**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(MarkOne)**

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

 

**Forthe transition period from                 to                 **

 

**CommissionFile Number**

**0-22233**

 

**ENDOCARDIALSOLUTIONS, INC.**

(Exact name ofregistrant as specified 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’stelephone number, including area code)

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  ý   No o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act). Yes ýNo  o

 

As of August3, 2004 the number of shares outstanding of the registrant’s common stock, parvalue $.01 per share, was 22,134,528.

 

 

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**INDEX**

 

**EndocardialSolutions, Inc.**

 
| **PART I. FINANCIAL INFORMATION**                                                                      |
|--------------------------------------------------------------------------------------------------------|
| Item  1. Financial Statements                                                                          |
| Consolidated Balance Sheets—June 30, 2004 and December 31, 2003                                   |
| Consolidated Statements of Operations—Three and six months ended June  30, 2004 and 2003          |
| Consolidated Statements of Cash Flows—Six months ended June 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 3 and Item 5 have been omitted since all items are inapplicable or  answers negative. |
| Item  4. Submission of Matters to a Vote of Security Holders                                           |
| Item  6. Exhibits and Reports on Form 8-K                                                              |

 

2

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**PARTI — FIN****ANCIALINFORMATION**

 

**Item1. Fina****ncialStatements**

 

**EndocardialSolutions, Inc.**

 

**Consolidated Balanc****e Sheets**

 
| ** **                                                                                                                                      | ** ** | **As of June 30,  2004** | ** ** | **As of December 31,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                      | ** ** | **(Unaudited)**          | ** ** | ** **                   | ** ** |
|                                                                                                                                            |       |                     |       |                         |       |
| **Assets**                                                                                                                                      |       |                     |       |                         |       |
| Current assets:                                                                                                                                 |       |                     |       |                         |       |
| Cash and cash equivalents                                                                                                                       |       | $                        | 8,799,281  |                         | $          | 10,216,385 |   |
| Accounts receivable, net of allowance for  doubtful accounts (2004 — $151,996; 2003 — $151,996)                                       |       | 12,035,751               |       | 10,378,401                   |       |
| Inventories                                                                                                                                     |       | 3,949,875                |       | 4,075,747                    |       |
| Prepaid expenses and other current assets                                                                                                       |       | 706,888                  |       | 1,435,102                    |       |
|                                                                                                                                            |       |                     |       |                         |       |
| Total current assets                                                                                                                            |       | 25,491,795               |       | 26,105,635                   |       |
|                                                                                                                                            |       |                     |       |                         |       |
| Furniture and equipment                                                                                                                         |       | 10,265,930               |       | 9,331,606                    |       |
| Less accumulated depreciation                                                                                                                   |       | (7,027,049               | )          | (6,628,801                   | )          |
|                                                                                                                                            |       | 3,238,881                |       | 2,702,805                    |       |
| Deposits                                                                                                                                        |       | 50,857                   |       | 51,179                       |       |
| Notes receivable                                                                                                                                |       | 206,226                  |       | 206,226                      |       |
| Other assets                                                                                                                                    |       | 676,531                  |       | 624,760                      |       |
| Intangible assets, net of accumulated  amortization (2004 — $158,359; 2003 — $125,266)                                                |       | 564,279                  |       | 585,032                      |       |
|                                                                                                                                            |       |                     |       |                         |       |
| Total assets                                                                                                                                    |       | $                        | 30,228,569 |                         | $          | 30,275,637 |   |
|                                                                                                                                            |       |                     |       |                         |       |
| **Liabilities and stockholders’ equity**                                                                                                   |       |                     |       |                         |       |
| Current liabilities:                                                                                                                            |       |                     |       |                         |       |
| Accounts payable and accrued expenses                                                                                                           |       | $                        | 4,833,918  |                         | $          | 5,683,372 |   |
| Bank line of credit                                                                                                                             |       | 1,000,000                |       | 1,000,000                    |       |
| Current portion of capital lease  obligations                                                                                                   |       | 191,867                  |       | 318,011                      |       |
| Current portion of deferred revenue                                                                                                             |       | 2,250,552                |       | 2,634,751                    |       |
|                                                                                                                                            |       |                     |       |                         |       |
| Total current liabilities                                                                                                                       |       | 8,276,337                |       | 9,636,134                    |       |
|                                                                                                                                            |       |                     |       |                         |       |
| Long-term liabilities:                                                                                                                          |       |                     |       |                         |       |
| Capital lease obligations                                                                                                                       |       | —                   |       | 63,956                       |       |
| Deferred revenue                                                                                                                                |       | 223,954                  |       | 262,282                      |       |
| Total long-term liabilities                                                                                                                     |       | 223,954                  |       | 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 — June 30,  2004 — 21,995,151; December 31, 2003 — 21,597,241 |       | 219,347                  |       | 215,972                      |       |
| Additional paid-in capital                                                                                                                      |       | 106,589,046              |       | 104,680,168                  |       |
| Accumulated deficit                                                                                                                             |       | (84,256,142              | )          | (84,956,006                  | )          |
| Accumulated other comprehensive income                                                                                                          |       | 138,384                  |       | 486,525                      |       |
| Deferred compensation                                                                                                                           |       | (962,357                 | )          | (113,394                     | )          |
| Total stockholders’ equity                                                                                                                 |       | 21,728,278               |       | 20,313,265                   |       |
| Total liabilities and stockholders’ equity                                                                                                 |       | $                        | 30,228,569 |                         | $          | 30,275,637 |   |

 

*See accompanying notes.*

 

3

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**Consolidated Statementsof Operations**

 

