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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
 FORM 10-Q (Mark One) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended
    
    June 30, 2004
 or o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
 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.     þYes   oNo Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 126-2 of the Exchange Act):          þYes   oNo APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date. 34,550,152 shares of common stock outstanding as of July 29, 2004    1




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ORTHOLOGIC CORP.
INDEX Page No.Part I
    
    Financial InformationItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets as of June 30,
2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for
the Three months and Six months ended June 30, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for
the Six months ended June 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
    
    
    13Item 3. Quantitative and Qualitative Disclosures
about Market Risk
    
    
    21Item 4. Controls and Procedures
    
    
    22Part II
    
    Other InformationItem 4. Submission of Matters to a vote of Security Holders
    
    
    31Item 6. Exhibits and Reports
    
    
    32EX-31.1EX-31.2EX-32
  2




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PART I  Financial Information 
 Item 1. Financial Statements
 ORTHOLOGIC CORP. 
    June 30,
    
    December 31,2004
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    58,403
    
    
    $
    84,357Short-term investments
    
    
    54,566
    
    
    
    32,499Accounts receivable less allowance for doubtful accounts,
$418 and $556
    
    
    86
    
    
    
    792Prepaids and other current assets
    
    
    1,168
    
    
    
    882Total current assets
    
    
    114,223
    
    
    
    118,530Furniture and equipment, net
    
    
    479
    
    
    
    560Long-term investments
    
    
    2,891
    
    
    
    4,156Escrow receivable, net
    
    
    5,128
    
    
    
    5,144Deferred income taxes  non-current
    
    
    770
    
    
    
    770Deposits and other assets
    
    
    306
    
    
    
    196Investment in Chrysalis BioTechnology
    
    
    750
    
    
    
    750Total assets
    
    $
    124,547
    
    
    $
    130,106LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    649
    
    
    $
    201Accrued compensation
    
    
    373
    
    
    
    609Accrued taxes
    
    
    93
    
    
    
    2,924Excess space reserve
    
    
    105
    
    
    
    314Other current liabilities
    
    
    2,722
    
    
    
    1,875Total current liabilities
    
    
    3,942
    
    
    
    5,923Deferred rent and capital lease obligation
    
    
    173
    
    
    
    208Total liabilities
    
    
    4,115
    
    
    
    6,131Stockholders EquityCommon stock, $.0005 par value;
50,000,000 shares authorized; and 34,550,152 and
33,533,443 shares issued and outstanding
    
    
    17
    
    
    
    16Additional paid-in capital
    
    
    146,221
    
    
    
    142,329Accumulated deficit
    
    
    (25,669
    )
    
    
    (18,233
    )Treasury stock at cost, 41,800 shares
    
    
    (137
    )
    
    
    (137
    )Total stockholders equity
    
    
    120,432
    
    
    
    123,975Total liabilities and stockholders equity
    
    $
    124,547
    
    
    $
    130,106
 See Notes to Unaudited Condensed Consolidated Financial Statements 3




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ORTHOLOGIC CORP. 
    Three months ended June 30,
    
    Six months ended June 30,2004
    
    2003
    
    2004
    
    2003OPERATING EXPENSESGeneral and administrative
    
    $
    616
    
    
    $
    1,278
    
    
    $
    1,171
    
    
    $
    2,567Research and development
    
    
    3,987
    
    
    
    2,236
    
    
    
    7,358
    
    
    
    3,626CPM divestiture and related gains
    
    
    (81
    )
    
    
    (345
    )
    
    
    (192
    )
    
    
    (345
    )Total operating expenses
    
    
    4,522
    
    
    
    3,169
    
    
    
    8,337
    
    
    
    5,848OPERATING LOSS
    
    
    (4,522
    )
    
    
    (3,169
    )
    
    
    (8,337
    )
    
    
    (5,848
    )OTHER INCOMEInterest income, net
    
    
    301
    
    
    
    131
    
    
    
    607
    
    
    
    263Loss from continuing operations before taxes
    
    
    (4,221
    )
    
    
    (3,038
    )
    
    
    (7,730
    )
    
    
    (5,585
    )Income tax benefit
    
    
    0
    
    
    
    (1,170
    )
    
    
    (294
    )
    
    
    (2,150
    )Loss from continuing operations
    
    
    (4,221
    )
    
    
    (1,868
    )
    
    
    (7,436
    )
    
    
    (3,435
    )Discontinued operations (Note 2)Income from operations of Bone Device Business
net of taxes of $0, $1,183, $0 and $2,177
    
    
    0
    
    
    
    2,426
    
    
    
    0
    
    
    
    4,135Income from discontinued operations
    
    
    0
    
    
    
    2,426
    
    
    
    0
    
    
    
    4,135NET INCOME (LOSS)
    
    $
    (4,221
    )
    
    $
    558
    
    
    $
    (7,436
    )
    
    $
    700Loss from continuing operationsBasic
    
    $
    (0.12
    )
    
    $
    (0.05
    )
    
    $
    (0.22
    )
    
    $
    (0.11
    )Diluted
    
    $
    (0.12
    )
    
    $
    (0.05
    )
    
