##### Table of Contents



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 SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2004 or [  ]
    
    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):
x Yes 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. 37,998,542 shares of
common stock outstanding as of November 8, 2004 1




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##### Table of Contents



ORTHOLOGIC CORP.
(A Development Stage Company)
INDEX Page No.Part I Financial InformationItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of
September 30, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for
the Three months and Nine months ended September 30,
2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for
the Nine months ended September 30, 2004 and 2003
    
    
    5Notes to Unaudited 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
    
    
    23Item 4. Controls and Procedures
    
    
    23Part II Other InformationItem 5. Other Information
    
    
    33Item 6. Exhibits
    
    
    34EX-10.2EX-10.3EX-31.1EX-31.2EX-32
 2




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##### Table of Contents



PART I  Financial Information 
 Item 1. Financial Statements ORTHOLOGIC CORP.
(A Development Stage Company) 
  
 September 30,
    
    December 31,2004
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    43,011
    
    
    $
    84,357Short-term investments
    
    
    60,406
    
    
    
    32,499Accounts receivable less allowance for doubtful
accounts, $405 and $556
    
    
    343
    
    
    
    792Prepaids and other current assets
    
    
    302
    
    
    
    882Total current assets
    
    
    104,062
    
    
    
    118,530Furniture and equipment, net
    
    
    495
    
    
    
    560Escrow account
    
    
    6,809
    
    
    
    5,144Long-term investments
    
    
    5,937
    
    
    
    4,156Deferred income taxes  non-current
    
    
    801
    
    
    
    770Trademarks
    
    
    2,142
    
    
    
    0Deposits and other assets
    
    
    309
    
    
    
    196Investment in Chrysalis BioTechnology
    
    
    0
    
    
    
    750Total assets
    
    $
    120,555
    
    
    $
    130,106LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    707
    
    
    $
    201Accrued compensation
    
    
    597
    
    
    
    609Accrued taxes
    
    
    57
    
    
    
    2,924Excess space reserve
    
    
    570
    
    
    
    314Other accrued liabilities
    
    
    2,625
    
    
    
    1,596Accrued severance and other divestiture costs
    
    
    0
    
    
    
    279Total current liabilities
    
    
    4,556
    
    
    
    5,923Deferred rent and capital lease obligation
    
    
    155
    
    
    
    208Total liabilities
    
    
    4,711
    
    
    
    6,131Stockholders EquityCommon stock, $.0005 par value;50,000,000
shares authorized; and 37,998,542and 33,533,443 shares issued and
outstanding
    
    
    19
    
    
    
    16Additional paid-in capital
    
    
    170,846
    
    
    
    142,329Accumulated deficit
    
    
    (55,021
    )
    
    
    (18,233
    )Treasury stock at cost, 41,800 shares
    
    
    0
    
    
    
    (137
    )Total stockholders equity
    
    
    115,844
    
    
    
    123,975Total liabilities and stockholders equity
    
    $
    120,555
    
    
    $
    130,106
 See Notes to Unaudited Condensed Consolidated Financial Statements 3




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ORTHOLOGIC CORP.
(A Development Stage Company) 
  
 Three months ended September 30,
    
    Nine months ended September 30,
    
    As a DevelopmentStage Company2004
    
    2003
    
    2004
    
    2003
    
    8/5/04 - 9/30/04(Note 1)OPERATING EXPENSESGeneral and administrative
    
    $
    1,226
    
    
    $
    1,116
    
    
    $
    2,397
    
    
    $
    3,683
    
    
    $
    970Research and development
    
    
    4,803
    
    
    
    2,437
    
    
    
    12,163
    
    
    
    6,063
    
    
    
    3,127CPM divestiture and related gains
    
    
    (79
    )
    
    
    (132
    )
    
    
    (272
    )
    
    
    (477
    )
    
    
    (50
    )CBI in process research and development
    
    
    25,840
    
    
    
    0
    
    
    
    25,840
    
    
    
    0
    
    
    
    25,840Total operating expense
    
    
    (31,790
    )
    
    
    (3,421
    )
    
    
    (40,128
    )
    
    
    (9,269
    )
    
    
    (29,887
    )Interest income, net
    
    
    344
    
    
    
    124
    
    
    
    950
    
    
    
    387
    
    
    
    237Loss from continuing operations before taxes
    
    
    (31,446
    )
    
    
    (3,297
    )
    
    
    (39,178
    )
    
    
    (8,882
    )
    
    
    (29,650
    )Income tax benefit
    
    
    (411
    )
    
    
    (1,596
    )
    
    
    (705
    )
    
    
    (3,747
    )
    
    
    (411
    )Net loss from continuing operations
    
    
    (31,035
    )
    
    
    (1,701
    )
    
    
    (38,473
    )
    
    
    (5,135
    )
    
    
    (29,239
    )Discontinued operations (Note 3)Net gain on the sale of the Bone Device
Business
    
    
    1,685
    
    
    
    
    
    
    
    1,685
    
    
    
    
    
    
    
    1,685Income from operations of Bone Device
Business, net of taxes of $0, $1,596, $0
and $3,747
    
    
    
    
    
    
    2,207
    
    
    
    
    
    
    
    6,341Net income from discontinued operations
    
    
    1,685
    
    
    
    2,207
    
    
    
    1,685
    
    
    
    6,341
    
    
    
    1,685NET INCOME (LOSS)
    
    $
    (29,350
    )
    
    $
    506
    
    
    $
    (36,788
    )
    
    $
    1,206
    
    
    $
    (27,554
    )Per Share Information:Net loss from continuing operationsBasic
    
    $
    (0.85
    )
    
    $
    (0.05
    )
    
    $
    (1.09
    )
    
    $
    (0.15
    )Diluted
    
    $
    (0.85
    )
    
    $
    (0.05
    )
    
    $
    (1.09
    )
    
    $
    (0.15
    )Net income from discontinued operationsBasic
    
    $
    0.05
    
    
    $
    0.07
    
    
    $
    0.05
    
    
    $
    0.19Diluted
    
    $
    0.05
    
    
    $
    0.07
    
    
    $
    0.05
    
    
    $
    0.19Net income (loss)Basic
    
    $
    (0.80
    )
    
    $
    0.02
    
    
    $
    (1.04
    )
    
    $
    0.04Diluted
    
    $
    (0.80
    )
    
    $
    0.02
    
    
    $
    (1.04
    )
    
    $
    0.04Basic shares outstanding
    
    
    36,726
    
    
    
    32,975
    
    
    
    35,281
    
    
    
    32,892Equivalent shares
    
    
    0
    
    
    
    684
    
    
    
    0
    
    
    
    385Diluted shares outstanding
    
    
    36,726
    
    
    
    33,659
    
    
    
    35,281
    
    
    
    33,277
 See Notes to Unaudited Condensed Consolidated Financial Statements 4




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ORTHOLOGIC CORP.
(A Development Stage Company) 
  
 Nine months endedAs a DevelopmentSeptember 30,
    
    September 30,
    
    Stage Company2004
    
    2003
    
    8/5/04 - 9/30/04OPERATING ACTIVITIESNet income (loss)
    
    $
    (36,788
    )
    
    $
    1,206
    
    
    $
    (27,554
    )Non-cash items:Depreciation and amortization
    
    
    152
    
    
    
    487
    
    
    
    24Escrow account amortization
    
    
    20
    
    
    
    
    
    
    
    Deferred tax asset
    
    
    (31
    )
    
    
    
    
    
    
    (31
    )Gain on sale of the Bone Device Business
    
    
    (1,685
    )
    
    
    
    
    
    
    (1,685
    )CBI in process R&D
    
    
    25,840
    
    
    
    
    
    
    
    25,840Net change in other operating items:Accounts receivable
    
    
    449
    
    
    
    162
    
    
    
    (257
    )Inventories
    
    
    
    
    
    
    284Prepaids and other current assets
    
    
    590
    
    
    
    3
    
    
    
    788Deposits and other assets
    
    
    (113
    )
    
    
    (81
    )
    
