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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (Mark One) x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004 OR o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM  TO . COMMISSION FILE NUMBER: 000-27212 ENDOCARE, INC.  DELAWARE
    
    33-0618093(State of Incorporation)
    
    (I.R.S. Employer I.D. No.)
 201 TECHNOLOGY DRIVE, IRVINE, CALIFORNIA 92618
(Address of Principal Executive Office, Including Zip Code)
(949) 450-5400
(Registrants Telephone Number, Including Area Code) Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
(1) Yes o No x; (2) Yes x No o. The number of shares of the Registrants common stock, par value $.001 per
share, outstanding at March 31, 2004 was 23,992,382.




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Endocare, Inc.
Form 10-Q, Quarter Ended March 31, 2004 TABLE OF CONTENTS PagePART I - FINANCIAL INFORMATION
    
    
    3ITEM
1. Condensed Consolidated Financial Statements
    
    
    3Condensed Consolidated Statements of Operations (Unaudited)
    
    
    3Condensed Consolidated Balance Sheets
    
    
    4Condensed Consolidated Statements of Cash Flows
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    31ITEM 4. Controls and Procedures
    
    
    32PART II - OTHER INFORMATION
    
    
    33ITEM 1. Legal Proceedings
    
    
    33ITEM 2. Changes in Securities
    
    
    34ITEM 3. Defaults Upon Senior Securities
    
    
    34ITEM 4. Submission of Matters to a Vote of Security Holders
    
    
    34ITEM 5. Other Information
    
    
    34ITEM
6. Exhibits and Reports on Form 8-K.
    
    
    35SIGNATURE PAGE
    
    
    37EXHIBITSEXHIBIT 2.10EXHIBIT 2.11EXHIBIT 2.12EXHIBIT 10.1EXHIBIT 10.2EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I -  FINANCIAL INFORMATION 
 ITEM 1.    Condensed Consolidated Financial Statements ENDOCARE, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS  (Unaudited)
 Three Months Ended March 31,2004
    
    2003Total revenues
    
    $
    7,381,624
    
    
    $
    7,661,784Costs and expenses:Cost of revenues
    
    
    4,234,082
    
    
    
    3,996,046Research and development
    
    
    536,381
    
    
    
    332,813Selling, general and administrative
    
    
    11,179,490
    
    
    
    9,547,856Total costs and expenses
    
    
    15,949,953
    
    
    
    13,876,715Loss from operations
    
    
    (8,568,329
    )
    
    
    (6,214,931
    )Interest income
    
    
    44,917
    
    
    
    221,229Interest expense
    
    
    (27
    )
    
    
    (4,777
    )Loss before minority interests
    
    
    (8,523,439
    )
    
    
    (5,998,479
    )Minority interests
    
    
    (100,036
    )
    
    
    (89,419
    )Net loss
    
    $
    (8,623,475
    )
    
    $
    (6,087,898
    )Net loss per share of common stockbasic and diluted
    
    $
    (0.36
    )
    
    $
    (0.25
    )Weighted average shares of common stock outstanding
    
    
    24,087,818
    
    
    
    24,151,962
 The accompanying notes are an integral part of these consolidated financial
statements. 3




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ENDOCARE, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 March 31,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    15,111,865
    
    
    $
    23,976,539Accounts receivable, net
    
    
    3,485,492
    
    
    
    3,822,570Inventories
    
    
    3,831,347
    
    
    
    2,609,046Prepaid expenses and other current assets
    
    
    2,375,329
    
    
    
    4,432,578Total current assets
    
    
    24,804,033
    
    
    
    34,840,733Property and equipment, net
    
    
    5,039,820
    
    
    
    5,638,579Goodwill
    
    
    17,538,224
    
    
    
    17,538,224Intangibles, net
    
    
    11,444,759
    
    
    
    11,745,778Investments and other assets
    
    
    1,960,275
    
    
    
    2,233,601Total assets
    
    $
    60,787,111
    
    
    $
    71,996,915LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    3,181,086
    
    
    $
    3,035,242Accrued compensation
    
    
    3,260,534
    
    
    
    3,858,527Other accrued liabilities
    
    
    7,398,218
    
    
    
    8,942,830Total current liabilities
    
    
    13,839,838
    
    
    
    15,836,599Minority interests
    
    
    744,208
    
    
    
    839,029Total liabilities
    
    
    14,584,046
    
    
    
    16,675,628Stockholders equityPreferred stock, $.001 par value; 1,000,000 shares authorized; none issued
and outstanding at March 31, 2004 and December 31, 2003
    
    
    
    
    
    
    Common stock, $.001 par value; 50,000,000 shares authorized; 23,992,382 and
24,183,254 issued and outstanding at March 31, 2004 and December 31, 2003,
respectively
    
    
    23,992
    
    
    
    24,390Additional paid-in capital
    
    
    169,185,816
    
    
    
    171,875,434Accumulated deficit
    
    
    (123,002,360
    )
    
    
    (114,378,885
    )Deferred compensation
    
    
    (4,383
    )
    
    
    (107,271
    )Treasury stock at cost 206,200 shares at December 31, 2003
    
    
    
    
    
    
    (2,092,381
    )Total stockholders equity
    
    
    46,203,065
    
    
    
    55,321,287Total liabilities and stockholders equity
    
    $
    60,787,111
    
    
    $
    71,996,915
 The accompanying notes are an integral part of these consolidated financial
statements. 4




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ENDOCARE, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (Unaudited)
 Three Months Ended March 31,2004
    
    2003Net cash
used in operating activities
    
    $
    (10,645,131
    )
    
    $
    (4,142,814
    )Cash flows from investing activities:Sales of property and equipment
    
    
    210,000
    
    
    
    Purchases of property and equipment
    
    
    (160,284
    )
    
    
    (240,874
    )Proceeds from divestitures
    
    
    2,500,000
    
    
    
    Intangibles
    
    
    
    
    
    
    (61,000
    )Sale (purchase) of available for sale securities
    
    
    
    
    
    
    8,025,126Other assets
    
    
    (70,673
    )
    
    
    (635,854
    )Net cash (used in) provided by investing activities
    
    
    2,479,043
    
    
    
    7,087,398Cash flows from financing activities:Partnership distributions to minority interests
    
    
    (194,857
    )
    
    
    (96,073
    )Treasury
stock received in settlement
    
    
    (503,729
    )
    
    
    Net cash provided by financing activities
    
    
    (698,586
    )
    
    
    (96,073
    )Net increase (decrease) in cash and cash equivalents
    
    
    (8,864,674
    )
    
    
    2,848,511Cash and cash equivalents, beginning of period
    
    
    23,976,539
    
    
    
    18,177,825Cash and cash equivalents, end of period
    
    $
    15,111,865
    
    
    $
    21,026,336Non-cash activities:Transfer of inventory to property and equipment
    
    $
    113,453
    
    
    $
    417,745Retirement
of treasury shares held
    
    
    2,593,473
    
    
    
    Deferred
compensation on options forfeited
    
    
    93,905
    
    
    
    Unrealized loss on available for sale securities
    
    
    
    
    
    
    38,094Total non-cash activities
    
    $
    2,800,831
    
    
    $
    455,839Interest paid
    
    $
    27
    
    
    $
    4,777Income taxes paid
    
    
    1,600
    
    
    
    1,600
 The accompanying notes are an integral part of these consolidated financial
statements. 5




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ENDOCARE, INC. 
 Notes to Condensed Consolidated Financial Statements
 1. Organization and Operations of the Company Endocare, Inc. (Endocare or the Company) is a medical device company
focused on developing, manufacturing and selling cryosurgical products with the
potential to improve the treatment of cancer and other tumors. In addition,
the Company offers vacuum therapy systems for non-pharmaceutical treatment of
erectile dysfunction. The Company was formed in 1990 as a research and
development division of Medstone International, Inc., a manufacturer of
shockwave lythotripsy equipment for the treatment of kidney stones. Following
its incorporation under the laws of the state of Delaware in 1994, the Company
became an independent, publicly-owned corporation upon Medstones distribution
of the Companys stock to the existing stockholders on January 1, 1996. Following
the rules and regulations of the Securities and Exchange
Commission (the SEC), the Company has omitted footnote disclosures in the
report that would substantially duplicate the disclosures contained
in the Companys annual audited
financial statements. The accompanying unaudited condensed consolidated
financial statements should be read together with the consolidated financial
statements and the notes thereto included in the Companys December 31, 2003 Annual
Report on Form 10-K, filed with the SEC on March 15, 2004. The accompanying unaudited condensed consolidated financial statements
reflect all adjustments, consisting solely of normal recurring accruals, needed
to present fairly the financial results for these interim periods. The
condensed consolidated results of operations presented for the interim periods are not
necessarily indicative of the results for a full year. All intercompany transactions and accounts have been eliminated in
consolidation. 2. Recent Operating Results and Liquidity The Companys operating results for the first quarter of 2004 reflect the
impact of divestitures in 2003 of certain non-core lines of business. While
these divestitures have allowed the Company to better concentrate on its core
businesses, they have also eliminated some sources of revenue and gross profit
for the Company. In addition, while the Company lowered certain operating
costs in 2003 by consolidating functions that were formerly performed
by its subsidiaries into the Irvine California
headquarters, the Company has
also incurred significant one-time charges associated with ongoing
investigations related to its historical accounting and financial reporting.
These costs were approximately $14.3 million during the fiscal
year 2003 (including executive severance charges of $3.6 million) and
$1.0 million and $3.3 million in the first quarters of 2003 and 2004,
respectively. The costs in the three months ended March 31, 2003
and 2004 are primarily legal, audit and accounting support fees. Since inception, the Company has incurred losses from operations and has
reported negative cash flows. As of March 31, 2004, the Company had an
accumulated deficit of $123.0 million and cash and cash equivalents of $15.1
million. The Company has no long-term debt and no other material financial
commitments other than those under operating lease agreements and purchase
commitments for raw materials used in manufacturing its products. Management
anticipates further growth in procedure revenues during 2004. However the
Company also expects to record another loss in 2004. The Company will continue
to invest in sales and marketing activities to increase market penetration and
in research and development to improve its existing products and develop new
ones. The Company also faces potentially large costs related to directors and
officers liability insurance, delinquent state and local tax obligations, as
well as additional expenditures needed to bring the Company into compliance
with SEC rules and regulations, including with Section 404 of the
Sarbanes-Oxley Act of 2002 and efforts to regain listing on a national exchange
or market. In addition to the cash needed to fund the Companys ongoing operations,
there have been and will continue to be substantial demands on cash related to
ongoing investigations of the Companys historical accounting and financial
reporting. There may also be material cash payments required in connection
with resolving a class action and a derivative law suit (see Note 7.) The
Company may be required to pay judgments or settlements and to incur expenses
in defending against these claims that could exceed the Companys directors
and officers liability insurance coverage. Regulators may fine the Company
when the investigations are complete. 6




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The Company will continue to use cash reserves, which it believes to be
adequate, to finance its projected 2004 cash flow deficit. If the Company is
unable to generate cash flow from operations, it may need to raise additional
capital to fund operations through the sale of equity securities to public or
private investors, debt or the sale or licensing of its assets. Additional
capital, if needed, might not be available on terms acceptable to the Company,
or at all. If additional capital were raised through the issuance of equity
securities, the percentage of the Companys stock owned by its then-current
stockholders would be reduced. 3. Stock-Based Compensation At March 31, 2003, Endocare had four stock-based compensation plans. The
Company accounts for the plans under the recognition and measurement principles
(the intrinsic-value method) prescribed in Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees,and related
interpretations. Compensation cost for stock options granted to employees is
reflected in net income (loss) and is measured as the excess of the market
price of the Companys stock at the date of grant over the amount an employee
must pay to acquire the stock, or the exercise price. Compensation costs for
fixed awards that are subject to vesting is recognized pro-rata over the
vesting period. In practice, the Company has only awarded stock options to its
employees with exercise prices equal to the fair market value of the stock at
the date of grant. The Company has adopted the disclosure provisions required by Statement of
Financial Accounting Standard (SFAS) No. 148, Accounting for Stock-Based
Compensation  Translation and Disclosure.The following table illustrates the
effect on net loss and loss per share if the Company had applied the fair value
recognition provisions to stock-based employee compensation. Three Months Ended March 31,2004
    
    2003Net loss, as reported (a)
    
    $
    (8,623,475
    )
    
    $
    (6,087,898
    )Reconciling items (net of related tax effects):Add: Stock-based employee compensation expense
determined under the intrinsic-value-based
method for all awards (b)
    
    
    8,720
    
    
    
    8,956Less: Stock-based compensation expense
determined under the fair-value-based method
for all awards expense
    
    
    (820,312
    )
    
    
    (1,309,706
    )Net adjustment
    
    
    (811,592
    )
    
    
    (1,300,750
    )Net loss, as adjusted
    
    $
    (9,435,067
    )
    
    $
    (7,388,648
    )Basic and diluted loss per share:As reported
    
    $
    (0.36
    )
    
    $
    (0.25
    )As adjusted
    
    $
    (0.39
    )
    
    $
    (0.31
    )
  (a)
    
    The Company issues stock options and warrants to consultants for services
performed. Compensation expense for the fair value of these options is
determined by the Black-Scholes option-pricing model and is charged to
operations over the service period or as the performance goals are
achieved. Such expense is included in net loss as reported. 7




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(b)
    
    Since the Company issues options with exercise prices equal to or
exceeding the fair values of the underlying common stock, no compensation
expense is recorded for options issued to employees, except for
compensation expense equal to the intrinsic value of unvested options
assumed in the Companys acquisition of Timm Medical Technologies, Inc.
(Timm Medical) and amortized over the remaining vesting period. 4. Goodwill and Intangible Assets The excess of the purchase price over the fair value of net assets
acquired has been allocated to goodwill and identifiable intangible assets.
The Company had no reported goodwill prior to January 1, 2002. The Company
does not amortize goodwill, which is consistent with the provisions of SFAS No.
142, Goodwill and other Intangible Assets,but goodwill is subject to impairment tests
on an annual basis or more frequently if impairment indicators exist. Under
the guidance of SFAS no. 142, the Company uses a discounted cash flow
methodology to assess the fair values of its reporting units. Impairment is
measured by comparing the goodwill derived from the hypothetical purchase price
allocation to the carrying value of the goodwill balance. No goodwill
impairment indicators existed for the three months ended March 31, 2004 and, as
a result, interim impairment testing was not required. Intangible assets that are deemed to have finite useful lives are recorded
at cost and amortized using the straight-line method over their estimated
useful lives of the assets.  Estimated useful lives of such intangible assets are as
follows: Trade name
    