    $
    (0.22
    )
    
    $
    (0.11
    )Income from discontinued operationsBasic
    
    $
    (0.00
    )
    
    $
    0.07
    
    
    $
    (0.00
    )
    
    $
    0.13Diluted
    
    $
    (0.00
    )
    
    $
    0.07
    
    
    $
    (0.00
    )
    
    $
    0.13Net income (loss)Basic
    
    $
    (0.12
    )
    
    $
    0.02
    
    
    $
    (0.22
    )
    
    $
    0.02Diluted
    
    $
    (0.12
    )
    
    $
    0.02
    
    
    $
    (0.22
    )
    
    $
    0.02Basic shares outstanding
    
    
    34,528
    
    
    
    32,889
    
    
    
    34,419
    
    
    
    32,849Equivalent shares
    
    
    
    
    
    
    242
    
    
    
    
    
    
    
    230Diluted shares outstanding
    
    
    34,528
    
    
    
    33,131
    
    
    
    34,419
    
    
    
    33,079
 See Notes to Unaudited Condensed Consolidated Financial Statements 4




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ORTHOLOGIC CORP. 
    Six months ended June 30,2004
    
    2003OPERATING ACTIVITIESNet income (loss)
    
    $
    (7,436
    )
    
    $
    700Non-cash items:Depreciation and amortization
    
    
    115
    
    
    
    339Escrow account amortization
    
    
    16Change in operating assets and liabilities:Accounts receivable
    
    
    706
    
    
    
    681Inventories
    
    
    
    
    
    
    123Prepaids and other current assets
    
    
    (286
    )
    
    
    144Deposits and other assets
    
    
    (110
    )
    
    
    19Accounts payable
    
    
    448
    
    
    
    226Accrued liabilities
    
    
    (2,464
    )
    
    
    (252
    )Accrued liabilities on CPM divestiture and related
charges
    
    
    
    
    
    
    (172
    )Net cash (used in) provided by operating activities
    
    
    (9,011
    )
    
    
    1,808INVESTING ACTIVITIESExpenditures for equipment and furniture
    
    
    (34
    )
    
    
    (170
    )Purchases of investments
    
    
    (40,960
    )
    
    
    (12,989
    )Maturities of investments
    
    
    20,158
    
    
    
    12,697Net cash used in investing activities
    
    
    (20,836
    )
    
    
    (462
    )FINANCING ACTIVITIESNet proceeds from stock option exercises
    
    
    3,893
    
    
    
    295Net cash provided by financing activities
    
    
    3,893
    
    
    
    295NET DECREASE IN CASH AND CASH EQUIVALENTS
    
    
    (25,954
    )
    
    
    1,641CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    84,357
    
    
    
    11,286CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    58,403
    
    
    $
    12,927SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND
FINANCING ACTIVITES:Cash paid during the period for interest
    
    $
    3
    
    
    $
    7Cash paid during the period for income taxes
    
    $
    2,673
    
    
    $
    27Common stock issued for legal settlement
    
    $
    0
    
    
    $
    2,078
 See Notes to Unaudited Condensed Consolidated Financial Statements. 5




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ORTHOLOGIC CORP. 
 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  1.
    
    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of the Business. OrthoLogic is a drug development company focused on the healing of
musculoskeletal tissue, through biopharmaceutical approaches. Our research is
focused exclusively on the potential commercialization of our Chrysalin®
Product Platform. Chrysalin, or TP508, is a 23-amino acid synthetic peptide
representing a receptor-binding domain of the human thrombin molecule, a
naturally occurring molecule in the body responsible for both blood clotting
and initiating many of the cellular events responsible for tissue repair in
bone and cartilage. We are currently enrolling patients in a Phase 3 Chrysalin
product human clinical trial for fracture indications, have just completed the
enrollment of patients in a Phase 1/2 spine fusion clinical trial, have one
potential product in late-stage preclinical development, and are planning the
development for two additional areas of research. On November 26, 2003, we sold our Bone Device Business to dj Orthopedic,
LLC for a purchase price of approximately $93.0 million in cash and the
assumption of substantially all of the Bone Device Business trade payables and
other current liabilities. Through this divestiture, we sold all of our
revenue producing operations. The Bone Device Business assets included the
rights to produce and market the OL1000, OL1000 SC, SpinaLogic and
OrthoFrame/Mayo. As of June 30, 2004, we had cash and cash equivalents of $58.4 million,
short-term investments of $54.6 million and long-term investments of $2.9
million. We will be relying on these resources to fund the development,
testing and commercialization of our Chrysalin product platform. On April 28, 2004, we signed a definitive agreement to acquire
substantially all of the assets and intellectual property of Chrysalis
Biotechnology, Inc. (CBI), a privately held company which has the exclusive
license for the Chrysalin patent, the basis for our Chrysalin product platform. The transaction closed on August 5, 2004. We purchased substantially all
of CBIs assets, including its key intellectual property asset, its exclusive
Chrysalin patent license agreement, for $2.5 million in cash and $25.0 million
in OrthoLogic common stock issued at the closing. We issued 3,462,124 shares
of OrthoLogic common stock to CBI based on the 10-day average closing price of
$7.221. Pursuant to the terms of the definitive agreement, we must issue
additional shares of OrthoLogic common stock valued at $7.0 million upon the
occurrence of certain trigger events, which include the sale or other
transaction that results 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 asset purchase closed subsequent to the end of the second fiscal
quarter and is not reflected in the interim financial statements. Approximately
$26.0 million of the purchase price will be expensed as In-process Research and
Development. The remainder of the purchase price and acquisition costs will be
allocated to patents and trademarks. If a triggering event 6




