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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
 FORM 10-Q (Mark One) x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934
 For the quarterly period
ended March 31, 2004 or o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934
 For the transition period from___________________________to ____________________ Commission File Number: 0-21214 ORTHOLOGIC CORP.  Delaware
    
    86-0585310(State of other jurisdiction of incorporation or organization)
    
    (IRS Employer Identification No.)
 1275 W. Washington Street, Tempe, Arizona
    
    85281(Address of principal executive offices)
    
    (Zip Code)
 (602) 286-5520      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. x Yes o No Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 126-2 of the Exchange Act):
xYes o No APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date. 34,527,152 shares of common stock outstanding as of April 30, 2004 1




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ORTHOLOGIC CORP.
INDEX Page No.Part I Financial InformationItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the Three months ended March 31, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the Three months ended March 31, 2004 and 2003
    
    
    5Notes to Unaudited Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    18Item 4. Controls and Procedures
    
    
    18Part II Other InformationItem 6. Exhibits and Reports
    
    
    27EX-31.1EX-31.2EX-32
  2




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PART I  Financial Information 
 Item 1. Financial Statements
 ORTHOLOGIC CORP. 
  
 March 31,
    
    December 31,2004
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    67,114
    
    
    $
    84,357Short-term investments
    
    
    48,364
    
    
    
    32,499Accounts receivable less allowance for doubtful accounts,
$435 and $556
    
    
    348
    
    
    
    792Prepaids and other current assets
    
    
    1,089
    
    
    
    882Total current assets
    
    
    116,915
    
    
    
    118,530Furniture and equipment, net
    
    
    528
    
    
    
    560Long-term investments
    
    
    4,609
    
    
    
    4,156Escrow receivable, net
    
    
    5,138
    
    
    
    5,144Deferred income taxes  non-current
    
    
    770
    
    
    
    770Deposits and other assets
    
    
    196
    
    
    
    196Investment in Chrysalis BioTechnology
    
    
    750
    
    
    
    750Total assets
    
    $
    128,906
    
    
    $
    130,106LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    665
    
    
    $
    201Accrued compensation
    
    
    200
    
    
    
    609Accrued taxes
    
    
    1,146
    
    
    
    2,924Excess space reserve
    
    
    209
    
    
    
    314Other current liabilities
    
    
    1,994
    
    
    
    1,596Accrued severance and other divestiture costs
    
    
    
    
    
    
    279Total current liabilities
    
    
    4,214
    
    
    
    5,923Deferred rent and capital lease obligation
    
    
    190
    
    
    
    208Total liabilities
    
    
    4,404
    
    
    
    6,131Stockholders EquityCommon stock, $.0005 par value;
50,000,000 shares authorized; and 34,525,069 and
33,533,443 shares issued and outstanding
    
    
    17
    
    
    
    16Additional paid-in capital
    
    
    145,933
    
    
    
    142,329Accumulated deficit
    
    
    (21,448
    )
    
    
    (18,233
    )Treasury stock at cost, 41,800 shares
    
    
    
    
    
    
    (137
    )Total stockholders equity
    
    
    124,502
    
    
    
    123,975Total liabilities and stockholders equity
    
    $
    128,906
    
    
    $
    130,106
 See Notes to Unaudited Condensed Consolidated Financial Statements 3




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ORTHOLOGIC CORP. 
  
 Three months ended March 31,2004
    
    2003OPERATING EXPENSESGeneral and administrative
    
    $
    555
    
    
    $
    1,289Research and development
    
    
    3,371
    
    
    
    1,390CPM divestiture and related gains
    
    
    (111
    )
    
    
    Total operating expenses
    
    
    (3,815
    )
    
    
    (2,679
    )OPERATING LOSS
    
    
    (3,815
    )
    
    
    (2,679
    )OTHER INCOMEInterest income, net
    
    
    306
    
    
    
    132Loss from continuing operations before taxes
    
    
    (3,509
    )
    
    
    (2,547
    )Income tax benefit
    
    
    (294
    )
    
    
    (981
    )Net loss from continuing operations
    
    
    (3,215
    )
    
    
    (1,566
    )Discontinued operationsIncome from operations of Bone Device Business,
net of taxes of $0 and $994
    
    
    
    
    
    
    1,708Net income from discontinued operations
    
    
    
    
    
    
    1,708NET INCOME (LOSS)
    
    $
    (3,215
    )
    
    $
    142Net loss from continuing operationsBasic
    
    $
    (0.09
    )
    
    $
    (0.05
    )Diluted
    
    $
    (0.09
    )
    
    $
    (0.05
    )Net income from discontinued operationsBasic
    
    $
    
    
    
    $
    0.05Diluted
    
    $
    
    
    
    $
    0.05Net lossBasic
    
    $
    (0.09
    )
    
    $
    Diluted
    
    $
    (0.09
    )
    
    $
    Basic shares outstanding
    
    
    34,310
    
    
    
    32,809Equivalent shares
    
    
    
    
    
    
    219Diluted shares outstanding
    
    
    34,310
    
    
    
    33,028
 See Notes to Unaudited Condensed Consolidated Financial Statements 4




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ORTHOLOGIC CORP. 
  
 Three months ended March 31,2004
    
    2003OPERATING ACTIVITIESNet income (loss)
    
    $
    (3,215
    )
    
    $
    142Non-cash items:Depreciation and amortization
    
    
    70
    
    
    
    173Performance based stock option expense
    
    
    (56
    )
    
    
    Change in operating assets and liabilities:Accounts receivable
    
    
    444
    
    
    
    418Inventories
    
    
    
    
    
    
    (148
    )Prepaids and other current assets
    
    
    (207
    )
    
    
    (79
    )Deposits and other assets
    
    
    
    
    
    
    14Accounts payable
    
    
    464
    
    
    
    215Accrued liabilities
    
    
    (2,191
    )
    
    
    (113
    )Accrued liabilities on CPM divestiture and related
charges
    
    
    
    
    
    
    (26
    )Net cash (used in) provided by operating activities
    
    
    (4,691
    )
    
    
    596INVESTING ACTIVITIESExpenditures for equipment and furniture
    
    
    (32
    )
    
    
    (101
    )Purchases of investments
    
    
    (21,181
    )
    
    
    (7,341
    )Maturities of investments
    
    
    4,863
    
    
    
    6,009Net cash used in investing activities
    
    
    (16,350
    )
    
    
    (1,433
    )FINANCING ACTIVITIESNet proceeds from stock option exercises
    
    
    3,798
    
    
    
    257Net cash provided by financing activities
    
    
    3,798
    
    
    
    257NET DECREASE IN CASH AND CASH EQUIVALENTS
    
    
    (17,243
    )
    
    
    (580
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    84,357
    
    
    
    11,286CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    67,114
    
    
    $
    10,706SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES:Cash paid during the period for interest
    
    $
    2
    
    
    $
    4Cash paid during the period for income taxes
    
    $
    1,474
    
    
    $
    27Common stock issued for legal settlement
    
    $
    0
    
    
    $
    2,078
 See Notes to Unaudited Condensed Consolidated Financial Statements. 5