    15 yearsDomain name
    
    5 yearsCovenant not to compete
    
    3 to 5 yearsDeveloped technology
    
    15 yearsPatents
    
    3 to 15 years Changes in circumstances (for example, changes in
laws or regulations to which we are subject, technological
advances or changes in the Companys strategies) may result
in changes to the useful lives from initial estimates. Factors
such as changes in the planned use of intangibles may result
from changes in customer base, contractual agreements, or
regulatory requirements and may result in shorter useful lives.
In such circumstances, the Company will revise the useful life
of the long-lived asset and amortize the remaining net book
value over the adjusted remaining useful life. There were no
changes in estimated useful lives during 2001, 2002 and 2003. 5. Amendment to Purchase
Agreement of the Mobile Prostate Treatment Business On
September 30, 2002, the Company completed the acquisition of
certain general and limited equity interests in the mobile prostate
and BPH treatment businesses (Mobile Businesses) from a
group of affiliated companies collectively known as USMD. Under the
original agreement, the Company agreed to forgive $7.7 million
in loans and an earnest deposit if the Mobile Businesses achieve
$12 million in gross revenues during the period October 1,
2002 to December 31, 2005 (the Forgiveness Period).
The purchase agreement was amended February 2004 to extend the
Forgiveness Period to December 31, 2008. In addition, effective
January 1, 2004, the Company reduced the service fee it pays to
one of the partnerships for the use of their Cryocare Surgical
Systems from $2,500 to $2,000 per procedure, representing an
adjustment to market rate. As a result, the reduction in service fee
does not require a reallocation of goodwill. 8




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6. Dispositions and Restructuring Activities In 2003, the Company embarked on a strategy to refocus its core
technological competence and primary market emphasis on the development of
minimally invasive technologies for tissue and cancer ablation. Part of this
strategy entailed divestiture of certain product lines unrelated to the
Companys core businesses. The Company also undertook a review of its
strategic plans and operational infrastructure in order to maximize efficiency
and promote optimal use of resources. In addition to the divestiture of a
Florida billing and contracting subsidiary in December 2002, which reduced
headcount by 12 employees, the Company downsized its Eden Prairie, Minnesota,
operations in June 2003, consolidating many administrative functions at its
Irvine, California, headquarters and reducing headcount by 26 employees. The
Companys Board of Directors also approved the divestiture of certain non-core
product lines and assets in the first quarter of 2003, including the sale of
the Dura II penile implants, the cardiac-related product manufacturing
operations and license of related technology, and the urinary incontinence and
urodynamics product lines. Dura II Penile Implants On April 7, 2003, Timm Medical sold certain assets related to the Dura II
positionable urological prostheses product line to American Medical Systems,
Inc. for approximately $2.15 million in cash. Assets sold include developed
technology, intellectual property, customer lists, production equipment and
Dura II inventory. The sale resulted in a loss of $35,000 in the second
quarter of 2003. Cryosurgical Products for Cardiac Applications On April 14, 2003, the Company sold its cardiac-related product
manufacturing operations and licensed the related intellectual property to
CryoCath for $10 million and a nine-year descending royalty based on net sales
of products incorporating the licensed technology. Upon the consummation of
the sale, the Company terminated its pre-existing distribution agreement with
CryoCath. CryoCath was the exclusive distributor for cryoprobes and consoles
in connection with the SurgiFrost system, a cryoablation system designed to
treat cardiac arrhythmias. The sale resulted in a 2003 second quarter gain of
$10 million. The $10 million was collected in four
installments, three in 2003 and one in the first quarter of 2004. The royalty
stream decreases from 10% to 3% of net sales from the
SurgiFrost system during
the period 2004 to 2012. The first royalty payment of $131,000 was collected
and recorded in the first quarter of 2004, based on CryoCath revenues for the first
three months of the current year. Minnesota Facility Subsequent to the acquisition of Timm Medical, the Company undertook a
review of the Companys operational and financial infrastructure. To maximize
operational efficiency and resource utilization, the Board of Directors
approved a plan in the first quarter of 2003 to close Timm Medicals former
manufacturing facility in Minnesota after the sale of the Dura II and urinary
incontinence product lines. With the exception of certain marketing and
financial functions, all operations were transferred to the Companys Irvine,
California, headquarters in June 2003 or were outsourced. The cost of the
restructuring totaled $386,000, which included $266,000 in severance payments
and $120,000 in lease losses for vacating the unused leased space. These
losses were recorded in the second quarter of 2003 upon the communication of
the separation terms to the affected employees. Urinary
Incontinence and Urodynamics On
October 15, 2003, Timm Medical agreed to sell the manufacturing assets
related to its urodynamics and urinary incontinence product lines to
SRS Medical Corp. (SRS) for a $2,694,000 note. The note bears interest at 7.5%
and is secured by the assets sold. Under the terms of the original agreement,
quarterly payments were to begin on March 31, 2004, equal to the higher of (a)
minimum quarterly payments as defined or (b) 15% of the net revenues related to
the urinary incontinence assets acquired and 15% of the net revenues related to
SRS existing urodynamics business, including the urodynamics assets acquired.
These minimum quarterly payments were to commence at $112,500 for the quarter
ended March 31, 2004, and increase to $298,406 for the quarter
ended March 31, 2007. Amounts which remain outstanding at
March 31, 2007 were to be payable at $250,000 per quarter
thereafter until fully paid. The carrying values of the urodynamics
and urinary incontinence related assets were $1,314,000 on the date
of sale. Management concluded that collection of the note from SRS was
not reasonably assured. As a result, a loss of $1,314,000 was
recorded in the fourth quarter of 2003 equal to the carrying value of
the assets sold. Collections on the note, if any, will be reported as
gain in the period received. In March 2004, the Company agreed to
amend the purchase agreement to reduce the minimum quarterly payments
to $45,000, increasing to $60,000 for the quarter ended December 31, 2005.
Amounts which remain outstanding at December 31, 2005 will be payable at $60,000 per quarter
until the outstanding principal and accrued interest are paid in full. 9




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Mobile Prostate Treatment Businesses In late 2003 and early 2004, the Company initiated the dissolution of five
of the 13 partnerships acquired from U.S. Medical Development, Inc.,
and its affiliates, U.S.M.D., Ltd. and U.S.M.D. I L.L.C.
(collectively USMD), two of which were engaged in benign
prostatic hyperplasia (BPH)
treatment and three of which were engaged in cryosurgical procedures for
prostate cancer. The BPH partnerships discontinued operations beginning
in the first quarter of 2003 due to significant reduction in payor
reimbursements and the Companys desire to exit the non-core BPH business. The
Company elected to terminate the cryosurgical partnerships due to decisions by
certain of the limited partner physicians to withdraw from these partnerships.
After the dissolution, the Cryocare Surgical Systems held by these partnerships
will be redeployed to other markets as placement units. The assets held by the
BPH partnerships will be liquidated. 7. Commitments and Contingencies Former
Chief Executive Officer and Chairman of the Board The Company entered into a Separation Agreement and a one-year Consulting
Agreement with the Companys former Chief Executive Officer and Chairman of the
Board (the former CEO), each effective as of July 31, 2003. Under the
Separation Agreement, the former CEO was entitled to receive a
$375,000 severance payment and a $375,000 upfront payment for a one-year covenant not to compete
and an agreement to provide consulting services. The Company recorded a charge
of $775,500 in the third quarter of 2003 for the severance and related
benefits. The total severance payment was deposited into an escrow account
held by the Company and released to the former CEO 10




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in March 2004. Former Chief Financial Officer The Company entered into an employment agreement, dated March 3, 2003 (the
Employment Agreement), with the Companys former Chief Financial Officer
(former CFO). Under the Employment Agreement, upon any
Qualified Termination (as defined) the former CFO was entitled to
receive a cash payment of $616,000, continued participation in the Companys
benefit plans for 24 months, a $50,000 relocation allowance and an additional
payment to cover the tax liabilities relating to the allowance. In addition,
the Employment Agreement also provided that all of the former CFOs options to
purchase outstanding common stock (385,000 shares) would be cancelled and
replaced by immediately exercisable options to be granted between September 4,
2003 and November 3, 2003. Effective July 31, 2003, the Company terminated the
former CFOs employment other than for cause. The Company recorded a charge of
$731,000 in the third quarter of 2003 for the severance and related benefits
due under the Employment agreement. In addition, the Company recorded a third
quarter charge for $1,715,000 for the fair value of the 385,000 replacement
options issued to the former CFO on October 30, 2003 determined using the
Black-Scholes option-pricing model. The total severance payments due of
$616,000 were deposited into an escrow account held by the Company. In March
2004, all amounts due under the Separation Agreement to the former CFO were
released from the escrow account. 2002
Executive Separation Benefits Plan Effective
July 17, 2002, the Company adopted the 2002 Executive Separation
Benefits Plan (Separation Plan) to provide separation
benefits to certain designated employees upon or following a change
in control, as defined. In February 2004, the Board of Directors
voted to terminate the Separation Plan effective July 18, 2004. Legal Matters The Company is a party to lawsuits in the normal course of its business.
Litigation and governmental investigation can be expensive and disruptive to
normal business operations. Moreover, the results of complex legal proceedings
are difficult to predict. The Company can provide no assurance that
significant judgments or settlements in connection with the legal proceedings
described below will not have a material adverse effect on the Companys
business, financial condition, results of operations and cash flows.
See Part I, Item 2  Managements Discussion and Analysis of Financial Condition and
Results of Operations. Other than as described below, the Company is not a
party to any material legal proceedings. In November 2002, the Company was named as a defendant, together with
certain former officers, one of whom is also a former board member, in a
class-action lawsuit filed in the United States District Court for the Central
District of California. On February 2, 2003, the court issued an order
consolidating this action with various other similar complaints and ordering
plaintiffs to file a consolidated complaint, which was filed on October 31,
2003. The consolidated complaint asserts two claims for relief, alleging that
the defendants violated sections of the Securities Exchange Act of 1934 by
purportedly issuing false and misleading statements regarding the
Companys revenues and
expenses in press releases and SEC filings. Plaintiffs seek class
certification and unspecified damages from the Company, as well as forfeiture
and reimbursement of bonus compensation received by two of the individual
defendants. On April 26, 2004, the court issued an order denying the
Companys motion to
dismiss the consolidated complaint. The Company intends to defend the case
vigorously, but cannot assure you that it will be resolved in the Companys
favor. On
November 26, 2002, BioLife Solutions, Inc. (BioLife) filed an action against the Company in the
Delaware Court of Chancery seeking damages for alleged breaches of contract
stemming from the Companys acquisition, pursuant to an asset purchase
agreement dated May 28, 2002, of the tangible and intangible assets related to
BioLifes cryosurgical business. In the action, styled as BioLife Solutions,
Inc. v. Endocare, Inc., Del. Ch., C.A. No. 20057-NC, BioLife alleged that the
Company failed to timely register 120,022 shares of its common stock that were
provided to BioLife in connection with the asset purchase agreement, in
violation of a registration rights agreement relating to the shares that was
executed in conjunction with the asset purchase agreement. BioLife sought
damages of approximately $1.6 million. The Company defended the action on the
grounds that its obligation to register the shares was excused for various
reasons, including as a consequence of BioLifes failure to transfer assets in
accordance with the asset purchase agreement. Trial on all but one of the
claims in the action was held during the week of March 31, 2003. On October 1,
2003, the Delaware Court ruled in favor of BioLife, awarding BioLife
$1,648,000, plus pre-judgment interest and costs (including legal fees), and
requiring BioLife to surrender the 120,022 shares of the Companys common stock to the
Company. That ruling became an appealable final order and judgment on October
10, 2003. On February 20, 2004, the Company agreed with BioLife to settle all claims.
As part of the settlement the Company paid to BioLife $1,887,000, which
represented a discount of $150,000 from the total judgment amount (including
accrued interest and costs), 11