    
    (3
    )Accounts payable
    
    
    506
    
    
    
    511
    
    
    
    (13
    )Accrued liabilities and deferred rent
    
    
    (2,066
    )
    
    
    865
    
    
    
    1,298Cash flows used (provided by) in operating activities
    
    
    (13,126
    )
    
    
    3,437
    
    
    
    (1,593
    )INVESTING ACTIVITIESExpenditures for furniture and equipment
    
    
    (68
    )
    
    
    (234
    )
    
    
    (33
    )Cash paid for CBI acquisition
    
    
    (3,668
    )
    
    
    
    
    
    
    (3,668
    )Purchase of investments
    
    
    (67,316
    )
    
    
    (19,945
    )
    
    
    (22,791
    )Maturities of investments
    
    
    37,628
    
    
    
    17,066
    
    
    
    12,386Cash flows used in investing activities
    
    
    (33,424
    )
    
    
    (3,113
    )
    
    
    (14,106
    )FINANCING ACTIVITIESNet proceeds from stock option exercises
    
    
    5,204
    
    
    
    677
    
    
    
    1,303Cash flows provided by financing activities
    
    
    5,204
    
    
    
    677
    
    
    
    1,303NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
    
    
    (41,346
    )
    
    
    1,001
    
    
    
    (14,396
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    84,357
    
    
    
    11,286
    
    
    
    57,407CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    43,011
    
    
    $
    12,287
    
    
    $
    43,011SUPPLEMENTAL SCHEDULE OF NON-CASH, INVESTING
AND FINANCING ACTIVITIES:Cash paid during the period for interest
    
    $
    4
    
    
    $
    9
    
    
    $
    1Cash paid during the period for income taxes
    
    
    2,679
    
    
    
    21
    
    
    $
    6Common stock issued for legal settlement
    
    
    
    
    
    $
    2,078CBI Acquisition:Current assets acquired
    
    
    29
    
    
    
    
    
    
    
    29Trademarks acquired
    
    
    2,142
    
    
    
    
    
    
    
    2,142Liabilities acquired
    
    
    (140
    )
    
    
    
    
    
    
    (140
    )Original investment reversal
    
    
    (750
    )
    
    
    
    
    
    
    (750
    )In process R&D acquired
    
    
    25,840
    
    
    
    
    
    
    
    25,840Common stock issued for acquisition
    
    
    (23,453
    )
    
    
    
    
    
    
    (23,453
    )Cash paid for CBI acquisition
    
    $
    3,668
    
    
    
    
    
    
    $
    3,668
 See Notes to Unaudited Condensed Consolidated Financial Statements 5




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ORTHOLOGIC CORP.
(A Development Stage Company) 
 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of the organization. OrthoLogic is a drug development company focused on the healing of
musculoskeletal, dermal and cardiovascular 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. We are currently enrolling patients in a Chrysalin Phase 3
human clinical trial for acceleration of fracture repair and have recently
submitted a new protocol for an Investigational New Drug (IND) application to
begin an additional human clinical trial for this indication. In the spring of
2004 we completed enrollment of patients in a Chrysalin Phase 1/2 human
clinical trial for spine fusion. Data from this trial is expected to be
available during the summer of 2005. We are also planning to conduct a
Chrysalin human clinical trial for cartilage defect repair, a second Chrysalin
human clinical trial in dermal wound healing (diabetic ulcer), and additional
preclinical research in cardiovascular repair and tendon repair. On August 5, 2004, we purchased substantially all of the assets and
intellectual property of Chrysalis Biotechnology, Inc. (CBI), including its
exclusive worldwide license for Chrysalin for all medical indications for $2.5
million in cash and $25.0 million in OrthoLogic common stock. We issued
3,462,124 shares of OrthoLogic common stock to CBI for this transaction, based
on the 10-day average closing price of $7.221. Pursuant to the terms of the
definitive agreement, we must issue an additional number of shares of
OrthoLogic common stock valued at $7.0 million upon the occurrence of certain
trigger events, which include the sale or other transactions that result in a
change of control of OrthoLogic or the acceptance by the U.S. Food and Drug
Administration of a new drug application for a product based on Chrysalin, if
either such trigger occurs within five years of closing. The largest portion
of the purchase price was expensed as In-process Research and Development of
$25.8 million. The remainder of the purchase price was allocated to trademarks
totaling $2.1 million, liabilities of $140,000 and other assets of $29,000. If
a triggering event occurs, the additional $7.0 million will be allocated in the
same manner as the initial purchase price. On November 26, 2003, we sold our bone growth stimulation and fracture
fixation device business (Bone Device Business) to dj Orthopedics, 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. The Bone Device Business assets included the rights to produce and
market the OL1000, OL1000 SC, SpinaLogic and OrthoFrame/Mayo. As of September 30, 2004, we had cash and cash equivalents of $43.0
million, short-term investments of $60.4 million and long-term investments of
$5.9 million. We currently intend to utilize these resources to fund the
development, testing and commercialization of our Chrysalin product platform. 6




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We began operating as a development stage company upon the acquisition of
CBI and following the prior divestitures of our revenue producing operations,
effective August 5, 2004. Subsequently, all of our collective efforts are
focused on research and development of the Chrysalin Product Platform, with the
goal of commercializing our products. Excluding the initial 1998 equity
investment of $750,000 and the 2004 purchase price for the assets of CBI, we
have spent approximately $34.4 million in total research and development
efforts on the Chrysalin product platform to date. We have incurred $4.8
million and $12.2 million on the Chrysalin research efforts during the last
three-month and nine-month periods, respectively. 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 former business line of bone growth stimulation and fracture
fixation devices, including the OL1000 product line, SpinaLogic®, OrthoFrame®
and OrthoFrame/Mayo. 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 purchase price allocations, 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 CBI purchase price allocation,
allowance for doubtful accounts (approximately $405,000 and $556,000 at
September 30, 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, the 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
condensed consolidated financial statements in accordance with accounting
principles generally accepted in the United States of America for interim
financial statements. Accordingly, the accompanying condensed consolidated
financial statements do not include all information and notes required for
complete financial statements. 7




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The following briefly describes the significant accounting policies used
in the preparation of 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 the 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 (SFAS) No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets effective
January 1, 2002. 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 payable to us from
dj Orthopedics, LLP, related to the sale of the Bone Device Business was
required to be placed in escrow (Note 3). 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 currently determine
the discounted fair value to be approximately $228,000 which is reflected as a
reduction of the escrow receivable. The discount of $22,000 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. Prior to the asset acquisition of CBI on
August 5, 2004, we owned a minority ownership interest in CBI, which is
recorded at cost (see Note 2) through December 31, 2003. We purchased
substantially all of the assets and intellectual property of CBI, replacing our
initial investment. 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 sublease space is anticipated to be vacant. In the opinion of
management, the reserve balance of $570,000 at September 30, 2004 is
appropriate 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 jurisdictions.
Pursuant to SFAS No. 109, we have determined that the majority of the deferred
tax assets at September 30, 2004 require a valuation allowance. We believe the
remaining 8




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deferred tax asset of $801,000 will be realized as it relates to
alternative minimum tax credits that do not expire. G. Research and development. Research and development represents costs
incurred internally for research and development activities, costs incurred to
fund the research activities we have contracted externally 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 September 30, 2004, we had two
stock-based employee compensation plans. We account for those plans under the
recognition and measurement principles of Accounting Priniciples Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations. In the quarter ended September 30, 2004, we recorded
approximately $23,000 in net compensation expense related to the vesting of
performance-based options. In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure 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 illustrate the effect on net income and earnings per share if we had
applied the fair value recognition provisions of SFAS No. 123, Accounting for
Stock-Based Compensation to stock-based employee compensation (in thousands
except per share data). Three months ended September 30,
    
    Nine months ended September 30,2004
    
    2003
    
    2004
    
    2003Estimated weighted-average fair value
of options granted during the period
    
    $
    2.74
    
    
    $ none
    
    $
    2.32
    
    
    $
    1.74Net income (loss) attributable to
common stockholders:As reported
    
    $
    (29,350
    )
    
