 2003                           |
| Consolidated  Statements of Operations—Three and Nine months ended September 30, 2004 and  2003 |
| Consolidated  Statements of Cash Flows—Nine months ended September 30, 2004 and 2003            |
| Notes to  Consolidated Financial Statements                                                          |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations |
| Item  3. Quantitative and Qualitative Disclosures about Market Risk                                  |
| Item 4. Controls and  Procedures                                                                     |
| **PART II. OTHER INFORMATION**                                                                       |
| Items 1 through 5 have  been omitted since all items are inapplicable or answers negative.           |
| Item 6. Exhibits                                                                                     |

 

 

 

 

2

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**PART I — FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**EndocardialSolutions, Inc.**

 

**ConsolidatedBalance Sheets**

 
| ** **                                                                                                                                          | ** ** | **As of  September 30, 2004** | ** ** | **As of  December 31, 2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                          | ** ** | **(Unaudited)**                    | ** ** | ** **                        | ** ** |
| **Assets**                                                                                                                                          |       |                               |       |                              |       |
| Current assets:                                                                                                                                     |       |                               |       |                              |       |
| Cash and cash equivalents                                                                                                                           |       | $                                  | 9,254,727  |                              | $          | 10,216,385 |   |
| Accounts receivable, net of allowance for doubtful accounts (2004 —  $151,996; 2003 — $151,996)                                           |       | 12,549,484                         |       | 10,378,401                        |       |
| Inventories                                                                                                                                         |       | 3,595,624                          |       | 4,075,747                         |       |
| Prepaid expenses and other current assets                                                                                                           |       | 906,438                            |       | 1,435,102                         |       |
|                                                                                                                                                |       |                               |       |                              |       |
| Total current assets                                                                                                                                |       | 26,306,273                         |       | 26,105,635                        |       |
|                                                                                                                                                |       |                               |       |                              |       |
| Furniture and equipment                                                                                                                             |       | 10,655,924                         |       | 9,331,606                         |       |
| Less accumulated depreciation                                                                                                                       |       | (7,232,350                         | )          | (6,628,801                        | )          |
|                                                                                                                                                |       | 3,423,574                          |       | 2,702,805                         |       |
| Deposits                                                                                                                                            |       | 86,837                             |       | 51,179                            |       |
| Notes receivable                                                                                                                                    |       | 206,226                            |       | 206,226                           |       |
| Other assets                                                                                                                                        |       | 863,615                            |       | 624,760                           |       |
| Intangible assets, net of accumulated amortization (2004 — $180,883;  2003 — $125,266)                                                    |       | 711,317                            |       | 585,032                           |       |
|                                                                                                                                                |       |                               |       |                              |       |
| Total assets                                                                                                                                        |       | $                                  | 31,597,842 |                              | $          | 30,275,637 |   |
|                                                                                                                                                |       |                               |       |                              |       |
| **Liabilities and stockholders’ equity**                                                                                                       |       |                               |       |                              |       |
| Current liabilities:                                                                                                                                |       |                               |       |                              |       |
| Accounts payable and accrued expenses                                                                                                               |       | $                                  | 6,430,006  |                              | $          | 5,683,372 |   |
| Bank line of credit                                                                                                                                 |       | 1,000,000                          |       | 1,000,000                         |       |
| Current portion of capital lease obligations                                                                                                        |       | 127,911                            |       | 318,011                           |       |
| Current portion of deferred revenue                                                                                                                 |       | 2,421,218                          |       | 2,634,751                         |       |
|                                                                                                                                                |       |                               |       |                              |       |
| Total current liabilities                                                                                                                           |       | 9,979,135                          |       | 9,636,134                         |       |
|                                                                                                                                                |       |                               |       |                              |       |
| Long-term liabilities:                                                                                                                              |       |                               |       |                              |       |
| Capital lease obligations                                                                                                                           |       | —                             |       | 63,956                            |       |
| Deferred revenue                                                                                                                                    |       | 215,586                            |       | 262,282                           |       |
| Total long-term liabilities                                                                                                                         |       | 215,586                            |       | 326,238                           |       |
|                                                                                                                                                |       |                               |       |                              |       |
| Stockholders’ equity:                                                                                                                          |       |                               |       |                              |       |
| Undesignated preferred stock, par value $0.1 per share:                                                                                             |       |                               |       |                              |       |
| Authorized shares — 10,000,000 Issued and outstanding shares — none                                                                       |       | —                             |       | —                            |       |
| Common stock, $0.01 par value:                                                                                                                      |       |                               |       |                              |       |
| Authorized shares — 40,000,000 Issued and outstanding shares —  September 30, 2004 — 22,144,616; December 31, 2003 — 21,597,241 |       | 219,478                            |       | 215,972                           |       |
| Additional paid-in capital                                                                                                                          |       | 106,641,861                        |       | 104,680,168                       |       |
| Accumulated deficit                                                                                                                                 |       | (84,861,636                        | )          | (84,956,006                       | )          |
| Accumulated other comprehensive income                                                                                                              |       | 250,275                            |       | 486,525                           |       |
| Deferred compensation                                                                                                                               |       | (846,857                           | )          | (113,394                          | )          |
| Total stockholders’ equity                                                                                                                     |       | 21,403,121                         |       | 20,313,265                        |       |
| Total liabilities and stockholders’ equity                                                                                                     |       | $                                  | 31,597,842 |                              | $          | 30,275,637 |   |
|                                                                                                                                                     |            |                                    |            |                                   |            |  |  |  |  |  |

 

*Seeaccompanying notes.*

 

 

3

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**ConsolidatedStatements of Operations**

 

**(Unaudited)**

 

 
| ** **                                       | ** ** | **For the Three Months Ended  September 30,** | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                       | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue                                          |       | $                                             | 11,389,968 |                                         | $          | 9,696,248 |   | $ | 33,820,092 |   | $ | 26,281,643 |   |
| Cost of goods sold                               |       | 2,802,378                                     |       | 3,369,757                                    |       | 9,468,934 |   | 9,232,020 |   |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Gross margin                                     |       | 8,587,590                                     |       | 6,326,491                                    |       | 24,351,158 |   | 17,049,623 |   |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Operating expenses:                              |       |                                          |       |                                         |       |   |   |   |   |
| Research and development                         |       | 1,033,203                                     |       | 1,430,372                                    |       | 3,259,039 |   | 4,463,675 |   |
| General and administrative                       |       | 2,802,339                                     |       | 862,605                                      |       | 4,957,335 |   | 2,384,358 |   |
| Sales and marketing                              |       | 5,225,679                                     |       | 4,888,638                                    |       | 15,792,632 |   | 14,569,077 |   |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Total operating expenses                         |       | 9,061,221                                     |       | 7,181,615                                    |       | 24,009,006 |   | 21,417,110 |   |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Operating income (loss)                          |       | (473,631                                      | )          | (855,124                                     | )          | 342,152 |   | (4,367,487 | ) |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Other expense                                    |       | (131,863                                      | )          | (24,097                                      | )          | (247,782 | ) | (92,762 | ) |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Net income (loss)                                |       | $                                             | (605,494   | )                                            | $          | (879,221 | ) | $ | 94,370 |   | $ | (4,460,249 | ) |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Net income (loss) per share — basic         |       | $                                             | (0.03      | )                                            | $          | (0.04 | ) | $ | 0.00 |   | $ | (0.22 | ) |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Weighted average shares outstanding — basic |       | 22,108,310                                    |       | 20,476,741                                   |       | 21,951,067 |   | 19,916,656 |   |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Net income (loss) per share — diluted       |       | $                                             | (0.03      | )                                            | $          | (0.04 | ) | $ | 0.00 |   | $ | (0.22 | ) |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Weighted average shares outstanding - diluted    |       | 22,108,310                                    |       | 20,476,741                                   |       | 23,158,131 |   | 19,916,656 |   |