**(Unaudited)**

 

 
| ** **                                       | ** ** | **For the Three Months Ended  June 30,** | ** ** | **For the Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **2004**                                 | ** ** | **2003**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                       | ** ** | ** **                               | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                          |       | $                                        | 11,825,515 |                                   | $          | 9,293,651 |   | $ | 22,430,124 |   | $ | 16,585,395 |   |
| Cost of goods sold                               |       | 3,120,473                                |       | 3,447,258                              |       | 6,666,556 |   | 5,862,262 |   |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Gross margin                                     |       | 8,705,042                                |       | 5,846,393                              |       | 15,763,568 |   | 10,723,133 |   |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Operating  expenses:                             |       |                                     |       |                                   |       |   |   |   |   |
| Research and development                         |       | 1,058,620                                |       | 1,487,933                              |       | 2,225,836 |   | 3,033,304 |   |
| General and administrative                       |       | 1,151,688                                |       | 774,524                                |       | 2,154,996 |   | 1,521,753 |   |
| Sales and marketing                              |       | 5,520,714                                |       | 4,973,057                              |       | 10,566,953 |   | 9,680,438 |   |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Total operating expenses                         |       | 7,731,022                                |       | 7,235,514                              |       | 14,947,785 |   | 14,235,495 |   |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Operating income (loss)                          |       | 974,020                                  |       | (1,389,121                             | )          | 815,783 |   | (3,512,362 | ) |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Other expense                                    |       | (49,003                                  | )          | (30,000                                | )          | (115,919 | ) | (68,666 | ) |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Net income (loss)                                |       | $                                        | 925,017    |                                   | $          | (1,419,121 | ) | $ | 699,864 |   | $ | (3,581,028 | ) |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Net income (loss) per share — basic         |       | $                                        | 0.04       |                                   | $          | (0.07 | ) | $ | 0.03 |   | $ | (0.18 | ) |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Weighted average shares outstanding – basic |       | 21,966,965                               |       | 19,688,926                             |       | 21,896,518 |   | 19,636,613 |   |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Net income (loss) per share — diluted       |       | $                                        | 0.04       |                                   | $          | (0.07 | ) | $ | 0.03 |   | $ | (0.18 | ) |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Weighted average shares outstanding -  diluted   |       | 23,332,866                               |       | 19,688,926                             |       | 23,244,815 |   | 19,636,613 |   |

 

*See accompanying notes.*

 

4

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**Consolidated Statementsof Cash Flows**

 

**(Unaudited)**

 

 
| ** **                                                                            | ** ** | **For the Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                            | ** ** | **2004**                               | ** ** | **2003** | ** ** |
|                                                                                  |       |                                   |       |   |   |
| **Operating activities**                                                              |       |                                   |       |   |   |
| Net income (loss)                                                                     |       | $                                      | 699,864    |   | $ | (3,581,028 | ) |
| Adjustments to reconcile net income (loss)  to net cash used in operating activities: |       |                                   |       |   |   |
| Depreciation and amortization                                                         |       | 549,554                                |       | 533,567 |   |
| Amortization of deferred compensation                                                 |       | 192,037                                |       | 44,141 |   |
| Changes in operating assets and  liabilities:                                         |       |                                   |       |   |   |
| Accounts receivable                                                                   |       | (1,783,347                             | )          | (2,253,634 | ) |
| Inventories                                                                           |       | 147,608                                |       | (388,760 | ) |
| Prepaid expenses                                                                      |       | 709,895                                |       | (65,062 | ) |
| Other assets                                                                          |       | (241,232                               | )          | 483,675 |   |
| Accounts payable and accrued expenses                                                 |       | (829,488                               | )          | 169,786 |   |
| Deferred revenue                                                                      |       | (407,065                               | )          | (166,584 | ) |
| Net cash used in operating activities                                                 |       | (962,174                               | )          | (5,223,899 | ) |
| **Investing activities**                                                              |       |                                   |       |   |   |
| Purchases of furniture and equipment                                                  |       | (935,653                               | )          | (803,663 | ) |
| Net cash used in investing activities                                                 |       | (935,653                               | )          | (803,663 | ) |
| **Financing activities**                                                              |       |                                   |       |   |   |
| Principal payments on notes payable and  capital lease obligations                    |       | (190,100                               | )          | (292,805 | ) |
| Proceeds from issuance of common stock                                                |       | 871,253                                |       | 7,970,918 |   |
| Net cash provided by financing activities                                             |       | 681,153                                |       | 7,678,113 |   |
| Effect of exchange rate changes on cash                                               |       | (200,430                               | )          | (295,200 | ) |
| (Decrease) increase in cash and cash  equivalents                                     |       | (1,417,104                             | )          | 1,355,351 |   |
| Cash and cash equivalents at beginning of  period                                     |       | 10,216,385                             |       | 1,347,753 |   |
| Cash and cash equivalents at end of period                                            |       | $                                      | 8,799,281  |   | $ | 2,703,104 |   |
| **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.**

 

**Notesto Consolidated Fina****ncial Statements**

 

**1. Basis of Presentation**

 

Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with generally accepted accounting principles for interim financialinformation and with the instructions to Form 10-Q and Article 10 of RegulationS-X.  Accordingly, they do not includeall the information and footnotes required by generally accepted accountingprinciples for complete financial statements. In the opinion of management, all adjustments (consisting of normalrecurring adjustments) considered necessary for a fair presentation have beenincluded.  Operating results for thethree and six months ended June 30, 2004 are not necessarily indicative of theresults 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**

 

Inventoriesare carried at the lower of cost (first-in, first-out basis) or market.