    $
    506
    
    
    $
    (36,788
    )
    
    $
    1,206Stock based compensation expense
    
    
    (45
    )
    
    
    (115
    )
    
    
    (597
    )
    
    
    (355
    )Pro forma
    
    $
    (29,395
    )
    
    $
    391
    
    
    $
    (37,385
    )
    
    $
    851Basic net income per share:As reported
    
    $
    (0.80
    )
    
    $
    0.02
    
    
    $
    (1.04
    )
    
    $
    0.04Pro forma
    
    $
    (0.80
    )
    
    $
    0.01
    
    
    $
    (1.06
    )
    
    $
    0.03Diluted net income per share:As reported
    
    $
    (0.80
    )
    
    $
    0.02
    
    
    $
    (1.04
    )
    
    $
    0.04Pro forma
    
    $
    (0.80
    )
    
    $
    0.01
    
    
    $
    (1.06
    )
    
    $
    0.03Black Scholes model assumptions:Risk free interest rate
    
    
    3.1
    %
    
    
    1.6
    %
    
    
    3.1
    %
    
    
    1.6
    %Expected volatility
    
    
    41
    %
    
    
    44
    %
    
    
    44
    %
    
    
    41
    %Expected term
    
    2.7 Years
    
    
    2.7 Years
    
    
    2.7 Years
    
    
    2.7 YearsDividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
 9




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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 gain on the
sale of the Bone Device Business and related results of operations for 2003,
prior to the sale, have been presented as discontinued operations in the
financial statements. 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 ACQUISITION OF CHRYSALIS BIOTECHNOLOGY, INC. In January 1998, we acquired a minority equity investment (less than 10%)
in 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 process. On August 5, 2004, we purchased substantially all of the assets and
intellectual property of CBI, including its exclusive worldwide license for
Chrysalin for all medical indications for $2.5 million in cash and $25.0
million in OrthoLogic common stock issued. We issued 3,462,124 shares of
OrthoLogic common stock to CBI for this transaction based on the 10-day average
closing price of $7.221. Pursuant to the terms of the definitive agreement, we
must issue an additional number of shares of OrthoLogic common stock valued at
$7.0 million upon the occurrence of certain trigger events, which include the
sale or other transactions that result in a change of control of OrthoLogic or
the acceptance by the U.S. Food and Drug Administration of a new drug
application for a product based on Chrysalin, if either such trigger occurs
within five years of closing. The largest portion of the purchase price and
acquisition costs was expensed as In-process Research and Development of $25.8
million. The remainder of the purchase price was allocated to trademarks
totaling $2.1 million, liabilities of $140,000 and other assets of $29,000. If
a triggering event occurs, the additional $7.0 million will be allocated in the
same manner as the initial purchase price. The initial $750,000 investment was recognized as part of the purchase
price of the transaction. In return for the initial investment in CBI, we
received 214,234 shares of OrthoLogic common stock as the prorated share of the
purchase price, in accordance with the 10




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liquidation plan adopted by CBI at the time of the asset acquisition. The
shares of OrthoLogic common stock, valued at $1.5 million, were accumulated
with the other 41,800 shares of Treasury Stock previously outstanding and
reverted back into the authorized but unissued common stock during the third
quarter of 2004. Pursuant to the Asset Purchase Agreement, fifteen percent of the shares of
OrthoLogic common stock issued for the acquisition of CBI were placed in escrow
for eighteen months from the closing date to cover indemnifications for the
representations and warranties made by CBI in the Asset Purchase Agreement. We
assumed the CBI lease for the location in Galveston, Texas, with approximately
6,000 sq. ft. of office space and laboratory space. We hired eight of the
eleven full time CBI employees, and retained the President and founder of the
company through a two-year consulting agreement. 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 will be necessary to complete development of these products. The CBI acquisition has been accounted for using the purchase method of
accounting whereby the total purchase price has been allocated to tangible and
intangible assets acquired and liabilities assumed based on their estimated
fair market values as of the acquisition date. The purchase price was
comprised of the following (in thousands): Cash paid including acquisition costs
    
    $
    3,668Common stock issued (less treasury stock received)
    
    
    23,453Original investment in CBI
    
    
    750Total purchase price
    
    $
    27,871
 The fair value of CBI net assets acquired: Trademarks
    
    $
    2,142In-process research and development
    
    
    25,840Furniture, equipment and other
    
    
    29Liabilities acquired
    
    
    (140
    )Fair value of the assets purchased
    
    $
    27,871
 The following unaudited pro forma condensed consolidated statements of
operations are based on the historical consolidated financial statements of
OrthoLogic, adjusted to give effect to the acquisition of substantially all the
assets of CBI for the three and nine months ended September 30, 2004, as if the
transaction had occurred on January 1, 2004. The pro forma consolidated financial information is presented for
illustrative purposes only, and is not necessarily indicative of the operating
results or financial position that would have occurred if all the events
described had occurred on the first day of the respective periods presented,
nor is it necessarily indicative of future operating results or financial
position. 11




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Selected Historical Financial Data
(in thousands, expect per share data) Three months ended September 30,
    
    Nine months ended September 30,2004
    
    2003
    
    2004
    
    2003Total operating expenses
    
    $
    31,853
    
    
    $
    3,401
    
    
    $
    41,876
    
    
    $
    9,665Loss from continuing operations
    
    
    (31,104
    )
    
    
    (1,680
    )
    
    
    (40,266
    )
    
    
    (5,527
    )Gain from discontinued
operations
    
    
    1,685
    
    
    
    2,207
    
    
    
    1,685
    
    
    
    6,341Net loss (income)
    
    $
    (29,420
    )
    
    $
    527
    
    
    $
    (38,582
    )
    
    $
    814Basic loss per share for
continuing operations
    
    $
    (0.85
    )
    
    $
    (0.05
    )
    
    $
    (1.14
    )
    
    $
    (0.17
    )Basic income per share fordiscontinued operations
    
    $
    0.05
    
    
    $
    0.07
    
    
    $
    0.05
    
    
    $
    0.19Basic loss per share
    
    $
    (0.80
    )
    
    $
    0.02
    
    
    $
    (1.09
    )
    
    $
    0.02
 3. 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, LLP is eligible for indemnity and breach of contract
claims, if any, 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 reserved
for the potential liability at closing was $1.9 million related to the fair
value of the representation and warranties in the Asset Purchase Agreement. We
received updated information during the third quarter of 2004 that eliminated
most of the potential exposure of the representations and warranties in the
Asset Purchase Agreement, substantiating a decrease in the reserve of
approximately $1.7 million, leaving a net reserve of approximately $228,000.
This decrease in the reserve resulted in an additional $1.7 million gain to be
recognized on the sale of the Bone Device Business in discontinued operations
during the current quarter. 12




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The sale of the Bone Device Business 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 shorter. The sale of the Bone Device Business is accounted for as discontinued
operations. The income from the divested business and related tax effects is
summarized as discontinued operations in the consolidated statement of
operations. Included in the discontinued operations for the 2003 period is the
net income from the Bone Device Business of $2.2 million and $6.3 million
resulting from the three months and nine months of operations through September
30, 2003, respectively. 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 such business. The revenue, cost of
revenue, gross profit and pretax income attributable to the Bone Device
Business for the three months and nine months ending September 30, 2003 were as
follows (in thousands): Three months ended
    
    Nine months endedSeptember 30, 2003
    
    September 30, 2003Net revenue
    
    $
    12,523
    
    
    $
    34,263Cost of sales
    
    
    1,926
    
    
    
    5,088Gross profit
    
    
    10,597
    
    
    
    29,175Pretax income
    
    $
    3,803
    
    
    $
    10,088
 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. 4. CPM DIVESTITURE AND RELATED GAINS In July 2001, we announced the sale of our continuous passive motion
(CPM) business to OrthoRehab, Inc. 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. Payments of $79,000 and $272,000, and $132,000 and $477,000 were
collected during the three months and nine months ended September 30, 2004 and
2003, respectively, and recognized on the CPM divestiture and related 13