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ORTHOLOGIC CORP. 
 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of the Business. OrthoLogic is a drug-development company focused on the healing of
musculoskeletal tissue, through biopharmaceutical approaches. Our research is
focused exclusively on the potential commercialization of our Chrysalin®
Product Platform. Chrysalin, or TP508, is a 23-amino acid synthetic peptide
representing a receptor-binding domain of the human thrombin molecule, a
naturally occurring molecule in the body responsible for both blood clotting
and initiating many of the cellular events responsible for tissue repair in
bone and cartilage. We are currently enrolling patients in a Phase 3 Chrysalin
product human clinical trial for fracture indications, have just completed the
enrollment of patients in a Phase 1/2 spine fusion clinical trial, have one
potential product in late-stage pre-clinical development, and are planning the
development for two additional areas of research. On November 26, 2003, we sold our Bone Device Business to dj Orthopedic,
LLC for a purchase price of approximately $93.0 million in cash and the
assumption of substantially all of the Bone Device Business trade payables and
other current liabilities. Through this divestiture, we sold all of our
revenue producing operations and became a pure drug development company. The
Bone Device Business assets included the rights to produce and market the
OL1000, OL1000 SC, SpinaLogic and OrthoFrame/Mayo. As of March 31, 2004, we had cash and cash equivalents of $67.1 million,
short-term investments of $48.4 million and long-term investments of $4.6
million. We will be relying on these resources to fund the development,
testing and commercialization of our Chrysalin product platform. On April 29, 2004, we announced that we had signed a definitive agreement
to acquire substantially all of the assets and intellectual property of
privately held Chrysalis BioTechnology, Inc. (CBI), based in Galveston,
Texas, for $2.5 million in cash and up to $32.0 million in common stock. The
agreement covers exclusive rights to proprietary technology and intellectual
property in developing synthetic peptide-based therapeutics for a variety of
indications. The transaction is subject to approval of the CBI stockholders,
effectiveness of the registration statement to be filed by us with the
Securities and Exchange Commission and other customary closing conditions.
Closing of the acquisition is anticipated during the third quarter of 2004. In these notes, references to we, our and the Company refer to
OrthoLogic Corp. and its subsidiaries. References to our Bone Device Business
refer to our bone growth stimulation and fracture fixation device business,
including our former OL1000 and SpinaLogic products. 6




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Financial Statement Presentation In the opinion of management, the unaudited interim financial statements
include all adjustments necessary for the fair presentation of our financial
position, results of operations, and cash flows. The results of operations for
the interim periods are not necessarily indicative of the results to be
expected for the complete fiscal year. The balance sheet as of December 31,
2003 is derived from our audited financial statements included in the 2003
Annual Report on Form 10-K. These financial statements should be read in
conjunction with the financial statements and notes thereto included in the
2003 Annual Report on Form 10-K. Use of estimates. The preparation of the financial statements in
conformity with accounting principles generally accepted in the United States
of America 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 and the reported
amounts of revenue and expenses during the reporting period. These estimates
and assumptions form the basis for the carrying values of assets and
liabilities. On an on-going basis we evaluate these estimates, including those
related to allowance for doubtful accounts, guarantees, income taxes,
contingencies and litigation. Management bases its estimates on historical
experience and various other assumptions and believes its estimates are
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities not
readily apparent from other sources. Under different assumptions and
conditions, actual results may differ from these estimates. The significant estimates include the allowance for doubtful accounts
(approximately $435,000 and $556,000 at March 31, 2004 and December 31, 2003,
respectively), the fair value of certain representations and warranties issued
in conjunction with the sale of the Bone Device Business, excess space reserve
and the valuation allowance for deferred tax assets. Principles of consolidation. The consolidated financial statements
include the accounts of OrthoLogic and its wholly-owned subsidiaries. All
intercompany accounts and transactions have been eliminated. We prepare our
consolidated financial statements in accordance with accounting principles
generally accepted in the United States of America. Accordingly, the
consolidated financial statements do not include all information and notes
required for complete financial statements. The following briefly describes
the significant accounting policies used in the preparation of the our
financial statements. A. Cash and cash equivalents. Cash and cash equivalents consist of cash
on hand and cash deposited with financial institutions, including money market
accounts, and commercial paper purchased with an original maturity of three
months or less. B. Furniture and equipment. Furniture and equipment are stated at cost
or, in the case of leased assets under capital leases, at the present value of
future lease payments at inception of the lease. Depreciation is calculated on
a straight-line basis over the estimated useful lives of the various assets,
which range from three to seven years. Leasehold improvements and leased
assets under capital leases are amortized over the life of the asset or the
period of the respective lease using the straight-line method, whichever is the
shortest. We adopted Statement of Financial Accounting Standards No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS No.
144) effective January 1, 2002. SFAS No. 144 addresses financial accounting
and reporting for the impairment or disposal of 7




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long-lived assets, and supersedes Statement of Financial Accounting
Standards No. 121, Accounting of the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed of. SFAS No. 144 requires that we evaluate
long-lived assets based on the net future cash flow expected to be generated
from the asset on an undiscounted basis whenever significant events or changes
in circumstances occur that indicate that the carrying amount of an asset may
not be recoverable. C. Escrow receivable. A portion of the purchase price related to the
sale of the Bone Device Business was required to be placed in escrow (Note 2).
Under Financial Accounting Standards Board (FASB) Interpretation No. 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of the Indebtedness of Others, indemnifications,
representations and warranties issued in conjunction with the sale of a
business are required to be valued and recorded in the financial statements.
We made certain representations and warranties in conjunction with the sale of
the Bone Device Business and determined the discounted fair value to be
approximately $1.9 million, which is reflected as a reduction of the escrow
receivable. The discount is being accreted to interest expense through November
26, 2005, which is when the portion of the purchase price allocated to the
representations and warranties is required to be released from escrow. D. Investment in Chrysalis. We own a minority ownership interest in
Chrysalis BioTechnology, Inc., which is recorded at cost (see Note 4). E. Excess Space Reserve. We lease a facility in Tempe, Arizona and
sublease portions to other tenants. We have established a reserve for the
period the available sublease space is anticipated to be vacant. In the
opinion of management, the reserve balance of $209,000 at March 31, 2004 is
adequate to allow for time necessary to acquire an additional tenant for the
building. F. Income taxes. Under SFAS No. 109, Accounting for Income Taxes,
income taxes are recorded based on current year amounts payable or refundable,
as well as the consequences of events that give rise to deferred tax assets and
liabilities. We base our estimate of current and deferred taxes on the tax
laws and rates that are currently in effect in the appropriate jurisdiction.
Pursuant to SFAS No. 109, we have determined that the majority of the deferred
tax asset at March 31, 2004 requires a valuation allowance. We believe the
remaining deferred tax asset of $770,000 will be realized as it relates to
alternative minimum tax credits that do not expire. G. Research and development. Research and development represents both
costs incurred internally for research and development activities, as well as
costs incurred to fund the research activities with which we have contracted
and certain milestone payments regarding the continued clinical testing of
Chrysalin. All research and development costs are expensed when incurred. H. Stock-based compensation. At March 31, 2004, we had two stock-based
employee compensation plans. We account for those plans under the recognition
and measurement principles of APB Opinion No. 25, Accounting for Stock Issued
to Employees, and related interpretations. In the quarter ended March 31,
2004, we recorded a reduction of approximately $56,000 in compensation expense
related to the vesting of performance based options. In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, Accounting for Stock-Based Compensation  Transition and
Disclosure (SFAS No. 8




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148) which is effective for fiscal years ended after December 15, 2002.
SFAS No. 148 amends SFAS No. 123 to provide alternative methods of transition
to SFAS No. 123s fair value method of accounting for stock-based employee
compensation if a company elects to account for its equity awards under this
method. SFAS No. 148 also amends the disclosure provisions of SFAS No. 123 and
APB Opinion No. 28, Interim Financial Reporting, to require disclosure of the
effects of an entitys accounting policy with respect to stock-based employee
compensation on reported net income and earnings per share in both annual and
interim financial statements. We have provided the required additional annual
disclosures below which illustrates the effect on net income and earnings per
share if we had applied the fair value recognition provisions of FASB Statement
No. 123, Accounting for Stock-Based Compensation, to stock-based employee
compensation (in thousands except per share data). Three months ended March 31,2004
    