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BioLife returned to the Company the 120,022 shares
of the Companys common stock referred to above and the Company agreed to
abandon its appeal. On December 6, 2002, Frederick Venables filed a purported derivative
action against the Company and certain former officers and certain current and
former board members in the California Superior Court for the County of Orange
alleging breach of fiduciary duty, abuse of control, gross mismanagement, waste
of corporate assets and unjust enrichment. On April 23, 2004, the parties
filed a stipulation agreeing to a conditional stay of the action for 270 days.
Assuming that the court enters this stipulated order, the deadline to respond
to the complaint will be continued until after expiration of the stay. The
complaint seeks unspecified monetary damages, equitable relief and injunctive
relief based upon allegations that the defendants issued false and misleading
statements regarding the Companys revenues and expenses in press releases and
SEC filings. The Company intends to defend the case vigorously, but cannot
assure you that it will be resolved in the Companys favor. The SEC is currently conducting an investigation to determine whether any
federal securities laws were violated in connection with the filing of the
Companys financial statements for 2001 and the first two quarters of 2002,
including investigation into allegations that the Company and certain of the
Companys current and former officers and directors issued or caused to be
issued false and misleading statements regarding the Companys revenues and
expenses in those SEC filings. The Company is cooperating fully with this
investigation. The Company cannot assure you that this matter will be resolved
in its favor. The
Department of Justice (DOJ) is currently conducting an investigation into allegations that the
Company and certain of its current and former officers and directors
intentionally issued or caused to be issued false and misleading statements
regarding the Companys revenues and expenses in SEC filings. The Company is
cooperating fully with this investigation. The Company cannot assure you that
this matter will be resolved in its favor. 8. Related Party Transactions Loans to Officers In November 1999, the Company received a full recourse promissory note for
$1,028,125 in connection with the sale of 175,000 common shares at fair value
to the Companys then Senior Vice President, Sales and Marketing. The
four-year note bore interest at 5.99% per annum, payable annually, and was
recorded as a reduction in stockholders equity. The Company agreed to forgive
the principal on the note ratably over four years subject to performance of
certain objectives that were to be mutually agreed upon by the borrower and the
Company and subject to the borrower remaining an employee of the Company. The
Company forgave $64,000 in the first quarter of 2003, which was recorded as
compensation expense (included in selling, general and administrative expense).
At December 31, 2003, the full value of the note had been written off. In
August 2003, the Company terminated the individuals employment and is
currently negotiating with this individual regarding repayment of the loan.
Recoveries, if any, will be recorded as reductions to compensation
expense when received. In January 2003, the Company extended a $344,000 non-recourse loan to an
individual who is a shareholder and consultant. The Company previously entered
into an asset purchase agreement with the shareholder in
February 2002 to acquire certain patents and a covenant not to
compete for 100,000 shares of the Company's common stock valued at
$1,410,000. The Company extended the loan to the shareholder to assist with the payment of
related federal income taxes arising from the 2002 purchase transaction. The
loan is secured by the shares issued, bears interest at 1.8% and is due at the
earlier of January 2005 or 30 days after the borrower ceases to be a consultant
to the Company. 9. Capital Stock and Earnings Per Share During
the first quarter ended March 31, 2004, the Company retired
326,222 of its common shares held in treasury, including 120,022
shares purchased from BioLife for $503,729 in February 2004 in
conjunction with the settlement. Basic earnings (loss) per share are computed by dividing net income (loss)
by the weighted average number of common shares outstanding for the respective
periods. Diluted earnings (loss) per share, calculated using the treasury
stock method, gives effect to the potential dilution that could occur upon the
exercise of certain stock options that were outstanding during the respective
periods presented. Since the Company reported a net loss for the quarters
ending March 31, 2004 and 2003, these potentially dilutive common shares were
excluded from the diluted loss per share calculation because they were
anti-dilutive. 12




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Basic and diluted loss per share for the respective periods are set forth
in the table below: Three Months Ended March 31,2004
    
    2003Net loss
    
    $
    (8,623,475
    )
    
    $
    (6,087,898
    )Basic and
diluted loss per common share
    
    $
    (0.36
    )
    
    $
    (0.25
    )Basic weighted average shares
    
    
    24,087,818
    
    
    
    24,151,962Dilutive effect of outstanding stock options and warrants
    
    
    
    
    
    
    Dilutive weighted average shares
    
    
    24,087,818
    
    
    
    24,151,962
 10. Income Taxes The Company reported no income tax expense for each of the quarters ended
March 31, 2003 and 2004 due to its operating losses. The continuing operating
losses resulted in an increase in the valuation allowance of $2.4 million and
$3.4 million during the quarters ended March 31, 2003 and
2004, respectively.
Due to the Companys history of operating losses, management has not determined
that it is more likely than not that the Companys deferred tax assets will be
realized through future earnings. Accordingly, valuation allowances were
recorded to fully reserve the Companys deferred tax assets as of March 31,
2003 and 2004. 11. Subsequent Event Through
its acquisition of Timm Medical in February 2002, the Company obtained
offices, manufacturing and research facilities for its erectile dysfunction
products in a 28,066 square foot building in Eden Prairie, MN. This lease
expired on April 30, 2004. Due to the net downsizing of its Minnesota
operations and divestiture of several product lines acquired in the purchase of
Timm Medical, the Company decided not to renew its existing lease and
instead negotiated a lease for a smaller facility. In May 2004,
the Company agreed to enter into a new lease
on 8,919 square feet in the existing facility to house its Minnesota
operations. The monthly rental payment during the term of the lease will range
from $0.61 to $0.67 per square foot, excluding common area maintenance costs.
The aggregate rental obligation over the term of the lease will be
approximately $343,000. The lease for this office and warehouse facility
expires in 2009. 13




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ITEM 2. Managements Discussion and Analysis of Financial Condition and Results
of Operations The following discussion and analysis should be read in conjunction with
the unaudited condensed consolidated financial statements and notes thereto
included in Part IItem 1 of this report, and the audited consolidated
financial statements, and notes thereto, and Managements Discussion and
Analysis of Financial Condition and Results of Operations contained in the
Annual Report onForm 10-Kfor the fiscal year ended December 31, 2003. This discussion contains forward-looking statements based on our current
expectations. There are various factors  many beyond our control  that could
cause our actual results or the occurrence or timing of expected events to
differ materially from those anticipated in these forward-looking statements.
Some of these factors are described below and other factors are described
elsewhere in this Quarterly Report onForm 10-Q. In addition, there are
factors not described in this Quarterly Report onForm 10-Qthat could cause
our actual results or the occurrence or timing of expected events to differ
materially from those anticipated in these forward-looking statements. All
forward-looking statements included in this Quarterly Report onForm 10-Qare
based on information available to us as of the date hereof, and we assume no
obligation to update any such forward-looking statements. Overview We are a medical device company focused on developing, manufacturing and
selling cryosurgical products with the potential to improve the treatment of
cancer and other tumors and on manufacturing and marketing vacuum technology as
a non-pharmacological option for treatment of erectile dysfunction. Our cryosurgical product, the Cryocare Surgical System, employs a
computerized device and disposable probes to freeze cancerous tissue or other
tumors through our proprietary argon gas-based technology. We recently
introduced the next generation of our Cryocare Surgical System, the Cryocare
CS. Our erectile dysfunction products include the ErecAid Esteem and the
ErecAid Classic for treatment of impotence as well as the RigiScan for
diagnostic evaluation of this condition. Currently, our cryosurgical products are sold chiefly to hospitals for the
treatment of prostate cancer. In addition, we are exploring the application of
our cryosurgical technologies for ablation of other tumors, specifically in the
treatment of tumors of the kidney, lung, and liver and for pain management
related to metastatic bone cancer. We sell our vacuum therapy products for
treatment of erectile dysfunction primarily to individual patients on a
prescription basis. Our RigiScan products are sold to physicians. We have incurred significant operating losses and negative cash flows from
operations in each full fiscal year since January 1, 1996. We incurred a net
loss of approximately $8.6 million for the quarter ended March 31, 2004 and a
loss of $25.4 million for the year ended December 31, 2003. As of March 31,
2004, we had an accumulated deficit of $123.0 million. We expect to incur
additional losses as we continue our sales and marketing efforts,
improve our financial reporting processes and controls, improve our
products, and incur further costs related to the ongoing
investigations by the SEC and DOJ, as well as expenses related to the
shareholder litigation. Results of Operations Three Months Ended March 31, 2004 Compared to Three Months Ended March 31,
2003 Revenues. We generate revenues from sales of our Cryocare Surgical
Systems, disposable cryoprobes and other disposable devices used in
cryoablation procedures. We also contract with hospitals and other health care
payors for the use of our Cryocare Surgical Systems in cryoablation treatments
for which we charge a per-procedure fee. Beginning with the first quarter of 2003, we shifted our sales emphasis
for cryosurgical products in the urology market from equipment sales to
procedure growth. Through our placement program, we provide equipment to
hospitals with high-volume potential for cryosurgery procedures and charge them
a per-procedure fee for use of the equipment. 14




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The procedure fee typically includes a procedure kit containing
cryoprobes and other disposables needed to perform a cryosurgical procedure, in
addition to a service component. The service component of the procedure fee
generally consists of rental and transport of a Cryocare Surgical System as
well as the services of a technician to assist the physician with the set-up,
use and monitoring of the equipment. In certain instances, we will provide the
service component of the procedure to the hospital as well as the devices. At
other times, we will contract with third parties to perform the service
component of the procedures and will remit a service fee to the third party
upon invoicing the hospital. Approximately 47% of our prostate cancer cases
were serviced by third-party service providers in the first quarter of 2004.
We also sell just the disposable devices to hospitals, minus the service
component, where the hospital either owns the equipment or independently
contracts with a service provider. In addition to our cryosurgery products, we sell other urological products
acquired when we purchased Timm Medical, a urological device manufacturer, in
the first quarter of 2002. We continue to sell our ErecAid vacuum therapy
systems and RigiScan monitors, although in 2003 we either divested or
discontinued the remaining product lines acquired in the Timm Medical purchase.
The reduction in year-over-year sales of our Timm urology products is
primarily attributable to these divestitures. Sales of divested or
discontinued product lines acquired in the Timm Medical purchase totaled
$922,000 for the first three months of 2003. A
portion of our revenue also comes from sales of the SurgiFrost
cryosurgical line which we developed for treatment of cardiac
arrythmia. In 2002 and through the first quarter of 2003, we sold
these products to CryoCath under the terms of a distribution
agreement. In April 2003, we licensed to CryoCath the manufacturing
and intellectual property rights to these products and sold them related assets. Beginning with
the first quarter of 2004, we became entitled to royalty income based
on CryoCaths continued sales of these products. For further
discussion see Notes 1 and 6 to our consolidated financial statements
for the quarter ended March 31, 2003. Revenues for the three months ended March 31, 2004 decreased 3.7% to
$7,382,000 compared to $7,662,000 for the three months ended March 31, 2003.
The reduction in revenues was primarily attributable to divestitures of the
urinary incontinence products and the Dura II line of penile implants acquired
in the Timm Medical purchase, offset by an increase in sales of disposables and
procedure fees related to our cryosurgical business. Sales of probes and
procedures related to our cryosurgical sales into the urology and
interventional radiology markets increased by 41.7% from $3,335,000 for the
first quarter of 2003 compared to $4,726,000 for the first quarter of
2004. In addition, we recorded royalty revenue in 2004 of $131,000 from CryoCath
pursuant to our licensing agreement with them for sales of cryosurgical
products in the cardiology market. Sales of capital equipment related to our
cryosurgical systems were down from $421,000 in the first quarter of 2003
compared to $363,000 for the first quarter of 2004. This is primarily due
to our strategy of promoting adoption of our technology through an emphasis on
growth in cryosurgical procedures, rather than through sales of capital
equipment. Cost of Revenues.Cost of revenues consists of fixed and variable costs
incurred in the manufacture of our products in addition to depreciation of
Cryocare Surgical Systems placed in the field with customers under our
placement program or with our sales and service personnel. We incur an
additional cost of revenues in the form of a fee for equipment usage and other
services when a procedure is performed on a box owned by an unrelated service
provider. That portion of the procedure fee remitted to the third-party
service provider is charged to cost of revenues when the procedure is performed
and billed. We retain a larger profit on procedures performed on systems owned
by us where no outside service fees are incurred. In addition, we have
incurred charges for product warranties as well as excess and obsolete
inventory, shrinkage and other inventory carrying costs. Also included in cost
of revenues are costs of maintaining patents or other intellectual property
rights to processes or technologies related to our products, royalties on
product sales and amortization of developed technology acquired in connection
with our acquisition of Timm Medical. Cost of revenues for the three months ended March 31, 2004 increased 6.0%
to $4,234,000 from $3,996,000 for the three months ended March 31, 2003. The
increase in cost of revenues resulted primarily from growth in the number of
disposable cryosurgical probes sold combined with higher depreciation expense
related to an increase in the number of placed Cryosurgical Systems in the
field. Divestiture of several product lines partially offset the increases in cost of revenues. 15




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Gross Margins. Gross margins on revenues decreased 5.2% to 42.6% for the
three months ended March 31, 2004 compared to 47.8% for the three months ended
March 31, 2003. The decrease in gross margins is partially explained by an
increase in the percentage of cryosurgical cases serviced by third parties as
opposed to cases in which we provide the service component of the
procedure. In a cryosurgical procedure where we contract with a
third-party service provider to transport the cryosurgical system to the
hospital and to provide the surgeon with assistance in setting up and
monitoring the equipment, as much as one-half of the procedure revenue is paid
to that third party, with a corresponding reduction in the gross margin on that
procedure. Product mix also accounts for part of the reduction in gross
margin. Divestiture of the non-core urological product lines acquired in the
Timm Medical acquisition resulted in the loss of revenues from these relatively
high-margin products. Research and Development Expenses. Research and development expenses
include expenses associated with the design and development of new products as
well as significant enhancements to existing products. These expenses consist
primarily of salaries and related benefits and overhead costs for staff engaged
in research and development activities, costs for materials and supplies used
in performing research and development activities, costs of clinical trials
conducted for the purpose of obtaining regulatory approval of our products,
consulting and advisory fees for outside service providers directly involved in
research and development activities, and depreciation on equipment used
directly for research and development activities. We expense research and
development expenses when incurred. Our research and development efforts are
periodically subject to significant non-recurring expenses and fees that can
cause some variability in our quarterly research and development expenses. Research and development expenses for the three months ended March 31,
2004 increased 61.2% to $536,000 compared to $333,000 for the three months
ended March 31, 2003. The increase is primarily due to initiation of two
significant programs in 2004 based on re-designing our probes and cryosurgical
systems. Selling, General and Administrative Expenses. Selling, general and
administrative expenses primarily consist of salaries, commissions and related
benefits and other overhead costs for employees and activities in the areas of
sales, marketing, customer service, legal affairs, finance, information
technology, human resources and administration. Fees for attorneys,
independent auditors and certain other outside consultants and suppliers are
included where their services or products are related to selling, general and
administrative activities. Expenses associated with advertising, trade shows,
promotional and training costs related to marketing our products are also
classified as selling, general and administrative expenses as are the costs of
conducting clinical research studies for the purpose of collecting clinical
data used in promoting our products. Selling, general and administrative expenses for the three months ended
March 31, 2004 increased 17.1% to $11,179,000 compared to $9,548,000 for the
three months ended March 31, 2003. Legal and accounting fees associated with
ongoing investigations into possible accounting and financial reporting
irregularities explain much of this variance. In addition, we have
incurred significant costs related to strengthening our internal
controls and financial reporting processes. In the first quarter of 2003,
these non-recurring costs were approximately $1.0 million compared to $3.3
million in the first quarter of 2004. In addition, our directors and
officers liability insurance coverage premiums increased approximately $159,000
from $132,000 in the first three months of 2003 to $291,000 during the same
period in 2004. Sales and marketing costs were up by approximately
$570,000 primarily
due to an increase in commissions paid on higher sales of our cryosurgical
disposables and an increase in expenses related to training new cryosurgeons. Interest Income, Net. Interest income, net, for the three months ended
March 31, 2004 was $45,000 compared to $216,000 for the three months ended
March 31, 2003. The difference is related primarily to a reduction in our
average cash balances for the first three months of 2004 compared to the same
period in 2003. Minority Interests.Minority interests represent earnings attributable to
minority investors in the mobile prostate treatment businesses we acquired from
USMD on September 30, 2002. The amount recorded for minority interests
increased 11.9% from $100,000 for the three months ended March 31, 2004 compared
to $89,000 for the same period in 2003. Revenues and earnings from these
businesses grew in line with the overall increase in sales of our cryosurgical
probes and procedures. 16