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gains line item on the Consolidated Statement of Operations. The
remaining balance plus interest is scheduled to be paid over the next 18
months. Due to the uncertainty of the future payments, income on the
settlement will continue to be recorded as cash is received. 5. LITIGATION OrthoLogic Corp. v. Maricopa County, Superior Court of the State of
Arizona, Arizona Tax Court, No. TX2004-000657. On October 28, 2004, the
Company filed a complaint and notice of tax appeal against Maricopa County.
The Maricopa County Assessor valuated the Corporations leased property located
at 1275 W. Washington St., Tempe, AZ 85281 and billed the Company in the
amount of $228,574.40 for the 2004 personal property tax. The Company paid
$114,288 of the property tax bill, and accrued $57,114 for the amount due
through September 30, 2004. The leased property is owned by the City of Tempe
and the underlying real property is owned by Salt River Project, an
agricultural improvement district. The leased property was previously exempt
from personal property taxes. Upon information and belief, the Company has
been taxed pursuant to a recent change in the state taxation law that allows
taxation in the name of the lessee or sublessee of otherwise tax exempt
improvements located on land owned by an agricultural improvement district.
The Company believes that this taxation is illegal and if legal, was applied
incorrectly. The Company intends to pursue this matter vigorously. The Company is involved in various 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 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®, 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 14




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##### Table of Contents



December 31, 2003 and the Special Note Regarding Forward Looking
Statements below, following Item 4. Overview On August 5, 2004, we purchased substantially all of the assets and
intellectual property of Chrysalis Biotechnology, Inc. (CBI), including its
exclusive worldwide license for Chrysalin for all medical indications, for $2.5
million in cash and $25.0 million in OrthoLogic common stock. We issued
3,462,124 shares of OrthoLogic common stock to CBI for this transaction, based
on the 10-day average closing price of $7.221. Pursuant to the terms of the
definitive agreement, we must issue an additional number of shares of
OrthoLogic common stock valued at $7.0 million upon the occurrence of certain
trigger events, which include the sale or other transactions that result in a
change of control of OrthoLogic or the acceptance by the U.S. Food and Drug
Administration of a new drug application for a product based on Chrysalin, if
either such trigger occurs within five years of closing. The largest portion
of the purchase price was expensed as In-process Research and Development of
$25.8 million. The remainder of the purchase price was allocated to trademarks
totaling $2.1 million, liabilities of $140,000 and other assets of $29,000. If
a triggering event occurs, the additional $7.0 million will be allocated in the
same manner as the initial purchase price. 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 September 30, 2004, we had cash and cash equivalents of $43.0
million, short-term investments of $60.4 million and long-term investments of
$5.9 million. We currently intend to utilize these resources to fund the
development, testing and commercialization of our Chrysalin product platform. 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. The Chrysalin molecule
serves as the basis for a family of potential therapeutic products we refer to
collectively as the Chrysalin product platform. To date, we have identified
six potential medical applications for Chrysalin:  
    
    fracture repair;
    
    spine fusion;
    
    dermal wound healing (diabetic ulcers);
    
    cartilage defect repair; 15




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##### Table of Contents




    
    cardiovascular repair, and
    
    tendon repair.  Fracture Repair We are currently enrolling patients in a Chrysalin Phase 3 human clinical
trial for acceleration of fracture repair. We have recently submitted a new
protocol for an Investigational New Drug (IND) application to begin an
additional human clinical trial to provide dosing information to support a
potential future New Drug Application (NDA). The focus of the Phase 3 trial
is to identify if a single injection of Chrysalin into the fracture can
accelerate healing. Our preclinical fracture repair studies currently underway
focus on isolating and identifying functions of Chrysalin in acceleration of
fracture repair, and what genes are stimulated by the injection of the
Chrysalin peptide. 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. Preclinical studies using segmental defect, distraction
osteogenesis and non-union models 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 preclinical studies on spine fusion address questions of safety and
efficacy when the Chrysalin peptide is used for spine fusion surgeries. These
studies are performed by collaborators at academic institutions, with the
experimental study design provided by OrthoLogic scientists. We completed
enrollment in a Chrysalin Phase 1/2 human clinical trial for spine fusion
during the second quarter of 2004. We may conduct preclinical studies
evaluating Chrysalin for interbody spinal fusion. Should these studies be
performed, and based on this preclinical data, we plan to seek FDA
authorization to begin a human clinical trial evaluating Chrysalin for
interbody spinal fusion. Dermal Wound Healing Our preclinical studies and initial Phase 1/2 human clinical trial
evaluate Chrysalin as a potential product for diabetic ulcer healing in a
saline formulation. We are currently evaluating various gel formulations to
develop the protocol for a future Chrysalin human clinical trial for this
indication. We plan to determine a final gel formulation for this indication
before the end of 2005 with the potential to initiate a new human clinical
trial in 2006. Cartilage Defect Repair Our preclinical cartilage repair studies are performed at academic
institutions with the protocol designed by OrthoLogic scientists. The goal of
these studies is to understand the way Chrysalin works to stimulate cartilage
defect repair as well as to address formulation questions. 16




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##### Table of Contents



Data permitting, we intend to submit an IND to the FDA and begin a human
clinical trial for this indication in 2005. Cardiovascular Repair The focus of our research is to evaluate delivery mechanisms for a
Chrysalin-based potential product for myocardial revascularization. We plan to
conduct preclinical studies for this indication during 2005. Tendon Repair Our first Chrysalin preclinical tendon repair study has begun in
collaboration with an academic institution. The results from this study should
be available in the first half of 2005. The development of each of our potential product candidates in the
Chrysalin product platform is based on our collective 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 and
enhancing tissue repair and is based on the ability of Chrysalin to mimic
specific attributes of the human thrombin molecule to stimulate the bodys
natural healing process. We are developing the Chrysalin-based product candidates in parallel. We
expect to learn from the results of each trial and apply the findings to the
development of the other product candidates. We believe there are distinct
research activities within the product candidates whose outcomes and results
will apply across the product platform in terms of safety and efficacy. The fracture repair studies are furthest in the development process. We
are currently enrolling patients in the Phase 3 human clinical trial for this
indication and after the appropriate follow-up period, expect to have data from
this trial before the end of 2005. We are in the process of beginning an
additional human clinical trial for this indication to generate additional
dosing information. Should these studies be performed, and based on the
results of this data, we intend to submit a NDA for the acceleration of fresh
fracture repair to the FDA before the end of 2006. Our current timeline for
potential product development anticipates the commercialization of this product
candidate in the 2007-2008 timeframe. This would be the first period in which
we expect to begin to receive cash flows resulting from our research and
development efforts. Excluding the initial 1998 equity investment of $750,000 and the 2004
purchase price for the assets of CBI, we have spent approximately $34.4 million
in total research and development efforts on the Chrysalin product platform.
We have incurred $4.8 million and $12.2 million on the Chrysalin research
efforts during the last three-month and nine-month periods, respectively. All of our collective efforts are focused on the research and development
of the Chrysalis product platform. We estimate our 2004 net cash expenditures,
including the cash associated with the CBI acquisition, will be approximately
$20.0 million. We continue to evaluate our research projects to determine
future cash flow requirements for the product development for the expanded
indications, beyond orthopedics. Based on current research and development
plans, we expect our 2005 cash expenditures to be approximately $35.0 million.
Assuming cash expenditures continue at approximately the same level, we expect
our cash reserves to support our research and development for approximately the
next three years. 17