    2003Estimated weighted-average fair value
of options granted during the period
    
    $
    2.45
    
    
    $
    1.67Net income (loss) attributable to
common stockholders:As reported
    
    $
    (3,215
    )
    
    $
    142Stock based compensation expense
    
    
    (600
    )
    
    
    (208
    )Pro forma
    
    $
    (3,815
    )
    
    $
    (66
    )Basic net income per share:As reported
    
    $
    (0.09
    )
    
    $
    0.00Pro forma
    
    $
    (0.11
    )
    
    $
    0.00Diluted net income per share:As reported
    
    $
    (0.09
    )
    
    $
    0.00Pro forma
    
    $
    (0.11
    )
    
    $
    0.00Black Scholes model assumptions:Risk free interest rate
    
    
    2.4
    %
    
    
    1.7
    %Expected volatility
    
    
    50
    %
    
    
    44
    %Expected term
    
    2.7 Years
    
    2.7 YearsDividend yield
    
    
    0
    %
    
    
    0
    %
 I. Income (loss) per common share. Income (loss) per common share is
computed on the weighted average number of common or common and equivalent
shares outstanding during each year. Basic earnings per share is computed as
net income (loss) divided by the weighted average number of common shares
outstanding during the period. Diluted earnings per share reflects the
potential dilution that could occur from common shares issuable through stock
options, warrants, and other convertible securities when the effect would be
dilutive. J. Discontinued operations. Under SFAS No. 144, Accounting for the
Impairment and Disposal of Long-Lived Assets, discontinued operations are
reported if a component of the entity is held for sale or sold during the
period. The Bone Device Business qualified as a component of the entity under
the standard as of the November 26, 2003 sale date. Therefore, the related
results of the Bone Device Business operations for 2003, prior to the sale,
have been presented as discontinued operations in the financial statements. 9




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K. New Accounting Pronouncements. In January 2003, the FASB issued
Interpretation No. 46 (FIN 46), Consolidation of Variable Interest
Entities, (revised in December 2003) which clarifies the application of
Accounting Research Bulletin No. 51, Consolidated Financial Statements,
relating to consolidation of certain entities. We do not participate in any
variable interest entities. The adoption of FIN 46 did not have a material
impact on our financial statements. L. Certain reclassifications. Certain reclassifications have been made
to the prior year financial statements to conform to the 2004 presentation. 2. ASSET SALE OF THE BONE DEVICE BUSINESS On November 26, 2003, we completed the sale of the Bone Device Business
assets and related liabilities (including the rights to produce and market the
OL1000, OL1000 SC, SpinaLogic and OrthoFrame/Mayo) to dj Orthopedics, LLC.
Pursuant to the asset purchase agreement, we sold substantially all of the
assets of the Bone Device Business (other than our Medicare accounts
receivable, which were $1.2 million in the aggregate), including substantially
all of the related machinery, equipment, inventory, work in process, licenses,
customer lists, intellectual property, certain agreements and contracts. dj
Orthopedics paid $93.0 million in cash at closing and assumed substantially all
of the Bone Device Business trade payables and other current liabilities less
payables in an amount approximately equal to the amount of retained Medicare
receivables. Upon the closing of the sale we assigned and dj Orthopedics
agreed to assume and perform the obligations outstanding on November 26, 2003,
related to the operation of the Bone Device Business (including various
liabilities related to the Companys employees). Of the $93.0 million we received in the sale, $7.5 million was placed in
an escrow account. The funds were divided into two accounts: $7.0 million from
which dj Orthopedics is eligible for indemnity and breach of contract claims,
if any, may be paid and $0.5 million from which a portion of the agreed upon
incentive stay bonuses will be paid by dj Orthopedics to former OrthoLogic
executives on the first anniversary of the closing. The funds in the $7.0
million escrow account, in excess of the amount of any pending claims, will be
released to us on the second anniversary of the closing. The amount included
in escrow receivable is net of the $1.9 million liability related to the fair
value of the representations and warranties. The transaction was considered an accelerating event for our stock-based
compensation plans. Terminated employees unvested options vested immediately
upon the sale. Our directors and employees who were retained had 75% of their
unvested options vest upon the sale, with the remainder vesting over a 12 month
period or on their regular vesting period, whichever is earlier. The sale of the Bone Device Business is accounted for as discontinued
operations. The income from the divested business, and related tax effects are
summarized as discontinued operations on the consolidated statement of
operations. Included in the discontinued operations for the 2003 period is the
net income from the Bone Device Business of $1.7 million resulting from the
three months of operations through March 31, 2003. The presentation of discontinued operations for the Bone Device Business
reflects the elimination of the historical revenues as well as historical
expenses related to the operations of 10




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business. The revenue, cost of revenue, gross profit and pretax income
attributable to the Bone Device Business for the March 31, 2003 quarter ended
were as follows (in thousands): Period ended March 31,2003Net revenue
    
    $
    10,372Cost of sale
    
    
    1,479Gross profit
    
    
    8,893Pretax income
    
    $
    2,702
 The historical expenses of the Bone Device Business were derived using a
variety of factors including percentage of revenues, headcount, and specific
identification. Subsequent to the sale, we no longer have any revenue
producing products. The sale of our Bone Device Business was a transaction taxable to us for
United States federal income tax purposes. We recognized taxable income for
fiscal year ended 2003 equal to the amount realized on the sale in excess of
our tax basis in the assets sold. A portion of the taxable gain was offset by
available net operating loss carry forwards. 3. CPM DIVESTITURE AND RELATED GAINS In July 2001, we announced the sale of our continuous passive motion
(CPM) business to OrthoRehab, Inc. We received $12.0 million in cash, with
OrthoRehab, Inc. assuming approximately $2.0 million in liabilities in
connection with the sale of certain CPM related assets that we had recorded in
our financial statements at a carrying value of approximately $20.7 million.
We recorded a $6.9 million charge to write down the CPM assets to their fair
value less direct costs of selling the assets. Under the CPM Asset Purchase
Agreement, we were eligible to receive up to an additional $2.5 million of cash
if certain objectives were achieved by OrthoRehab, Inc. We settled litigation over the $2.5 million payment and other matters in
April 2003. OrthoRehab, Inc. agreed to pay $1.2 million to settle the
contingent payment due to us, and all outstanding claims between the two
companies. No cash payments were received during the first quarter of 2003.
Payments of $111,000 were collected during the first quarter of 2004, and
recognized on the CPM divestiture and related gains line item on the
Consolidated Statement of Operations. The remaining balance plus interest is
scheduled to be paid over the next 24 months. Due to the uncertainty of the
future payments, income on the settlement will be recorded as cash is received. 4. LICENSING AGREEMENT FOR CHRYSALIN In January 1998, we acquired a minority equity investment (less than 10%)
in a biotech firm, Chrysalis BioTechnology, Inc. (CBI), for $750,000. As part
of the transaction, we were awarded a worldwide exclusive option to license the
orthopedic applications of Chrysalin, a patented 23-amino acid synthetic
peptide that had shown promise in accelerating the healing 11