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Net
Loss. Net loss for the three months ended March 31, 2004 was
$8,623,000 or $0.36 per diluted share on 24,088,000 weighted average shares
outstanding, compared to a net loss of $6,088,000 or $0.25 per share on
weighted average shares outstanding for the same period in 2003. The 41.6%
increase in the net loss for quarter ended March 31, 2004 over the net loss for
the same period in 2003 was primarily the result of $3.3 million in
non-recurring legal and accounting fees in the first quarter of 2004 combined
with new investment in research and development, higher selling costs related to our cryosurgical
products and reduced interest income. Critical Accounting Policies The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported amounts
of assets and liabilities and disclosure of contingent assets and liabilities
at the date of the financial statements. Estimates also affect the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from these estimates. Principal areas requiring the use of
estimates include: determination of allowances for uncollectible accounts and
sales returns, reserves for excess and obsolete inventory, valuation allowances
for investments and deferred tax assets, impairment of long-lived and
intangible assets, determination of stock-based compensation to employees and
consultants, and reserves for litigation. We cannot predict what
effect, if any, that these or other events or circumstances may have
on our
financial position, results of operations and cash flows. We believe the
following critical accounting policies affect our more significant judgment and
estimates used in the preparation of our consolidated financial statements. Revenue Recognition.We follow the provisions of Staff Accounting
Bulletin 101, Revenue Recognition in Financial Statements (SAB 101), for
revenue recognition. Under SAB 101, four conditions must be met before revenue
can be recognized: (i) there is persuasive evidence that an arrangement exists,
(ii) delivery has occurred or service has been rendered, (iii) the price is
fixed or determinable and (iv) collection is reasonably assured. Revenues for Cryocare Surgical Systems shipped to company controlled
locations for interim storage are deferred until subsequently shipped and
accepted by our customers. We also reduce our revenues for customer
concessions, and defer revenue recognition for minimum procedure guarantees and
contingent payment arrangements until a future date when the contingencies are
resolved. Where we own the equipment used in the procedure, we bill the hospital or
other payor and retain the entire procedure, or bundled, fee. In many
instances, however, the equipment is owned by a third-party who contracts with
us to perform the service component of the procedure. In the latter case, we
still invoice the payor but we remit a portion of the procedure fee to the
third-party service provider. The procedure fee is recorded as revenue in the
period when the procedure is performed and, where applicable, the fee paid to a
third-party service provider is included in cost of revenues for the same
period. Where a third-party service provider is not involved, we earn the entire
procedure fee, both the portion related to providing the disposable kits and
the portion related to providing mobile or placement Cryocare Surgical
Systems to customers. In these situations, we either loan a mobile Cryocare
Surgical System to a hospital or consign a stationary Cryocare Surgical System
with the hospital under our placement program and charge a fee for each
procedure in which the equipment is used. Cost of revenues includes
depreciation on the Cryocare Surgical Systems owned by us over an estimated
useful life of three years. Accounts Receivable.We routinely assess the financial strength of our
customers and, as a consequence, believe that our accounts receivable credit
risk exposure is limited. Accounts receivable are carried at original invoice
amount less all discounts and allowances, and less an estimate for doubtful
accounts and sales returns based on a periodic review of outstanding
receivables. Allowances are provided for known and anticipated credit losses
as determined by management in the course of regularly evaluating individual
customer receivables. This evaluation takes into consideration a customers
financial condition and credit history as well as current economic conditions.
Accounts receivable are written off when deemed uncollectible. Recoveries of
accounts receivable previously written off are recorded when received. 17




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Purchase Accounting.Our acquisitions of Timm Medical and certain general
and limited equity interests in the mobile prostate cancer and BPH treatment
businesses of USMD have been accounted for under the purchase method of
accounting for business combinations. We are required to allocate the purchase
price of acquired companies to the tangible and intangible assets acquired and
liabilities assumed based on their estimated fair values. The judgments made
in determining the estimated fair value and expected useful lives assigned to
each class of assets and liabilities acquired can significantly impact periodic
amortization expense and net income. Determining the fair value of certain assets and liabilities acquired is
judgmental in nature and often involves the use of significant estimates and
assumptions, especially with respect to intangibles. Critical estimates in
valuing certain intangible assets include: future expected cash flows from
customer contracts, customer lists and distribution agreements and acquired
developed technologies and patents; brand awareness and market position, as
well as assumptions about the period of time the brand will continue to be used
in our product portfolio; and discount rates. To assist in this process, we
obtained appraisals from independent valuation firms for certain significant
tangible and intangible assets and liabilities. While our estimates of fair
value are based upon assumptions believed to be reasonable, these estimates are
inherently uncertain and unpredictable, and as a result, actual results may
differ from estimates. Other estimates associated with the accounting for
acquisitions may also change as additional information becomes available
regarding the assets acquired and liabilities assumed. Goodwill Impairment.We account for goodwill in accordance with the
provisions of SFAS No. 142, Goodwill and Other Intangible Assets.We test for
goodwill impairment in the fourth fiscal quarter of each year, or sooner if
events or changes in circumstances indicate that the carrying amount may exceed
the fair value. Testing for potential goodwill impairment under SFAS 142
requires us to make judgments in determining appropriate assumptions to use in
the calculation, including assumptions regarding the timing and amounts of
estimated cash flows and discount rates, in addition to selecting comparable
public companies against which to compare our revenue multiples. Goodwill totaled $17.5 million at December 2002 and 2003, and represented
19% and 24% of our total assets, respectively. In 2002, we recognized an
impairment charge of $18.0 million to reduce the carrying value of the goodwill
acquired in the Timm Medical acquisitions. The impairment resulted from the
termination or abandonment of three of the acquired distribution agreements for
urological products following the acquisition. In 2003, we concluded that the
estimated fair value of each reporting unit exceeded the carrying amount, so
goodwill was not impaired. Absent earlier indications of impairment, we will undertake a formal
valuation of the goodwill on our balance sheet in the fourth quarter of 2004
and, based on the outcome of our valuation analysis, we will consider adjusting
the carrying value of our goodwill assets as necessary to ensure the carrying
amounts do not exceed the fair market value of these assets. Impairment of Long-Lived Assets.We have a significant amount of
property, equipment and amortizable intangible assets primarily consisting of
purchased patents and acquired technology. In accordance with Statement of
Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or
Disposal of Long Lived Assets,we review our long-lived assets and certain
identifiable intangibles for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset or asset group may
not be recoverable. Recoverability of long-lived and amortizable intangible
assets to be held and used is measured by a comparison of the carrying amount
of an asset to the undiscounted future operating cash flows expected to be
generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured as the amount by which the carrying
value of the assets exceeds their fair value. At March 31, 2004
we determined that a write down for impairment of any of our long-lived assets was
not required. Legal
and Other Loss Contingencies.We
are subject to contingencies, such as legal proceedings and claims arising out
of our business that cover a wide range of matters, including SEC and
DOJ investigations, shareholder litigation, tax matters,
product liability and workers compensation. In accordance with SFAS No. 5,
Accounting for Contingencies, we record accruals for such contingencies when it
is probable that a liability will be incurred and the amount of loss can be
reasonably estimated. A significant amount of management estimation is
required in determining when, or if, an accrual should be recorded for a
contingent matter and the amount of such accrual, if any. Due to the
uncertainty of determining the likelihood of a future event occurring and the
potential financial statement impact of such an event, 18




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it is possible that upon further development or resolution of a contingent
matter, a charge could be recorded in a future period that would be material to
our consolidated results of operations, financial position or cash flows. Other Investments.We review our equity investments for impairment based
on our determination of whether the decline in market value of the investment
below our carrying value is other than temporary. In making this
determination, we consider Accounting Principles Board Opinion (APB) No. 18,
The Equity Method of Accounting of Investments in Common Stock, which set forth
factors to be evaluated in determining whether a loss in value should be
recognized. Factors include the investees operational performance, indictors
of continued viability, financing status, liquidity prospects and cash flow
forecasts. We also consider our ability to hold the investment, the market
price and market price fluctuations of the investments publicly-traded shares
and the ability of the investee to sustain an earnings capacity which would
justify the carrying amount of the investment. Income Taxes.In the preparation of our consolidated financial
statements, we are required to estimate income taxes in each of the
jurisdictions in which we operate, including estimating both actual current tax
contingencies and assessing temporary differences resulting from differing treatment
of items for tax and accounting purposes. Assessment of actual current tax
exposure includes assessing tax strategies, the status of tax audits and open
audit periods with the taxing authorities. To the extent that we have deferred
tax assets, we must assess the likelihood that our deferred tax assets will be
recovered from taxable temporary differences, tax strategies or future taxable
income and to the extent that we believe that recovery is not likely, we must
establish a valuation allowance. As of March 31, 2004 we have established a
valuation allowance of $43.7 million against our deferred tax
assets due to our continuing losses. In the
future, we may adjust our estimates of the amount of valuation allowance needed
and such adjustment would impact our provision for income taxes in the period
of such change. Liquidity and Capital Resources Since inception, we have incurred losses from operations and have reported
negative cash flows. As of March 31, 2004, we had an accumulated deficit of
$123.0 million and cash and cash equivalents of $15.1 million. We currently
have no long-term debt, and no long-term financial obligations other than under
operating leases and purchase commitments for raw material used in
manufacturing our products. Although we believe that our existing cash and
cash equivalents will be sufficient to fund our working capital requirements,
capital expenditures and other obligations through 2004, there are certain
risks and uncertainties that could, in the future, change our opinion regarding
the adequacy of our capital resources. We recently made several significant payments that have reduced our cash
reserves. On March 8, 2004, we paid to our former Chief Executive Officer an
aggregate of $750,000, which we owed to him under a separation agreement and
consulting agreement that we previously executed. Also on March 8, 2004, we
paid to our former Chief Financial Officer an aggregate of $616,000, which we
owed to him under an employment agreement we previously executed. At the
request of the SEC, these payments were deposited into escrow accounts during
the fourth quarter of 2003 and released upon termination of the related escrow
agreements in the first quarter of 2004. The escrow of these payments required
us to classify the amount of these payments as restricted cash and to include
them included in prepaid expenses and other current assets as of December 31,
2003. In addition to the payments described in the prior paragraph, in February
2004 we paid approximately $1.5 million in directors and officers liability
insurance premiums, and we paid approximately $1.9 million to BioLife to settle
litigation, as described above in Note 7 to our consolidated financial
statements. In addition, during the first quarter of 2004 we incurred
approximately $3.3 million in non-recurring legal and accounting fees
associated with the ongoing investigations into possible irregularities in our
accounting and financial reporting in earlier periods. We face the possibility that there will be additional material cash
payments required in connection with resolving matters related to the
investigations into our historical accounting and financial reporting. We and
certain former officers and certain current and former board members have been
named defendants in a class action and a derivative lawsuit. We are generally
obliged, to the extent permitted by law, to indemnify our directors and
officers who are named defendants in these lawsuits. At this point in time we
are unable to provide a reasonable estimate of our potential liability in these
lawsuits. 19




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We may be required to pay judgments or settlements and to incur expenses
in defending against these claims that could be material. Further, while we
carry $20 million of directors and officers liability insurance coverage,
this coverage may not be adequate to cover all costs related to these lawsuits,
including any resulting judgments or settlements. As described below under
Risks Related to Our Business, two of our excess carriers have declined
coverage and filed arbitration complaints, contending our former management
made misstatements or omissions in the applications for insurance coverage.
Our third excess carrier has reserved the rights to disclaim coverage and to
rescind the policy if it is determined that, at the time it signed the policy
application, our former management was aware of facts that might have resulted
in future claims under the policy. Any of these unfavorable outcomes could
have a material adverse effect on our business, financial condition, results of
operations and cash flows. Beyond the factors described above, we expect to face significant demands
on our capital resources related to the execution of our 2004 operating plan,
regaining compliance with the SEC rules and regulations required of publicly
traded companies, including Section 404 of the Sarbanes-Oxley Act of 2002, and
fulfilling requirements prerequisite to becoming re-listed on a national stock
exchange or market. We are currently projecting an operating loss for fiscal
2004, as well as a net use of cash. We will continue to use cash reserves to finance our projected 2004 cash
flow deficit. Our 2004 forecast provides for an increase in revenues and
improvement in gross profit. At the same time,
however, we have planned new investments in sales and
marketing activities to increase our market penetration as well as in inventory
related to the introduction of our new Cryocare CS System. Additionally, we
expect to incur additional research and development costs to improve our
existing products and develop new ones. We have also planned expenditures on
staffing and infrastructure improvements in finance and information technology
to ensure that we will be able to comply with internal control and other SEC
requirements. Risks Related to Our Business The risks and uncertainties described below are not the only ones we face.
Additional risks and uncertainties not presently known to us or that we
currently deem immaterial may also impair our operations. The occurrence of
any of the following risks could harm our business. In that case, the trading
price of our common stock could decline, and you may lose all or part of your
investment. Our success will depend on our ability to attract and retain key personnel. In order to execute our business plan, we need to attract, retain and
motivate a significant number of highly qualified managerial, technical,
financial and sales personnel. If we fail to attract and retain skilled
scientific and marketing personnel, our research and development and sales and
marketing efforts will be hindered. Our future success depends to a
significant degree upon the continued services of key management personnel,
including Craig T. Davenport, our Chief Executive Officer, William J. Nydam,
our President and Chief Operating Officer, and Katherine Greenberg, our Senior
Vice President and Chief Financial Officer. None of our key management
personnel is covered by an insurance policy of which we are the beneficiary. Our management members have spent considerable time and effort dealing with
internal and external investigations and re-auditing of financial statements. In
addition to the challenges of the SEC investigation, the DOJ investigation,
a shareholder class-action and a derivative lawsuit and other
legal proceedings described below, our new management members have spent
considerable time and effort dealing with internal and external investigations
involving our previous internal controls, accounting policies and procedures,
disclosure controls and procedures and corporate governance policies and
procedures. The significant time and effort spent has adversely affected our
operations and may continue to do so in the future. 20