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occurs, the additional $7.0 million will be added to the purchase price of
the In-process Research and Development and will be expensed at that time. In these notes, references to we, our and the Company refer to
OrthoLogic Corp. and its subsidiaries. References to our 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. Financial Statement Presentation In the opinion of management, the unaudited interim financial statements
include all adjustments necessary for the fair presentation of our financial
position, results of operations, and cash flows. The results of operations for
the interim periods are not necessarily indicative of the results to be
expected for the complete fiscal year. The balance sheet as of December 31,
2003 is derived from our audited financial statements included in the 2003
Annual Report on Form 10-K. These financial statements should be read in
conjunction with the financial statements and notes thereto included in the
2003 Annual Report on Form 10-K. Use of estimates. The preparation of the financial statements in
conformity with accounting principles generally accepted in the United States
of America requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the reporting period. These estimates
and assumptions form the basis for the carrying values of assets and
liabilities. On an on-going basis we evaluate these estimates, including those
related to allowance for doubtful accounts, guarantees, income taxes,
contingencies and litigation. Management bases its estimates on historical
experience and various other assumptions and believes its estimates are
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities not
readily apparent from other sources. Under different assumptions and
conditions, actual results may differ from these estimates. The significant estimates include the allowance for doubtful accounts
(approximately $418,000 and $556,000 at June 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, 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. 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. 7




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B. Furniture and equipment. Furniture and equipment are stated at cost
or, in the case of leased assets under capital leases, at the present value of
future lease payments at inception of the lease. Depreciation is calculated on
a straight-line basis over the estimated useful lives of the various assets,
which range from three to seven years. Leasehold improvements and leased
assets under capital leases are amortized over the life of the asset or the
period of the respective lease using the straight-line method, whichever is the
shortest. We adopted Statement of Financial Accounting Standards No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS No.
144) effective January 1, 2002. SFAS No. 144 addresses financial accounting
and reporting for the impairment or disposal of long-lived assets. SFAS No.
144 requires that we evaluate long-lived assets based on the net future cash
flow expected to be generated from the asset on an undiscounted basis whenever
significant events or changes in circumstances occur that indicate that the
carrying amount of an asset may not be recoverable. C. Escrow receivable. A portion of the purchase price related to the
sale of the Bone Device Business was required to be placed in escrow (Note 2).
Under Financial Accounting Standards Board (FASB) Interpretation No. 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of the Indebtedness of Others, indemnifications,
representations and warranties issued in conjunction with the sale of a
business are required to be valued and recorded in the financial statements.
We made certain representations and warranties in conjunction with the sale of
the Bone Device Business and determined the discounted fair value to be
approximately $1.9 million, which is reflected as a reduction of the escrow
receivable. The discount is being accreted to interest expense through November
26, 2005, which is when the portion of the purchase price allocated to the
representations and warranties is required to be released from escrow. D. Investment in Chrysalis. We own a minority ownership interest in CBI,
which is recorded at cost (see Note 4). On August 5, 2004 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 available sublease space is anticipated to be vacant. In the
opinion of management, the reserve balance of $105,000 at June 30, 2004 is
adequate to allow for time necessary to acquire an additional tenant for the
building. F. Income taxes. Under SFAS No. 109, Accounting for Income Taxes,
income taxes are recorded based on current year amounts payable or refundable,
as well as the consequences of events that give rise to deferred tax assets and
liabilities. We base our estimate of current and deferred taxes on the tax
laws and rates that are currently in effect in the appropriate jurisdiction.
Pursuant to SFAS No. 109, we have determined that the majority of the deferred
tax assets at June 30, 2004 require a valuation allowance. We believe the
remaining deferred tax asset of $770,000 will be realized as it relates to
alternative minimum tax credits that do not expire. G. Research and development. Research and development represents both
costs incurred internally for research and development activities, as well as
costs incurred to fund the research activities with which we have contracted
and certain milestone payments regarding the continued clinical testing of
Chrysalin. All research and development costs are expensed when incurred. 8




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H. Stock-based compensation. At June 30, 2004, we had two stock-based
employee compensation plans. We account for those plans under the recognition
and measurement principles of APB Opinion No. 25, Accounting for Stock Issued
to Employees, and related interpretations. In the six months ended June 30,
2004, we recorded approximately $33,000 in net compensation expense related to
the vesting of performance-based options. In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, Accounting for Stock-Based Compensation  Transition and
Disclosure (SFAS No. 148) which is effective for fiscal years ended after
December 15, 2002. SFAS No. 148 amends SFAS No. 123 to provide alternative
methods of transition to SFAS No. 123s fair value method of accounting for
stock-based employee compensation if a company elects to account for its equity
awards under this method. SFAS No. 148 also amends the disclosure provisions
of SFAS No. 123 and APB Opinion No. 28, Interim Financial Reporting, to require
disclosure of the effects of an entitys accounting policy with respect to
stock-based employee compensation on reported net income and earnings per share
in both annual and interim financial statements. We have provided the required
additional annual disclosures below which illustrates the effect on net income
and earnings per share if we had applied the fair value recognition provisions
of FASB Statement No. 123, Accounting for Stock-Based Compensation, to
stock-based employee compensation (in thousands except per share data). Three months ended June 30,
    