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process. Our agreement with CBI contains provisions for us to continue
and expand our option to license Chrysalin contingent upon regulatory
approvals, successful pre-clinical trials, and certain trials and milestone
payments to CBI. At this stage of research, we are not yet able to apply for FDA approval
to market Chrysalin. The process of obtaining necessary government approvals
is time consuming and expensive. There can be no assurance that the necessary
approvals for new products or applications will be obtained by us or, if they
are obtained, that they will be obtained on a timely basis. Significant
additional costs for us will be necessary to complete development of these
products. CBI does not own the patents to Chrysalin, but owns an exclusive worldwide
license to Chrysalin from the University of Texas. Except for the $750,000
minority equity investment in Chrysalis, all payments made to Chrysalis have
been expensed as research and development. The license agreement with
Chrysalis calls for us to pay certain other additional milestone payments and
royalty fees, based upon the products development and our achievement of
commercial introduction. On April 29, 2004, we announced that we had signed a definitive agreement
to acquire substantially all of the assets and intellectual property of
privately held CBI, based in Galveston, Texas, for $2.5 million in cash and up
to $32.0 million in common stock. The agreement covers exclusive rights to
proprietary technology and intellectual property in developing synthetic
peptide-based therapeutics for a variety of indications. The transaction is
subject to approval of the CBI stockholders, effectiveness of the registration
statement to be filed by us with the Securities and Exchange Commission and
other customary closing conditions. Closing of the acquisition is anticipated
during the third quarter of 2004. 5. LITIGATION OrthoRehab, Inc. and OrthoMotion, Inc. v. OrthoLogic Corporation and
OrthoLogic Canada, Ltd., Superior Court of the State of Delaware, County of New
Castle, Case No. C.A. No. 01C-11-224 WCC. In November 2001, OrthoRehab, Inc.,
filed a complaint in connection with its acquisition of certain assets used in
the Companys CPM business in July 2001 alleging, among other things, that some
of the assets purchased were overvalued and that the Company had breached its
contract. We settled the case in April 2003 by a payment of $1.2 million to us
from OrthoRehab, Inc. In addition to the matters disclosed above, the Company is involved in
various other legal proceedings that arise in the ordinary course of business.
In managements opinion, the ultimate resolution of these other legal
proceedings are not likely to have a material adverse effect on the financial
position, results of operations or cash flows of the Company. The health care industry is subject to numerous laws and regulations of
federal, state, and local governments. Compliance with these laws and
regulations, specifically those relating to the Medicare and Medicaid programs,
can be subject to government review and interpretations, as well as regulatory
actions unknown and unasserted at this time. Recently, federal government
activity has increased with respect to investigations and allegations
concerning possible violations by health care providers of regulations, which
could result in the imposition of significant fines and penalties, as well as
significant repayments of previously billed and 12




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collected revenues from patient services. Management believes that the
Company is in substantial compliance with current laws and regulations. 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations. When used in this report, the terms OrthoLogic, we, our, or us
refer to OrthoLogic Corp. or OrthoLogic Corp. and its subsidiaries, as
appropriate in the context, and the term Bone Device Business refers to our
former business line of bone growth stimulation and fracture fixation devices,
including the OL1000 product line, SpinaLogic® and our fracture fixation
devices, OrthoFrame® and OrthoFrame/Mayo. The following is managements discussion of significant factors that
affected OrthoLogics interim financial condition and results of operations.
This should be read in conjunction with our Managements Discussion and
Analysis of Financial Condition and Results of Operations included in our
Annual Report on Form 10-K for the year ended December 31, 2003 and the
Special Note Regarding Forward Looking Statements below, following Item 4. Overview On November 26, 2003, we sold our Bone Device Business to djOrthopedics,
LLC for a purchase price of approximately $93.0 million in cash and the
assumption of substantially all of the Bone Device Business trade payables and
other current liabilities. Through this divestiture, we sold all of our
revenue producing operations and became a pure drug development company. Our
principal business remains focused on the healing of musculoskeletal tissue,
although through biopharmaceutical approaches rather than through the use of
medical devices. As of March 31, 2004, we had cash and cash equivalents of $67.1 million,
short-term investments of $48.4 million and long-term investments of $4.6
million. We will be relying on these resources to fund the development,
testing and commercialization of our Chrysalin product platform. On April 29, 2004, we announced that we had signed a definitive agreement
to acquire substantially all of the assets and intellectual property of
privately held Chrysalis BioTechnology, Inc. (CBI), based in Galveston,
Texas, for $2.5 million in cash and up to $32.0 million in common stock. The
agreement covers exclusive rights to proprietary technology and intellectual
property in developing synthetic peptide-based therapeutics for a variety of
indications. The transaction is subject to approval of the CBI stockholders,
effectiveness of the registration statement to be filed by us with the
Securities and Exchange Commission and other customary closing conditions.
Closing of the acquisition is anticipated during the third quarter of 2004. Research and Development of the Chrysalin Product Platform Chrysalin, or TP508, is a 23-amino acid synthetic peptide representing a
receptor-binding domain of the human thrombin molecule, a naturally occurring
molecule in the body responsible for both blood clotting and initiating many of
the cellular events responsible for tissue repair in bone and cartilage. The
Chrysalin molecule serves as the basis for a family of potential 13




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therapeutic products we refer to collectively as the Chrysalin product
platform. To date, we have identified five potential orthopedic uses of
Chrysalin:  
    
    fracture repair;
    
    spine fusion;
    
    cartilage defect repair;
    
    ligament repair; and
    
    tendon repair. We are currently enrolling patients in a Phase 3 Chrysalin product human
clinical trial for fracture indications, have just completed enrollment in a
Phase 1/2 human clinical trial for spine fusion indications, have one potential
product in late-stage pre-clinical development in cartilage defect repair, and
are planning the development for two additional areas of research in ligament
and tendon repair. Fracture Repair Our fracture repair studies currently underway focus on isolating and
identifying exact functions of Chrysalin in acceleration of fracture repair,
and what genes are stimulated by the injection of the Chrysalin peptide. We
are also conducting exploratory studies in bone defect repairs and distraction
osteogenesis, the medical procedure of slowly moving apart two bone segments in
a way that allows new bone tissue to grow to fill the gap. Our analysis of the
effect of Chrysalin at the genetic level is performed using gene array and
quantitative PCR technology, with this work performed both in house at
OrthoLogic and in collaboration with academic institutions. Segmental defect,
distraction osteogenesis and non-union experiments are performed by
collaborators at academic institutions. Preclinical segmental defect studies
are meant to mimic reconstructive surgical procedures. These studies provide
information on advanced formulations of Chrysalin and potential new clinical
indications to investigate. Distraction osteogenesis is a technique that is
used to replace lost segments of bone due to severe injury, or to correct
congenital deformity. Preclinical studies on non-union fractures address the
effects of Chrysalin to heal fractures that do not heal in the normal expected
time. Positive results in these studies may provide additional clinical
indications for Chrysalin. Spine Fusion Our clinical studies on spine fusion address questions of safety and
efficacy when the Chrysalin peptide is used in conjunction with allograft bone
in spine fusion surgeries. All of these studies are performed by collaborators
at academic institutions, with the experimental study design provided by
OrthoLogic scientists. We completed enrollment in the spine trial during the
first quarter of 2004. Cartilage Defect and Repair; Tendon and Ligament Repair All our pre-clinical cartilage repair studies are performed at academic
institutions. The goal of these studies is to understand the way Chrysalin
works to stimulate cartilage defect repair as well as to address formulation
questions. Pre-clinical ligament and tendon repair studies are slated to begin
this year and will be conducted in collaboration with academic institutions. 14