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##### Table of Contents



OrthoLogic cautions that its future cash expenditure levels are difficult
to estimate because the estimates include a number of assumptions about the
number of research projects OrthoLogic pursues, the pace at which it pursues
them, the quality of the data collected and the requests of the FDA to expand,
narrow or conduct additional clinical trials and data analysis. Changes in any
of these assumptions can change OrthoLogics estimated cash expenditure levels
significantly. However, absent any unforeseen changes to OrthoLogics current
business plans, OrthoLogic intends to maintain annual expenditure levels within
the $35.0 million range. Critical Accounting Policies and Estimates Income Taxes: SFAS No. 109 Accounting for Income Taxes 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 $801,000 at September 30, 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 gain from the sale of the Bone Device Business
and the related operational results, have been presented as discontinued
operations in the 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 at the time of closing the sale. We received updated
information during the third quarter of 2004 that eliminated most of the
potential exposure of the representations and warranties in the Asset Purchase
Agreement, substantiating a decrease in the reserve of approximately $1.7
million, leaving a net reserve of approximately $228,000. This decrease in the
reserve resulted in additional $1.7 million gain to be recognized on the sale
of the Bone Device Business during the current quarter. 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. 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 an industrial district. We have
subleased approximately 13,500 square feet of the building 18




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##### Table of Contents



through June 2005 and another 18,900 through March 2005. 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 is
anticipated to be vacant during the third quarter of 2004 for $570,000. In the
opinion of management, the reserve balance is adequate to allow for time
necessary to acquire an additional tenant for the building. Allowance for Doubtful Accounts: The Company retained certain receivables
related to the Bone Device Business after the divestiture. The allowance for
doubtful accounts (approximately $405,000 and $556,000 at September 30, 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. Results of Operations Comparing Three-Month Period Ended September 30, 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 increased by approximately 9.9% from $1.1
million to $1.2 million from the third quarter of 2003 to 2004. The increase
is substantially related to the additional excess space reserve established in
the third quarter of 2004, which represents the cost of the anticipated excess
space in our current building. Without the recognition of the excess space
reserve, the administrative expenses would have decreased from the prior year
period. 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
$4.8 million in the third quarter of 2004 compared to $2.4 million in the third
quarter of 2003. The increase in our research and development expenses is
attributed to the significant expansion of our research and preclinical
programs since the third quarter of 2003. The majority of the initial start up
activity to begin the additional human clinical trial for acceleration of
fracture repair was initiated during the third quarter of 2004. In addition,
the asset acquisition of CBI on August 5, 2004, expanded the research costs for
the Chrysalin platform to other indications during the third quarter. 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 repair
indication. Research and development expenses consisted primarily of Chrysalin
related expenses, which include preclinical studies in cartilage defect repair,
final patient enrollment and the early completion of the Phase 1/2 spinal
fusion 19




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clinical trial, start up costs for the additional human clinical trial for
fracture repair, 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. We received payments
totaling $79,000 during the third quarter of 2004. The payments appear on the
CPM divestiture and related gains line on the Statement of Operations. The
remaining balance plus interest is scheduled to be paid over the next 18
months. Due to the uncertainty of the future payments, income on the
settlement will be recorded as cash is received. Interest Income, net: Interest income in the third quarter increased from
$124,000 in 2003 to $344,000 in 2004, primarily as a result of the additional
interest earned on the cash and investments from the proceeds of 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 net
gain on the sale of the Bone Device Business during 2004 is due to the decrease
in the reserve for the potential exposure under the representations and
warranties in the sale agreement by approximately $1.7 million from the initial
discounted fair value of $1.9 million at the time of closing. The decrease in
the reserve resulted in an additional $1.7 million gain to be recognized in the
third quarter of 2004. The operating income from the divested business and
related tax effects are summarized as discontinued operations in the
consolidated statement of operations during 2003. Included in the discontinued
operations is the net income from the Bone Device Business of $2.2 million for
the third quarter of 2003, which is net of taxes. Net Income (Loss): We had a net loss in the third quarter of 2004 of
$29.4 million compared to net income of $506,000 for the third quarter of 2003.
The net loss in 2004 is substantially a result of the expanded research and
development programs, expense of in-process research and development of $25.8
million for the CBI acquisition, offset by the gain on the sale of discontinued
operations of $1.7 million. The net income in 2003 is composed primarily of
the income of $2.2 million from the discontinued operations of the Bone Device
Business and a $1.7 million loss resulting from continuing operations. Results of Operations Comparing Nine-Month Period Ended September 30, 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 34.9% from $3.7
million to $2.4 million from the nine-month period ending 2003 to 2004. Our
administrative functions previously serviced a larger organization that had
manufacturing, sales, healthcare reimbursement and 20




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research and development functions, compared to the pure research and
development company that exists currently. Research and Development Expenses: Research and development expenses were
$12.2 million in the first nine months of 2004 compared to $6.1 million in the
first nine months of 2003. The increase in our research and development
expenses is attributed to the significant expansion of our research and
preclinical programs since the equivalent period in 2003. We have more
patients enrolled in the clinical trials than in 2003, when we were starting
our Phase 3 human clinical trial for fracture repair indications. The start up
costs for an additional clinical trial for the acceleration of fracture repair
has been initiated during the second and third quarters of 2004. In addition,
the asset acquisition of CBI on August 5, 2004 expanded the research costs for
the Chrysalin platform to other indications during the third quarter. 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 repair
indication. Research and development expenses consisted primarily of Chrysalin
related expenses, which include preclinical studies in cartilage defect repair,
final patient enrollment and the early completion of the Phase 1/2 spinal
fusion clinical trial, start up costs for the additional human clinical trial
for acceleration of fracture repair 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. Payments totaling
$272,000 were received during the nine-month period ended September 30, 2004,
and appear on the CPM divestiture and related gains line on the Statement of
Operations. The remaining balance plus interest is scheduled to be paid over
the next 18 months. Due to the uncertainty of the future payments, income on
the settlement will be recorded as cash is received. Interest Income, net: Interest income in the nine-month period increased
from $387,000 in 2003 to $950,000 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 net
gain on the sale of the Bone Device Business during 2004 is due to the decrease
in the reserve for the potential exposure of the representations and warranties
in the sale agreement by approximately $1.7 million from the initial discounted
fair value of $1.9 million at the time of closing. The decrease in the reserve
resulted in an additional $1.7 million gain to be recognized in the third
quarter of 2004. 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 is the net
income from the Bone Device Business of $6.3 million for the nine-month period
ended September 30, 2003, which is net of taxes. Net Income (Loss): We had a net loss during the nine-month period ended
September 30, 2004 of $36.8 million compared to net income of $1.2 million for
the same period of 2003. The net loss in 2004 is primarily a result of the
expanded research and development programs, expense of in-process research and
development of $25.8 million for the CBI acquisition, offset by the gain on the
sale of discontinued operations of $1.7 million. The net income for the first 21




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nine months of 2003 is composed primarily of the income of $6.3 million
from the discontinued operations of the Bone Device Business and a $5.1 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 $86.0 million in cash from the sale of our Bone Device
Business. The remaining $7.0 million escrow held from the sale of the Bone
Device Business is due to be released in November of 2005. At September 30,
2004, we had cash and cash equivalents of $43.0 million, short-term investments
of $60.4 million and long-term investments of $5.9 million. With the exception of the purchase of substantially all of the assets of
CBI, we do not expect to make significant capital investments during the
remainder of 2004, but anticipate growing our research and development
expenditures related to the human clinical trials for Chrysalin in fresh
fracture repair and spinal fusion and for further studies in articular
cartilage repair, dermal wound healing, and cardiovascular indications. As of the end of the 2003 fiscal year, our cash reserves were
approximately $121.0 million and were approximately $109.4 million at the end
of the third quarter of 2004. We estimate that our 2004 net cash expenditures,
including the cash associated with the CBI acquisition, will be approximately
$19.0 million. We continue to evaluate our research projects to determine
future cash flow requirements. However, based on current research and
development plans, OrthoLogic expects its 2005 cash expenditures to be
approximately $35.0 million. Assuming cash expenditures continue at
approximately the same level, OrthoLogic expects its cash reserves to support
its research and development for the next three years. We caution that our future cash expenditure levels are difficult to
estimate because the estimates include a number of assumptions about the number
of research projects OrthoLogic pursues, the pace at which it pursues them, the
quality of the data collected and the requests of the FDA to expand, narrow or
conduct again clinical trials and analyze data. Changes in any of these
assumptions can change significantly OrthoLogics estimated cash expenditure
levels. However, absent any unforeseen changes to OrthoLogics current business
plans, OrthoLogic intends to maintain annual expenditure levels within the
$35.0 million range. 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. 22