 

*See accompanying notes.*

 

 

4

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**ConsolidatedStatements of Cash Flows**

 

**(Unaudited)**

 

 
| ** **                                                                            | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                            | ** ** | **2004**                                     | ** ** | **2003** | ** ** |
| **Operating activities**                                                              |       |                                         |       |   |   |
| Net income (loss)                                                                     |       | $                                            | 94,370     |   | $ | (4,460,249 | ) |
| Adjustments to reconcile net income (loss) to net cash used in  operating activities: |       |                                         |       |   |   |
| Depreciation and amortization                                                         |       | 836,860                                      |       | 702,031 |   |
| Amortization of deferred compensation                                                 |       | 307,537                                      |       | 64,728 |   |
| Loss on disposal of equipment                                                         |       | —                                       |       | 8,053 |   |
| Changes in operating assets and liabilities:                                          |       |                                         |       |   |   |
| Accounts receivable                                                                   |       | (2,193,616                                   | )          | (2,148,034 | ) |
| Inventories                                                                           |       | 512,988                                      |       | (263,495 | ) |
| Prepaid expenses                                                                      |       | 482,694                                      |       | (209,186 | ) |
| Other assets                                                                          |       | (487,328                                     | )          | — |   |
| Intangible assets                                                                     |       | (169,563                                     | )          | 550,495 |   |
| Accounts payable and accrued expenses                                                 |       | 753,402                                      |       | 492,622 |   |
| Deferred revenue                                                                      |       | (253,747                                     | )          | (4,856 | ) |
| Net cash used in operating activities                                                 |       | (116,403                                     | )          | (5,267,891 | ) |
| **Investing activities**                                                              |       |                                         |       |   |   |
| Purchases of furniture and equipment                                                  |       | (1,364,546                                   | )          | (962,415 | ) |
| Net cash used in investing activities                                                 |       | (1,364,546                                   | )          | (962,415 | ) |
| **Financing activities**                                                              |       |                                         |       |   |   |
| Principal payments on notes payable and capital lease obligations                     |       | (254,056                                     | )          | (399,771 | ) |
| Proceeds from issuance of common stock                                                |       | 924,198                                      |       | 14,978,814 |   |
| Net cash provided by financing activities                                             |       | 670,142                                      |       | 14,579,043 |   |
| Effect of exchange rate changes on cash                                               |       | (150,851                                     | )          | 126,612 |   |
| (Decrease) increase in cash and cash equivalents                                      |       | (961,658                                     | )          | 8,475,349 |   |
| Cash and cash equivalents at beginning of period                                      |       | 10,216,385                                   |       | 1,347,753 |   |
| Cash and cash equivalents at end of period                                            |       | $                                            | 9,254,727  |   | $ | 9,823,102 |   |
| **Supplemental disclosure of non-cash investing  and financing activities**           |       |                                         |       |   |   |
| Value of restricted stock granted in connection with consulting  agreement            |       | $                                            | 1,041,000  |   | $ | — |   |
|                                                                                       |            |                                              |            |  |  |  |  |  |  |

 

*See accompanying notes.*

 

 

5

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**EndocardialSolutions, Inc.**

 

**Notes toConsolidated Financial Statements**

 

**1. Basis of Presentation**

 

The accompanying unauditedconsolidated financial statements have been prepared in accordance withgenerally accepted accounting principles for interim financial information andwith the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.  Inthe opinion of management, all adjustments (consisting of normal recurringadjustments) considered necessary for a fair presentation have beenincluded.  Operating results for thethree and nine months ended September 30, 2004 are not necessarily indicativeof the results that may be expected for the year ending December 31, 2004.  The December 31, 2003 consolidated balancesheet is derived from our audited consolidated balance sheet as of December 31,2003.  These financial statements shouldbe read in conjunction with the audited financial statements and accompanyingnotes for the fiscal year ended December 31, 2003 contained in the Company’sForm 10-K.

 

**2. Inventories**

 

Inventories are carried atthe lower of cost (first-in, first-out basis) or market.

 

Inventories consisted of thefollowing:

 

 

| ** **       | ** ** | **September 30, 2004** | ** **    | **December 31, 2003** | ** ** |
|------------------|------------|----------------------------------|---------------|----------------------------|------------|
| Raw materials    | ** ** | **$**                            | **2,316,337** |                       | $          | 2,852,690 |   |
| Work-in-progress | ** ** | **500,512**                      |          | 168,231                    |       |
| Finished goods   | ** ** | **778,775**                      |          | 1,054,826                  |       |
| ** **       |       | **$**                            | **3,595,624** |                       | $          | 4,075,747 |   |
|                  |            |                                  |               |                            |            |  |  |  |  |

 

**3. Stock-Based Compensation**

 

The Company accounts forstock-based compensation in accordance with the provisions of AccountingPrinciples Board (APB) Opinion No. 25, *Accountingfor**Stock Issued to Employees*,and related interpretations.  Thefollowing table illustrates the effect on net income (loss) and net income(loss) per share if the Company had applied the fair value recognitionprovisions of Financial Accounting Standards Board (FASB) Statement ofFinancial Accounting Standards (SFAS) No. 123, *Accountingfor Stock-based Compensation*, to stock- based employee compensation.

 

 

 

6

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| ** **                                                                                | ** ** | **For the three months ended September 30,** | ** **     | **For the nine months ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------|----------------|---------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                                          | ** **     | **2003**                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss), as reported:                                                           | ** ** | **$**                                             | **(605,494**   | **)**                                             | $          | (879,221 | ) | **$** | **94,370** |   | $ | (4,460,249 | ) |
| Add: Stock-based compensation, as reported                                                | ** ** | **117,723**                                       | ** **     | 20,587                                            |       | **309,760** |   | 64,728 |   |
|                                                                                      |       |                                              | ** **     |                                              |       |   |   |   |   |
| Deduct: Stock-based compensation determined under fair-value-based  method for all awards | ** ** | **(609,729**                                      | **)**          | (339,031                                          | )          | **(1,494,820** | **)** | (1,070,910 | ) |
|                                                                                      |       |                                              | ** **     |                                              |       |   | ** ** |   |   |
| Adjusted net loss, assuming fair-value-based method for all  stock-based awards           | ** ** | **$**                                             | **(1,097,500** | **)**                                             | $          | (1,197,665 | ) | **$** | **(1,090,690** | **)** | $ | (5,466,431 | ) |
|                                                                                      |       |                                              | ** **     |                                              |       |   | ** ** |   |   |
| Basic income (loss) per share, as reported                                                | ** ** | **$**                                             | **(0.03**      | **)**                                             | $          | (0.04 | ) | **$** | **0.00** | ** ** | $ | (0.22 | ) |
|                                                                                      |       |                                              | ** **     |                                              |       |   | ** ** |   |   |
| Basic income (loss) per share, pro forma                                                  | ** ** | **$**                                             | **(0.05**      | **)**                                             | $          | (0.06 | ) | **$** | **(0.05** | **)** | $ | (0.27 | ) |
|                                                                                      |       |                                              | ** **     |                                              |       |   | ** ** |   |   |
| Diluted income (loss) per share, as reported                                              | ** ** | **$**                                             | **(0.03**      | **)**                                             | $          | (0.04 | ) | **$** | **0.00** | ** ** | $ | (0.22 | ) |
|                                                                                      |       |                                              | ** **     |                                              |       |   | ** ** |   |   |
| Diluted income (loss) per share, pro forma                                                | ** ** | **$**                                             | **(0.05**      | **)**                                             | $          | (0.06 | ) | **$** | **(0.05** | **)** | $ | (0.27 | ) |