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Critical Accounting Policies and Estimates Allowance for Doubtful Accounts: The Company retained certain receivables
related to the Bone Device Business after the divestiture. The allowance for
doubtful accounts (approximately $435,000 and $556,000 at March 31, 2004 and
December 31, 2003, respectively) is based primarily on trends in historical
collection rates, consideration of current events, payor mix and other
considerations. In the opinion of management, adequate allowances have been
provided for doubtful accounts. If the financial condition of the third-party
payors were to deteriorate, resulting in an inability to make payments, or the
other considerations underlying the estimates was to change, additional
allowances might be necessary. Income Taxes: SFAS No. 109 requires that a valuation allowance be
established when it is more likely than not that all or a portion of a deferred
tax asset will not be realized. Changes in valuation allowances from period to
period are included in the tax provision in the period of change. In
determining whether a valuation allowance is required, we take into account all
evidence with regard to the utilization of a deferred tax asset included in
past earnings history, expected future earnings, the character and jurisdiction
of such earnings, unsettled circumstances that, if unfavorably resolved, would
adversely affect utilization of a deferred tax asset, carryback and
carryforward periods, and tax strategies that could potentially enhance the
likelihood of realization of a deferred tax asset. The valuation allowance
reduces deferred tax assets to an amount that management believes will more
likely than not to be realized. We believe that the net deferred tax asset of
$770,000 at March 31, 2004 will be realized as it relates to alternative
minimum tax credits that do not expire. However, the amount of the deferred
tax assets actually realized could differ if we have little or no future
earnings. Discontinued Operations: Under SFAS No. 144, Accounting for the
Impairment and Disposal of Long-Lived Assets, discontinued operations are
reported if a component of the entity is held for sale or sold during the
period. The Bone Device Business qualifies as a component of the entity under
the standard. Therefore, the related results of the Bone Device Business
operations prior to the sale have been presented as discontinued operations in
the 2003 financial statements. Liability for Representations and Warranties Made in Conjunction with the
Sale of the Bone Device Business: Under FASB Interpretation No. 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of the Indebtedness of Others, indemnifications,
representations and warranties issued in conjunction with the sale of a
business are required to be valued and recorded in the financial statements.
We made certain representations and warranties in conjunction with the sale of
the Bone Device Business and determined the discounted fair value to be
approximately $1.9 million, which is reflected as a reduction to the escrow
receivable. The discount is being accreted to interest expense through
November 26, 2005, which is when the portion of the purchase price allocated to
the representations and warranties is required to be released from escrow. Investment in CBI: We own a minority ownership interest in CBI, recorded
on the balance sheet at cost. We recently announced a definitive agreement to
acquire substantially all of the assets and intellectual property of CBI. Excess Space Reserve: We lease a facility in Tempe, Arizona. This
approximately 100,000 square foot facility is designed and constructed for
industrial purposes and is located in 15




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an industrial district. In November 2003, we subleased approximately
35,000 square feet of the facility to dj Orthopedics, LLC, the company which
purchased our Bone Device Business. We previously subleased approximately
13,500 square feet of the building through June 2005 to another company. We
believe the facility is well-maintained and adequate for use in the forseeable
future. We believe the remainder of the facility that we are using is suitable
for our purposes and is effectively utilized. While we believe the facility is
well maintained and adequate for use in the forseeable future, there can be no
guarantee that a different lessee will assume the remaining lease obligation.
We established a reserve for the period the available sublease space was
anticipated to be vacant. In the opinion of management, the reserve balance of
$209,000 at March 31, 2004 is adequate to allow for time necessary to acquire
an additional tenant for the building. Results of Operations Comparing Three-Month Period Ended March 31, 2004 to the
Corresponding Period in 2003. Revenues, Cost of Revenues and Gross profits: We are a research and
development company. We had no revenues, costs of revenues, or gross profit
from continuing operations in 2004 or 2003. The Bone Device Business revenue
is included as discontinued operations and is presented reflecting only the net
income after tax under the line item Income from operations of Bone Device
Business, net of taxes. General and Administrative (G&A) Expenses: G&A expenses related to our
ongoing development operations decreased by approximately 56.9% from $1.3
million to $555,000 from the first quarter of 2003 to 2004. Our administrative
functions previously serviced a large organization that had manufacturing,
sales, healthcare reimbursement and research and development functions,
compared to the pure research and development company that exists currently. Research and Development Expenses: Research and development expenses were
$3.4 million in 2004 compared to $1.4 million in 2003. The rise in our
research and development expenses is attributed to our significant expansion of
our research and preclinical programs since the first quarter of 2003. In
addition, we have more patients enrolled in the clinical trials than in 2003,
when we had just begun our Phase 3 human clinical trial for fracture repair
indications. During 2004, we incurred additional research costs for the
development of specific programs that we believe will enhance our ability to
successfully receive authorization for a new drug application filing for our
fracture indication. Research and development expenses consisted primarily of
Chrysalin related expenses, which include pre-clinical studies in cartilage
defect repair, final patient enrollment and the early completion of the Phase
1/2 spinal fusion clinical trial and continuation of the Phase 3 human clinical
trial for fracture repair. During 2004, we expect to double our research and
development expenses over 2003 levels of $9.0 million. CPM Divestiture and Change in Estimated Collectability of CPM Receivables:
In July 2001, we announced the sale of our continuous passive motion (CPM)
business to OrthoRehab, Inc. We settled litigation over certain contingent
purchase price payment matters in April 2003. OrthoRehab, Inc. agreed to pay
$1.2 million to settle the dispute arising out of a contingent payment due to
us, and all outstanding claims between the two companies. The payments of
$111,000 appearing on the CPM divestiture and related gains line on the
Statement of Operations were received during the first quarter of 2004. The
remaining balance 16




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plus interest is scheduled to be paid over the next 24 months. Due to the
uncertainty of the future payments, income on the settlement will be recorded
as cash is received. Other Income: Other income in 2004 and 2003 consisted primarily of
interest income. Other income increased from $132,000 in 2003 to $306,000 in
2004 primarily as a result of the additional interest earned on the cash and
investments from the sale of the Bone Device Business. Discontinued operations of the Bone Device Business: The sale of the Bone
Device Business in 2003 is accounted for as discontinued operations. The
operating income from the divested business and related tax effects are
summarized as discontinued operations on the consolidated statement of
operations. Included in the discontinued operations for the first quarter of
2003 is the net income from the Bone Device Business of $1.7 million, which is
net of taxes. Net Income (Loss): We had a net loss in the first quarter of 2004 of $3.2
million compared to net income of $142,000 in 2003. The net income in 2003 is
composed primarily of the income of $1.7 million from the discontinued
operations of the Bone Device Business and a ($1.6) million loss resulting from
continuing operations. Liquidity and Capital Resources We have historically financed our operations through operating cash flows
and the public and private sales of equity securities. With the sale of our
Bone Device Business, we sold all of our revenue producing operations. We
received approximately $93.0 million in cash from the sale of our Bone Device
Business. At March 31, 2004, we had cash and cash equivalents of $67.1
million, short-term investments of $48.4 million and long-term investments of
$4.6 million. With the exception of the anticipated purchase of substantially all of the
assets of CBI, we do not expect to make significant capital investments in
2004, but anticipate growing our research and development expenditures related
to clinical trials for Chrysalin in fresh fracture repair and spinal fusion and
for further studies in articular cartilage repair. We anticipate that our cash
and short term investments will be sufficient to meet our presently projected
research and development expenses and other working capital requirements for
the next 12 months. However, we believe our research and development of our
Chrysalin product platform will require substantial additional capital beyond
2004. Our forecasts of the period of time through which our financial
resources will be adequate to support our research and development depends on
many factors, most notably the progress of our research and development
relative to our projections and to the pace of our competitors. If we decide
to expand our clinical trials, in particular, or if we consider other
opportunities in the market, our projected expense levels may change, which
could require us to seek other sources of financial resources. There is no
assurance that we will be successful in obtaining such other resources. If
such a situation were to arise, we may be required to scale back or delay our
research and development programs. The following table sets forth all known commitments as of March 31, 2004
and the year in which these commitments become due or are expected to be
settled (in thousands): 17




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Accounts PayableYear
    
    Operating Leases
    
    and Other Liabilities
    
    Total2004
    
    $
    809
    
    
    $
    4,404
    
    
    $
    5,2132005
    
    $
    1,078
    
    
    
    
    
    
    $
    1,0782006
    
    $
    1,078
    
    
    
    
    
    
    $
    1,0782007
    
    $
    989
    
    
    
    
    