 

Inventoriesconsisted of the following:

 

 
| ** **       | ** ** | **June 30,  2004** | ** **    | **December 31,  2003** | ** ** |
|------------------|------------|--------------------|---------------|------------------------|------------|
|             |       |               |          |                   |       |
| Raw materials    |       | **$**              | **2,611,578** |                   | $          | 2,852,690 |   |
| Work-in-progress |       | **211,022**        |          | 168,231                |       |
| Finished goods   |       | **1,127,275**      |          | 1,054,826              |       |
|             |       | **$**              | **3,949,875** |                   | $          | 4,075,747 |   |

 

**3. Stock-Based Compensation**

 

The Companyaccounts for stock-based compensation in accordance with the provisions ofAccounting Principles Board (APB) Opinion No. 25, *Accounting for**StockIssued to Employees*, and related interpretations.  The following table illustrates the effect onnet income (loss) and net income (loss) per share if the Company had appliedthe fair value recognition provisions of Financial Accounting Standards Board(FASB) Statement of Financial Accounting Standards (SFAS) No. 123, *Accounting for Stock-based Compensation*,to stock- based employee compensation.

 

6

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| ** **                                                                                | ** ** | **For the three months ended  June 30,** | ** **  | **For the six months ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------------------|-------------|----------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                                 | ** **  | **2003**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                      |       |                                     |        |                                   |       |   |   |   |   |
| Net income (loss), as reported:                                                           |       | **$**                                    | **925,017** |                                   | $          | (1,419,121 | ) | **$** | **699,864** | ** ** | $ | (3,581,028 | ) |
| Add: Stock-based compensation, as reported                                                |       | **117,723**                              |        | 21,327                                 |       | **192,037** | ** ** | 44,141 |   |
|                                                                                      |       | ** **                               |        |                                   |       | ** ** | ** ** |   |   |
| Deduct: Stock-based compensation determined  under fair-value-based method for all awards |       | **(504,138**                             | **)**       | (357,265                               | )          | **(857,230** | **)** | (731,879 | ) |
|                                                                                      |       | ** **                               | ** **  |                                   |       | ** ** | ** ** |   |   |
| Adjusted net income (loss), assuming  fair-value-based method for all stock-based awards  |       | **$**                                    | **538,602** | ** **                             | $          | (1,755,059 | ) | **$** | **34,671** | ** ** | $ | (4,268,766 | ) |
|                                                                                      |       | ** **                               | ** **  |                                   |       | ** ** | ** ** |   |   |
| Basic income (loss) per share, as reported                                                |       | **$**                                    | **0.04**    |                                   | $          | (0.07 | ) | **$** | **0.03** | ** ** | $ | (0.18 | ) |
|                                                                                      |       | ** **                               |        |                                   |       | ** ** | ** ** |   |   |
| Basic income (loss) per share, pro forma                                                  |       | **$**                                    | **0.02**    |                                   | $          | (0.09 | ) | **$** | **0.00** | ** ** | $ | (0.22 | ) |
|                                                                                      |       | ** **                               |        |                                   |       | ** ** | ** ** |   |   |
| Diluted income (loss) per share, as  reported                                             |       | **$**                                    | **0.04**    |                                   | $          | (0.07 | ) | **$** | **0.03** | ** ** | $ | (0.18 | ) |
|                                                                                      |       | ** **                               |        |                                   |       | ** ** | ** ** |   |   |
| Diluted income (loss) per share, pro forma                                                |       | **$**                                    | **0.02**    |                                   | $          | (0.09 | ) | **$** | **0.00** | ** ** | $ | (0.22 | ) |

 

**4. Comprehensive Income (Loss)**

 

The componentsof comprehensive income (loss), net of related tax, were as follows:

 
| ** **                              | ** ** | **For the three months ended  June 30,** | ** **  | **For the six months ended  June 30,** | ** ** |
|-----------------------------------------|------------|------------------------------------------|-------------|----------------------------------------|------------|
| ** **                              | ** ** | **2004**                                 | ** **  | **2003**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                    |       |                                     |        |                                   |       |   |   |   |   |
| Net income (loss)                       |       | **$**                                    | **925,017** | ** **                             | $          | (1,419,121 | ) | **$** | **699,864** | ** ** | $ | (3,581,028 | ) |
| Foreign currency translation adjustment |       | **(146,670**                             | **)**       | 10,691                                 |       | **(348,141** | **)** | 138,791 |   |
| Comprehensive income (loss)             |       | **$**                                    | **778,347** | ** **                             | $          | (1,408,430 | ) | **$** | **351,723** | ** ** | $ | (3,442,237 | ) |

 

 

**5. Guarantees and Contractual Obligations**

 

In November2002, the Financial Accounting Standards Board issued Interpretation No. 45(FIN 45), *Guarantor’s Accounting andDisclosure**Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of**Others*(the “Interpretation”).  The Interpretation requires disclosure inperiodic financial statements of certain guarantee arrangements.  The Interpretation also clarifies situationswhere a guarantor is required to recognize the fair value of certain guaranteesin the financial statements.  The Companydoes not have any guarantees that require recognition at fair value under theInterpretation.

 

The Companysells extended warranty agreements that include service and support, and mayalso include the right 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 thesix months ended June 30, 2004 are as follows:

 
| Balance, December 31, 2003                     |   | $          | 2,897,033 |   |
|------------------------------------------------|--------|------------|-----------|--------|
| Revenue deferred during the period             |   | 2,590,351  |      |
| Deferred revenue recognized during the  period |   | (3,012,878 | )         |
| Balance, June 30, 2004                         |   | $          | 2,474,506 |   |

 

7

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**6. Reclassifications**

 

Certain prioryear and prior period items have been reclassified to conform to current periodpresentation.

 

**7. Restricted Stock**

 

On February16, 2004, the Company issued a restricted grant of 100,000 shares of theCompany’s common stock in connection with the execution of a consultingagreement.

 

**8. Income Taxes**

 

The Companyrecorded current tax expense of $350,000 during the second quarter of2004.  This tax expense was offset by thereversal of $350,000 from the previously established valuation allowanceagainst the Company’s deferred tax assets related to its cumulative netoperating loss carryforwards.  As aresult, the Company recorded no income tax expense for the second quarter of2004.  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 June 30, 2004 are offset by a full valuation allowance in accordance withSFAS No. 109, *Accounting for Income Taxes*.