    Six months ended June 30,2004
    
    2003
    
    2004
    
    2003Estimated weighted-average fair value
of options granted during the period
    
    $
    0
    
    
    $
    1.16
    
    
    $
    2.46
    
    
    $
    1.23Net income (loss) attributable to
common stockholders:As reported
    
    $
    (4,221
    )
    
    $
    558
    
    
    $
    (7,436
    )
    
    $
    700Stock based compensation expense
    
    
    (34
    )
    
    
    (137
    )
    
    
    (613
    )
    
    
    (266
    )Pro forma
    
    $
    (4,255
    )
    
    $
    421
    
    
    $
    (8,049
    )
    
    $
    434Basic net income per share:As reported
    
    $
    (0.12
    )
    
    $
    0.02
    
    
    $
    0.22
    
    
    $
    0.02Pro forma
    
    $
    (0.12
    )
    
    $
    0.01
    
    
    $
    0.23
    
    
    $
    0.01Diluted net income per share:As reported
    
    $
    (0.12
    )
    
    $
    0.02
    
    
    $
    0.22
    
    
    $
    0.02Pro forma
    
    $
    (0.12
    )
    
    $
    0.01
    
    
    $
    0.23
    
    
    $
    0.01Black Scholes model assumptions:Risk free interest rate
    
    
    3.6
    %
    
    
    1.4
    %
    
    
    3.6
    %
    
    
    1.4
    %Expected volatility
    
    
    41
    %
    
    
    36
    %
    
    
    45
    %
    
    
    40
    %Expected term
    
    2.7 Years
    
    2.7 Years
    
    2.7 Years
    
    2.7 YearsDividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
 I. Income (loss) per common share. Income (loss) per common share is
computed on the weighted average number of common or common and equivalent
shares outstanding during each year. Basic earnings per share is computed as
net income (loss) divided by the weighted average number of common shares
outstanding during the period. Diluted earnings per share reflects the
potential dilution that could occur from common shares issuable through stock
options, warrants, and other convertible securities when the effect would be
dilutive. 9




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J. Discontinued operations. Under SFAS No. 144, Accounting for the
Impairment and Disposal of Long-Lived Assets, discontinued operations are
reported if a component of the entity is held for sale or sold during the
period. The Bone Device Business qualified as a component of the entity under
the standard as of the November 26, 2003 sale date. Therefore, the related
results of the Bone Device Business operations for 2003, prior to the sale,
have been presented as discontinued operations in the financial statements. K. New Accounting Pronouncements. In January 2003, the FASB issued
Interpretation No. 46 (FIN 46), Consolidation of Variable Interest
Entities, (revised in December 2003) which clarifies the application of
Accounting Research Bulletin No. 51, Consolidated Financial Statements,
relating to consolidation of certain entities. We do not participate in any
variable interest entities. The adoption of FIN 46 did not have a material
impact on our financial statements. L. Certain reclassifications. Certain reclassifications have been made
to the prior year financial statements to conform to the 2004 presentation.  2.
    
    ASSET SALE OF THE BONE DEVICE BUSINESS On November 26, 2003, we completed the sale of the Bone Device Business
assets and related liabilities (including the rights to produce and market the
OL1000, OL1000 SC, SpinaLogic and OrthoFrame/Mayo) to dj Orthopedics, LLC.
Pursuant to the asset purchase agreement, we sold substantially all of the
assets of the Bone Device Business (other than our Medicare accounts
receivable, which were $1.2 million in the aggregate), including substantially
all of the related machinery, equipment, inventory, work in process, licenses,
customer lists, intellectual property, certain agreements and contracts. dj
Orthopedics paid $93.0 million in cash at closing and assumed substantially all
of the Bone Device Business trade payables and other current liabilities less
payables in an amount approximately equal to the amount of retained Medicare
receivables. Upon the closing of the sale we assigned and dj Orthopedics
agreed to assume and perform the obligations outstanding on November 26, 2003,
related to the operation of the Bone Device Business (including various
liabilities related to the Companys employees). Of the $93.0 million we received in the sale, $7.5 million was placed in
an escrow account. The funds were divided into two accounts: $7.0 million from
which dj Orthopedics is eligible for indemnity and breach of contract claims,
if any, may be paid and $0.5 million from which a portion of the agreed upon
incentive stay bonuses will be paid by dj Orthopedics to former OrthoLogic
executives on the first anniversary of the closing. The funds in the $7.0
million escrow account, in excess of the amount of any pending claims, will be
released to us on the second anniversary of the closing. The amount included
in escrow receivable is net of the $1.9 million liability related to the fair
value of the representations and warranties. The transaction was considered an accelerating event for our stock-based
compensation plans. Terminated employees unvested options vested immediately
upon the sale. Our directors and employees who were retained had 75% of their
unvested options vest upon the sale, with the remainder vesting over a 12 month
period or on their regular vesting period, whichever is earlier. The sale of the Bone Device Business is accounted for as discontinued
operations. The income from the divested business, and related tax effects are
summarized as discontinued 10