    
    $
    989Total
    
    $
    3,954
    
    
    $
    4,404
    
    
    $
    8,358
 Approximately 17% of the leased facility is subleased through June 2005
and another approximately 44% is subleased through November of 2004, payments
from which will offset a portion of the lease commitments listed above. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk We have no debt outstanding and no derivative instruments at March 31,
2004. Our Canadian operations were sold as part of the CPM asset sale, and
consequently we have no exposure to foreign currency exchange rate risks as of
March 31, 2004. Our investment portfolio is used to preserve our capital until it is
required to fund our operations. All of these investment instruments are
classified as held-to-maturity. We do not own derivative financial instruments
in our investment portfolio. Our investment portfolio contains instruments
that are subject to the risk of a decline in interest rates. We maintain a
non-trading investment portfolio of investment grade, liquid debt securities
that limit the amount of credit exposure to any one issue, issuer or type of
instrument. Due to the short duration and conservative nature of these
instruments, we do not believe that we have a material exposure to interest
rate risk. We have deposited our cash with national banking institutions which we
believe are stable. Even though our accounts in each of these banks have
balances in excess of the $100,000 limit that is insured by the Federal Deposit
Insurance Corporation, we believe these accounts are not subject to significant
market risk due to bank failure. 
 Item 4. Controls and Procedures Our Chief Executive Officer and Chief Financial Officer have reviewed and
evaluated the effectiveness of our disclosure controls and procedures as of the
end of the period covered by this Form 10-Q, which included inquiries made to
certain other employees. Based on their evaluation, the Chief Executive
Officer and Chief Financial Officer have each concluded that, as of the end of
such period, our disclosure controls and procedures are effective and
sufficient to ensure that we record, process, summarize, and report information
required to be disclosed in the reports we file under the Securities Exchange
Act of 1934 within the time periods specified by the Securities and Exchange
Commissions rules and forms. There have been no significant changes in our
internal controls over financial reporting during our most recent fiscal
quarter that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting. 18




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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS We may from time to time make written or oral forward-looking statements,
including statements contained in our filings with the Securities and Exchange
Commission and its reports to stockholders. This report contains
forward-looking statements made pursuant to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995. In connection with these
safe harbor provisions, we identify important factors that could cause actual
results to differ materially from those contained in any forward-looking
statements made by or on our behalf. Any such forward-looking statement is
qualified by reference to the following cautionary statements. Risks Related to Our Industry We are in a highly regulated field with high investment costs and high risks. Our Chrysalin product platform is currently in the human testing phase for
two potential products and earlier preclinical testing phases for another
potential product. The U.S. Food and Drug Administration (FDA) and
comparable agencies in many foreign countries impose substantial limitations on
the introduction of new pharmaceuticals through costly and time-consuming
laboratory and clinical testing and other procedures. The process of obtaining
FDA and other required regulatory approvals is lengthy, expensive and
uncertain. Chrysalin, as a new drug, is subject to the most stringent level of
FDA review. Even after we have invested substantial funds in the development of our
three Chrysalin products and even if the results of our current clinical trials
are favorable, there can be no guarantee that the FDA will grant approval of
Chrysalin for the indicated uses or that it will do so in a timely manner. If we successfully bring one or more products to market, there is no
assurance that we will be able to successfully manufacture or market the
products or that potential customers will buy them if, for example, a
competitive product has greater efficacy or is deemed more cost effective. In
addition, the market in which we will sell any such products is dominated by a
number of large corporations that have vastly greater resources than we have,
which may impact our ability to successfully market our products or maintain
any technological advantage we might develop. We also would be subject to
changes in regulations governing the manufacture and marketing of our products,
which could increase our costs, reduce any competitive advantage we may have
and/or adversely affect our marketing effectiveness. The results of our late stage clinical trials may be insufficient to obtain FDA
approval. Positive results from preclinical studies and early clinical trials do not
ensure positive results in more advanced clinical trials. If we are unable to
demonstrate that a product candidate will be safe and effective in advanced
clinical trials involving larger numbers of patients, we will be unable to
submit the new drug application (NDA) necessary to receive approval from the
FDA to commercialize that product. 19




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We are currently conducting a Phase 3 human clinical trial on Chrysalin
for fracture repair indications. We expect to have enrollment for the trial
completed by late summer/fall of 2004. If we fail to achieve the primary
endpoints in this Phase 3 clinical trial or the results are ambiguous, we will
have to determine whether to redesign our Chrysalin fracture repair product
candidate and our protocols and continue with additional testing, or cease
activities in this area. Redesigning the product could be extremely costly and
time-consuming. A substantial delay in obtaining FDA approval or termination
of the Chrysalin fracture repair product candidate could result in a delay in
our ability to generate revenue. Patients may discontinue their participation in our clinical studies, which may
negatively impact the results of these studies and extend the timeline for
completion of our development programs. As with all clinical trials, we are subject to the risk that patients
enrolled in our clinical studies may discontinue their participation at any
time during the study as a result of a number of factors, including,
withdrawing their consent or experiencing adverse clinical events, which may or
may not be judged related to our product candidates under evaluation. We are
subject to the risk that if a large number of patients in any one of our
studies discontinue their participation in the study, the results from that
study may not be positive or may not support an NDA for regulatory approval of
our product candidates. In addition, the time required to complete clinical trials is dependent
upon, among other factors, the rate of patient enrollment. Patient enrollment
is a function of many factors, including:  
    
    the size of the patient population;
    
    the nature of the clinical protocol requirements;
    
    the diversion of patients to other trials or marketed therapies;
    
    our ability to recruit and manage clinical centers and associated trials;
    
    the proximity of patients to clinical sites; and
    
    the patient eligibility criteria for the study. Even if we obtain marketing approval, our products will be subject to ongoing
regulatory oversight, which may affect our ability to successfully
commercialize any products we may develop. Even if we receive regulatory approval of a product candidate, the
approval may be subject to limitations on the indicated uses for which the
product is marketed or require costly post-marketing follow-up studies. After
we obtain marketing approval for any product, the manufacturer and the
manufacturing facilities for that product will be subject to continual review
and periodic inspections by the FDA and other regulatory agencies. The
subsequent discovery of previously unknown problems with the product, or with
the manufacturer or facility, may result in restrictions on the product or
manufacturer, including withdrawal of the product from the market. If we fail to comply with applicable regulatory requirements, we may be
subject to fines, suspension or withdrawal of regulatory approvals, product
recalls, seizure of products, operating restrictions and criminal prosecution. 20




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Our product candidates may not gain market acceptance among physicians,
patients and the medical community. Even if we obtain regulatory approval for our products, market acceptance
will depend on our ability to demonstrate to physicians and patients the
benefits of our products in terms of safety, efficacy, convenience, ease of
administration and cost effectiveness. In addition, we believe market
acceptance depends on the effectiveness of our marketing strategy, the pricing
of our products and the reimbursement policies of government and third-party
payors. Physicians may not prescribe our products, and patients may determine,
for any reason, that our product is not useful to them. If any of our product
candidates fails to achieve market acceptance, our ability to generate revenue
will be limited. Our success also depends on our ability to operate and commercialize products
without infringing on the patents or proprietary rights of others. Third parties may claim that we or our licensors or suppliers are
infringing their patents or are misappropriating their proprietary information.
In the event of a successful claim against us or our licensors or suppliers
for infringement of the patents or proprietary rights of others, we may be
required to, among other things:  
    
    pay substantial damages;
    
    stop using our technologies;
    
    stop certain research and development efforts;
    
    develop non-infringing products or methods; and
    
    obtain one or more licenses from third parties. A license required under any such patents or proprietary rights may not be
available to us, or may not be available on acceptable terms. If we or our
licensors or suppliers are sued for infringement, we could encounter
substantial delays in, or be prohibited from, developing, manufacturing and
commercializing our product candidates. The pharmaceutical industry is subject to stringent regulation, and failure to
obtain regulatory approval will prevent commercialization of our products. Our research, development, preclinical and clinical trial activities and
the manufacture and marketing of any products that we may successfully develop
are subject to an extensive regulatory approval process by the FDA and other
regulatory agencies in the United States and abroad. The process of obtaining
required regulatory approvals for drugs is lengthy, expensive and uncertain,
and any such regulatory approvals may entail limitations on the indicated usage
of a drug, which may reduce the drugs market potential. In order to obtain FDA approval to commercialize any product candidate, an
NDA must be submitted to the FDA demonstrating, among other things, that the
product candidate is safe and effective for use in humans for each target
indication. Our regulatory submissions may be delayed, or we may cancel plans
to make submissions for product candidates for a number of reasons, including:  
    
    negative or ambiguous preclinical or clinical trial results;
    
    changes in regulations or the adoption of new regulations;
    
    unexpected technological developments; and
    
    developments by our competitors that are more effective than our
product candidates. 21