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The following table sets forth all known commitments as of September 30,
2004 and the year in which these commitments become due or are expected to be
settled (in thousands): Accounts PayableYear
    
    Operating Leases
    
    and Other Liabilities
    
    Total2004
    
    $
    304
    
    
    $
    4,556
    
    
    $
    4,8602005
    
    $
    1,084
    
    
    
    55
    
    
    $
    1,2392006
    
    $
    1,078
    
    
    
    
    
    
    $
    1,0782007
    
    $
    989
    
    
    
    
    
    
    $
    989Total
    
    $
    3,455
    
    
    $
    4,711
    
    
    $
    8,166
 Approximately 17% of the leased facility is subleased through June 2005
and another approximately 20% is subleased through March of 2005, payments from
which will offset a portion of the lease commitments listed above. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk We had no debt outstanding and no derivative instruments at September 30,
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 limits the amount of credit exposure of 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 of
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 provide
reasonable assurance 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. We have performed extensive financial reporting
and data system reviews of internal controls to formalize and standardize the
documentation of these operating procedures. As part of this process, 23




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additional procedures and operational functions have been adopted to provide
further verification of effective operating internal controls. 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 of OrthoLogics Business OrthoLogic is a development stage biopharmaceutical company with no
revenue generating operations and high investment costs. OrthoLogic expects to
incur losses for a number of years as it expands its research and development
projects. There is no assurance that OrthoLogics current level of funds will
be sufficient to support all research expenses to achieve commercialization. With the November 2003 sale of its bone growth stimulation business,
OrthoLogic currently has no revenue generating operations. With the acquisition
of CBI, OrthoLogic is now a pure research and development company. As of the
end of the 2003 fiscal year, OrthoLogics cash and investments were
approximately $121.0 million and were approximately $109.4 million at the end
of the third quarter of 2004. OrthoLogic estimates that its 2004 net cash
expenditures, including the cash associated with the CBI acquisition, will be
approximately $20.0 million. OrthoLogic is currently evaluating other research
projects from the CBI acquisition to determine future cash flow requirements.
Based on current research and development plans, OrthoLogic expects its 2005
cash expenditures to be approximately $35.0 million. Assuming cash expenditures
continue at approximately the same level, OrthoLogic expects its cash reserves
to support its research and development for the next three years. OrthoLogic cautions that its future cash expenditure levels are difficult
to forecast because the forecast is based on assumptions about the number of
research projects OrthoLogic pursues, the pace at which it pursues them, the
quality of the data collected and the requests of the FDA to expand, narrow or
conduct again clinical trials and analyze data. Changes in any of these
assumptions can change significantly OrthoLogics estimated cash expenditure
levels. However, absent any unforeseen changes to OrthoLogics current business
plans, OrthoLogic intends to maintain annual expenditure levels within the
$35.0 million range. OrthoLogics product candidates are in various stages of development and
may not be successfully developed or commercialized. If it fails to
commercialize its product candidates, it will not be able to generate revenue: OrthoLogic currently does not sell any products. OrthoLogics product
candidates are at the following stages of development: 24




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
    
    Acceleration of Fracture Repair  Phase 3 human clinical trials
    
    Spine Fusion  Phase 1/2 human clinical trials
    
    Dermal Wound Healing (Diabetic Ulcers)   Phase 1/2 human clinical trials
    
    Cartilage Defect Repair  Late stage preclinical trials
    
    Cardiovascular Repair  Early stage preclinical trials
    
    Tendon Repair  Early stage preclinical trials Consequently, OrthoLogic is subject to the risk that:  
    
    the FDA finds some or all of OrthoLogics product candidates ineffective or unsafe;
    
    OrthoLogic does not receive necessary regulatory approvals;
    
    OrthoLogic is unable to get some or all of its product
candidates to market in a timely manner;
    
    OrthoLogic is not able to produce its product candidates in
commercial quantities at reasonable costs;
    
    OrthoLogics products undergo post-market evaluations
resulting in marketing restrictions or withdrawal; or
    
    the patient and physician community does not accept
OrthoLogics products. In addition, OrthoLogics 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 clinical trials;
    
    inability to locate, recruit, qualify and retain a sufficient number of patients for
clinical trials;
    
    regulatory delays or other regulatory actions;
    
    difficulties in obtaining sufficient quantities of the particular product candidate or any other components needed for OrthoLogics preclinical testing or clinical
trials;
    
    change in the focus of OrthoLogics development efforts; and
    
    re-evaluation of OrthoLogics clinical development strategy. OrthoLogic cannot predict whether it will successfully develop and
commercialize any of its product candidates. If it fails in such development or
commercialization, it will not be able to generate revenue. OrthoLogics product candidates are all based on the same synthetic
peptide, Chrysalin. If one of OrthoLogics product candidates reveals safety or
fundamental inefficacy issues in clinical trials, it could impact the
development path for all OrthoLogics other current product candidates. 25




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The development of each of OrthoLogics product candidates in the
Chrysalin product platform is based on OrthoLogics 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 OrthoLogic is developing the product candidates in the Chrysalin
product platform in parallel, OrthoLogic expects to learn from the results of
each trial and apply some of OrthoLogics 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 OrthoLogic finds that one of the biopharmaceutical product
candidates is unsafe, it could impact the development of OrthoLogics other
product candidates in clinical trials. OrthoLogics rights to Chrysalin are licensed from the University of Texas
and if the license is invalid or unenforceable, OrthoLogic may lose its rights
to use the Chrysalin technology, which would ultimately prevent OrthoLogic from
commercializing and selling any Chrysalin-based products. At the closing of the CBI asset acquisition on August 5, 2004, the license
agreements between CBI and OrthoLogic for the development, use, and marketing
of the therapeutic products within the Chrysalin product platform were replaced
by a direct license agreement with the University of Texas, which OrthoLogic
and Chrysalis negotiated in conjunction with the asset acquisition. Under this
direct license, OrthoLogic expanded its current license for Chrysalin from a
license for only orthopedic soft tissue indications to a license for any and
all indications. In return, OrthoLogic must pay the University of Texas
continuing royalties, sublicense fees and various other fees in connection with
filing and maintaining Chrysalin-related patents. The license agreement will
expire upon the expiration of all licensed patents, and is not subject to
termination by the University of Texas, except for fraud by OrthoLogic or a
payment default following assignment of the license by OrthoLogic. If
OrthoLogic loses its rights to Chrysalin under the license agreement,
OrthoLogic would be unable to continue its product development programs and its
business and prospects would be materially harmed. If OrthoLogic cannot protect the Chrysalin patent or its intellectual
property generally, OrthoLogics ability to develop and commercialize its
products will be severely limited. OrthoLogics success will depend in part on the University of Texas and
OrthoLogics 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
OrthoLogic has incurred. OrthoLogics 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 OrthoLogics rights to use its or its licensors
patents or to defend against 26