 

**4. Comprehensive Loss**

 

The components ofcomprehensive loss, net of related tax, were as follows:

 
| ** **                              | ** ** | **For the three months ended September 30,** | ** **   | **For the nine months ended September 30,** | ** ** |
|-----------------------------------------|------------|---------------------------------------------------|--------------|--------------------------------------------------|------------|
| ** **                              | ** ** | **2004**                                          | ** **   | **2003**                                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss)                       | ** ** | **$**                                             | **(605,494** | **)**                                            | $          | (879,221 | ) | **$** | **94,370** |   | $ | (4,460,249 | ) |
| Foreign currency translation adjustment | ** ** | **111,891**                                       | ** **   | 135,149                                          |       | **(236,250** | **)** | 273,940 |   |
| Comprehensive loss                      | ** ** | **$**                                             | **(493,603** | **)**                                            | $          | (744,072 | ) | **$** | **(141,880** | **)** | $ | (4,186,309 | ) |

 

 

**5. Guarantees and Contractual Obligations**

 

In November 2002, theFinancial Accounting Standards Board issued Interpretation No. 45 (FIN 45), *Guarantor’s Accounting and Disclosure**Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of**Others*(the “Interpretation”).  TheInterpretation requires disclosure in periodic financial statements of certainguarantee arrangements.  TheInterpretation also clarifies situations where a guarantor is required torecognize the fair value of certain guarantees in the financialstatements.  The Company does not haveany guarantees that require recognition at fair value under the Interpretation.

 

The Company sells extendedwarranty agreements that include service and support, and may also include theright to receive software and/or hardware upgrades.  These items are required to be disclosed inperiodic financial statements under the Interpretation.  Revenue from the sale of extended warrantyagreements is deferred and recognized ratably over the period in which theservices are provided, and revenue from the sale of hardware upgrades isdeferred and recognized at the time the upgrades are performed.  Costs associated with service and supportprovided under extended warranty agreements are recognized at the time theservice is provided, while costs associated with hardware upgrades arerecognized at time the upgrades are performed.

 

Changes in deferred revenue amounts for the nine months ended September30, 2004 are as follows:

 
| Balance, December 31, 2003                    |   | $          | 2,897,033 |   |
|-----------------------------------------------|--------|------------|-----------|--------|
| Revenue deferred during the period            |   | 3,845,162  |      |
| Deferred revenue recognized during the period |   | (4,105,391 | )         |
| Balance, September 30, 2004                   |   | $          | 2,636,804 |   |

 

 

7

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**6. Reclassifications**

 

Certain prior year itemshave been reclassified to conform to current period presentation.

 

**7. Restricted Stock**

 

On February 16, 2004, theCompany issued a restricted grant of 100,000 shares of the Company’s commonstock in connection with the execution of a consulting agreement.

 

**8. Income Taxes**

 

The Company recorded a currenttax benefit of $230,000 during the third quarter of 2004.  This tax benefit was offset by $230,000 ofadditional valuation allowance against the Company’s deferred tax assetsrelated to net operating loss carryforwards. As a result, the Company recorded no income tax benefit for the thirdquarter of 2004.  The Company’s abilityto realize the benefits of these deferred tax assets depends on the Companybeing able to generate taxable income from the sale of current and futureproducts.  Because the Company’s abilityto generate sufficient taxable income necessary to realize these deferred taxassets is uncertain, the Company’s net deferred tax assets of approximately $30million as of September 30, 2004 are offset by a full valuation allowance inaccordance with SFAS No. 109, *Accounting for IncomeTaxes*.

 

**9. Segment Reporting**

 

Revenue by geographic destinationas a percentage of total revenue was as follows:

 
| ** **     | ** ** | **For the three months ended September 30** | ** ** | **For the nine months ended September 30** | ** ** |
|----------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **     | ** ** | **2004**                                         | ** ** | **2003**                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
| Domestic       |       | 71                                               | %          | 78                                              | %          | 67 | % | 77 | % |
| International: |       |                                             |       |                                            |       |   |   |   |   |
| Europe         |       | 24                                               | %          | 18                                              | %          | 25 | % | 15 | % |
| Asia Pacific   |       | 3                                                | %          | 4                                               | %          | 7 | % | 7 | % |
| Canada/Mexico  |       | 2                                                | %          | 0                                               | %          | 1 | % | 1 | % |

 

 

**10. Subsequent Event**

 

OnOctober 8, 2004, Biosense Webster, a division of Johnson & Johnson, filed alawsuit against the Company, alleging that certain of the Company’s products,including the Company's EnSite System and its EnSite NavX surface electrodeproduct, infringe upon certain named patents of Biosense Webster.  The lawsuit, which was filed in the U.S.District Court of Los Angeles, California, seeks unspecified monetary damagesand injunctive relief.  The Company’s EnSite products andtechnology are covered by a significant portfolio of U.S. and internationalissued and pending patents.  The Company intendsto vigorously defend its products and technology, but cannot predict the outcomeof this dispute.

 

 

**Item 2. Management’s Discussion and Analysis ofFinancial Condition and Results****of Operations**

 

**Overview**

 

Endocardial Solutions,Inc. (“ESI” or the “Company”) designs, develops, manufactures and sells theEnSite® advanced intracardiac mapping and navigation system, adiagnostic and navigation platform that allows electrophysiologists (“EPs”) torapidly and precisely locate the multiple, unpredictable points of origin ofcomplex cardiac arrhythmias, and enables the three-dimensional, non-fluoroscopicnavigation and precise placement of conventional linear electrophysiologycatheters used in the diagnosis and treatment of a variety of cardiacarrhythmias.  The EnSite System consistsof the EnSite® clinical workstation and the patient interface unit(collectively, the “EnSite System”), the EnSite ArrayTM catheter (“EnSite Array”),and EnSite NavXTM surface electrode kits (“EnSite NavX”).  The Company also has released the initialcommercial version of its EnSite digital image fusion technology (“EnSite DIF”),which currently is used in conjunction with EnSite NavX procedures.

 

The EnSite Array is apercutaneous, non-contact, single-use, multi-electrode catheter that enablesthe rapid diagnosis, mapping, and identification of the optimal site or sitesfor the delivery of ablation therapy for a variety of complex sustained andnon-sustained atrial and ventricular arrhythmias.  The EnSite Array catheter contains 64electrodes that sense and measure the electrical activity generated from theendocardial wall and blood pool of the cardiac chamber, and capture more than3,000 points of electrical activity in a single beat of the heart withouttouching the endocardial wall of the heart chamber.  The advanced proprietary algorithms of theEnSite System process and reconstruct data from the EnSite Array to create ahigh resolution, real-time, three-dimensional geometric reconstruction of thecardiac chamber, on which is displayed an isopotential or isochronal color mapof the electrical activation pattern of that heart chamber.  The electrical activity of the cardiacchamber can be viewed at any of the more than 3,000 points, and the locationand movements of the diagnostic or therapeutic catheters used during the procedurecan be tracked and

 

 

8

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displayed in real-time.  The EnSite System allows these integratedcardiac maps to be viewed in three dimensions from any perspective in space,either as a snapshot in time or an animated playback at adjustable rates ofspeed.