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Consequently, we cannot assure you that we will make our submissions to
the FDA in the timeframe that we have planned, or at all, or that our
submissions will be approved by the FDA. Even if regulatory clearance is
obtained, post-market evaluation of our products, if required, could result in
restrictions on a products marketing or withdrawal of a product from the
market as well as possible civil and criminal sanctions. Clinical trials are subject to oversight by institutional review boards
and the FDA to ensure compliance with the FDAs good clinical practice
regulations, as well as other requirements for good clinical practices. We
depend, in part, on third-party laboratories and medical institutions to
conduct preclinical studies and clinical trials for our products and other
third-party organizations, usually universities, to perform data collection and
analysis, all of which must maintain both good laboratory and good clinical
practices. If any such standards are not complied with in our clinical trials,
the FDA may suspend or terminate such trial, which would severely delay our
development and possibly end the development of a product candidate. We also currently and in the future will depend upon third party
manufacturers of our products, which are and will be required to comply with
the applicable FDA Good Manufacturing Practice regulations. We cannot be
certain that our present or future manufacturers and suppliers will comply with
these regulations. The failure to comply with these regulations may result in
restrictions in the sale of, or withdrawal of the products from the market.
Compliance by third parties with these standards and practices are outside of
our direct control. In addition, we are subject to regulation under state and federal laws,
including requirements regarding occupational safety, laboratory practices,
environmental protection and hazardous substance control, and may be subject to
other local, state, federal and foreign regulation. We cannot predict the
impact of such regulations on us, although they could impose significant
restrictions on our business and require us to incur additional expenses to
comply. If our competitors develop and market products that are more effective than
ours, or obtain marketing approval before we do, our commercial opportunities
will be reduced or eliminated. Competition in the pharmaceutical and biotechnology industries is intense
and is expected to increase. Several biotechnology and pharmaceutical
companies, as well as academic laboratories, universities and other research
institutions, are involved in research and/or product development for various
treatments for or involving fracture repair, spine fusion surgery, cartilage
defect repair and ligament and tendon repair. Many of our competitors have
significantly greater research and development capabilities, experience in
obtaining regulatory approvals and manufacturing, marketing, financial and
managerial resources than we have. Our competitors may succeed in developing products that are more effective than
the ones we have under development or that render our proposed products or
technologies noncompetitive or obsolete. In addition, certain of such
competitors may achieve product commercialization before we do. If any of our
competitors develops a product that is more effective than one we are
developing or plan to develop, or is able to obtain FDA approval for
commercialization before we do, we may not be able to achieve significant
market acceptance for certain products of ours, which would have a material
adverse effect on our business. 22




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Healthcare reform and restrictions on reimbursements may limit our financial
returns. Our ability to successfully commercialize our products may depend in part
on the extent to which government health administration authorities, private
health insurers and other third party payors will reimburse consumers for the
cost of these products. Third party payors are increasingly challenging both
the need for, and the price of, novel therapeutic drugs and uncertainty exists
as to the reimbursement status of newly approved therapeutics. Adequate third
party reimbursement may not be available for our drug products to enable us to
maintain price levels sufficient to realize an appropriate return on our
investments in research and product development, which could restrict our
ability to commercialize a particular drug candidate. We caution that the foregoing list of important factors is not exclusive.
We do not undertake to update any forward-looking statement that may be made
from time to time by or on behalf of us. Risks Related to Our Business We are a biopharmaceutical company with no revenue generating operations and
high investment costs. On November 26, 2003, we sold all of our revenue generating operations to
become a pure drug development company. We are now focused on developing and
testing the product candidates in our Chrysalin product platform and have
allocated most of our resources to bringing these product candidates to the
market. We may invest in other orthobiologic or complementary technology in
the future, but we have no current specific plans to do so at this time. We
currently have no pharmaceutical products being sold or ready for sale and do
not expect to be able to introduce any pharmaceutical products for at least
several years. As a result of our significant research and development,
clinical development, regulatory compliance and general and administrative
expenses and the lack of any products to generate revenue, we expect to incur
losses for at least the next several years and expect that our losses will
increase as we expand our research and development activities and incur
significant expenses for clinical trials. Our cash reserves, including the
cash received from the sale of our bone growth stimulation device business in
November 2003, are the primary source of our working capital. We do not expect
to receive any revenue from product sales unless and until we receive
regulatory approval and begin commercialization of our product candidates. We
cannot predict when that will occur or if it will occur. Our product candidates are in various stages of development and may not be
successfully developed or commercialized. We currently do not sell any products. We are subject to the risk that:  
    
    the FDA finds some or all of our product candidates ineffective or unsafe;
    
    we do not receive necessary regulatory approvals;
    
    we are unable to get some or all of our product candidates to
market in a timely manner;
    
    we are not able to produce our product candidates in
commercial quantities at reasonable costs;
    
    our products undergo post-market evaluations resulting in
marketing restrictions or withdrawal of our products; or 23




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
    
    the patient and physician community does not accept our
products. In addition, our product development programs may be curtailed, redirected
or eliminated at any time for many reasons, including:  
    
    adverse or ambiguous results;
    
    undesirable side effects which delay or extend the trials;
    
    inability to locate, recruit, qualify and retain a sufficient
number of patients for our trials;
    
    regulatory delays or other regulatory actions;
    
    difficulties in obtaining sufficient quantities of the
particular product candidate or any other components needed for our
preclinical testing or clinical trials;

    
    change in the focus of our development efforts; and
    
    re-evaluation of our clinical development strategy. We cannot predict whether we will successfully develop and commercialize
any of our product candidates. If we fail to do so, we will not be able to
generate revenue. Our product candidates are all based on the same chemical peptide, Chrysalin.
If one of our product candidates reveals safety or fundamental inefficacy
issues in clinical trials, it could impact the development path for all our
other current product candidates. The development of each of our product candidates in the Chrysalin product
platform is based on our knowledge and understanding of how the human thrombin
molecule contributes to the repair of soft tissue and bone. While there are
important differences in each of the product candidates in terms of their
purpose (fracture repair, spine fusion, cartilage repair, etc.), each product
candidate is focused on accelerating the repair of soft tissue and bone and is
based on the ability of Chrysalin to mimic specific attributes of the human
thrombin molecule to stimulate the bodys natural healing processes. Since we are developing the product candidates in the Chrysalin product
platform in parallel, we expect to learn from the results of each trial and
apply some of our findings to the development of the other product candidates
in the platform. If one of the product candidates has negative clinical trial
results or is shown to be ineffective, it could impact the development path or
future development of the other product candidates in the platform. If we find
that one of the biopharmaceutical product candidates is unsafe, it could impact
the development of our other product candidates in clinical trials. If we fail to meet our obligations under our license agreements, or our license
agreements are terminated for any other reason, we may lose our rights to use
the Chrysalin technology. Our rights to the development, use and marketing of all of our therapeutic
products within the Chrysalin product platform are governed by a series of
licensing agreements from Chrysalis BioTechnology, Inc. Chrysalis
BioTechnology, Inc., which is still managed by the University of Texas
professor who discovered the peptide, has a license for the exclusive worldwide
rights to Chrysalin from the University of Texas. As part of our acquisition
of a minority interest in Chrysalis, Chrysalis granted a sublicense to us with
worldwide rights to use Chrysalin for all orthopedic indications. We extended
our worldwide license for Chrysalin to include the rights for orthopedic soft
tissue indications including cartilage, tendon and ligament repair. Our
failure to achieve milestones, or meet any of our financial or other 24