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allegations that OrthoLogic infringes 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,
OrthoLogic employs individuals who were previously employed at other
biotechnology or pharmaceutical companies, including OrthoLogics competitors
or potential competitors. To the extent OrthoLogics employees are involved in
research areas which are similar to those areas in which they were involved at
their former employers, OrthoLogic may be subject to claims that such employees
and/or OrthoLogic 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 OrthoLogic, even if it is successful in defending
such claims. OrthoLogic also relies on its business on trade secrets, know-how and
other proprietary information. OrthoLogic seeks to protect this information, in
part, through the use of confidentiality agreements with employees,
consultants, advisors and others. Nonetheless, OrthoLogic cannot assure you
that those agreements will provide adequate protection for its 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 technical information independently developed by them or by
others to OrthoLogics proposed products, disputes may arise as to the
proprietary rights to such information, which may not be resolved in
OrthoLogics favor. The breach by other parties of confidentiality agreements
with OrthoLogic, or OrthoLogics trade secrets becoming known or independently
discovered by competitors, could adversely affect OrthoLogic by enabling its
competitors, who may have greater experience and financial resources, to copy
or use its trade secrets and other proprietary information in the advancement
of their products, methods or technologies. Some of OrthoLogics product candidates are in early stages of development
and may never be commercialized. Research, development and preclinical testing are long, expensive and
uncertain processes. Other than indications for fracture repair, spine fusions
and wound healing, none of OrthoLogics other Chrysalin product candidates have
reached clinical trial testing. OrthoLogics development of Chrysalin for
cartilage defect repair, cardiovascular repair, and tendon repair is currently
in preclinical testing or the research stage. OrthoLogics future success
depends, in part, on its ability to complete preclinical development of these
and other product candidates and advance them through the clinical trial
process. If OrthoLogic is unsuccessful in advancing its early stage product
candidates into and through clinical testing for any reason, its business
prospects may be harmed. The loss of OrthoLogics key scientific personnel may hinder its ability
to execute its business plan. As a small company with approximately 40 employees, OrthoLogics success
depends on the continuing contributions of OrthoLogics scientific personnel
and maintaining relationships with the network of medical and academic centers
in the United States that conduct its clinical trials. OrthoLogic is most
highly dependent on the services of Dr. James Ryaby, its Senior Vice-President
and Chief Technology Officer, whom OrthoLogic considers its key scientific
employee. A long time employee of OrthoLogic, Dr. Ryaby oversees all of
OrthoLogics clinical 27




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trials, is a well respected orthopedic scientist and is OrthoLogics
primary contact with the medical community. Like all companies in its field,
OrthoLogic faces intense competition in its hiring efforts with other
pharmaceutical and biotechnology companies, as well as universities and
nonprofit research organizations, and it may have to pay higher salaries to
attract and retain qualified personnel. The loss of one or more members of
OrthoLogics current management team or any of its scientific personnel, could
delay OrthoLogics business plan. The loss of Dr. Ryaby, depending on what
stage of development OrthoLogics research is at upon Dr. Ryabys departure,
could cause a substantial delay in implementing OrthoLogics business plan. Not
only could the nationwide search for a similarly qualified candidate be
lengthy, but Dr. Ryabys replacement would need time to become familiar with
OrthoLogics Chrysalin product platform. OrthoLogic does not maintain key man
insurance on Dr. Ryaby. However, OrthoLogic currently has in place employment
contracts with several members of its senior management team, including Dr.
Ryaby. OrthoLogic faces an inherent risk of liability in the event that the use
or misuse of its products results in personal injury or death. The use of OrthoLogics product candidates in clinical trials, and the
sale of any approved products, may expose OrthoLogic to product liability
claims, which could result in financial losses. OrthoLogics clinical liability
insurance coverage may not be sufficient to cover claims that may be made
against the possible risk related to its clinical trials. In addition,
OrthoLogic may not be able to maintain insurance coverage at a reasonable cost
or in sufficient amounts or scope to protect it against losses. Any claims
against OrthoLogic, regardless of their merit, could severely harm OrthoLogics
financial condition, strain its management and other resources and adversely
impact or eliminate the prospects for commercialization of the product which is
the subject of any such claim. OrthoLogics stock price is volatile and fluctuates due to a variety of
factors. OrthoLogics stock price has varied significantly in the past (from a low
of $3.22 to a high of $8.96 since January 1, 2002) and may vary in the future
due to a number of factors, including:  
    
    fluctuations in OrthoLogics research and development efforts;
    
    developments in litigation to which OrthoLogic 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 OrthoLogic or its competitors;
    
    FDA and international regulatory actions;
    
    actions with respect to reimbursement matters;
    
    developments with respect to OrthoLogic or its
competitors patents or proprietary rights;
    
    public concern as to the safety of products developed by OrthoLogic or others;
    
    changes in health care policy in the United States;
    
    changes in stock market analyst recommendations
regarding OrthoLogic, other drug development companies or the
pharmaceutical industry generally; and 28




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
    
    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 OrthoLogics stock. Risks of OrthoLogics Industry OrthoLogic is in a highly regulated field with high investment costs and
high risks. OrthoLogics Chrysalin product platform is currently in the human testing
phase for three potential products and earlier preclinical testing phases for
three other potential products. 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. 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 OrthoLogic successfully brings one or more products to market, there is
no assurance that it 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 OrthoLogic will sell any such products is
dominated by a number of large corporations that have vastly greater resources
than OrthoLogic has, which may impact OrthoLogics ability to successfully
market its products or maintain any technological advantage OrthoLogic has or
might develop. OrthoLogic also would be subject to changes in regulations
governing the manufacture and marketing of its products, which could increase
its costs, reduce any competitive advantage it may have and/or adversely affect
its marketing effectiveness. The results of OrthoLogics late stage clinical trials may be insufficient
to obtain FDA approval which could result in a substantial delay in
OrthoLogics ability to generate revenue. Positive results from preclinical studies and early clinical trials do not
ensure positive results in more advanced clinical trials. If OrthoLogic is
unable to demonstrate that a product candidate will be safe and effective in
advanced clinical trials involving larger numbers of patients, OrthoLogic will
be unable to submit the new drug application necessary to receive approval from
the FDA to commercialize that product. OrthoLogic is currently conducting a Chrysalin Phase 3 human clinical
trial for the acceleration of fracture repair and is in the process of
beginning an additional human clinical trial for this indication. OrthoLogic
expects to complete enrollment and have results for the Phase 3 trial before
the end of 2005. If this Phase 3 trial fails to achieve the clinical benefits
sought or the results are ambiguous, OrthoLogic will have to determine whether
to redesign its Chrysalin fracture repair product candidate and its
corresponding 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
OrthoLogics ability to generate revenue. 29




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Patients may discontinue their participation in OrthoLogics clinical
studies, which may negatively impact the results of these studies and extend
the timeline for completion of OrthoLogics development programs. As with all clinical trials, OrthoLogic is subject to the risk that
patients enrolled in its 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 its product candidates under evaluation.
OrthoLogic is subject to the risk that if a large number of patients in any one
of its 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 OrthoLogics 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;
    
    OrthoLogics 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 OrthoLogic obtains marketing approval, its products will be
subject to ongoing regulatory oversight, which may affect OrthoLogics ability
to successfully commercialize any products it may develop. Even if OrthoLogic receives 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
OrthoLogic obtains 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 OrthoLogic fails to comply with applicable regulatory requirements, it
may be subject to fines, suspension or withdrawal of regulatory approvals,
product recalls, seizure of products, operating restrictions and criminal
prosecution. OrthoLogics product candidates may not gain market acceptance among
physicians, patients and the medical community.If OrthoLogics product
candidates fail to achieve market acceptance, its ability to generate revenue
will be limited. Even if OrthoLogic obtains regulatory approval for its products, market
acceptance will depend on its ability to demonstrate to physicians and patients
the benefits of its products in terms of safety, efficacy, convenience, ease of
administration and cost effectiveness. In addition, OrthoLogic believes market
acceptance depends on the effectiveness of its marketing strategy, the pricing
of its products and the reimbursement policies of government and third-party
payors. 30




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Physicians may not prescribe OrthoLogics products, and patients may
determine, for any reason, that OrthoLogics product is not useful to them. If
OrthoLogics product candidates fail to achieve market acceptance, its ability
to generate revenue will be limited. OrthoLogics success also depends on its ability to operate and
commercialize products without infringing on the patents or proprietary rights
of others. Third parties may claim that OrthoLogic or its licensors or suppliers are
infringing their patents or are misappropriating their proprietary information.
In the event of a successful claim against OrthoLogic or its licensors or
suppliers for infringement of the patents or proprietary rights of others,
OrthoLogic may be required to, among other things:  
    
    pay substantial damages;
    
    stop using certain OrthoLogic 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 OrthoLogic or
its licensors or suppliers are sued for infringement, OrthoLogic could
encounter substantial delays in, or be prohibited from, developing,
manufacturing and commercializing OrthoLogics product candidates. The pharmaceutical industry is subject to stringent regulation, and
failure to obtain regulatory approval from the United States Food and Drug
Administration will prevent commercialization of OrthoLogics products. OrthoLogics research, development, preclinical and clinical trial
activities and the manufacture and marketing of any products that it may
successfully develop are subject to an extensive regulatory approval process by
the FDA. 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. OrthoLogics regulatory submissions may be delayed, or OrthoLogic
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 OrthoLogics competitors that are more
effective than OrthoLogics product candidates. 31