 

The Company receivedapproval from the European Union (“EU”) and commercially released the EnSiteSystem with the EnSite Array catheter in Europe in 1998, and followingclearance from the FDA, commercially released the EnSite System and EnSite Arrayin the U.S. and Canada in 1999.  TheEnSite Array was approved for mapping right atrial tachycardias in the U.S.,and for mapping atrial and left ventricular tachycardias in Europe and Canada.  The Company has received general approval tomarket the EnSite System for cardiac mapping in Australia, Korea, Thailand,Malaysia, China and Hong Kong in 2000, and in Taiwan in 2001.

 

The Company commerciallyreleased EnSite NavX during the second quarter of 2003 following clearance fromthe FDA and the EU.  EnSite NavX is anopen-platform, catheter navigation and localization technology consisting ofthree pairs of surface electrodes (collectively, one EnSite NavX surfaceelectrode kit) which are placed on a patient’s body in orthogonal directions(neck-leg; front-back; and left-right on the patient’s thorax) to create athree-dimensional navigation field. Intracardiac diagnostic and RF ablation catheters from any manufacturerare inserted percutaneously and guided into the cardiac chamber of interest,and the electrodes on each intracardiac catheter are identified, measured anddisplayed in three dimensions on the EnSite workstation.  As part of any EnSite NavX procedure, EPs canchoose whether or not to create and display a high resolution,three-dimensional, geometric reconstruction of the cardiac chamber, and thenvisualize, navigate, and position, non-fluoroscopically, in real-time and inthree dimensions, up to 64 electrodes on 8 different conventional lineardiagnostic or therapeutic catheters, with or without cardiac geometries.  EnSite NavX allows EPs to visualize andnavigate the diagnostic or therapeutic catheter(s) of their choice duringdiagnostic and therapeutic procedures for a variety of cardiac arrhythmias.  EnSite NavX is approved for use in all fourchambers of the heart in all markets where the EnSite System and EnSite Arrayare approved for sale and distribution.

 

In the fourth quarter of 2003, ESI introduced itsinitial version of EnSite DIFTM, which allows the display on the EnSiteworkstation of computed tomography (“CT”) images of a patient’s cardiac anatomythat have been “segmented” using third-party software to isolate the cardiacchamber in which the procedure is being performed.  These segmented cardiac images are displayedside-by-side with the cardiac geometry created with EnSite NavX, which allowsphysicians to visualize and understand the unique anatomical structure of eachpatient’s cardiac chamber of interest, a clinical step that is especiallyimportant for the diagnosis and treatment of atrial fibrillation with RFablation where the anatomy of the left atrium is often complex and challenging.

 

The EnSite System is aninnovative and expanding technology platform for mapping cardiac arrhythmias,and enabling the precise three-dimensional, non-fluoroscopic visualization andnavigation of a variety of linear electrophysiology catheters used in thediagnosis and treatment of cardiac arrhythmias. The Company’s ability to increase revenues and derive future profitsfrom this business in the future depends, in part, on the Company’s ability toeffectively market and sell the EnSite System to the approximately 2,200electrophysiology laboratories worldwide in which electrophysiology ablationprocedures are performed, and to have the physicians who perform theseprocedures continue to increase their clinical adoption and use of the EnSiteSystem with current and future products introduced by the Company.

 

The Company employs a directsales force in the United States and Europe, and uses third-party distributorsfor certain domestic and international markets. The Company has established an exclusive distribution arrangement inJapan with Nihon Kohden, one of Japan’s leading manufacturers, developers anddistributors of medical electronic products. The Company continues to await the regulatory approval for Nihon Kohdento begin selling the EnSite System and EnSite Array in Japan.  Although the Company and Nihon Kohden hadexpected to receive Japanese regulatory approval in 2004, it appears approval willbe delayed until 2005.  The Companyestablished a third-party sales representation and distributor relationship withSt. Jude Medical for the markets in Spain and Italy in the second quarter of2004.  The Company believes this relationshiphas and will continue to help the Company increase penetration of EnSiteSystems in these countries into accounts that are capital constrained andreimbursement challenged by bundling EnSite Systems and disposable productswith the broader electrophysiology-focused product offerings of St. JudeMedical.  With more than 410 EnSiteSystems now installed globally, the Company continues to expand its sales andmarketing efforts to include smaller, regional and community-basedelectrophysiology labs who are seeking to acquire and utilize advanced EPmapping and navigation technologies such as the EnSite System, as well largermedical centers who are adding electrophysiology labs in response to thecontinuing increase in a variety of electrophysiology procedures.

 

The Company derives revenuesfrom the sale of the EnSite products described above, the sale of extendedservice and support warranty agreements, and the sale of miscellaneousancillary support products used in conjunction with the EnSite System.  The Company reported net sales for the threemonths ended September 30, 2004 of approximately $11.4 million, an increase of17.5% over the same period in 2003.  Forthe nine months ended September 30, 2004, net sales were approximately $33.8million, an increase of 28.5% over the same period in 2003.  The Company’s gross profit margin for thethree months ended September 30, 2004 was 75.4%, compared with 65.2% during thesame period in 2003.  For the nine monthsended September 30, 2004, gross profit margin was 72.0%, compared with 64.9 %during the same period in 2003.

 

OnSeptember 23, 2004, the Company and St. Jude Medical, Inc. announced theexecution of a definitive agreement pursuant to which St. Jude Medical willacquire all of the issued and outstanding stock of the Company at a price of$11.75 per share, for a total cash value of approximately $273 million.  The closing of the transaction is subject tocertain regulatory approvals and approval by a majority of the shareholders ofthe Company at a special meeting of the Company’s stockholders to be held assoon as reasonably practicable.  TheCompany has filed a preliminary proxy statement with the Securities andExchange Commission (“SEC”) in connection with its special meeting to approvethe proposed transaction.  Company stockholders are urged to read the definitiveproxy statement regarding the proposed transaction when it becomes available,because it will contain important information.

 

Companystockholders will be able to obtain a free copy of the definitive proxystatement, as well as other filings containing information about St. JudeMedical and the Company, without charge, at the SEC’s Internet site(http://www.sec.gov).  Copies of thedefinitive proxy statement and the Company’s other filings with the SEC  can also be obtained, without charge, bydirecting a request to Endocardial Solutions, Inc., 1350 Energy Lane, Suite110, St. Paul, Minnesota 55108, Attention: Secretary, or by telephone at (651)523-6900.

 

**Subsequent Event**

OnOctober 8, 2004, Biosense Webster, a division of Johnson & Johnson, filed alawsuit against the Company alleging that certain of the Company’s products,including the Company's EnSite System and its EnSite NavX surface electrodeproduct, infringe upon certain named patents of Biosense Webster.  The lawsuit, which was filed in the U.S.District Court in Los Angeles, California, seeks unspecified monetary damagesand injunctive relief.  The Companyintends to vigorously defend its products and technology against this legalaction, and will, if and when appropriate, include counterclaims and othercauses of action that may arise from the filing and timing of this lawsuit.

9

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**Results of Operations**

 

**General**. Net loss was$605,494, or $0.03 per share, for the three months ended September 30, 2004,compared to a net loss of $879,221, or $0.04 per share, for the same period in2003.  For the nine months endedSeptember 30, 2004, net income was $94,370 or $0.00 per share, compared to anet loss of $4.5 million, or $0.22 per share, for the same period in 2003.