 

**9. Segment Reporting**

 

Revenue bygeographic destination as a percentage of total revenue was as follows:

 
| ** **     | ** ** | **For the three months  ended June 30** | ** ** | **For the six months  ended June 30** | ** ** |
|----------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **     | ** ** | **2004**                                | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
|           |       |                                    |       |                                  |       |   |   |   |   |
| Domestic       |       | 64                                      | %          | 79                                    | %          | 64 | % | 76 | % |
| International: |       |                                    |       |                                  |       |   |   |   |   |
| Europe         |       | 28                                      | %          | 14                                    | %          | 26 | % | 13 | % |
| Asia Pacific   |       | 7                                       | %          | 4                                     | %          | 9 | % | 9 | % |
| Canada/Mexico  |       | 1                                       | %          | 3                                     | %          | 1 | % | 2 | % |

 

**Item 2. Manage****ment’s Discussion and Analysis of Financial Conditionand Results****of Operations**

 

**Overview**

 

Endocardial Solutions,Inc. (“ESI” or the “Company”) designs, develops, manufactures and sells theEnSite® advanced cardiac mapping and navigation system, a diagnosticand navigation platform that allows electrophysiologists (“EPs”) to rapidly andprecisely locate the multiple, unpredictable points of origin of complexcardiac 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 (“EnSiteArray”), and EnSite NavXTM surface electrode kits (“EnSite NavX”).  The Company also has released its initialcommercial version of 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 theprocedure can 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 Companyreceived approval from the European Union (“EU”) and commercially released theEnSite System with the EnSite Array catheter in Europe in 1998, and followingclearance from the FDA, commercially released the EnSite System and EnSiteArray in the U.S. and Canada in 1999. The EnSite Array was approved for mapping right atrial tachycardias inthe U.S., and for mapping atrial and left ventricular tachycardias in Europeand Canada.  The Company has receivedgeneral approval to market 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 cardiacarrhythmias.  EnSite NavX is approved foruse in all four chambers of the heart in all markets where the EnSite Systemand EnSite Array are 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 EnSiteSystem is an innovative and expanding technology platform for mapping cardiacarrhythmias, and enabling the precise three-dimensional, non-fluoroscopicvisualization and navigation of a variety of linear electrophysiology cathetersused in the diagnosis and treatment of cardiac arrhythmias.  The Company’s ability to increase revenuesand derive future profits from this business in the future depends, in part, onthe Company’s ability to effectively market and sell the EnSite System to theapproximately 2,200 electrophysiology laboratories worldwide in whichelectrophysiology ablation procedures are performed, and to have the physicianswho perform these procedures continue to increase their clinical adoption anduse of the EnSite System with current and future products introduced by theCompany.

 

The Companyemploys a direct sales force in the United States and Europe, and usesthird-party distributors for certain domestic and international markets.  The Company has established an exclusivedistribution arrangement in Japan with Nihon Kohden, one of Japan’s leadingmanufacturers, developers and distributors of medical electronic products, andexpects regulatory approval for the sale of its products in Japan in 2004.  The Company has established a new third-partysales representation relationship for the Spain and Italy markets.  The Company believes this new third-partysales representative will help the Company increase the penetration of EnSiteSystems in these markets to accounts that are capital constrained andreimbursement challenged by bundling EnSite Systems and disposable productswith their electrophysiology-focused product offerings.  With more than 390 EnSite Systems now installedglobally, the Company continues to expand its sales and marketing efforts toinclude smaller, regional and community-based electrophysiology labs who areseeking to acquire and utilize advanced EP mapping and navigation technologiessuch as the EnSite System, as well larger medical centers who are addingelectrophysiology labs in response to the continuing increase in a variety ofelectrophysiology procedures.

 

The Companyderives revenues from the sale of the EnSite products described above, the saleof extended service and support warranty agreements, and the sale ofmiscellaneous ancillary support products used in conjunction with the EnSiteSystem.  The Company reported net salesfor the three months ended June 30, 2004 of approximately $11.8 million, anincrease of 27% over the same period in 2003. For the six months ended June 30, 2004, net sales were approximately$22.4 million, an increase of 35% over the same period in 2003.  The Company’s gross profit margin for thethree months ended June 30, 2004 was 73.6%, compared with 62.9% during the sameperiod in 2003.  For the six months endedJune 30, 2004, gross profit margin was 70.3%, compared with 64.7 % during thesame period in 2003.

 

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**Results of Operations**

 

**General**.Net income was $925,017, or $0.04 per share, for the three months ended June30, 2004, compared to a net loss of $1.4 million, or $0.07 per share, for thesame period in 2003.  For the six monthsended June 30,2004, net income was $699,864 or $0.03 per share, compared to anet loss of $3.6 million, or $0.18 per share, for the same period in 2003.

 

**Revenue**.

 

Informationregarding our sales by major products and geographic distribution is set forthin the following table:

 