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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 $2.4 million and $4.1 million resulting from the three
months and six months of operations through June 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 business. The revenue, cost of revenue,
gross profit and pretax income attributable to the Bone Device Business for the
three months and six months ending June 30, 2003 were as follows (in
thousands): Three months ended
    
    Six months endedJune 30, 2003
    
    June 30, 2003Net revenue
    
    $
    11,368
    
    
    $
    21,740Cost of sale
    
    
    1,682
    
    
    
    3,161Gross profit
    
    
    9,686
    
    
    
    18,579Pretax income
    
    $
    3,609
    
    
    $
    6,312
 The historical expenses of the Bone Device Business were derived using a
variety of factors including percentage of revenues, headcount, and specific
identification. Subsequent to the sale, we no longer have any revenue
producing products. The sale of our Bone Device Business was a transaction taxable to us for
United States federal income tax purposes. We recognized taxable income for
fiscal year ended 2003 equal to the amount realized on the sale in excess of
our tax basis in the assets sold. A portion of the taxable gain was offset by
available net operating loss carry forwards.  3.
    
    CPM DIVESTITURE AND RELATED GAINS In July 2001, we announced the sale of our continuous passive motion
(CPM) business to OrthoRehab, Inc. We received $12.0 million in cash, with
OrthoRehab, Inc. assuming approximately $2.0 million in liabilities in
connection with the sale of certain CPM related assets that we had recorded in
our financial statements at a carrying value of approximately $20.7 million.
We recorded a $6.9 million charge to write down the CPM assets to their fair
value less direct costs of selling the assets. Under the CPM Asset Purchase
Agreement, we were eligible to receive up to an additional $2.5 million of cash
if certain objectives were achieved by OrthoRehab, Inc. We settled litigation over the $2.5 million payment and other matters in
April 2003. OrthoRehab, Inc. agreed to pay $1.2 million to settle the
contingent payment due to us, and all outstanding claims between the two
companies. No cash payments were received during the first quarter of 2003.
Payments of $81,000 and $192,000 were collected during the three months and six
months ending June 30, 2004, and recognized on the CPM divestiture and
related gains line item on the Consolidated Statement of Operations. The
remaining balance plus interest is 11




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scheduled to be paid over the next 22 months. Due to the uncertainty of
the future payments, income on the settlement will be recorded as cash is
received.  4.
    
    LICENSING AGREEMENT FOR CHRYSALIN In January 1998, we acquired a minority equity investment (less than 10%)
in a biotech firm, Chrysalis BioTechnology, Inc. (CBI), for $750,000. As part
of the transaction, we were awarded a worldwide exclusive option to license the
orthopedic applications of Chrysalin, a patented 23-amino acid synthetic
peptide that had shown promise in accelerating the healing process. Our
agreement with CBI contains provisions for us to continue and expand our option
to license Chrysalin contingent upon regulatory approvals, successful
preclinical trials, and certain trials and milestone payments to CBI. At this stage of research, we are not yet able to apply for FDA approval
to market Chrysalin. The process of obtaining necessary government approvals
is time consuming and expensive. There can be no assurance that the necessary
approvals for new products or applications will be obtained by us or, if they
are obtained, that they will be obtained on a timely basis. Significant
additional costs will be necessary to complete development of these products. CBI does not own the patents to Chrysalin, but owns an exclusive worldwide
license to Chrysalin from the University of Texas. Except for the $750,000
minority equity investment in Chrysalis, all payments made to CBI have been
expensed as research and development. The license agreement with CBI requires
us to pay certain other additional milestone payments and royalty fees, based
upon the products development and our achievement of commercial introduction. On April 28, 2004, we signed a definitive agreement to acquire
substantially all of the assets and intellectual property of privately held
CBI, based in Galveston, Texas, for $2.5 million in cash and up to $32.0
million in common stock. The agreement covers exclusive rights to proprietary
technology and intellectual property in developing synthetic peptide-based
therapeutics, including Chrysalin for all medical indications. (See Note 6).  5.
    