 

**Revenue**.

 

Information regarding oursales by major products and geographic distribution is set forth in thefollowing table:

 

In Millions,except percentages

 
| ** **                                                                             | ** ** | **For the Three Months Ended September 30,** | ** ** | **Percent Change** | ** ** | **For the Nine Months Ended September 30,** | ** ** | **Percent Change** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|--------------------|------------|-------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                             | ** ** | **2004**                                          | ** ** | **2003**           | ** ** | ** **                                            | **2004**   | ** **         | **2003**   | ** ** | ** ** |
| **Revenue:**                                                                           |       |                                              |       |               |       |                                                  |       |               |       |   |   |   |   |
| **EnSite clinical workstations (net of revenue  deferred for warranty obligations)**   |       |                                              |       |               |       |                                                  |       |               |       |   |   |   |   |
| Domestic                                                                               |       | $                                                 | 2.5        |               | $          | 2.2                                                   |       | 14                 | %          | $ | 6.4 |   | $ | 6.3 |   | 2 | % |
| International                                                                          |       | 0.6                                               |       | 0.8                |       | (25                                                   | %)         | 4.4                |       | 2.4 |   | 83 | % |
|                                                                                   |       | 3.1                                               |       | 3.0                |       | 3                                                     | %          | 10.8               |       | 8.7 |   | 24 | % |
|                                                                                   |       |                                              |       |               |       |                                                  |       |               |       |   |   |   |   |
| **EnSite disposables (EnSite Array catheters and  EnSite NavX suface electrode kits)** |       |                                              |       |               |       |                                                  |       |               |       |   |   |   |   |
| Domestic                                                                               |       | 5.1                                               |       | 4.5                |       | 13                                                    | %          | 13.5               |       | 11.4 |   | 18 | % |
| International                                                                          |       | 2.1                                               |       | 0.9                |       | 133                                                   | %          | 5.2                |       | 2.6 |   | 100 | % |
|                                                                                   |       | 7.2                                               |       | 5.4                |       | 33                                                    | %          | 18.7               |       | 14.0 |   | 34 | % |
|                                                                                   |       |                                              |       |               |       |                                                  |       |               |       |   |   |   |   |
| **Other (deferred revenue, upgrades and  accessories and repairs)**                    |       |                                              |       |               |       |                                                  |       |               |       |   |   |   |   |
| Domestic                                                                               |       | 0.8                                               |       | 0.8                |       | 0                                                     | %          | 3.1                |       | 2.4 |   | 29 | % |
| International                                                                          |       | 0.3                                               |       | 0.5                |       | (40                                                   | %)         | 1.2                |       | 1.2 |   | 0 | % |
|                                                                                   |       | 1.1                                               |       | 1.3                |       | (15                                                   | %)         | 4.3                |       | 3.6 |   | 19 | % |
|                                                                                   |       |                                              |       |               |       |                                                  |       |               |       |   |   |   |   |
| **Total Revenue**                                                                      |       |                                              |       |               |       |                                                  |       |               |       |   |   |   |   |
| Domestic                                                                               |       | 8.4                                               |       | 7.5                |       | 12                                                    | %          | 23.0               |       | 20.1 |   | 14 | % |
| International                                                                          |       | 3.0                                               |       | 2.2                |       | 36                                                    | %          | 10.8               |       | 6.2 |   | 74 | % |
|                                                                                   |       | $                                                 | 11.4       |               | $          | 9.7                                                   |       | 18                 | %          | $ | 33.8 |   | $ | 26.3 |   | 29 | % |

 

**Three Months Ended September 30,2004 Compared to Three Months Ended September 30, 2003**

 

Worldwide revenue for thethree months ended September 30, 2004 was $11.4 million, an increase ofapproximately $1.7 million, or 17.5%, over the same period in 2003.  The Company’s gross profit margin for thethree months ended September 30, 2004 was 75.4%, compared with 65.2% during thesame period in 2003.

 

*EnSite Systems*

 

Worldwide revenue from thesale of EnSite Systems during the three months ended September 30, 2004 wasapproximately $3.1 million, compared to approximately $3.0 million for the sameperiod in 2003, an increase of 3.3%.  Domesticsales accounted for 80.6% of total EnSite System sales during the period,compared to 73.3% during the same period in 2003.  The Company sold a total of 20 EnSite Systemsduring the period with 15 sold domestically and 5 sold internationally.  The gross profit margin

 

 

10

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on EnSite System sales for the three monthsended September 30, 2004 was 71.3% compared to 61.9% for the same period in2003, a 15.2% increase.  This grossmargin improvement was primarily driven by a 9.0% increase in the average saleprice of the EnSite System and by the Company’s conversion from a SiliconGraphics computing platform to a significantly more powerful, but lower cost,Intel® Xeon computing platform for it EnSite System in the fourthquarter of 2003.

 

*EnSite Disposable Products*

 

Worldwide revenue from thesale of EnSite “disposable products” (EnSite Array catheters and EnSite NavXsurface electrode kits) during the three months ended September 30, 2004 wasapproximately $7.2 million, compared to $5.4 million during the same period in2003, an increase of 33.3%.  Domesticrevenue from the sale of EnSite disposable products accounted for 71.3% oftotal EnSite disposable product revenue during the three months ended September30, 2004, compared to 82.3% during the same period in 2003.  Revenues increased during the three monthsended September 30, 2004 compared to the same period in 2003 due to theincreased number of installed EnSite Systems and increased disposableutilization rates.  The gross profitmargin on EnSite disposable product sales for the three months ended September30, 2004 was 83.3%, as compared to 76.2% for the same period in 2003.

 

*Other Revenue*

 

Other revenue, whichincludes (i) the recognition of deferred revenue generated from the sale ofextended warranty and service agreements, (ii) the recognition of deferredrevenue from the installation of hardware and software upgrades to configureEnSite Systems to be able to utilize the most recent version of EnSite NavX,(iii) revenue from the service and repair of EnSite Systems that are not underthe Company’s warranty or extended warranty plans, and (iv) the sale ofaccessories related to the EnSite Systems, was approximately $1.1 million duringthe three months ended September 30, 2004, a decrease of approximately $0.2million, or 13.8%, compared to the same period in 2003.  The decrease in “other revenue” is due to thefact the Company has now completed upgrading a majority of the installed EnSiteSystems with EnSite NavX, and therefore, fewer upgrades were performed duringthe three months ended September 30, 2004 compared to the same period in 2003 (17upgrades compared with 64 upgrades performed in the three months endedSeptember 30, 2004 and 2003, respectively, or a decrease in revenue of $0.4million).  Deferred revenue related to theseEnSite NavX upgrades was recognized at the time the upgrade was installed.  That portion of “other revenue” related tothe recognition of deferred revenue from extended warranty and serviceagreements increased by $0.2 million for the same periods, which is recognizedratably over the warranty and service period (typically one year).  The gross profit margin on “other revenue”was 41.8% for the three months ended September 30, 2004 compared to 33.8% forthe same period in 2003.

 

**Researchand Development Expense**. Research and development expenses include compensation and benefit costsfor personnel in the clinical, software, hardware, catheter, and appliedresearch groups, together with regulatory and clinical study expenses.  Research and development expenses wereapproximately $1.0 million for the three months ended September 30, 2004,compared to $1.4 million during the same period in 2003, a decrease of $0.4million, or 27.8%. This decrease was primarily due to the Company’s decision todiscontinue its “left atrial mapping protocol” clinical study of the EnSiteArray catheter in the fourth quarter of 2003. The Company expects to make continued significant investments in EnSiteproduct development and clinical studies throughout the remainder of 2004.

 

**General andAdministrative Expense**. General and administrative expenses were approximately $2.8 million and$863,000 for the three month periods ended September 30, 2004 and 2003,respectively.  This increase in theCompany’s general and administrative expenses over the same period in 2003 wasdue to $1.3 millionof  non-recurring transaction costsassociated with the Company’s pending acquisition by St. Jude Medical, Inc.,expenses incurred as part of implementing the Company’s compliance with therequirements of the Sarbanes-Oxley Act of 2002, and certain other legalfees.  The Company has also incurredincreased expenses related to insurance, recruiting fees and depreciation ofits new integrated financial reporting system.