In Millions, except percentages

 
| ** **                                                                             | ** ** | **For the Three Months  Ended June 30,** | ** ** | **Percent** | ** ** | **For the Six Months  Ended June 30,** | ** ** | **Percent** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------------------------------------|------------|-------------|------------|----------------------------------------|------------|-------------|------------|
| ** **                                                                             | ** ** | **2004**                                 | ** ** | **2003**    | ** ** | **Change**                             | ** ** | **2004**    | ** ** | **2003** | ** ** | **Change** | ** ** |
| **Revenue:**                                                                           |       |                                     |       |        |       |                                   |       |        |       |   |   |   |   |
| **EnSite clinical workstations (net of  revenue deferred for warranty obligations)**   |       |                                     |       |        |       |                                   |       |        |       |   |   |   |   |
| Domestic                                                                               |       | $                                        | 2.2        |        | $          | 2.2                                    |       | 0           | %          | $ | 3.9 |   | $ | 4.1 |   | (5 | )% |
| International                                                                          |       | 2.1                                      |       | 0.4         |       | 425                                    | %          | 3.8         |       | 1.6 |   | 138 | % |
|                                                                                   |       | 4.3                                      |       | 2.6         |       | 65                                     | %          | 7.7         |       | 5.7 |   | 35 | % |
|                                                                                   |       |                                     |       |        |       |                                   |       |        |       |   |   |   |   |
| **EnSite disposables (EnSite Array catheters  and EnSite NavX suface electrode kits)** |       |                                     |       |        |       |                                   |       |        |       |   |   |   |   |
| Domestic                                                                               |       | 4.2                                      |       | 4.0         |       | 5                                      | %          | 8.4         |       | 6.9 |   | 22 | % |
| International                                                                          |       | 1.7                                      |       | 0.9         |       | 89                                     | %          | 3.1         |       | 1.7 |   | 82 | % |
|                                                                                   |       | 5.9                                      |       | 4.9         |       | 20                                     | %          | 11.5        |       | 8.6 |   | 34 | % |
|                                                                                   |       |                                     |       |        |       |                                   |       |        |       |   |   |   |   |
| **Other (deferred revenue, upgrades and  accessories and repairs)**                    |       |                                     |       |        |       |                                   |       |        |       |   |   |   |   |
| Domestic                                                                               |       | 1.2                                      |       | 1.2         |       | 0                                      | %          | 2.3         |       | 1.6 |   | 44 | % |
| International                                                                          |       | 0.4                                      |       | 0.6         |       | (33                                    | )%         | 0.9         |       | 0.7 |   | 29 | % |
|                                                                                   |       | 1.6                                      |       | 1.8         |       | (11                                    | )%         | 3.2         |       | 2.3 |   | 39 | % |
|                                                                                   |       |                                     |       |        |       |                                   |       |        |       |   |   |   |   |
| **Total Revenue**                                                                      |       |                                     |       |        |       |                                   |       |        |       |   |   |   |   |
| Domestic                                                                               |       | 7.6                                      |       | 7.4         |       | 3                                      | %          | 14.6        |       | 12.6 |   | 16 | % |
| International                                                                          |       | 4.2                                      |       | 1.9         |       | 121                                    | %          | 7.8         |       | 4.0 |   | 95 | % |
|                                                                                   |       | $                                        | 11.8       |        | $          | 9.3                                    |       | 27          | %          | $ | 22.4 |   | $ | 16.6 |   | 35 | % |

 

**ThreeMonths Ended June 30, 2004 Compared to Three Months Ended June 30, 2003**

 

Worldwiderevenue for the three months ended June 30, 2004 was $11.8 million, an increaseof approximately $2.5 million, or 27%, over the same period in 2003.  The Company’s gross profit margin for thethree months ended June 30, 2004 was 73.6%, compared with 62.9% during the sameperiod in 2003.

 

*EnSiteSystems*

 

Worldwiderevenue from the sale of EnSite Systems during the three months ended June 30,2004 was approximately $4.3 million, compared to approximately $2.6 million forthe same period in 2003, an increase of 65%. Domestic sales accounted for 51% of total EnSite System sales during theperiod, compared to 85% during the same period in 2003.  The Company sold a total of 29 EnSite Systemsduring the period with 15 sold domestically and 14 sold internationally.  Of the 14 EnSite Systems soldinternationally, 8 systems were sold pursuant to the new sales representativerelationship established for the Spain and Italy markets *(see furtherdiscussion under Overview above)*. The gross profit margin

 

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on EnSite System sales for thethree months ended June 30, 2004 was 73.0% compared to 64.5% for the sameperiod in 2003, a 13.2% increase.  Thisgross margin improvement was primarily driven by the Company’s conversion froma Silicon Graphics computing platform to a significantly more powerful, butlower cost, Intel® Xeon computing platform for it EnSite System inthe fourth quarter of 2003.

 

*EnSiteDisposable Products*

 

Worldwiderevenue from the sale of EnSite “disposable products” (EnSite Array cathetersand EnSite NavX surface electrode kits) during the three months ended June 30,2004 was approximately $5.9 million, compared to $4.9 million during the sameperiod in 2003, an increase of 20%. Domestic revenue from the sale of EnSite disposable products accountedfor 71% of total EnSite disposable product revenue during the three monthsended June 30, 2004, compared to 80% during the same period in 2003.  Revenues increased during the three monthsended June 30, 2004 compared to the same period in 2003 due to the increasednumber of installed EnSite Systems and increased disposable utilizationrates.  The gross profit margin on EnSitedisposable product sales for the three months ended June 30, 2004 was 83.0%, ascompared to 77.4% for the same period in 2003.

 

*OtherRevenue*

 

Other revenue,which includes (i) the recognition of deferred revenue generated from the saleof extended 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 $1.6 millionduring the three months ended June 30, 2004, a decrease of approximately $0.2million, or 11%, 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 June 30, 2004 compared to the same period in 2003 (87upgrades compared with 115 upgrades performed in the three months ended June30, 2004 and 2003, respectively, or a decrease in revenue of $0.4million).  Deferred revenue related tothese EnSite NavX upgrades was recognized at the time the upgrade wasinstalled.  That portion of “otherrevenue” related to the recognition of deferred revenue from extended warrantyand service agreements increased by $0.2 million for the same periods, which isrecognized ratably over the warranty and service period (typically oneyear).  The gross profit margin on “otherrevenue” was 42.4% for the three months ended June 30, 2004 compared to 17.7%for the same period in 2003.

 

**Researchand Development Expense**.  Research and development expenses includecompensation and benefit costs for personnel in the clinical, software,hardware, catheter, and applied research groups, together with regulatory andclinical study expenses.  Research anddevelopment expenses were approximately $1.1 million for the three months endedJune 30, 2004, compared to $1.5 million during the same period in 2003, adecrease of $0.4 million, or 29%. This decrease was primarily due to theCompany’s decision to discontinue its “left atrial mapping protocol” clinicalstudy of the EnSite Array catheter in the fourth quarter of 2003.  The Company expects to make continuedsignificant investments in EnSite product development and clinical studiesthroughout the remainder of 2004.