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We face risks relating to our liquidity. Over the past 16 months we have incurred significant costs related to,
among other things, legal, accounting and other professional fees associated
with our internal reviews of various accounting and other matters, the ongoing
investigation of us by the SEC and DOJ, various shareholder class-action and
derivative lawsuits and other legal proceedings described below. In addition
we are making significant investments in the development and implementation of
sound internal controls and corporate governance policies and procedures
designed to enhance the accuracy, quality and consistency of our financial
information and reporting. We will continue to incur significant related
expenses in the future. If we are not able to significantly grow market share, improve our gross
margins and reduce our operating expenses, or if we become subject to
significant judgments or settlements in connection with the legal proceedings
described in Part II, Item 1 of this Quarterly Report on Form 10-Q, we will
require additional financing. Additional equity or debt financing may not be
available on acceptable terms, or at all, in part because our common stock was
de-listed from The Nasdaq Stock Market. If we are unable to obtain additional
capital, we may be required to reduce our sales and marketing activities,
reduce the scope of or eliminate our research and development programs,
relinquish rights to technologies that we might otherwise seek to develop or
commercialize, or sell certain assets. We recently made several significant payments that have reduced our cash
reserves. On March 8, 2004, we paid to our former Chief Executive Officer an
aggregate of $750,000, which we owed to him under a separation agreement and
consulting agreement that we previously executed. Also on March 8, 2004, we
paid to our former Chief Financial Officer an aggregate of $616,000, which we
owed to him under an employment agreement we previously executed. At the
request of the SEC, these payments were deposited into escrow accounts during
the fourth quarter of 2003; the funds were released upon termination of the
related escrow agreements. Additionally, on February 20, 2004, we paid
approximately $1.5 million in directors and officers liability insurance
premiums. Furthermore, as described below in Part II, Item 1 of this Quarterly
Report on Form 10-Q, in February 2004 we paid approximately $1.9 million to
BioLife to settle litigation. If we fail to adequately address our liquidity concerns, then our
independent auditors may issue a qualified opinion, to the effect that there is
substantial doubt about our ability to continue as a going concern. A
qualified opinion could itself have a material adverse effect on our business,
financial condition, results of operations and cash flows. For a further description of the nature of the risks relating to our
liquidity see, Part I, Item 2  Managements Discussion and Analysis of Financial
Condition and Results of Operations  Liquidity and Capital Resources. We have limited operating experience and a history of net losses, and we may
never reach or maintain profitability. We have limited experience in manufacturing, marketing and selling our
Cryocare Surgical System in commercial quantities. In addition, during 2002,
we completed our acquisitions of Timm Medical, the cryosurgical assets of
BioLife, and our acquisition of the mobile prostate treatment businesses owned
by USMD. As a result, we have a short history in marketing and selling the
products we acquired or have rights to commercialize through these acquisitions
or to market our products on the scale required by these acquisitions. In
addition, we have limited experience in managing the complex demands of a
business with multiple entities and locations, a large workforce and diverse
information technology systems. We have incurred annual operating losses each year since our inception.
For the quarters ended March 31, 2004, and 2003, we had losses from operations
of approximately $8.6 million and $6.1 million, respectively. As of March 31,
2004, our accumulated deficit was approximately $123.0 million. It is possible
that we will not generate sufficient revenues from product sales and service
revenues to achieve or sustain profitability. Even if we do achieve
significant revenues from our product sales and service revenues, we expect
that increased operating expenses will result in significant operating losses
over the next several quarters, as we, among other things: 21




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
    
    expand our infrastructure to support more robust internal controls,
including policies and procedures related to our accounting practices,
disclosure controls and corporate governance;
    
    incur costs related to legal proceedings, including ongoing
government investigations;
    
    expand our sales and marketing activities as we attempt to gain
market share for our Cryocare Surgical System; and
    
    continue our research and development efforts to improve our existing
products and develop new products. We will need to significantly increase the revenues we receive from sales
of our products and services as a result of these increased operating expenses.
We may be unable to do so, and therefore, may not achieve profitability. Even
if we do achieve profitability, we cannot be certain that we will be able to
sustain or increase profitability on a quarterly or annual basis. If we require future capital, we may not be able to secure additional funding
in order to expand our operations and develop new products. If we fail to achieve and maintain profitability and positive cash flow,
or if we undertake or accelerate significant research and development projects
for new products or pursue corporate acquisitions, we may need additional
outside financing. We may raise these additional funds by selling one or more
lines of business or products, selling our equity securities, incurring debt or
entering into collaborative arrangements. Any additional equity financing may
be dilutive to stockholders, and debt financing, if available, may involve
interest expense and restrictive covenants. Collaborative arrangements, if
necessary to raise additional funds, may require us to relinquish rights to
some of our technologies, products or marketing territories. Our failure to
raise capital when needed could have a material adverse effect on our business,
financial condition, results of operations and cash flows. We cannot assure you that we will not discover additional instances of
historical breakdowns in controls, policies and procedures affecting our
previously issued financial statements. We have made significant changes in our internal controls, accounting
policies and procedures, disclosure controls and procedures and corporate
governance policies and procedures. While we believe that our newly
implemented controls, policies and procedures will help to prevent the
occurrence of financial reporting problems in the future, it is possible that
we may discover additional instances of historical breakdowns in our internal
controls, policies and procedures of the types that led to restatements of our
financial statements for the years 2000 and 2001 and for the first two quarters
of 2002. In the event such breakdowns are discovered they could impact both
historical financial statements and future reported results. We face risks related to investigations by the SEC and DOJ and related to other
legal proceedings. The SEC and the DOJ are conducting investigations into allegations that we
and certain of our current and former officers and directors issued or caused
to be issued false and misleading statements regarding our revenues and
expenses in press releases and SEC filings. Although we have fully cooperated
with these governmental agencies in these matters and intend to continue to
fully cooperate, these agencies may determine we have violated federal
securities laws. We cannot predict when these investigations will be completed
or their outcomes. If it is determined that we have violated federal
securities laws or other laws or regulations, we may face sanctions, including,
but not limited to, significant monetary penalties and injunctive relief. In addition, we and certain former officers and certain current and former
board members have been named defendants in a class action and a derivative
lawsuit. The findings and outcome of the investigations described above may
affect the class action and the derivative lawsuit that are pending. We are
generally obliged, to the extent permitted by law, to indemnify our directors
and officers who are named defendants in some of these lawsuits. We are unable
to estimate what our liability in these matters may be, and we may be required
to pay judgments or settlements and incur expenses in aggregate amounts that
could have a material adverse effect on our business, financial condition,
results of operations and cash flows. 22




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We have $20 million of directors and officers liability insurance
coverage. The coverage is provided in four $5 million policies issued by a
primary insurance carrier and three excess insurance carriers. For claims
asserted during the period from June 10, 2002 through June 10, 2003, one of the
excess carriers has reserved the rights to disclaim coverage and to rescind the
policy if it is determined that, at the time it signed the policy application,
our former management was aware of facts that might have resulted in future
claims under the policy. The other two excess carriers have declined coverage
and filed arbitration complaints, contending our former management made
misstatements or omissions in the applications for insurance coverage. A claim
in excess of our insurance coverage would have to be paid out of cash reserves,
which could have a material adverse effect on our business, financial
condition, results of operations and cash flows. Our investors, customers, vendors and suppliers may react adversely to the
restatement of our historical financial statements and our inability to timely
file all of our SEC filings. Our future success depends in large part on the support of our investors,
customers, vendors, and suppliers. The restatement of our historical financial
statements and our inability to timely file all of our SEC filings has resulted
in negative publicity about us and has, and may continue to have, a negative
impact on the market price of our common stock. The restatement of our
historical financial statements and our inability to timely file all of our SEC
filings also could cause some of our customers or potential customers to
refrain from purchasing or to defer or cancel purchases of our products.
Additionally, our current and potential vendors and suppliers may re-examine
their willingness to do business with us, to develop critical interfaces for us
or to supply products and services if they lose confidence in our ability to
fulfill our commitments. Our common stock was de-listed from the Nasdaq Stock Market and, as a result,
trading of our common stock has become more difficult. Our common stock was de-listed from The Nasdaq Stock Market on January 16,
2003. One result of this action is a limited public market for our common
stock. Trading is now conducted in the over-the-counter market in the
so-called Pink Sheets. Consequently, selling our common stock is more
difficult because smaller quantities of shares can be bought and sold,
transactions can be delayed and security analyst and news media coverage of us
may be reduced. These factors could result in lower prices and larger spreads
in the bid and ask prices for shares of our common stock as well as lower
trading volume. Although we will seek to have our common stock re-listed on a
national stock exchange or market once we are in full compliance with our
obligations as a reporting company, we can provide no assurance that we will be
re-listed. As a result of the desisting of our common stock from The Nasdaq Stock
Market, our common stock has become subject to the penny stock regulations,
including Rule 15g-9 under the Securities Exchange Act of 1934. That rule
imposes additional sales practice requirements on broker-dealers that sell
low-priced securities to persons other than established customers and
institutional accredited investors. For transactions covered by this rule, a
broker-dealer must make a special suitability determination for the purchaser
and have received the purchasers written consent to the transaction prior to
sale. Consequently, the rule may affect the ability of broker-dealers to sell
our common stock and affect the ability of holders to sell their shares of our
common stock in the secondary market. To the extent our common stock remains
subject to the penny stock regulations, the market liquidity for the shares
will be adversely affected. We expect to derive a significant portion of our future revenues from our
cryosurgical products, which could fail to achieve market acceptance or
generate significant revenue. We introduced our Cryocare Surgical System to the market in July 1999. We
derived a significant portion of our revenues in 2001 and 2002 from sales of
Cryocare Surgical Systems and related disposable cryoprobes and temperature
probes, as well as from per-procedure fees. In 2003, we shifted our business
model to focus on sales of procedures and disposable devices rather than on
sales of Cryocare Surgical Systems. We expect sales of cryosurgical products
and the related procedure fees will constitute a significant portion of our
revenues for the foreseeable future, although we expect revenue from system
sales to fluctuate from quarter to quarter and decrease, over time, as a
percentage of our revenue. 23




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Our success is reliant on the acceptance by doctors and patients of the
Cryocare Surgical System as a preferred treatment for tumor ablation.
Cryosurgery has existed for many years, but has not been widely accepted
primarily due to concerns regarding safety and efficacy and widespread use of
alternative therapies. Because the technology previously lacked precise
monitoring capabilities, cryosurgical procedures performed in the 1970s
resulted in high cancer recurrence and negative side effects, such as rectal
fistulae and incontinence, and gave cryosurgical treatment negative publicity.
To overcome these negative side effects, we have developed ultrasound guidance
and temperature sensing to enable more precise monitoring in our Cryocare
Surgical System. Nevertheless, we will need to overcome the earlier negative
publicity associated with cryosurgery in order to obtain market acceptance for
our products. In addition, use of our Cryocare Surgical System requires
significant physician education and training. As a result, we may have
difficulty obtaining recommendations and endorsements of physicians and
patients for our Cryocare Surgical System. We may also have difficulty raising
the brand awareness necessary to generate interest in our Cryocare Surgical
System. Any adverse side effects, including impotence or incontinence,
recurrence of cancer or future reported adverse events or other unfavorable
publicity involving patient outcomes from the use of cryosurgery, whether from
our products or the products of our competitors, could adversely affect
acceptance of cryosurgery. In addition, emerging new technologies and
procedures to treat cancer, prostate enlargement and other prostate disorders
may negatively affect the market acceptance of cryosurgery. If our Cryocare
Surgical System does not achieve broad market acceptance, we will likely remain
unprofitable. If we are unable to continue to develop and enhance our Cryocare Surgical
System, our business will suffer. Our
growth depends in part on our continued ability to successfully develop
enhancements to our Cryocare Surgical System. We may experience difficulties
that could delay or prevent the successful development and commercialization of
these products. Our products in development may not prove safe and effective
in clinical trials. Clinical trials may identify significant technical or
other obstacles that must be overcome before obtaining necessary regulatory or
reimbursement approvals. In addition, our competitors may succeed in
developing commercially viable products that render our products obsolete or
less attractive. Failure to successfully develop and commercialize new
products and enhancements would likely have a significant negative effect on
our financial prospects. Our strategy of divesting non-core product lines may not be successful. We are refocusing our business on the development of minimally invasive
technologies for tissue and tumor ablation. As part of this strategy, we have
begun divesting certain non-core product lines, as evidenced by our sale of our
Dura II Penile Prosthesis product line, our sale of our urodynamics and urinary
incontinence product lines and our licensing of our cardiac technology and sale
of related assets. We can provide no assurance that our strategy of focusing
on our core technologies for tumor ablation applications and our divestitures
of non-core technologies and product lines will be successful. There is uncertainty relating to third-party reimbursement, which is critical
to market acceptance of our products. Hospitals and other health care providers in the United States generally
rely on third-party payors, principally federal Medicare, state Medicaid and
private health insurance plans, to reimburse all or part of the cost of medical
procedures involving our products. While private health insurers in some areas
of the United States provide reimbursement for procedures in which our products
are used, we can provide no assurance that private insurance reimbursement will
be adopted nationally or by additional insurers. Furthermore, those private
insurance companies currently paying for procedures in which our products are
used may terminate such coverage. If reimbursement levels from Medicare,
Medicaid, other governmental health care programs or private insurers are not
sufficient, physicians may choose not to recommend, and patients may not
choose, procedures utilizing our products. Previously, reimbursement under Medicare for our cryosurgical disposable
products used in outpatient procedures was provided on a so-called
pass-through basis. This enabled the hospital or other health care provider
to obtain separate reimbursement for our disposable devices in addition to
reimbursement for the procedure fee. Pass-through status was terminated on
December 31, 2003. As a result, the cost of our disposable products now is
incorporated into the Hospital Outpatient Prospective Payment System and there will be no separate reimbursement for the
disposables. 24