 

**Sales andMarketing Expense**.  Sales andmarketing expenses were approximately $5.2 million and $4.9 million for thethree month periods ended September 30, 2004 and 2003, respectively, anincrease of approximately $0.3 million, or 6.9%.  This increase was primarily attributable toan increase in the number of U.S. and European field clinical support personneland associated travel expenses during the third quarter of 2004 as compared tothe same period in 2003, together with increased commission expense as a resultof the 17.5% increase in revenue compared to third quarter of 2003.  The Company expects that sales and marketingexpenses, as a percentage of revenue, will continue to decline in the fourthquarter of 2004 compared to the same period in 2003.

 

**OtherExpense**.  Other expense consists ofinterest expense, offset by interest income on cash and cash equivalentbalances, state income tax accruals and foreign exchange gains and losses ontransfers of inventory to the Company’s European subsidiary.  The $108,000 increase for the three monthsended September 30, 2004 compared to the same period in 2003 primarily consistsof increased state income tax accruals and foreign exchange losses.

 

**Income TaxExpense**.  The Company recorded currenttax benefit of $230,000 during the third quarter of 2004.  This tax benefit was offset by $230,000 ofadditional valuation allowance against the Company’s deferred tax assetsrelated to net operating loss carry-forwards. As a result, the Company recorded no income tax benefit for the thirdquarter of 2004.  The Company’s abilityto realize the benefits of these deferred tax assets depends on the Companybeing able to generate taxable income from the sale of current and futureproducts.  Because the Company’s abilityto generate sufficient taxable income necessary to realize these deferred taxassets is uncertain, the Company’s net deferred tax assets of approximately $30million as of September 30, 2004 are offset by a full valuation allowance inaccordance with SFAS No. 109, *Accounting for IncomeTaxes*.

 

 

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**Nine Months Ended September 30,2004 Compared to Nine Months Ended September 30, 2003**

 

Worldwide revenue for thenine months ended September 30, 2004 was approximately $33.8 million, anincrease of $7.5 million or 28.7% over the same period in 2003.  The Company’s gross profit margin for thenine months ended September 30, 2004 was 72.0%, compared with 64.9% during thesame period in 2003.

 

*EnSite Systems*

 

Worldwide revenue from thesale of EnSite Systems during the nine months ended September 30, 2004 wasapproximately $10.8 million, compared to approximately $8.7 million for thesame period in 2003, an increase of 24.5%.  Domestic sales accounted for 59.3% of totalEnSite System sales during the period, compared to 72.4% during the same periodin 2003.  The Company sold a total of 74EnSite Systems during the period, with 40 sold domestically and 34 soldinternationally.  Of the 34 EnSiteSystems sold internationally, 10 were sold under an exclusive distributionarrangement in Japan with Nihon Kohden, one of Japan’s leading manufacturers,developers and distributors of medical electronic products and 10 were soldpursuant to the new sales representative and distribution relationship enteredinto by and between the Company and St. Jude Medical for the markets in Spainand Italy *(see further discussion under Overview above).*  The gross profit margin on EnSite Systemsales for the nine months ended September 30, 2004 was 71.6% compared to 62.8%for the same period in 2003, an increase of 8.8%.  This improvement in gross margins wasprimarily driven by the Company’s conversion from a Silicon Graphics computingplatform to a significantly more powerful, but lower cost, Intel®Xeon computing platform for its EnSite System in the fourth quarter of2003.  However, the 10 EnSite systemssold to Nihon Kohden discussed above contained the more expensive SiliconGraphics computer workstation, which reduced overall EnSite System gross profitmargins for this nine-month period.

 

*EnSite Disposable Products*

 

Worldwide revenue from thesale of EnSite disposable products during the nine months ended September 30,2004 was approximately $18.7 million, compared to $14.0 million during the sameperiod in 2003, an increase of 33.3%. Domestic revenue from the sale of EnSite disposable products accountedfor 72.2% of total EnSite disposable product revenue during the nine monthsended September 30, 2004, compared to 81.4% during the same period in2003.  Revenues increased during the ninemonths ended September 30, 2004 compared to the same period in 2003 due to thelarger number of installed EnSite Systems and increased EnSite disposableproduct utilization rates.  The grossprofit margin on EnSite disposable product sales for the nine months endedSeptember 30, 2004 was 83.2%, as compared to 75.4% for the same period in 2003.

 

*Other Revenue*

 

Other revenue, whichincludes (i) the recognition of deferred revenue generated from the sale ofextended warranty and service agreements, (ii) the recognition of deferredrevenue from the installation of hardware and software upgrades to configureEnSite Systems to be able to utilize the most recent version of EnSite NavX,(iii) revenue from the service and repair of EnSite Systems that are not underthe Company’s warranty or extended warranty plans, and (iv) the sale ofaccessories related to the EnSite Systems, was approximately $4.3 millionduring the nine months ended September 30, 2004, an increase of approximately$0.7 million, or 19%, compared to the same period in 2003.  $0.2 million of the increase in other revenueis the result of more EnSite NavX hardware and software upgrades beingcompleted during the nine months ended September 30, 2004 compared to the sameperiod in 2003 (210 versus 179 upgrades) due to the fact that the EnSite NavXupgrade process did not begin until the second quarter of 2003.  The portion of deferred revenue related tothese EnSite System upgrades was recognized at the time the upgrade wasinstalled.  Other revenue also increasedby $0.5 million from the recognition of deferred revenue generated by extendedwarranty and service agreements.  Revenuerelated to extended warranty and service agreements is recognized ratably overthe warranty and service period (typically one year).  Gross profit margins on other revenue were 30.9%for the nine months ended September 30, 2004 compared to 36.1% for the sameperiod in 2003.

 

**Researchand Development Expense**. Research and development expenses include compensation and benefit costsfor personnel in the clinical, software, hardware, catheter, and appliedresearch groups, as well as costs associated with regulatory and clinical studyexpenses.  Research and development expenseswere approximately $3.3 million for the nine months ended September 30, 2004,compared to $4.5 million during the same period in 2003, a decrease of $1.2million, or 27.0%.  This decrease inresearch and development expense was primarily due to the Company’s decision todiscontinue its “left atrial mapping protocol” study of the EnSite Arraycatheter in the fourth quarter of 2003. The Company expects to make continued significant investments in EnSiteproduct development and clinical studies throughout the remainder of 2004.

 

 

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**General andAdministrative Expense**.  Generaland administrative expenses were approximately $5.0 million and $2.4 millionfor the nine month periods ended September 30, 2004 and 2003,respectively.  This increase in theCompany’s general and administrative expenses over the same period in 2003 wasdue to $1.3 millionof expenses incurred in the third quarter of 2004, which included non-recurringtransaction costs associated with the Company’s pending acquisition by St. JudeMedical, Inc., expenses incurred as part of implementing the Company’scompliance with the requirements of the Sarbanes-Oxley Act of 2002, and certainother legal fees.  The Company’s normalgeneral and administrative expenses have also increased in 2004 over the sameperiod in 2003, primarily related to insurance, recruiting fees anddepreciation of the Company’s new integrated financial reporting system.

 

**Sales andMarketing Expense**.  Sales andmarketing expenses were approximately $15.8 million and $14.6 million for thenine month periods ended September 30, 2004 and 2003, respectively, an increaseof approximately $1.2 million, or 8.4%. This increase was primarily attributable to an increase in the number ofU.S. and European field clinical support personnel and associated travelexpenses during the first nine months of 2004 as compared to the same period in2003, together with increased commissions as a result of a 28.7% increase inrevenue compared to the same period in 2003. The Company expects that sales and marketing expenses, as a percentageof revenue, will continue to decline in the fourth quarter of 2004 compared to thesame period in 2003.