 

**Generaland Administrative Expense**.  General and administrative expenses wereapproximately $1.2 million and $774,000 for the three month periods ended June30, 2004 and 2003, respectively.  Thisincrease in the Company’s general and administrative expenses over the sameperiod in 2003 was due to certain non-recurring fees and professional serviceexpenses necessary to comply with the requirements of the Sarbanes-Oxley Act of2002, increased insurance expenses and recruiting fees, and certain legalexpenses relating to patent applications.

 

**Salesand Marketing Expense**. Sales and marketing expenses were approximately $5.5 million and $5.0million for the three month periods ended June 30, 2004 and 2003, respectively,an increase of approximately $0.5 million, or 11%.  This increase was primarily attributable toan increase in the number of U.S. and European field clinical support personneland associated travel expenses during the second quarter of 2004 as compared tothe same period in 2003, together with increased commissions as a result of the27% increase in revenue compared to the second quarter of 2003.  The Company expects that sales and marketingexpenses, as a percentage of revenue, will continue to decline in 2004 comparedto 2003.

 

**OtherExpense**.  Otherexpense consists of interest expense, offset by interest income on cash andcash equivalent balances, state income tax accruals and foreign exchange gainsand losses on transfers of inventory to the Company’s European subsidiary.  The $19,000 increase for the three monthsended June 30, 2004 compared to the same period in 2003 primarily consists ofincreased state income tax accruals and foreign exchange losses.

 

**IncomeTax Expense**. The Company recorded current tax expense of $350,000 during the secondquarter of 2004.  This tax expense wasoffset by the reversal of $350,000 from the previously established valuationallowance against the Company’s deferred tax assets related to its cumulativenet operating loss carryforwards.  As aresult, the Company recorded no income tax expense for the second quarter of2004.  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 June 30, 2004 are offset by a full valuation allowance in accordance withSFAS No. 109, *Accounting for Income Taxes.*

 

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**Six MonthsEnded June 30, 2004 Compared to Six Months Ended June 30, 2003**

 

Worldwiderevenue for the six months ended June 30, 2004 was approximately $22.4 million,an increase of $5.8 million or 35% over the same period in 2003.  The Company’s gross profit margin for the sixmonths ended June 30, 2004 was 70.3%, compared with 64.7% during the sameperiod in 2003.

 

*EnSiteSystems*

 

Worldwiderevenue from the sale of EnSite Systems during the six months ended June 30,2004 was approximately $7.7 million, compared to approximately $5.7 million forthe same period in 2003, an increase of 35%. Domestic sales accounted for 51% of total EnSite System sales during theperiod, compared to 72% during the same period in 2003.  The Company sold a total of 54 EnSite Systemsduring the period, with 25 sold domestically and 29 sold internationally.  Of the 29 EnSite Systems soldinternationally, 10 were sold under an exclusive distribution arrangement inJapan with Nihon Kohden, one of Japan’s leading manufacturers, developers anddistributors of medical electronic products and 8 were sold pursuant to the newsales representative relationship established for the Spain and Italy markets *(see further discussion under Overview above)*.  The gross profit margin on EnSite Systemsales for the six months ended June 30, 2004 was 69.2% compared to 62.4% forthe same period in 2003, an increase of 10.9%. This improvement in gross margins was primarily driven by the Company’sconversion from a Silicon Graphics computing platform to a significantly morepowerful, but lower cost, Intel® Xeon computing platform for itEnSite System in the fourth quarter of 2003. However, the 10 EnSite systems sold to Nihon Kohden discussed abovecontained the more expensive Silicon Graphics platform, which reduced overallEnSite System gross profit margins for this six-month period.

 

*EnSiteDisposable Products*

 

Worldwiderevenue from the sale of EnSite disposable products during the six months endedJune 30, 2004 was approximately $11.5 million, compared to $8.6 million duringthe same period in 2003, an increase of 34%. Domestic revenue from the sale of EnSite disposable products accountedfor 73% of total EnSite disposable product revenue during the six months endedJune 30, 2004, compared to 80% during the same period in 2003.  Revenues increased during the six monthsended June 30, 2004 compared to the same period in 2003 due to the largernumber of installed EnSite Systems and increased EnSite disposable productutilization rates.  The gross profitmargin on EnSite disposable product sales for the six months ended June 30,2004 was 83.1%, as compared to 74.9% for the same period in 2003.

 

*OtherRevenue*

 

Other revenue,which includes (i) the recognition of deferred revenue generated from the saleof extended 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 under theCompany’s warranty or extended warranty plans, and (iv) the sale of accessoriesrelated to the EnSite Systems, was approximately $3.2 million during the sixmonths ended June 30, 2004, an increase of approximately $0.9 million, or 39%,compared to the same period in 2003. $0.6 million of the increase in other revenue is the result of moreEnSite NavX hardware and software upgrades being completed during the sixmonths ended June 30, 2004 compared to the same period in 2003 (193 versus 115upgrades) due to the fact that the EnSite NavX upgrade process did not beginuntil the second quarter of 2003.  Theportion of deferred revenue related to these EnSite System upgrades wasrecognized at the time the upgrade was installed.  Other revenue also increased by $0.3 millionfrom the recognition of deferred revenue generated by extended warranty andservice agreements.  Revenue related toextended warranty and service agreements is recognized ratably over thewarranty and service period (typically one year).  Gross profit margins on other revenue were27.2% for the three months ended June 30, 2004 compared to 27.5% for the sameperiod in 2003.