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Consequently, OrthoLogic cannot assure you that it will make its
submissions to the FDA in the timeframe that OrthoLogic has planned, or at all,
or that its submissions will be approved by the FDA. Even if regulatory
clearance is obtained, post-market evaluation of OrthoLogics 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.
OrthoLogic depends, in part, on third-party laboratories and medical
institutions to conduct preclinical studies and clinical trials for its
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
OrthoLogics clinical trials, the FDA may suspend or terminate such trials,
which would severely delay OrthoLogics development of, and possibly end the
development of, a product candidate. OrthoLogic also currently depends and in the future will depend upon third
party manufacturers of its products, which are and will be required to comply
with the applicable FDA Good Manufacturing Practices regulations. OrthoLogic
cannot be certain that its present or future manufacturers and suppliers will
comply with these regulations. The failure to comply with these regulations may
result in restrictions on the sale of, or withdrawal of the products from the
market. Compliance by third parties with these standards and practices are
outside of OrthoLogics direct control. If OrthoLogics competitors develop and market products that are more
effective than OrthoLogics, or obtain marketing approval before OrthoLogic
does, OrthoLogics 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, diabetic ulcer
healing, cartilage defect repair, tendon repair and cardiovascular repair.
Many of OrthoLogics competitors have significantly greater research and
development capabilities, experience in obtaining regulatory approvals and
manufacturing, marketing, financial and managerial resources than OrthoLogic
has. OrthoLogic is currently aware of the following development efforts by its
competitors:  
    
    Acceleration of Fracture Repair:While there is
currently no product approved by the FDA for acceleration of
fracture repair, at least one large pharmaceutical company,
Pfizer, Inc., has received FDA clearance to begin human clinical
trials in the United States for this indication.
    
    Spine Fusion:Although there are already many products
approved by the FDA for use in spinal fusion, only two products,
InFuse from Medtronic and OP-1 from Stryker, both bone
morphogenic protein (BMP), includes a bioactive component.
OrthoLogic knows other candidates are in the development stage,
but none are yet in human clinical trials in the United States.
    
    Dermal Wound Healing (Diabetic Ulcers):Only one
product, Regranix from Johnson and Johnson has been FDA approved
for a diabetic ulcer indication. 32




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
    
    Cartilage Defect Repair:Several products with
bioactive components are in the development stage for this
indication, including BMPs. However, OrthoLogic believes no
company has yet received FDA authorization for a drug product to
begin human clinical trials in the United States for this
indication.
    
    Cardiovascular Repair:This is a very large and
complicated market with numerous products FDA approved or under
development for a variety of indications. There are significant
product opportunities that still exist, particularly in the area
of myocardial revascularization.
    
    Tendon Repair:There are currently no drug products
specifically approved for a tendon repair indication. Physicians
currently employ a variety of surgical techniques to address this
medical problem. OrthoLogics competitors may succeed in developing products that are more
effective than the ones OrthoLogic has under development or that render
OrthoLogics proposed products or technologies noncompetitive or obsolete. In
addition, certain of such competitors may achieve product commercialization
before OrthoLogic does. If any of OrthoLogics competitors develops a product
that is more effective than one OrthoLogic is developing or plans to develop,
or is able to obtain FDA approval for commercialization before OrthoLogic does,
OrthoLogic may not be able to achieve significant market acceptance for certain
of its products, which would have a material adverse effect on OrthoLogics
business. Healthcare reform and restrictions on reimbursements may limit
OrthoLogics financial returns. OrthoLogics ability to successfully commercialize its products will
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
OrthoLogics drug products to enable OrthoLogic to maintain price levels
sufficient to realize an appropriate return on OrthoLogics investments in
research and product development, which could restrict OrthoLogics ability to
commercialize a particular drug candidate. 
 Part II  Other Information 
 Item 5. Other Information On November 8, 2004, we entered into a Third Amended and Restated
Employment Agreement with Sherry A. Sturman (the Sturman Agreement) under
which Ms. Sturman will continue to serve as our Senior Vice President / Chief
Financial Officer. The Sturman Agreement provides for a minimum base salary of
$200,000 per year. Ms. Sturman will also be eligible for annual and long-term
incentives, including performance-based bonuses and stock option grants. Under
the terms of the Sturman Agreement, OrthoLogic or Ms. Sturman may elect to
begin a two-year transition leading to the termination of Ms. Sturmans
employment with OrthoLogic. Ms. Sturman may make such an election at any time
after June 30, 2005 and we may make such an election at any time. In the event
an election is made by either Ms. Sturman 33




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or OrthoLogic, Ms. Sturman would be entitled to continue receiving salary, at declining base salary rates, and benefits for a period of two years. 
 Item 6.
    
    
    ExhibitsSee Exhibit List following this report
 34




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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. 
 Signature
    
    Title
    
    Date/s/ Thomas R. Trotter

Thomas R. Trotter
    
    President and Chief Executive Officer
(Principal Executive Officer)
    
    November 9, 2004/s/ Sherry A. Sturman

Sherry A. Sturman
    
    Senior Vice-President and Chief
Financial Officer
(Principal Financial and Accounting
Officer)
    
    November 9, 2004
 35




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OrthoLogic Corp.
Exhibit Index to Quarterly Report on Form 10-Q
For the Quarterly Period Ended September 30, 2004 ExhibitNo.
    
    Description
    
    Incorporated by Reference To:
    
    Filed Herewith3.1
    
    Amended and Restated
Certificate of
Incorporation,
executed May 9, 2000
    
    Exhibit 3.1 to the Companys
Form 10-Q for the quarter
ended September 30, 2003
(September 2003 10-Q)3.2
    
    Certificate of
Designation of
Series A Preferred
Stock
    
    Exhibit 3.2 to the Companys
September 2003 10-Q3.3
    
    Bylaws of the Company
    
    Exhibit 3.4 to Companys
Amendment No. 2 to
Registration Statement on
Form S-1 (No. 33-47569)
filed with the SEC on
January 25, 19934.1
    
    Rights Agreement
dated as of March 4,
1997, between the
Company and Bank of
New York, and
Exhibits A, B and C
thereto
    
    Exhibit 4.1 to the Companys
Registration Statement on
Form 8-A filed with the SEC
on March 6, 19974.2
    
    1987 Stock Option
Plan of the Company,
as amended and
approved by
stockholders (1)
    
    Exhibit 4.4 to the Companys
Form 10-Q for the quarter
ended June 30, 1997 (June
1997 10-Q)4.3
    
    1997 Stock Option
Plan of the
Company, as amended and approved by the stockholders(1)
    
    Exhibit 4.5 to the Companys
June 1997 10-Q10.1
    
    Amendment No. 2 to
the Asset Purchase
Agreement and Plan
of Reorganization
between OrthoLogic
Corp. and Chrysalis
Biotechnology, Inc.,
dated August 5, 2004
*
    
    Exhibit 2.1 to Current
Report on Form 8-K, filed
August 6, 200410.2
    
    Consulting Agreement
with Darrell H.
Carney, Ph.D., dated
August 5, 2004
    
    
    
    X10.3
    
    Third Amended and
Restated Employment
Agreement effective
November 8, 2004,
between the Company
and Sherry A.
Sturman
    
    
    
    X31.1
    
    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
Securities 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.**
 Thomas R. Trotter
 Sherry A. Sturman
 (1)Management
contract or compensatory plan or arrangement

     *OrthoLogic Corp. agrees to furnish supplementally a copy of any schedule
to the Asset Purchase Agreement and Plan of Reorganization dated as of April
28, 2004 and to Amendment Nos. 1 and 2 omitted from this filing to the
Securities and Exchange Commission upon its request.
     **Furnished herewith 36