    LITIGATION OrthoRehab, Inc. and OrthoMotion, Inc. v. OrthoLogic Corporation and
OrthoLogic Canada, Ltd., Superior Court of the State of Delaware, County of New
Castle, Case No. C.A. No. 01C-11-224 WCC. In November 2001, OrthoRehab, Inc.,
filed a complaint in connection with its acquisition of certain assets used in
the Companys CPM business in July 2001 alleging, among other things, that some
of the assets purchased were overvalued and that the Company had breached its
contract. We settled the case in April 2003 by a payment of $1.2 million to us
from OrthoRehab, Inc. In addition to the matter disclosed above, the Company is involved in
various other legal proceedings that arise in the ordinary course of business.
In managements opinion, the ultimate resolution of these other legal
proceedings are not likely to have a material adverse effect on the financial
position, results of operations or cash flows of the Company. 12




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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. 6. Subsequent Events On August 5, 2004, we purchased substantially all the assets, including
intellectual property assets, of Chrysalis Biotechnology, Inc. (CBI). CBI is
a privately held biopharmaceutical company developing synthetic peptide
compounds targeted at tissue repair and regeneration. CBI has operated as a
development stage company since its inception. This acquisition gives
OrthoLogic the exclusive rights to Chrysalin for all indications. The
transaction was approved by the CBI stockholders. We issued 3,462,124 shares of
OrthoLogic common stock valued at $25.0 million to CBI at the time of closing,
based on the 10-day average closing price of $7.221, along with a cash payment
of $2.5 million. In addition, we must issue additional shares of OrthoLogic
common stock valued at $7.0 million upon the occurrence of certain trigger
events, which include the sale or other transaction that results in a change of
control of OrthoLogic or the acceptance by the FDA of a new drug application
for a product based on Chrysalin, if either such trigger occurs within five
years of closing. The transaction will be accounted for as an asset
acquisition. Approximately $26.0 million of the purchase price will be
expensed as In-process Research and Development. The remainder of the purchase
price and acquisition costs will be allocated to patents and trademarks. If a
triggering event occurs, the additional $7.0 million will be added to the
purchase price of the In-process Research and Development and will be expensed
at that time. 
 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 December 31, 2003 and the
Special Note Regarding Forward Looking Statements below, following Item 4. 13




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Overview On November 26, 2003, we sold our Bone Device Business to djOrthopedics,
LLC for a purchase price of approximately $93.0 million in cash and the
assumption of substantially all of the Bone Device Business trade payables and
other current liabilities. Through this divestiture, we sold all of our
revenue producing operations and became a pure drug development company. Our
principal business remains focused on the healing of musculoskeletal tissue,
although through biopharmaceutical approaches rather than through the use of
medical devices. As of June 30, 2004, we had cash and cash equivalents of $58.4 million,
short-term investments of $54.6 million and long-term investments of $2.9
million. We will be relying on these resources to fund the development,
testing and commercialization of our Chrysalin product platform. On April 28, 2004, we signed a definitive agreement to acquire
substantially all of the assets and intellectual property of Chrysalis
Biotechnology, Inc. (CBI), a privately held company which has the exclusive
license for the Chrysalin patent, the basis for our Chrysalin product platform. The transaction closed on August 5, 2004. We purchased substantially all
of CBIs assets, including its key intellectual property asset, its exclusive
Chrysalin patent license agreement, for $2.5 million in cash and $25.0 million
in OrthoLogic common stock issued at the closing. We issued 3,462,124 shares
of OrthoLogic common stock to CBI based on the 10-day average closing price of
$7.221. Pursuant to the terms of the definitive agreement, we must issue
additional shares of OrthoLogic common stock valued at $7.0 million upon the
occurrence of certain trigger events, which include the sale or other
transaction that results 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 asset purchase closed subsequent to the end of the second fiscal
quarter and is not reflected in the interim financial statements. Approximately
$26.0 million of the purchase price will be expensed as In-process Research and
Development. The remainder of the purchase price and acquisition costs will be
allocated to patents and trademarks. If a triggering event occurs, the
additional $7.0 million will be added to the purchase price of the In-process
Research and Development and will be expensed at that time. Research and Development of the Chrysalin Product Platform Chrysalin, or TP508, is a 23-amino acid synthetic peptide representing a
receptor-binding domain of the human thrombin molecule, a naturally occurring
molecule in the body responsible for both blood clotting and initiating many of
the cellular events responsible for tissue repair in bone and cartilage. The
Chrysalin molecule serves as the basis for a family of potential therapeutic
products we refer to collectively as the Chrysalin product platform. To date,
we have identified five potential orthopedic uses of Chrysalin:  
    
    fracture repair;  
    
    spine fusion;  
    
    cartilage defect repair; 14




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
    
    ligament repair; and  
    
    tendon repair. Fracture Repair We are currently enrolling patients in a Phase 3 human clinical trial for
fracture repair indications. 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 Phase 1/2 human clinical trial for spine fusion during the
second quarter of 2004. We plan to conduct preclinical studies evaluating
Chrysalin for interbody spinal fusion. Data permitting, we intent to seek FDA
authorization to begin a human clinical trial evaluating Chrysalin for
interbody fusion before the end of 2005. Cartilage Defect and Repair; Tendon and Ligament Repair Most of our preclinical cartilage repair studies are performed at academic
institutions. The goal of these studies is to understand the way Chrysalin
works to stimulate cartilage defect repair as well as to address formulation
questions. Data permitting, we intend to submit an IND to the FDA for this
indication by the end of 2004. A preclinical tendon repair study has begun and
a ligament repair study is slated to begin this year and will be conducted in
collaboration with academic institutions. 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 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 process. 15