 

**Researchand Development Expense**.  Research and development expenses includecompensation and benefit costs for personnel in the clinical, software,hardware, catheter, and applied research groups, as well as costs associatedwith regulatory and clinical study expenses. Research and development expenses were approximately $2.2 million forthe six months ended June 30, 2004, compared to $3.0 million during the sameperiod in 2003, a decrease of $0.8 million, or 27%.  This decrease in research and developmentexpense was primarily due to the Company’s decision to discontinue its “leftatrial mapping protocol” study of the EnSite Array catheter in the fourthquarter of 2003.  The Company expects tomake continued significant investments in EnSite product development andclinical studies throughout the remainder of 2004.

 

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**Generaland Administrative Expense**. General andadministrative expenses were approximately $2.2 million and $1.5 million forthe six month periods ended June 30, 2004 and 2003, respectively.  This increase in the Company’s general andadministrative expenses over the same period in 2003 was due to certainnon-recurring fees and professional service expenses necessary to comply withthe requirements of the Sarbanes-Oxley Act of 2002, increased insuranceexpenses and recruiting fees, and certain legal expenses relating to patentapplications.

 

**Salesand Marketing Expense**. Sales and marketing expenses were approximately $10.6 million and $9.7million for the six month periods ended June 30, 2004 and 2003, respectively,an increase of approximately $0.9 million, or 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 first six months of 2004 as comparedto the same period in 2003, together with increased commissions as a result ofa 35% increase in revenue compared to the same period in 2003.  The Company expects that sales and marketingexpenses, as a percentage of revenue, will continue to decline in 2004 comparedto 2003.

 

**OtherExpense**.  Otherexpense consists of interest expense, offset by interest income on cash andcash equivalent balances, state income tax accruals and foreign exchange gainsand losses on transfers of inventory to the Company’s European subsidiary.  The $47,000 increase for the six months endedJune 30, 2004 compared to the same period in 2003 primarily consists ofincreased state income tax accruals and foreign exchange losses.

 

**IncomeTax Expense**. The Company recorded current tax expense of $350,000 during the sixmonth period ended June 30, 2004.  Thistax expense was offset by the reversal of $350,000 from the previouslyestablished valuation allowance against the Company’s deferred tax assetsrelated to its cumulative net operating loss carryforwards.  As a result, the Company recorded no incometax expense for the six month period ended June 30, 2004.  The Company’s ability to realize the benefitsof these deferred tax assets depends on the Company being able to generatetaxable 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 June 30, 2004 are offset by a full valuation allowance in accordance withSFAS No. 109, *Accounting for Income Taxes.*

 

**Liquidityand Capital Resources**.

 

The Company’soperations since inception have been partially funded by net proceeds from thesale of common and preferred stock totaling approximately $104.3 million.  As of June 30, 2004 and December 31, 2003,the Company had cash and cash equivalents of approximately $8.8 million and$10.2 million, respectively.

 

For the sixmonths ended June 30, 2004, the Company used cash of approximately $1.0 millionin its operations, compared to approximately $5.2 million for the same periodin 2003.

 

The Company’saccounts receivable balance was approximately $12.0 million as of June 30,2004, an increase of approximately $1.7 million from December 31, 2003. The increasein accounts receivable was primarily attributable to the increase in revenuesduring the six months ended June 30, 2004 compared to previous periods.

 

The Company’sinventory balance at June 30, 2004 was approximately $3.9 million, a 3%decrease compared to December 31, 2003. The Company believes its inventory of EnSite clinical workstationcomponents will decrease over the course of 2004 as the number of EnSiteSystems remaining to be upgraded with EnSite NavX continues to decline.  Inventories of EnSite Array catheters andEnSite NavX surface electrode kits are expected to remain relatively constantthroughout 2004.

 

The Company’saccounts payable (including accrued expenses) balance at June 30, 2004 wasapproximately $4.8 million, a decrease of approximately $0.9 million fromDecember 31, 2003.  This decreasereflects the timely payment of certain liabilities in the first half of 2004,including the Company’s accrued 2003 year-end incentive bonuses in the firstquarter.  The Company expects accountspayable and accrued expenses to remain relatively constant throughout theremainder of 2004.

 

The Companyhad no short-term investment portfolio as of June 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 September2003, the Company entered into a $4.5 million credit facility agreement withSilicon Valley Bank (“SVB”). This credit facility replaced a prior creditfacility with SVB that the Company entered into in June 2001, and modified inMay 2002 to extend the term of the initial agreement.  The September 2003 credit facility with SVBconsists of a $3.0 million domestic line of credit, and a $1.5 million international(EXIM) credit line.  This facilityoperates as a revolving line of credit, with $1.3 million reserved for use as acapital lease line.  The terms of thiscredit facility include certain restrictive financial covenants, including theCompany’s obligation to maintain a specified ratio of “current assets” to“current liabilities” (“quick ratio”), as well as a minimum “tangible networth.”  As of March 31, 2004, and June30, 2004 the Company was in compliance with the financial covenants of thecredit 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 metits monthly

 

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financial reportingrequirements during the second quarter of 2004. As of June 30, 2004, the Company had $0.2 million outstanding related tocapital leases and had an additional $1.0 million outstanding on the creditline.

 

The Companybelieves its existing cash, cash equivalents and bank financing will besufficient to fund the operations of the Company, and the Company does notcurrently anticipate raising additional financing to fund capital expendituresor operations 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)the costs, timing and method of expansion of sales, marketing, research anddevelopment and manufacturing activities; and (vi) the Company’s ability toobtain additional bank financing, if necessary.

 

**Critical Accounting Policies**

 

The Company’sconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the U.S., which require the Company to makeestimates and assumptions in certain circumstances that affect amounts reportedin the accompanying consolidated financial statements and relatedfootnotes.  In preparing theseconsolidated financial statements, the Company’s management has made its bestestimates and judgments of certain amounts included in the consolidated financialstatements, giving due consideration to materiality.  The Company does not believe there is a greatlikelihood that materially different amounts would be reported related to theaccounting policies described below. However, application of these accounting policies involves the exerciseof judgment and use of assumptions as to future uncertainties and, as a result,actual results could differ from these estimates.