 

**OtherExpense**.  Other expense consists ofinterest expense, offset by interest income on cash and cash equivalentbalances, state income tax accruals and foreign exchange gains and losses ontransfers of inventory to the Company’s European subsidiary.  The $155,000 increase for the nine monthsended September 30, 2004 compared to the same period in 2003 primarily consistsof increased state income tax accruals and foreign exchange losses.

 

**Income TaxExpense**.  The Company recorded currenttax expense of $36,000 during the nine month period ended September 30,2004.  This tax expense was offset by thereversal of $36,000 from the previously established valuation allowance againstthe Company’s deferred tax assets related to its cumulative net operating losscarry-forwards.  As a result, the Companyrecorded no income tax expense for the nine month period ended September 30,2004.  The Company’s ability to realizethe benefits of these deferred tax assets depends on the Company being able togenerate taxable income from the sale of current and future products.  Because the Company’s ability to generatesufficient taxable income necessary to realize these deferred tax assets isuncertain, the Company’s net deferred tax assets of approximately $30 millionas of September 30, 2004 are offset by a full valuation allowance in accordancewith SFAS No. 109, *Accounting for IncomeTaxes.*

 

**Liquidityand Capital Resources**.

 

The Company’s operationssince inception have been partially funded by net proceeds from the sale ofcommon and preferred stock totaling approximately $105.2 million.  As of September 30, 2004 and December 31, 2003,the Company had cash and cash equivalents of approximately $9.3 million and$10.2 million, respectively.

 

For the nine months endedSeptember 30, 2004, the Company used cash of approximately $116,000 in itsoperations, compared to approximately $5.3 million for the same period in 2003.

 

The Company’s accountsreceivable balance was approximately $12.5 million as of September 30, 2004, anincrease of approximately $2.2 million from December 31, 2003. The increase inaccounts receivable was primarily attributable to the increase in revenuesduring the nine months ended September 30, 2004 compared to previous periods.

 

The Company’s inventorybalance at September 30, 2004 was approximately $3.6 million, a 11.8% decreasecompared to December 31, 2003.  The Company’sinventory of EnSite clinical workstation components has decreased over thecourse of 2004 as the number of EnSite Systems remaining to be upgraded withEnSite NavX has declined.  Inventories ofEnSite Array catheters and EnSite NavX surface electrode kits have remainedrelatively constant throughout 2004 and the Company expects its inventorybalance will remain relatively constant through the remainder of 2004.

 

The Company’s accountspayable (including accrued expenses) balance at September 30, 2004 wasapproximately $6.4 million, an increase of approximately $0.7 million fromDecember 31, 2003.  This increasereflects the accruals for the transaction costs associated with the Company’spending acquisition by St. Jude Medical, Inc., offset by the timely payment ofcertain liabilities during 2004, including the Company’s accrued 2003 year-endincentive bonuses in the first quarter of 2004. The Company expects accounts payable and accrued expenses to remainrelatively constant through the remainder of 2004.

 

The Company had noshort-term investment portfolio as of September 30, 2004 and December 31,2003.  A majority of the Company’savailable cash was in money market funds consistent with the Company’sinvestment policy.

 

In September 2003, the Companyentered into a $4.5 million credit facility agreement with Silicon Valley Bank(“SVB”). This credit facility replaced a prior credit facility with SVB thatthe Company entered into in June 2001, and modified in May 2002 to extend theterm of the initial agreement.  TheSeptember 2003 credit facility with SVB consists of a $3.0 million domesticline of credit, and a $1.5 million international (EXIM) credit line.  This facility operates as a revolving line ofcredit, with $1.3 million reserved for use as a capital lease line.  In September 2004, the Company extended thematurity date under the terms of the credit facility to December 23, 2004.  The terms of this credit facility includecertain restrictive financial covenants, including the Company’s obligation tomaintain a specified ratio of “current assets” to “current liabilities” (“quickratio”), as well as a minimum “tangible net worth.”  As of March 31, 2004, June 30, 2004 andSeptember 30, 2004, the Company was in compliance with the financial covenantsof the credit facility.  During the firstquarter of 2004, the Company’s implementation of a new integrated financialreporting system prevented the Company from delivering certain intra-quartermonthly financial statements required by SVB. The Company met its financial reporting requirements to SVB for thethree month period ended March 31, 2004, and SVB granted the Company a writtenwaiver of the “intra-quarter monthly financial reporting defaults” from Januaryand February of 2004.  The Company met itsmonthly

 

 

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financial reporting requirements during thesecond and third quarters of 2004.  InSeptember 2004, the Company determined that the fact it was maintaining cash inthe Company’s European subsidiary, Endocardial Solutions, N.V./S.A., at afinancial institution in Belgium other than SVB, the Company was in default ofa negative covenant under the terms of the credit facility.  SVB granted the Company a written waiver ofthis negative covenant default in September 2004.  As of September 30, 2004, the Company had$0.1 million outstanding related to capital leases and had an additional $1.0million outstanding on the credit line.

 

The Company believes itsexisting cash, cash equivalents and bank financing will be sufficient to fundthe operations of the Company, and the Company does not currently anticipatethe need to raise additional financing to fund capital expenditures oroperations during the remainder of 2004. If the Company achieves profitability as forecasted, the need foradditional financing is not presently anticipated.  The Company’s future liquidity and capitalrequirements will depend on numerous factors, including (i) the timing ofregulatory actions regarding the Company’s current and future products; (ii)the results of future clinical trials; (iii) market acceptance of productscompetitive with the Company’s products; (iv) the extent to which the Company’sEnSite System and disposable products gain additional market acceptance; (v) thecosts, timing and method of expansion of sales, marketing, research anddevelopment and manufacturing activities; (vi) the costs of funding litigationassociated with a patent infringement lawsuit that was filed against theCompany in October 2004 by Biosense Webster, a division of Johnson &Johnson, and any potential monetary damages resulting therefrom in the event ofa final determination adverse to the Company; (vii) the timing of thecompletion of the acquisition of the Company by St. Jude Medical, Inc.; and (viii)the Company’s ability to obtain additional bank financing, if necessary.

 

**Critical Accounting Policies**

 

The Company’s consolidatedfinancial statements are prepared in accordance with accounting principlesgenerally accepted in the U.S., which require the Company to make estimates andassumptions in certain circumstances that affect amounts reported in theaccompanying consolidated financial statements and related footnotes.  In preparing these consolidated financialstatements, the Company’s management has made its best estimates and judgmentsof certain amounts included in the consolidated financial statements, givingdue consideration to materiality.  TheCompany does not believe there is a great likelihood that materially differentamounts would be reported related to the accounting policies describedbelow.  However, application of theseaccounting policies involves the exercise of judgment and use of assumptions asto future uncertainties and, as a result, actual results could differ fromthese estimates.

 

*RevenueRecognition. *Revenue fromthe sale of the Company’s EnSite Systems, EnSite Array catheters, and EnSiteNavX surface electrode kits is recognized at the time of shipment in instanceswhere the Company has evidence of a contract or binding commitment, thepurchase price is fixed and determinable, and collection is probable.  Revenue associated with service and supportwarranties from new system sales, and the sale of extended service and supportagreements, together with hardware upgrades is deferred and recognized ratablyover the period the service and support is provided, or as the upgrades areperformed, respectively. The Securities and Exchange Commission’s StaffAccounting Bulletins (SAB) Nos. 101 and 104, “Revenue Recognition” and ETIF00-21 “Accounting for Revenue Arrangements with Multiple Deliverables” provideguidance on the application of generally accepted accounting principles toselected revenue recognition issues.  TheCompany has concluded that its revenue recognition policies are appropriate andin accordance with this guidance.