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We are developing the 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. The fracture repair studies are furthest in the development process. We
expect to have enrollment completed for the Phase 3 clinical trials on
Chrysalin for fresh fracture repair indication by end of 2004. We plan to
begin an additional pivotal human clinical trial for this indication in the
fall of 2004. Data permitting, we intend to submit a New Drug Application
(NDA) with the FDA in 2006. Our current timeline for potential product
development anticipates the commercialization of this product candidate in
2008. This is 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 in CBI that we made to gain
the option to license the orthopedic applications of Chrysalin, we have spent
approximately $29.6 million in total research and development efforts on this
program. We have incurred $4.0 million and $7.4 million on these research
efforts during the last three-month and six-month periods, respectively. All of our collective efforts as a company 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. OrthoLogic anticipates evaluating both its and
CBIs research projects during the balance of 2004 to determine future cash
flow requirements. However, based on current research and development plans,
OrthoLogic expects its 2005 cash expenditures to be approximately $25.0-$30.0
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 and a half years. 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 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 $25.0  $30.0 million range. Critical Accounting Policies and Estimates Allowance for Doubtful Accounts: The Company retained certain receivables
related to the Bone Device Business after the divestiture. The allowance for
doubtful accounts (approximately $418,000 and $556,000 at June 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. 16




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Income Taxes: SFAS No. 109 requires that a valuation allowance be
established when it is more likely than not that all or a portion of a deferred
tax asset will not be realized. Changes in valuation allowances from period to
period are included in the tax provision in the period of change. In
determining whether a valuation allowance is required, we take into account all
evidence with regard to the utilization of a deferred tax asset included in
past earnings history, expected future earnings, the character and jurisdiction
of such earnings, unsettled circumstances that, if unfavorably resolved, would
adversely affect utilization of a deferred tax asset, carryback and
carryforward periods, and tax strategies that could potentially enhance the
likelihood of realization of a deferred tax asset. The valuation allowance
reduces deferred tax assets to an amount that management believes will more
likely than not to be realized. We believe that the net deferred tax asset of
$770,000 at June 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 related results of the Bone Device Business
operations prior to the sale have been presented as discontinued operations in
the 2003 financial statements. Liability for Representations and Warranties Made in Conjunction with the
Sale of the Bone Device Business: Under FASB Interpretation No. 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of the Indebtedness of Others, indemnifications,
representations and warranties issued in conjunction with the sale of a
business are required to be valued and recorded in the financial statements.
We made certain representations and warranties in conjunction with the sale of
the Bone Device Business and determined the discounted fair value to be
approximately $1.9 million, which is reflected as a reduction to the escrow
receivable. The discount is being accreted to interest expense through
November 26, 2005, which is when the portion of the purchase price allocated to
the representations and warranties is required to be released from escrow. Investment in CBI: We own a minority ownership interest in CBI, recorded
on the balance sheet at cost as of June 30, 2004. Subsequent to quarter end,
we signed an Asset Purchase Agreement to acquire substantially all of the
assets and intellectual property of CBI. Excess Space Reserve: We lease a facility in Tempe, Arizona. This
approximately 100,000 square foot facility is designed and constructed for
industrial purposes and is located in an industrial district. In November
2003, we subleased approximately 35,000 square feet of the facility to dj
Orthopedics, LLC, the company which purchased our Bone Device Business. We
previously subleased approximately 13,500 square feet of the building through
June 2005 to another company. We believe the facility is well-maintained and
adequate for use in the forseeable future. We believe the remainder of the
facility that we are using is suitable for our purposes and is effectively
utilized. While we believe the facility is well maintained and adequate for
use in the forseeable future, there can be no guarantee that a different lessee
will assume the remaining lease obligation. We established a reserve for the
period the available sublease space was anticipated to be vacant. In the
opinion of management, the reserve balance of $105,000 at June 30, 2004 is
adequate to allow for time necessary to acquire an additional tenant for the
building. 17




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Results of Operations Comparing Three-Month Period Ended June 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 52.8% from $1.3
million to $616,000 from the second quarter of 2003 to 2004. Our
administrative functions previously serviced a large organization that had
manufacturing, sales, healthcare reimbursement and research and development
functions, compared to the pure research and development company that exists
currently. Research and Development Expenses: Research and development expenses were
$4.0 million in the second quarter of 2004 compared to $2.2 million in the
second 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 second quarter of 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. 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. In addition, we
recognize initial planning costs for an additional pivotal human clinical trial
for fracture repair during the second quarter of 2004. 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 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. A payment of $81,000
was received during the second quarter of 2004, and appears 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 21
months. Due to the uncertainty of the future payments, income on the
settlement will be recorded as cash is received. Other Income: Other income earned during the second quarter of 2004 and
2003 consisted primarily of interest income. Other income in the second
quarter increased from $131,000 in 2003 to $301,000 in 2004 primarily as a
result of the additional interest earned on the cash and investments from the
sale of the Bone Device Business. Discontinued operations of the Bone Device Business: The sale of the Bone
Device Business in 2003 is accounted for as discontinued operations. The
operating income from the divested business and related tax effects are
summarized as discontinued operations in the 18