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obligations under these licensing agreements could result in the loss of
our rights to Chrysalin. If we lose our rights to Chrysalin under any of these
license agreements, we would be unable to continue our product development
programs and our business and prospects would be materially harmed. If we cannot protect the Chrysalin patent or our intellectual property
generally, our ability to develop and commercialize our products will be
severely limited. Our success will depend in part on Chrysalis, the University of Texas
and our ability to maintain and enforce patent protection for Chrysalin and
each product resulting from Chrysalin. Without patent protection, other
companies could offer substantially identical products for sale without
incurring the sizable discovery, development and licensing costs that we have
incurred. Our ability to recover these expenditures and realize profits upon
the sale of products would then be diminished. Chrysalin is patented and there have been no successful challenges to the
Chrysalin patent. However, if there were to be a challenge to the patent or
any of the patents for product candidates, a court may determine that the
patents are invalid or unenforceable. Even if the validity or enforceability
of a patent is upheld by a court, a court may not prevent alleged infringement
on the grounds that such activity is not covered by the patent claims. Any
litigation, whether to enforce our rights to use our or our licensors patents
or to defend against allegations that we infringe third party rights, will be
costly, time consuming, and may distract management from other important tasks. As is commonplace in the biotechnology and pharmaceutical industry, we
employ individuals who were previously employed at other biotechnology or
pharmaceutical companies, including our competitors or potential competitors.
To the extent our employees are involved in research areas which are similar to
those areas in which they were involved at their former employers, we may be
subject to claims that such employees and/or we have inadvertently or otherwise
used or disclosed the alleged trade secrets or other proprietary information of
the former employers. Litigation may be necessary to defend against such
claims, which could result in substantial costs and be a distraction to
management and which may have a material adverse effect on us, even if we are
successful in defending such claims. We also rely in our business on trade secrets, know-how and other
proprietary information. We seek to protect this information, in part, through
the use of confidentiality agreements with employees, consultants, advisors and
others. Nonetheless, we cannot assure you that those agreements will provide
adequate protection for our trade secrets, know-how or other proprietary
information and prevent their unauthorized use or disclosure. To the extent
that consultants, key employees or other third parties apply technological
information independently developed by them or by others to our proposed
products, disputes may arise as to the proprietary rights to such information,
which may not be resolved in our favor. The risk that other parties may breach
confidentiality agreements or that our trade secrets become known or
independently discovered by competitors, could adversely affect us by enabling
our competitors, who may have greater experience and financial resources, to
copy or use our trade secrets and other proprietary information in the
advancement of their products, methods or technologies. 25




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Some of our product candidates are in early stages of development and may never
be commercialized. Research, development and pre-clinical testing are long, expensive and
uncertain processes. Other than indications for fracture repair and spine
fusions, none of our other Chrysalin product candidates has reached clinical
trial testing. Our development of Chrysalin for the repair of cartilage
defects, ligaments and tendons is currently in pre-clinical testing or the
research stage. Our future success depends, in part, on our ability to
complete pre-clinical development of these and other product candidates and
advance them to the clinical trials. If we are unsuccessful in advancing our early stage product candidates
into clinical testing for any reason, our business prospects will be harmed. The loss of our key management and scientific personnel may hinder our ability
to execute our business plan. As a small company with 34 employees, our success depends on the
continuing contributions of our management team and scientific personnel, and
maintaining relationships with the network of medical and academic centers in
the United States that conduct our clinical trials. We are highly dependent on
the services of our key scientific employees, as well as the other principal
members of our management staff. Our success depends in large part upon our
ability to attract and retain highly qualified personnel. We face intense
competition in our hiring efforts with other pharmaceutical and biotechnology
companies, as well as universities and nonprofit research organizations, and we
may have to pay higher salaries to attract and retain qualified personnel. The
loss of one or more of such individuals, or our inability to attract additional
qualified personnel, could substantially impair our ability to implement our
business plan. We face an inherent risk of liability in the event that the use or misuse of
our products results in personal injury or death. The use of our product candidates in clinical trials, and the sale of any
approved products, may expose us to product liability claims, which could
result in financial losses. Our clinical liability insurance coverage may not
be sufficient to cover claims that may be made against us. In addition, we may
not be able to maintain insurance coverage at a reasonable cost or in
sufficient amounts or scope to protect us against losses. Any claims against
us, regardless of their merit, could severely harm our financial condition,
strain our management and other resources and adversely impact or eliminate the
prospects for commercialization of the product which is the subject of any such
claim. Our stock price is volatile and fluctuates due to a variety of factors. Our stock price has varied significantly in the past and may vary in the
future due to a number of factors, including:  
    
    fluctuations in our operating results;
    
    developments in litigation to which we or a competitor is subject;
    
    announcements and timing of potential acquisitions,
divestitures, and conversions of preferred stock,
    
    announcements of technological innovations or new products by
us or our competitors;
    
    FDA and international regulatory actions;
    
    actions with respect to reimbursement matters; 26




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
    
    developments with respect to our or our competitors patents or proprietary rights;
    
    public concern as to the safety of products developed by us or others;
    
    changes in health care policy in the United States and internationally;
    
    changes in stock market analyst recommendations regarding us,
other drug development companies or the pharmaceutical industry
generally; and
    
    general market conditions. In addition, the stock market has from time to time experienced
significant price and volume fluctuations that are unrelated to the operating
performance of particular companies. These broad market fluctuations may
adversely affect the market price of our stock. 
 Part II  Other Information 
 Item 6. Exhibits and Reports  (a)
    
    Exhibit IndexSee Exhibit List following this report(b)
    
    Reports on Form 8-KForm 8-K furnished January 27, 2004 announcing the appointment of
Michael D. Casey to the OrthoLogic Corp. Board of Directors. 27




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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. ORTHOLOGIC CORP.(Registrant)
 Signature
    
    Title
    
    Date/s/ Thomas R. Trotter
Thomas R. Trotter
    
    President and Chief Executive Officer
(Principal Executive Officer)
    
    May 10, 2004/s/ Sherry A. Sturman
Sherry A. Sturman
    
    Senior Vice-President and Chief
Financial Officer
(Principal Financial and Accounting
Officer)
    
    May 10, 2004
 28




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OrthoLogic Corp.
Exhibit Index to Quarterly Report on Form 10-Q
For the Quarterly Period Ended March 31, 2004 Incorporated by
    
    FiledExhibit No
    
    Description
    
    Reference to:
    
    Herewith31.1
    
    Certification of CEO pursuant to
Securities Exchange Act Rule 13a -
14 (a).
    
    
    
    X31.2
    
    Certification of CFO pursuant to
Securities Exchange Act Rule 13a -
14 (a).
    
    
    
    X32
    
    Certification pursuant to the Security
Exchange Act Rule 13a  14(b) and
18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
    
    
    
    X Thomas R. Trotter Sherry A. Sturman
 29