 

*Revenue Recognition. *Revenuefrom the sale of the Company’s EnSite Systems, EnSite Array catheters, andEnSite NavX surface electrode kits is recognized at the time of shipment ininstances where the Company has evidence of a contract or binding commitment,the purchase 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.

 

*Allowance for Doubtful Accounts. *TheCompany’s accounts receivable are reduced by an allowance for amountsthat may become uncollectible in the future. The estimated allowance is based on management’s review of accountsreceivable balances and historical write-offs. During the three months ended June 30, 2004, the Company did notwrite-off any material amount of outstanding accounts receivable balances.

 

*Inventories and 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 June 30, 2004, the Company believes itsallowance for excess and obsolete inventories was adequate.

 

*New Accounting Standards*.  In May 2003, the FASB issued SFAS No. 150, *Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity*. This statement establishes standards for the classification andmeasurement of certain financial instruments with characteristics of bothliabilities and equity.  This statementrequires that an issuer classify a financial instrument that is within itsscope as a liability (or an asset in some circumstances).  Many of those instruments were previouslyclassified as equity.  This statement iseffective for financial instruments entered into or modified after May 31, 2003and otherwise is effective at the beginning of the first interim periodbeginning after June 14, 2003.  TheCompany does not currently have financial instruments with characteristics ofboth liabilities and equity, and therefore, the adoption of SFAS No. 150 didnot have an impact on its financial condition, results of operations or cashflows.

 

**Item 3. Quantitativ****e and Qualitative Disclosures about Market Risk**

 

The Companyhad approximately $8.8 million of cash and cash equivalents on June 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 theseinvestments is interest rate risk.  TheCompany does not use derivative financial instruments to manage interest raterisk or to speculate on future changes in interest rates.  A rise in interest rates could negativelyaffect the fair value of the Company’s investments; however, because managementconsiders it unlikely that the Company would need or choose to substantiallyliquidate the Company’s investments prior to their maturity, managementbelieves that such an increase in interest rates would not have a materialimpact on the Company’s future earnings or cash flows.  Even though the Company conducts sales inforeign currencies through its European subsidiary, management does not believethe Company is exposed to any material foreign currency exchange rate risk.

 

**Item4. Cont****rols andProcedures**

 

*(a) Evaluation of disclosure controls and procedures. *Under thesupervision and with the participation of our management, including theCompany’s Chief Executive Officer and Chief Financial Officer, we evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of1934 (the “Exchange Act”)).  Based uponthat evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that, as of the end of the period covered by this report, theCompany’s disclosure controls and procedures were effective in timely alertingthem to the material information relating to the Company (or our consolidatedsubsidiaries) required to be included in the reports we file or submit underthe Exchange Act.

 

(b) *Changes in internal controls over financial reporting*.  During the quarter ended June 30, 2004, therewas no change in the Company’s internal control over financial reporting (asdefined in Rule 13a-15(f) under the Exchange Act) that has materially affected,or is reasonably likely to materially affect, the Company’s internal controlover financial reporting.

 

**Cautionary Statement**

 

Except for thehistorical information contained herein, this Quarterly Report on Form 10-Qcontains forward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the Securities ExchangeAct of 1934, as amended.  Theseforward-looking statements represent the Company’s expectations, beliefs,intentions or strategies concerning future events, including, but not limitedto, any statements 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.  Whenused in this Form 10-Q and in future filings by the Company with the Securitiesand Exchange Commission, in the Company’s press releases and in oral statementsmade with the approval of an authorized executive officer of the Company, theword or phrases “believes,” “anticipates,” “expects,” “intends,” “will likelyresult,” “estimates,” “projects” or similar expressions are intended toidentify such forward-looking statements, but are not the exclusive means ofidentifying such statements. However, any statements contained in this Form10-Q that are not statements of historical fact may be deemed to beforward-looking statements.

 

The Companycautions that these statements, by their nature, involve risks anduncertainties, certain of which are beyond its control, and actual results maydiffer materially depending on a variety of important factors, including, butnot limited to such factors as market demand, pressures on product pricing,changing market conditions, and competition and growth rates within the medicaldevice industry; changes in accounting policies; risks associated withoperations outside of the U.S.; changing economic conditions such as generaleconomic slowdown, decreased consumer confidence and the impact of war on theeconomy; and other risks and uncertainties, including those described inExhibit 99.1 to our Form 10-K for the year ended December 31, 2003.

 

**PART II. OTH****ER INFORMATION**

 

**Item4. Subm****ission ofMatters to a Vote of Security Holders**

 

The AnnualMeeting of the Company’s stockholders was held on May 18, 2004.  At the meeting, stockholders voted on theelection of two directors for terms expiring at the Annual Meeting of theCompany in 2007.  The votes cast for eachof the directors was as follows:  GraydonE. Beatty received 14,283,789 votes “For” and 384,141 votes were “Withheld”;James W. Bullock received 14,283,789 votes “For” and 384,141 votes were “Withheld”.

 

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**Item 6. Exhib****its and Reports on Form 8-K**

 

**(a) Exhibits**

 

 
| **Exhibits** | ** ** | **Description**                                                                                          |
|--------------|------------|----------------------------------------------------------------------------------------------------------|
| ** **   | ** ** | ** **                                                                                               |
| 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. |
|         |       |                                                                                                     |

 

 

(b)      Reports on Form 8-K

 

A Form 8-K was filed by the Company on April22, 2004; such report contained information disclosed under Item 12 andincluded as an exhibit under Item 7 a copy of a press release issued by theCompany announcing its first quarter ended March 31, 2004 earnings results.

 

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**SIGNATURES**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
| Dated: August 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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