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Given the end to pass-through status for our disposable cryoprobes and
temperature probes, we expect Medicare reimbursement for our products
used in outpatient settings to continue to fluctuate. This may
influence reimbursement rates for our products by private insurers as well. We
can provide no assurance that changes in outpatient reimbursement rates
will not affect our ability to negotiate favorable charges for our products to
hospitals. International market acceptance of our products may depend, in part, upon
the availability of reimbursement within prevailing health care payment
systems. Reimbursement and health care payment systems in international
markets vary significantly by country, and include both government sponsored
health care and private insurance. We may not obtain international
reimbursement approvals in a timely manner, if at all. Our failure to receive
international reimbursement approvals may negatively impact market acceptance
of our products in the international markets in which those approvals are
sought. Furthermore, from time to time significant attention has been focused on
reforming the health care system in the United States and other countries. Any
changes in Medicare, Medicaid or third-party medical expense reimbursement,
which may arise from health care reform, may have a material adverse effect on
reimbursement for our products or procedures in which our products are used and
may reduce the price we are able to charge for our products. In addition,
changes to the health care system may also affect the commercial acceptance of
products we are currently developing and products we may develop in the future.
Potential approaches that have been considered include controls on health care
spending and price controls. Several proposals have been made in the United
States Congress and various state legislatures recently that, if adopted, would
potentially reduce health care spending, which may result in a material adverse
effect on our business, financial condition, results of operations and cash
flows. We have limited sales and marketing experience with our Cryocare Surgical
System and any failure to significantly expand sales of this product will
negatively impact future revenue. We primarily handle the marketing, distribution and sales of our Cryocare
Surgical Systems through our own work force. We have limited experience
marketing and selling our Cryocare Surgical System in commercial quantities or
on a nationwide basis. We will face significant challenges and risks in
training, managing and retaining our sales and marketing teams, including
managing geographically dispersed efforts and adequately training our people in
the use and benefits of our Cryocare Surgical System. We may not be able to
hire significant additional personnel or deploy sufficient other resources
needed to create increased demand for our Cryocare Surgical System. In
addition, we have distribution arrangements, some of which are exclusive, for
the sale of our Cryocare Surgical System both domestically and internationally,
and we are dependent upon the sales and marketing efforts of our third-party
distributors. These distributors may not commit the necessary resources to
effectively market and sell our Cryocare Surgical System. If we are unable to
expand our sales and marketing capabilities or if our senior sales and
marketing personnel are not retained, we may not be able to effectively
commercialize our Cryocare Surgical System. We acquired Timm Medical, the cryosurgical assets of BioLife and the mobile
prostate treatment businesses of USMD and face risks associated with
integrating these businesses into our existing business operations. We continue to face numerous risks and expenses related to integration of
the businesses we acquired from Timm Medical, BioLife and USMD. In addition,
the acquired businesses have suffered because managements resources have been
consumed by, among other things, the internal and external investigations
involving various accounting and related matters as well as the work involved
in re-auditing and restating our consolidated financial statements for the
years ended December 31, 2000 and 2001 and for the first two quarters of 2002.
The businesses acquired from Timm Medical have suffered because resources have
been diverted in divesting certain non-core product lines and in downsizing our
Eden Prairie operations. The businesses we acquired from USMD have suffered
for many of the same reasons in addition to the fact that we recently assumed
administrative responsibility for management of these complex businesses. If
we do not successfully integrate and grow the acquired businesses, our business
will suffer. 25




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Introduction of alternative therapies may affect our revenues. We sell medical devices for the treatment of certain urological disorders.
If physicians and patients do not accept our products, our sales will decline.
Patient acceptance of our products depends on a number of factors, including
the failure of other therapies, the degree of invasiveness involved, the rate
and severity of complications from the procedures, and other adverse side
effects. Patients are more likely first to consider non-invasive alternatives
to treat their urological disorders. The introduction of new oral medications
or other less-invasive therapies may cause our sales to decline in the future. We could be difficult to acquire due to anti-takeover provisions in our
charter, our stockholders rights plan and Delaware law. Provisions of our certificate of incorporation and bylaws, as amended, may
have the effect of making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire, control of us. In
addition, in April 1999, our Board of Directors adopted a stockholder rights
plan in which preferred stock purchase rights were distributed as a dividend.
These provisions may make it more difficult for stockholders to take corporate
actions and may have the effect of delaying or preventing a change in control.
We are subject to the anti-takeover provisions of Section 203 of the Delaware
General Corporation Law. Subject to specified exceptions, this section
provides that a corporation may not engage in any business combination with any
interested stockholder during the three-year period following the time that
such stockholder becomes an interested stockholder. This provision could have
the effect of delaying or preventing a change of control of us. The foregoing
factors could limit the price that investors or an acquiror might be willing to
pay in the future for shares of our common stock. If we fail to protect our intellectual property rights, our competitors may
take advantage of our ideas and compete directly against us. Our success will depend to a significant degree on our ability to secure
and protect intellectual property rights and to enforce patent and trademark
protections relating to our technology. From time to time, litigation may be
advisable to protect our intellectual property position. However, these legal
means afford only limited protection and may not adequately protect our rights
or permit us to gain or keep any competitive advantage. Any litigation in this
regard could be costly, and it is possible that we will not have sufficient
resources to fully pursue this litigation or to protect our other intellectual
property rights. It could result in the rejection or invalidation of our
existing and future patents. Any adverse outcome in litigation relating to the
validity of our patents, or any failure to pursue litigation or otherwise to
protect our patent position, could have a material adverse effect on our
business, financial condition, results of operations and cash flows. Also,
even if we prevail in litigation, the litigation would be costly in terms of
management distraction as well as in money. In addition, confidentiality
agreements with our employees, consultants, customers, and key vendors may not
prevent the unauthorized disclosure or use of our technology. It is possible
that these agreements will be breached or that they will not be enforceable in
every instance, and that we will not have adequate remedies for any such
breach. Enforcement of these agreements may be costly and time consuming.
Furthermore, the laws of foreign countries may not protect our intellectual
property rights to the same extent as the laws of the United States. Because the medical device industry is litigious, we may be sued for allegedly
violating the intellectual property rights of others. The medical technology industry has in the past been characterized by a
substantial amount of litigation and related administrative proceedings
regarding patents and intellectual property rights. In addition, major medical
device companies have used litigation against emerging growth companies as a
means of gaining or preserving a competitive advantage. Should third parties file patent applications or be issued patents
claiming technology also claimed by us in pending applications, we may be
required to participate in interference proceedings in the U.S. Patent and
Trademark Office to determine the relative priorities of our inventions and the
third parties inventions. We could also be required to participate in
interference proceedings involving our issued patents and pending applications
of 26




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another entity. An adverse outcome in an interference proceeding could
require us to cease using the technology or to license rights from prevailing
third parties. Third parties may claim we are using their patented inventions and may go
to court to stop us from engaging in our normal operations and activities.
These lawsuits are expensive to defend and conduct and would also consume and
divert the time and attention of our management. A court may decide that we
are infringing a third partys patents and may order us to cease the infringing
activity. A court could also order us to pay damages for the infringement.
These damages could be substantial and could have a material adverse effect on
our business, financial condition, results of operations and cash flows. If we are unable to obtain any necessary license following an adverse
determination in litigation or in interference or other administrative
proceedings, we would have to redesign our products to avoid infringing a third
partys patent and could temporarily or permanently have to discontinue
manufacturing and selling some of our products. If this were to occur, it
would negatively impact future sales and, in turn, our business, financial
condition, results of operations and cash flows. We have limited experience manufacturing our products and if we are unable to
meet customer demand, we may not become profitable. We use internal manufacturing capacity and expertise to manufacture our
products. We have limited experience in producing our products in commercial
quantities. We may encounter difficulties in scaling up production of new
products, including problems involving production yields, quality control and
assurance, component supply and shortages of qualified personnel. Our failure
to overcome these manufacturing problems could have a material adverse effect
on our business, financial condition, results of operations and cash flows. Our success will depend in part upon our ability to manufacture our
products in compliance with the FDAs Quality System regulations and other
regulatory requirements in sufficient quantities and on a timely basis, while
maintaining product quality and acceptable manufacturing costs. We are dependent upon a number of third-party suppliers to manufacture our
products and the loss of any of these suppliers could harm our business. We depend upon a number of unaffiliated third-party suppliers for
components and materials used in the manufacture of our products and, as such,
our business would be seriously harmed if we were unable to develop and
maintain relationships with suppliers that allow us to obtain sufficient
quantities and quality materials and components on acceptable terms. If our
principal suppliers cease to supply the materials and components we need to
manufacture our products, the qualification of additional or replacement
suppliers could be a lengthy process and there may not be adequate alternatives
to meet our needs, which will have a material adverse effect on our business,
financial condition, results of operations and cash flows. We may not be able
to obtain the necessary components and materials used in our products in the
future on a timely basis, if at all. If we fail to obtain or maintain necessary regulatory clearances or approvals
for products, or if approvals are delayed or withdrawn, we will be unable to
commercially distribute and market our products or any product modifications. Government regulation has a significant impact on our business.
Government regulation in the United States and other countries is a significant
factor affecting the research and development, manufacture and marketing of our
products. In the United States, the FDA has broad authority under the federal
Food, Drug and Cosmetic Act to regulate the distribution, manufacture and sale
of medical devices. Foreign sales of drugs and medical devices are subject to
foreign governmental regulation and restrictions, which vary from country to
country. The process of obtaining FDA and other required regulatory clearances
and approvals is lengthy and expensive. We may not be able to obtain or
maintain necessary approvals for clinical testing or for the manufacturing or
marketing of our products. Failure to comply with applicable regulatory
approvals can, among other things, result in fines, suspension or withdrawal of
regulatory approvals, product recalls, operating restrictions, and criminal
prosecution. In addition, governmental regulations may be established which
could prevent, delay, modify or rescind regulatory 27




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approval of our products.
Any of these actions by the FDA, or change in FDA regulations, could have a
material adverse effect on our business, financial condition, results of
operations and cash flows. Regulatory approvals, if granted, may include significant limitations on
the indicated uses for which our products may be marketed. In addition, to
obtain such approvals, the FDA and foreign regulatory authorities may impose
numerous other requirements on us. FDA enforcement policy prohibits the
marketing of approved medical devices for unapproved uses. In addition,
product approvals can be withdrawn for failure to comply with regulatory
standards or unforeseen problems following initial marketing. We may not be
able to obtain or maintain regulatory approvals for our products on a timely
basis, or at all, and delays in receipt of or failure to receive such
approvals, the loss of previously obtained approvals, or failure to comply with
existing or future regulatory requirements could have a material adverse effect
on our business, financial condition, results of operations and cash flows. Our products may be subject to product recalls even after receiving FDA
clearance or approval, which would harm our reputation and our business. The FDA and similar governmental authorities in other countries have the
authority to request and, in some cases, require the recall of our products in
the event of material deficiencies or defects in design or manufacture. A
governmental mandated or voluntary recall by us could occur as a result of
component failures, manufacturing errors or design defects. Any recall of
product would divert managerial and financial resources and harm our reputation
with customers and our business. We could be negatively impacted by future interpretation or implementation of
the federal Stark law and other federal and state anti-referral laws. The federal Stark law prohibits a physician from referring medical
patients for certain services to an entity with which the physician has a
financial relationship. A financial relationship includes both investment
interests in an entity and compensation arrangements with an entity. Many
states have similar and often broader laws prohibiting referrals by any
licensed health care provider to entities with which they have a financial
relationship. These state laws generally apply to services reimbursed by both
governmental and private payors. Violation of these federal and state laws may
result in prohibition of payment for services rendered, loss of licenses,
fines, criminal penalties and exclusion from governmental and private payor
programs, among other things. We have financial relationships with physicians
and physician-owned entities, which in turn have financial relationships with
hospitals and other providers of designated health services. Although we
believe that our financial relationships with physicians and physician-owned
entities, as well as the relationships between physician-owned entities that
purchase or lease our products and hospitals, are not in violation of
applicable laws and regulations, governmental authorities might take a contrary
position. If our financial relationships with physicians or physician-owned
entities or the relationships between those entities and hospitals were found
to be illegal, we and/or the affected physicians and hospitals could be subject
to civil and criminal penalties, including fines, exclusion from participation
in government and private payor programs and requirements to refund amounts
previously received from government and private payors. In addition, expansion
of our operations to new jurisdictions, or new interpretations of laws in our
existing jurisdictions, could require structural and organizational
modifications of our relationships with physicians, physician-owned entities
and others to comply with that jurisdictions laws. If we become subject to claims, we may be required to pay damages that exceed
our insurance coverage. Our business exposes us to potential product liability claims that are
inherent in the testing, production, marketing and sale of medical devices. We
are also subject to various other claims as described below in
Part II, Item 1  Legal
Proceedings. While we believe that we are reasonably insured against these
risks, we may not be able to maintain insurance in amounts or scope sufficient
to provide us with adequate coverage against all potential liabilities. A
claim in excess of our insurance coverage would have to be paid out of cash
reserves, which could have a material adverse effect on our business, financial
condition, results of operations and cash flows. In addition, any product
liability claim likely would harm our reputation in the industry and our
business. We have $20 million of directors and officers liability insurance
coverage. The coverage is provided in four $5 million policies issued by a
primary insurance carrier and three excess insurance carriers. For claims
asserted during 28