 

*Allowancefor Doubtful Accounts. *The Company’s accounts receivable are reduced by an allowance foramounts that may become uncollectible in the future.  The estimated allowance is based onmanagement’s review of accounts receivable balances and historicalwrite-offs.  During the three months endedSeptember 30, 2004, the Company did not write-off any material amount ofoutstanding accounts receivable balances.

 

*Inventoriesand Related Allowance for Excess and Obsolete Inventory.* Inventories are valued at the lower of cost ormarket and have been reduced by an allowance for excess and obsoleteinventories.  The estimated allowance forexcess and obsolete inventory is based on management’s review of inventories onhand compared to estimated future usage and sales.  As of September 30, 2004, the Companybelieves its allowance for excess and obsolete inventories was adequate.

 

*NewAccounting Standards*.  In May2003, the FASB issued SFAS No. 150, *Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity*.  This statement establishes standards for theclassification and measurement of certain financial instruments withcharacteristics of both liabilities and equity. This statement requires that an issuer classify a financial instrumentthat is within its scope as a liability (or an asset in somecircumstances).  Many of those instrumentswere previously classified as equity. This statement is effective for financial instruments entered into ormodified after May 31, 2003 and otherwise is effective at the beginning of thefirst interim period beginning after June 14, 2003.  The Company does not currently have financialinstruments with characteristics of both liabilities and equity, and therefore,the adoption of SFAS No. 150 did not have an impact on its financial condition,results of operations or cash flows.

 

**Item 3. Quantitative and Qualitative Disclosures aboutMarket Risk**

 

The Company hadapproximately $9.3 million of cash and cash equivalents on September 30,2004.  Substantially all of this cash isinvested in money market funds.  Becauseof the credit risk criteria of the Company’s investment policies, the primarymarket risk

 

 

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associated with these investments is interestrate risk.  The Company does not usederivative financial instruments to manage interest rate risk or to speculateon future changes in interest rates.  Arise in interest rates could negatively affect the fair value of the Company’sinvestments; however, because management considers it unlikely that the Companywould need or choose to substantially liquidate the Company’s investments priorto their maturity, management believes that such an increase in interest rateswould not have a material impact on the Company’s future earnings or cashflows.  Even though the Company conductssales in foreign currencies through its European subsidiary, management doesnot believe the Company is exposed to any material foreign currency exchangerate risk.

 

**Item 4. Controls and Procedures**

 

*(a)Evaluation of disclosure controls and procedures. *Under the supervision andwith the participation of our management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, we evaluated the effectivenessof the design and operation of our disclosure controls and procedures (asdefined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “ExchangeAct”)).  Based upon that evaluation, theChief Executive Officer and Chief Financial Officer concluded that, as of theend of the period covered by this report, the Company’s disclosure controls andprocedures were effective in timely alerting them to the material informationrelating to the Company (or our consolidated subsidiaries) required to beincluded in the reports we file or submit under the Exchange Act.

 

(b) *Changes in internal controls over financial reporting*.  During the quarter ended September 30, 2004,there was no change in the Company’s internal control over financial reporting(as defined in Rule 13a-15(f) under the Exchange Act) that has materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

**Cautionary Statement**

 

Except for the historicalinformation contained herein, this Quarterly Report on Form 10-Q containsforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended.  These forward-lookingstatements represent the Company’s expectations, beliefs, intentions orstrategies concerning future events, including, but not limited to, anystatements regarding its current assumptions about future financialperformance; the continuation of historical trends; the sufficiency of its cashbalances and cash generated from operating activities for future liquidity andcapital resource needs; the expected impact of changes in accounting policieson the Company’s results of operations, financial condition or cash flows;anticipated problems and its plans for future operations; and the economy ingeneral or the future of the medical device industry, all of which are subjectto various risks and uncertainties.  Theseforward-looking statements also include statements about the pendingtransaction between St. Jude Medical, Inc. (“St. Jude Medical”) and the Company.  Such statements are based upon the currentbeliefs and expectations of the Company's management and are subject tosignificant risks and uncertainties. Actual results may differ from those setforth in the forward-looking statements. When used in this Form 10-Q and in future filings by the Company withthe Securities and Exchange Commission, in the Company’s press releases and inoral statements made with the approval of an authorized executive officer ofthe Company, the word or phrases “believes,” “anticipates,” “expects,” “intends,”“will likely result,” “estimates,” “projects” or similar expressions areintended to identify such forward-looking statements, but are not the exclusivemeans of identifying such statements. However, any statements contained in thisForm 10-Q that are not statements of historical fact may be deemed to beforward-looking statements.

 

The Company cautions thatthese statements, by their nature, involve risks and uncertainties, certain ofwhich are beyond its control, and actual results may differ materiallydepending on a variety of important factors, including, but not limited to suchfactors as market demand, pressures on product pricing, changing marketconditions, and competition and growth rates within the medical deviceindustry; changes in accounting policies; risks associated with operationsoutside of the U.S.; the outcome of pending litigation; changing economicconditions such as general economic slowdown, decreased consumer confidence andthe impact of war on the economy; and other risks and uncertainties that couldcause the Company’s results to differ materially from those described in theforward-looking statements, including those described in Exhibit 99.1 to the Company’sAnnual Report on Form 10-K for the year ended December 31, 2003, and filed withthe Securities and Exchange Commission (“SEC”) and available at the SEC’s Internetsite (http://www.sec.gov).

 

 

 

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**PART II.OTHER INFORMATION**

 

**Item 6. Exhibits**

 

**(a) Exhibits**

 

 
| **Exhibits** | ** ** | **Description**                                                                                                                                                                                                                                                                        |
|--------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **   | ** ** | ** **                                                                                                                                                                                                                                                                             |
| 2.1          |       | Amended and Restated Agreement and Plan of Merger, date as of  September 29, 2004, by and among the Company, St. Jude Medical, Inc. and  Dragonfly Merger Corp. (incorporated by reference to Exhibit 2.1 to the  Company’s Current Report on Form 8-K filed September 29, 2004). |
|         |       |                                                                                                                                                                                                                                                                                   |
| 4.1          |       | Amendment No. 1 to Rights Agreement, dated as of September 23, 2004,  between the Company and Wells Fargo Bank, N.A. as Rights Agent (incorporated  by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed  September 27, 2004).                           |
|         |       |                                                                                                                                                                                                                                                                                   |
| 10.1         |       | Limited Waiver and Amendment to Loan Documents dated as of September  22, 2004, by and between the Company and Silicon Valley Bank (incorporated by  reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed  September 27, 2004).                            |
|         |       |                                                                                                                                                                                                                                                                                   |
| 31.1         |       | Certification of the Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                   |
| 31.2         |       | Certification of the Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                   |
| 32.1         |       | Certification of the Chief Executive Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                   |
| 32.2         |       | Certification of the Chief Financial Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                   |

 

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 
| Dated: November 9, 2004 | ENDOCARDIAL SOLUTIONS, INC. |
|-------------------------|-----------------------------|
|                    |                        |   |
|                    | By:                         | /s/ James W. Bullock |
|                    |                        | James W. Bullock |
|                    |                        | President and Chief Executive Officer |
|                    |                        |   |
|                    |                        | /s/ J. Robert Paulson |
|                    |                        | J. Robert Paulson, Jr. |
|                    |                        | Chief Financial Officer |
|                    |                        | (Principal Accounting Officer) |

 

 

 

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