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the period from June 10, 2002 through June 10, 2003, one of the
excess carriers has reserved the right to disclaim coverage and to rescind the
policy if it is determined that, at the time it signed the policy application,
our former management was aware of facts that might have resulted in future
claims under the policy. The other two excess
carriers have declined coverage and filed arbitration complaints,
contending our former management made misstatements or omissions in the
applications for insurance coverage. A claim in excess of our insurance
coverage would have to be paid out of cash reserves, which could have a
material adverse effect on our business, financial condition, results of
operations and cash flows. We are faced with intense competition and rapid technological and industry
change, which may make it more difficult for us to achieve significant market
penetration. The medical device industry generally, and the urological disease
treatment market in particular, are characterized by rapid technological
change, changing customer needs, and frequent new product introductions. If
our competitors existing products or new products are more effective than or
considered superior to our products, the commercial opportunity for our
products will be reduced or eliminated. We face intense competition from
companies in the cryosurgical marketplace as well as companies offering other
treatment options, including radical surgery, radiation therapy and hormone
therapy. If we are successful in penetrating the market for treatment of
prostate cancer with our cryosurgical treatment, other medical device companies
may be attracted to the marketplace. Many of our potential competitors are
significantly larger than we are and have greater financial, technical,
research, marketing, sales, distribution and other resources than we do. We
believe there will be intense price competition for products developed in our
markets. Our competitors may develop or market technologies and products,
including drug-based treatments, that are more effective or commercially
attractive than any that we are developing or marketing. Our competitors may
obtain regulatory approval, and introduce and commercialize products before we
do. These developments could have a material adverse effect on our business,
financial condition, results of operations and cash flows. Even if we are able
to compete successfully, we may not be able to do so in a profitable manner. Fluctuations in our future operating results may negatively impact the market
price of our common stock. Our operating results have fluctuated in the past and can be expected to
fluctuate from time to time in the future. Some of the factors that may cause
these fluctuations include the following:  
    
    impact of legal proceedings;  
    
    costs of expanding our infrastructure to support more robust internal
controls, including more effective policies and procedures;  
    
    costs to strengthen our accounting practices, disclosure controls and corporate governance;  
    
    market acceptance of our existing products, as well as products in development;  
    
    timing of payments received and the recognition of such payments as
revenue under collaborative arrangements and strategic alliances;  
    
    ability to manufacture products efficiently;  
    
    timing of our research and development expenditures;  
    
    timing of customer orders;  
    
    changes in reimbursement rates for our products and procedures by
Medicare and other third-party payors;  
    
    potential impact of acquisitions;  
    
    timing of regulatory approvals for new products; 29




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
    
    outcomes of clinical studies by us or our competitors;  
    
    competition from other treatment modalities; and
    
    physician and patient acceptance of cryosurgery. If our operating results are below the expectations of securities analysts
or investors, the market price of our common stock may fall abruptly and
significantly. Our stock price may be volatile and your investment could decline in value. Our stock price has fluctuated significantly in the past and is likely to
continue to fluctuate significantly, making it difficult to resell shares when
investors want to at prices they find attractive. The market prices for
securities of emerging companies have historically been highly volatile.
Future events concerning us or our competitors could cause such volatility
including:  
    
    actual or anticipated variations in our operating results;  
    
    developments regarding government and third-party reimbursement;  
    
    changes in government regulation of our products and business practices;  
    
    developments concerning government investigation of us;  
    
    developments concerning proprietary rights;  
    
    developments concerning litigation or public concern as to the safety
of our products or our competitors products;  
    
    technological innovations or introduction of new products by us or our competitors;  
    
    investor and analyst perception of us and our industry;  
    
    general economic and market conditions; and  
    
    physician and patient acceptance of cryosurgery. In addition, the stock market is subject to price and volume fluctuations
that affect the market prices for companies in general, and
small-capitalization, high technology companies in particular, which are often
unrelated to the operating performance of these companies. Future sales of shares of our common stock may negatively affect our stock
price. Future sales of our common stock, including shares issued upon the
exercise of outstanding options and warrants or hedging or other derivative
transactions with respect to our stock, could have a significant negative
effect on the market price of our common stock. These sales also might make it
more difficult for us to sell equity securities or equity-related securities in
the future at a time and price that we would deem appropriate. Our intangible assets and goodwill could become impaired. 30




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Intangible assets acquired in a purchase, such as intellectual property or
developed technology, are generally amortized over various periods depending on
their anticipated economic benefits or useful lives. Long-lived assets,
including amortizable intangibles, are reviewed for impairment whenever events
or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison of the
carrying amount of an asset to future net cash flows expected to be generated
by the asset. Following a review, if such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which
the carrying value of the assets exceeds the fair value of the assets. We had no reported goodwill prior to January 1, 2002. With the adoption
of Statement of Financial Accounting Standards No. 142 Goodwill and Intangible
Assets, goodwill can no longer be amortized against earnings. Goodwill
balances are subject to an impairment review on an annual basis or sooner if
indicators of potential impairment exist. The test for impairment requires us
to first compare the fair value of the net assets of each reporting unit to
their carrying value, including goodwill. If the fair value of the reporting
unit is less than the carrying value, goodwill of the reporting unit is
potentially impaired and we next calculate the implied fair value of goodwill
by deducting the fair value of all tangible and intangible net assets of the
reporting unit from the fair value of the reporting unit. If the implied fair
value of goodwill is less then the carrying amount of goodwill, an impairment
loss is recognized equal to the difference. In the past, we have recorded
goodwill impairment related to our Timm Medical acquisition and an impairment
of our investment in U.S. Medical Development, Inc. Significant estimates,
including assumptions regarding future events and circumstances that cannot be
easily predicted are required to perform an analysis of the value of goodwill.
These estimates and assumptions may differ materially from actual outcomes and
occurrences. Furthermore, no assurance can be given that we will not have
further impairment charges related to Timm Medical or other acquisitions. Negative economic conditions in the United States may negatively impact our
ability to achieve profitability. During 2001, 2002 and into 2003, the United States and other international
markets experienced a significant economic downturn. In addition, the United
States and other countries suffered significant acts of hostility, terror and
war. Such acts may increase or prolong such negative economic conditions. The
economic downturn may impact our ability to maintain or increase profitability
by negatively affecting growth in demand for our products. There can be no
certainty as to the degree or severity of the duration of this downturn. We
also cannot predict the extent and timing of the impact of the economic
downturn in the United States and in other countries and geographic regions in
which we conduct our business. Our facilities and systems are vulnerable to natural disasters or other
catastrophic events. Our headquarters, cryosurgical products manufacturing facilities, research
facilities and much of our infrastructure, including computer servers, are
located in California, an area that is susceptible to earthquakes and other
natural disasters. Our erectile dysfunction products are assembled, packaged
and shipped in our Minneapolis facility. A natural disaster or other
catastrophic event, such as an earthquake, fire, flood, severe storm, break-in,
terrorist attack or other comparable problems could cause interruptions or
delays in our business and loss of data or render us unable to accept and
fulfill customer orders in a timely manner, or at all. In addition, as our
Minneapolis facility is located in an area that is susceptible to harsh
weather, a major storm, heavy snowfall or other similar event could prevent us
from delivering products in a timely manner. We have no formal disaster
recovery plan and our business interruption insurance may not adequately
compensate us for losses that may occur. In the event that an earthquake,
natural disaster or other catastrophic event were to destroy any part of our
facilities or interrupt our operations for any extended period of time, or if
harsh weather conditions prevent us from delivering products in a timely
manner, our business, financial condition and operating results would be
seriously harmed. 
 ITEM 3.    Quantitative and Qualitative Disclosures About Market Risk The primary objective of our investment activities is to preserve
principal while at the same time maximizing the income we receive from our
invested cash without significantly increasing risk of loss. Our financial
instruments include cash, cash equivalents, short-term investments, accounts
receivable, investments, accounts payable and accrued liabilities. At March
31, 2004, the carrying values of our financial instruments approximated their
fair values. Our policy is not to enter into derivative financial instruments.
In addition, we do 31




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not enter into any futures or forward contracts and
therefore, we do not have significant market risk exposure with respect to
commodity prices. Although we transact our business in U.S. dollars, future fluctuations in
the value of the U.S. dollar may affect the price competitiveness of our
products. However, we do not believe that we currently have any significant
direct foreign currency exchange rate risk and have not hedged exposures
denominated in foreign currencies or any other derivative financial
instruments. 
 ITEM 4.    Controls and Procedures (a)    Evaluation of Disclosure Controls and Procedures.As required by
Securities and Exchange Commission Rule 13a-15(b), our Chief Executive Officer
and our Senior Vice President, Chief Financial Officer have evaluated the
effectiveness of our disclosure controls and procedures as of the end of the
period covered by this report. Based on their evaluation, our Chief Executive
Officer and our Senior Vice President, Chief Financial Officer have concluded
our disclosure controls and procedures are not yet effective because we are not
currently able to timely file all reports required to be filed by us pursuant
to Section 15(d) of the Securities Exchange Act of 1934. Our inability to
timely file the required reports is due to, among other things, the fact that
managements time and attention have been consumed by the auditing and
re-auditing of our financial statements for the years ended December 31, 2000,
2001, 2002 and 2003, and the resulting restatements, by the development and
implementation of improvements to our internal controls and financial reporting
processes, and by the internal and external investigations into the accounting
and other matters described in our consolidated financial statements and the
related Notes contained in this report in Part I, Item 1 and in our Annual
Report on Form 10-K for the year ended December 31, 2003 and in Part I, Item 2
of this report, Managements Discussion and Analysis of Financial Condition and
Results of Operations. Since March 2003, management has implemented and continues to implement
significant changes in organization, policies and procedures designed to
enhance our disclosure controls and procedures and the related internal
controls. These include, among other measures: new restrictions and guidelines
governing sales personnel, terms and conditions of sale and revenue
recognition; new and more stringent credit approval policies; new policies
governing approval, review and recording of expenditures and other legal and
financial transactions; new procedures governing documentation and approval of
options and warrants issued in connection with legal and financial
transactions; and new internal reporting procedures. Nevertheless, during much
of 2003, many of these enhancements to our disclosure controls and procedures
and the related internal controls were not yet in place, or were only partially
in place. For this reason, management has undertaken an extensive and
substantive review and evaluation of all financial transactions that,
individually or collectively, could have a material impact on the information
contained in this Form 10-Q. These review procedures, in combination with the
changes in internal control that have been implemented as of the end of the
period covered by this report, form the basis for our determination that the
financial statements and other information contained in this report fairly
present, in all material respects, our financial condition, results of
operations and cash flows for the three months ended March 31,
2003 and 2004. (b)    Changes in Internal Controls.Except as described above in subsection
(a) of this Item 4, there was no change in our internal control over financial
reporting during our first fiscal quarter for 2004 that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting. 32




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PART II   OTHER INFORMATION 
 ITEM 1.    Legal Proceedings We are a party to lawsuits in the normal course of our business.
Litigation and governmental investigation can be expensive and disruptive to
normal business operations. Moreover, the results of complex legal proceedings
are difficult to predict. We can provide no assurance that significant
judgments or settlements in connection with the legal proceedings described
below will not have a material adverse effect on our business, financial
condition, results of operations and cash flows. See Part I, Item 2 
Managements Discussion and Analysis of Financial Condition and Results of
Operations. Other than as described below, we are not a party to any material
legal proceedings. In November 2002, we were named as a defendant, together with certain
former officers, one of whom is also a former board member, in a class-action
lawsuit filed in the United States District Court for the Central District of
California. On February 2, 2003, the court issued an order consolidating this
action with various other similar complaints and ordering plaintiffs to file a
consolidated complaint, which was filed on October 31, 2003. The consolidated
complaint asserts two claims for relief, alleging that the defendants violated
sections of the Securities Exchange Act of 1934 by purportedly issuing false
and misleading statements regarding our revenues and expenses in press releases
and SEC filings. Plaintiffs seek class certification and unspecified damages
from us, as well as forfeiture and reimbursement of bonus compensation received
by two of the individual defendants. On April 26, 2004, the court issued an
order denying our motion to dismiss the consolidated complaint. We intend to
defend the case vigorously, but cannot assure you that it will be resolved in
our favor. On November 26, 2002, BioLife filed an action against us in the Delaware
Court of Chancery seeking damages for alleged breaches of contract stemming
from our acquisition, pursuant to an asset purchase agreement dated May 28,
2002, of the tangible and intangible assets related to BioLifes cryosurgical
business. In the action, styled as BioLife Solutions, Inc. v. Endocare, Inc.,
Del. Ch., C.A. No. 20057-NC, BioLife alleged that we failed to timely register
120,022 shares of our common stock that were provided to BioLife in connection
with the asset purchase agreement, in violation of a registration rights
agreement relating to the shares that was executed in conjunction with the
asset purchase agreement. BioLife sought damages of approximately $1.6
million. We defended the action on the grounds that our obligation to register
the shares was excused for various reasons, including as a consequence of
BioLifes failure to transfer assets in accordance with the asset purchase
agreement. Trial on all but one of the claims in the action was held during
the week of March 31, 2003. On October 1, 2003, the Delaware Court ruled in
favor of BioLife, awarding BioLife $1,648,000, plus pre-judgment interest and
costs (including legal fees), and requiring BioLife to surrender the 120,022
shares of our common stock to us. That ruling became an appealable final order
and judgment on October 10, 2003. On February 20, 2004, we agreed with BioLife
to settle all claims. As part of the settlement: we paid to BioLife
$1,887,000, which represented a discount of $150,000 from the total judgment
amount (including accrued interest and costs); BioLife returned to us the
120,022 shares of our common stock referred to above; and we agreed to abandon
our appeal. On December 6, 2002, Frederick Venables filed a purported derivative
action against us and certain former officers and certain current and former
board members in the California Superior Court for the County of Orange
alleging breach of fiduciary duty, abuse of control, gross mismanagement, waste
of corporate assets and unjust enrichment. On April 23, 2004, the parties
filed a stipulation agreeing to a conditional stay of the action for 270 days.
Assuming that the court enters this stipulated order, the deadline to respond
to the complaint will be continued until after expiration of the stay. The
complaint seeks unspecified monetary damages, equitable relief and injunctive
relief based upon allegations that the defendants issued false and misleading
statements regarding our revenues and expenses in press releases and SEC
filings. We intend to defend the case vigorously, but cannot assure you that
it will be resolved in our favor. The SEC is currently conducting an investigation to determine whether any
federal securities laws were violated in connection with the filing of our
financial statements for 2001 and the first two quarters of 2002, including
investigation into allegations that we and certain of our current and former
officers and directors issued or caused to be issued false and misleading
statements regarding our revenues and expenses in those SEC filings. We are
cooperating fully with this investigation. We cannot assure you that this
matter will be resolved in our favor. 33




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The DOJ is currently conducting an investigation into allegations that we
and certain of our current and former officers and directors intentionally
issued or caused to be issued false and misleading statements regarding our
revenues and expenses in SEC filings. We are cooperating fully with this
investigation. We cannot assure you that this matter will be resolved in our
favor. 
 ITEM 2.    Changes in Securities and Use of Proceeds In addition, during the three months
ended March 31, 2004, we repurchased 120,022 shares of our common
stock at $4.20 per share in connection with settlement of the BioLife
litigation described above in Part II, Item I 
Legal Proceedings. 
 ITEM 3.    Defaults Upon Senior Securities Not applicable. 
 ITEM 4.    Submission of Matters to a Vote of Security Holders None. 
 ITEM 5.    Other Information In December 2003, our board of directors adopted amended and restated
bylaws. Among other things, these bylaws set forth the procedures that
stockholders must follow in order to nominate persons for election as
directors. The bylaws provide that such nominations must be made pursuant to
timely notice in writing to our corporate secretary, at 201 Technology Drive,
Irvine, California 92618. To be timely, a stockholders notice must be delivered to or mailed and
received at such address by no later than the due date for stockholder
proposals that is specified in our proxy statement released to stockholders in
connection with the previous years annual meeting of stockholders, which date
shall be not less than one hundred twenty (120) calendar days in advance of the
date of such proxy statement; provided, however, that in the event that no
annual meeting was held in the previous year or the date of the annual meeting
has been changed by more than thirty (30) days from the date of the previous
years annual meeting, notice by the stockholder to be timely must be so
received a reasonable time before we begin to print and mail our proxy
materials. Such stockholders notice shall set forth (i) as to each person, if any,
whom the stockholder proposes to nominate for election or re-election as a
director: (A) the name, age, business address and residence address of such
person, (B) the principal occupation or employment of such person, (C) the
class and number of our shares that are beneficially owned by such person, (D)
a description of all arrangements or understandings between the stockholder and
each nominee and any other person or persons (naming such person or persons)
pursuant to which the nominations are to be made by the stockholder, and (E)
any other information relating to such person that is required to be disclosed
in solicitations of proxies for election of directors, or is otherwise
required, in each case pursuant to Regulation 14A under the Securities Exchange
Act of 1934 (including without limitation such persons written consent to
being named in the proxy statement, if any, as a nominee and to serving as a
director if elected); and (ii) as to such stockholder giving notice, the
following information: (A) the name and address, as they appear on our books,
of such stockholder, (B) the class and number of our shares which are
beneficially owned by such stockholder, and (C) any material interest of such
stockholder in the election to our board of such nominee. 34




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ITEM 6.    Exhibits and Reports on Form 8-K. (a) Exhibits Exhibit No.
    
    Description2.1
    (1)
    
    Agreement and Plan of Reorganization dated February 21, 2002, by and among the Company,
Technologies, Inc., TMT Acquisition Corporation and certain stockholders of Timm Medical
Technologies, Inc. Certain schedules and other attachments to this exhibit were omitted.
We agree to furnish supplementally a copy of any omitted schedules or attachments to the
Commission upon request.2.2
    (2)
    
    Agreement and Plan of Merger dated June 30, 1999, by and among the Company, Advanced
Medical Procedures, Inc., Advanced Medical Procedures, LLC, Gary M. Onik, M.D., Robert F.
Byrnes and Jerry Anderson. Certain schedules and other attachments to this exhibit were
omitted. We agree to furnish supplementally a copy of any omitted schedules or
attachments to the Commission upon request.2.3
    (3)
    
    Asset Purchase Agreement, dated February 6, 2002, by and between the Company and Gary M.
Onik, M.D. Certain schedules and other attachments to this exhibit were omitted. We
agree to furnish supplementally a copy of any omitted schedules or attachments to the
Commission upon request.2.4
    (3)
    
    Asset Purchase Agreement dated May 28, 2002, by and among the Company and Cryomedical
Sciences, Inc. Certain schedules and other attachments to this exhibit were omitted. We
agree to furnish supplementally a copy of any omitted schedules or attachments to the
Commission upon request.2.5
    (4)
    
    Partnership and Limited Liability Company Membership Interest Purchase Agreement, dated as
of August 12, 2002, by and among Endocare, Inc. and U.S. Medical Development, Inc.,
U.S.M.D., Ltd. and U.S.M.D. I, L.L.C. Certain schedules and exhibits referenced in this
exhibit have been omitted. We agree to furnish supplementally a copy of any omitted
schedules or attachments to the Commission upon request.2.6
    (5)
    
    Amendment No. 1 to Partnership and Limited Liability Company Membership Interest Purchase
Agreement, dated as of August 12, 2002, by and among Endocare, Inc. and U.S. Medical
Development, Inc., U.S.M.D., Ltd. and U.S.M.D. I, L.L.C.2.7
    (6)
    
    Agreement of Purchase and Sale, dated as of April 7, 2003, by and among American Medical
Systems, Inc., the Company and Timm Medical Technologies, Inc.2.8
    (7)
    
    Asset Purchase and Technology License Agreement, dated as of April 29, 2003, by and
between the Company and CryoCathTechnologies Inc.2.9
    (8)
    
    Agreement of Purchase and Sale, dated as of October 15, 2003, by and between SRS Medical
Corp. and Timm Medical Technologies, Inc.2.10
    
    
    Amendment No. 2 to Partnership and Limited Liability Company Membership Interest Purchase
Agreement, dated as of February 27, 2004, by and among Endocare, Inc. and U.S. Medical
Development, Inc., U.S.M.D., Ltd. and U.S.M.D. I, L.L.C.2.11
    
    
    Service Fee Agreement, dated as of February 26, 2004, by and among Endocare, Inc. and the
Limited Partners of Mid-America Cryotherapy, L.P.2.12
    
    
    First Amendment to Agreement of Purchase and Sale, dated as of March 25, 2004, by and
between SRS Medical Corp. and Timm Medical Technologies, Inc.3.1
    (2)
    
    Certificate of Amendment of Restated Certificate of Incorporation of the Company.3.2
    (2)
    
    Certificate of Designation of Series A Junior Participating Preferred Stock of the Company.3.3
    (2)
    
    Restated Certificate of Incorporation.3.4
    (2)
    
    Amended and Restated Bylaws of the Company.10.1
    
    
    Executive Separation Benefits Plan, approved by the Compensation Committee of the Board of
Directors on July 17, 2002 and amended by the Board of Directors on February 13, 2004.
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Exhibit No.
    
    Description10.2
    
    
    Settlement Agreement, dated as of February 20, 2004, by and between the Company and
BioLife Solutions Inc.31.1
    
    
    Certification under Section 302 of the Sarbanes-Oxley Act of 2002 for Craig T. Davenport.31.2
    
    
    Certification under Section 302 of the Sarbanes-Oxley Act of 2002 for Katherine Greenberg.32.1
    
    
    Certification under Section 906 of the Sarbanes-Oxley Act of 2002 for Craig T. Davenport.32.2
    
    
    Certification under Section 906 of the Sarbanes-Oxley Act of 2002 for Katherine Greenberg.
   *
    
    We have requested confidential treatment with respect to certain portions
of these documents.
    
    Management contract or compensatory plan or arrangement(1)
    
    Previously filed as exhibits to our Form 8-K filed on March 5, 2002.(2)
    
    Previously filed as exhibits to our Registration Statement on Form S-3
filed on September 20, 2001 and October 31, 2001.(3)
    
    Previously filed as exhibits to our Form 10-Q filed on August 14, 2002.(4)
    
    Previously filed as exhibits to our Form 8-K filed on August 16, 2002.(5)
    
    Previously filed as an exhibit to our Form 8-K filed on October 15, 2002.(6)
    
    Previously filed as an exhibit to our Form 8-K filed on April 22, 2003.(7)
    
    Previously filed as an exhibit to our Form 8-K filed on April 29, 2003.(8)
    
    Previously filed as an exhibit to our Form 8-K filed on October 20, 2003. (b) Reports on Form 8-K We filed a Form 8-K under Item 5 on January 21, 2004 to report the
appointment to our board of directors of Craig T. Davenport and John R.
Daniels, M.D. We filed a Form 8-K under Item 5 on March 8, 2004 to report our settlement
of litigation with BioLife Solutions, Inc. We furnished a Form 8-K under Item 12 on March 16, 2004 to report the
release of our audited financial results for the year ended December 31, 2003. 36




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. Date: May 10, 2004 ENDOCARE, INC.By:
    
    
    
    /s/ Craig T. DavenportCraig T. DavenportChief Executive Officer and Chairman of the Board(Duly Authorized Officer)By:
    
    
    
    /s/ Katherine GreenbergKatherine GreenbergSenior Vice President and Chief Financial Officer(Principal Financial and Accounting Officer)
 37




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EXHIBIT INDEX Exhibit No.
    
    Description2.1
    (1)
    
    Agreement and Plan of Reorganization dated February 21, 2002, by and among the Company,
Technologies, Inc., TMT Acquisition Corporation and certain stockholders of Timm Medical
Technologies, Inc. Certain schedules and other attachments to this exhibit were omitted.
We agree to furnish supplementally a copy of any omitted schedules or attachments to the
Commission upon request.2.2
    (2)
    
    Agreement and Plan of Merger dated June 30, 1999, by and among the Company, Advanced
Medical Procedures, Inc., Advanced Medical Procedures, LLC, Gary M. Onik, M.D., Robert F.
Byrnes and Jerry Anderson. Certain schedules and other attachments to this exhibit were
omitted. We agree to furnish supplementally a copy of any omitted schedules or
attachments to the Commission upon request.2.3
    (3)
    
    Asset Purchase Agreement, dated February 6, 2002, by and between the Company and Gary M.
Onik, M.D. Certain schedules and other attachments to this exhibit were omitted. We
agree to furnish supplementally a copy of any omitted schedules or attachments to the
Commission upon request.2.4
    (3)
    
    Asset Purchase Agreement dated May 28, 2002, by and among the Company and Cryomedical
Sciences, Inc. Certain schedules and other attachments to this exhibit were omitted. We
agree to furnish supplementally a copy of any omitted schedules or attachments to the
Commission upon request.2.5
    (4)
    
    Partnership and Limited Liability Company Membership Interest Purchase Agreement, dated as
of August 12, 2002, by and among Endocare, Inc. and U.S. Medical Development, Inc.,
U.S.M.D., Ltd. and U.S.M.D. I, L.L.C. Certain schedules and exhibits referenced in this
exhibit have been omitted. We agree to furnish supplementally a copy of any omitted
schedules or attachments to the Commission upon request.2.6
    (5)
    
    Amendment No. 1 to Partnership and Limited Liability Company Membership Interest Purchase
Agreement, dated as of August 12, 2002, by and among Endocare, Inc. and U.S. Medical
Development, Inc., U.S.M.D., Ltd. and U.S.M.D. I, L.L.C.2.7
    (6)
    
    Agreement of Purchase and Sale, dated as of April 7, 2003, by and among American Medical
Systems, Inc., the Company and Timm Medical Technologies, Inc.2.8
    (7)
    
    Asset Purchase and Technology License Agreement, dated as of April 29, 2003, by and
between the Company and CryoCathTechnologies Inc.2.9
    (8)
    
    Agreement of Purchase and Sale, dated as of October 15, 2003, by and between SRS Medical
Corp. and Timm Medical Technologies, Inc.2.10
    
    
    Amendment No. 2 to Partnership and Limited Liability Company Membership Interest Purchase
Agreement, dated as of February 27, 2004, by and among Endocare, Inc. and U.S. Medical
Development, Inc., U.S.M.D., Ltd. and U.S.M.D. I, L.L.C.2.11
    
    
    Service Fee Agreement, dated as of February 26, 2004, by and among Endocare, Inc. and the
Limited Partners of Mid-America Cryotherapy, L.P.2.12
    
    
    First Amendment to Agreement of Purchase and Sale, dated as of March 25, 2004, by and
between SRS Medical Corp. and Timm Medical Technologies, Inc.3.1
    (2)
    
    Certificate of Amendment of Restated Certificate of Incorporation of the Company.3.2
    (2)
    
    Certificate of Designation of Series A Junior Participating Preferred Stock of the Company.3.3
    (2)
    
    Restated Certificate of Incorporation.3.4
    (2)
    
    Amended and Restated Bylaws of the Company.10.1
    
    
    Executive Separation Benefits Plan, approved by the Compensation Committee of the Board of
Directors on July 17, 2002 and amended by the Board of Directors on February 13, 2004.10.2
    
    
    Settlement Agreement, dated as of February 20, 2004, by and between the Company and
BioLife Solutions Inc.
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Exhibit No.
    
    Description31.1
    
    
    Certification under Section 302 of the Sarbanes-Oxley Act of 2002 for Craig T. Davenport.31.2
    
    
    Certification under Section 302 of the Sarbanes-Oxley Act of 2002 for Katherine Greenberg.32.1
    
    
    Certification under Section 906 of the Sarbanes-Oxley Act of 2002 for Craig T. Davenport.32.2
    
    
    Certification under Section 906 of the Sarbanes-Oxley Act of 2002 for Katherine Greenberg.
   *
    
    We have requested confidential treatment with respect to certain portions
of these documents.
    
    Management contract or compensatory plan or arrangement(1)
    
    Previously filed as exhibits on Form 8-K on March 5, 2002.(2)
    
    Previously filed as exhibits with our Registration Statement on Form S-3
filed on September 20, 2001 and October 31, 2001.(3)
    
    Previously filed as exhibits with our Form 10-Q filed on August 14, 2002.(4)
    
    Previously filed as an exhibit on Form 8-K on August 16, 2002.(5)
    
    Previously filed as an exhibit on Form 8-K on October 15, 2002.(6)
    
    Previously filed on Form 8-K on April 22, 2003.(7)
    
    Previously filed on Form 8-K on April 29, 2003.(8)
    
    Previously filed on Form 8-K on October 20, 2003. 39