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consolidated statement of operations. Included in the discontinued operations
is the net income from the Bone Device Business of $2.4 million for the second
quarter of 2003, which is net of taxes. Net Income (Loss): We had a net loss in the second quarter of 2004 of
$4.2 million compared to net income of $558,000 for the second quarter of 2003.
The net income in 2003 is composed primarily of the income of $2.4 million
from the discontinued operations of the Bone Device Business and a ($1.9)
million loss resulting from continuing operations. Results of Operations Comparing Six-Month Period Ended June 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 54.4% from $2.6
million to $1.2 million from the six-month period ending 2003 to 2004. Our
administrative functions previously serviced a larger 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
$7.4 million in the first six months of 2004 compared to $3.6 million in the
first six 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 time 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. 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. In
addition, we recognized initial planning costs for a second pivotal human
clinical trial for fracture repair during the second quarter of 2004. 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 and continuation of the Phase 3 human clinical trial for fracture repair.
During 2004, we expect to double our research and development expenses over
2003 levels of $9.0 million. CPM Divestiture and Change in Estimated Collectability of CPM Receivables:
In July 2001, we announced the sale of our continuous passive motion (CPM)
business to OrthoRehab, Inc. We settled litigation over certain contingent
purchase price payment matters in April 2003. OrthoRehab, Inc. agreed to pay
$1.2 million to settle the dispute arising out of a contingent payment due to
us, and all outstanding claims between the two companies. The payments of
$192,000 were received during the six-month period ended June 30, 2004, and
appear on the CPM divestiture and related gains line on the Statement of
Operations. The 19




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remaining balance plus interest is scheduled to be paid over the next 21
months. Due to the uncertainty of the future payments, income on the
settlement will be recorded as cash is received. Other Income: Other income earned during the six-month period ended June
30, 2004 and 2003 consisted primarily of interest income. Other income in the
six-month period increased from $263,000 in 2003 to $607,000 in 2004 primarily
as a result of the additional interest earned on the cash and investments from
the sale of the Bone Device Business. Discontinued operations of the Bone Device Business: The sale of the Bone
Device Business in 2003 is accounted for as discontinued operations. The
operating income from the divested business and related tax effects are
summarized as discontinued operations on the consolidated statement of
operations. Included in the discontinued operations is the net income from the
Bone Device Business of $4.1 million for the six-month period ended June 30,
2003, which is net of taxes. Net Income (Loss): We had a net loss during the six-month period ended
June 30, 2004 of $7.4 million compared to net income of $700,000 for the same
period of 2003. The net income for the first six months of 2003 is composed
primarily of the income of $4.1 million from the discontinued operations of the
Bone Device Business and a ($3.4) 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. At June 30, 2004, we had cash and cash equivalents of $58.4 million,
short-term investments of $54.6 million and long-term investments of $2.9
million. With the exception of the purchase of substantially all of the assets of
CBI, we do not expect to make significant capital investments in 2004, but
anticipate growing our research and development expenditures related to
clinical trials for Chrysalin in fresh fracture repair and spinal fusion and
for further studies in articular cartilage repair. As of the end of the 2003 fiscal year, OrthoLogics cash reserves were
approximately $121.0 million and were approximately $116.0 million at the end
of the second 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 anticipates evaluating both its and
CBIs 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 $25.0-$30.0 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 and a
half years. 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 again clinical trials and analyze data. Changes in any of
these assumptions can change significantly OrthoLogics estimated cash
expenditure 20




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levels. However, absent any unforeseen changes to OrthoLogics current business
plans, OrthoLogic intends to maintain annual expenditure levels within the
$25.0  $30.0 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. The following table sets forth all known commitments as of June 30, 2004
and the year in which these commitments become due or are expected to be
settled (in thousands): Year
    
    Operating Leases
    
    Accounts Payable
    
    Totaland Other Liabilities2004
    
    $
    539
    
    
    $
    3,942
    
    
    $
    4,6542005
    
    
    1,078
    
    
    
    173
    
    
    
    1,0782006
    
    
    1,078
    
    
    
    
    
    
    
    1,0782007
    
    
    989
    
    
    
    
    
    
    
    989Total
    
    $
    3,684
    
    
    $
    4,115
    
    
    $
    7,799
 Approximately 17% of the leased facility is subleased through June 2005
and another approximately 44% is subleased through November of 2004, payments
from which will offset a portion of the lease commitments listed above. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk We have no debt outstanding and no derivative instruments at June 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. 21




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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. There have been no significant changes in our
internal controls over financial reporting during our most recent fiscal
quarter that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting. 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 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 Chrysalis, OrthoLogic will be 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 $116.0 million at the end
of the second 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 anticipates evaluating CBIs research
projects after the closing of the asset purchase transaction to determine
future cash flow requirements. Based on current research and development plans,
OrthoLogic expects its 2005 cash expenditures to be approximately $25.0-$30.0
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 and a half 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 22




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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 $25.0-$30.0 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:  
    
    Acceleration of Fracture Repair  Phase 3 human clinical trials
    
    Spine Fusion  Phase 1/2 human clinical trials
    
    Cartilage Defect Repair  Late stage preclinical trials
    
    Tendon and Ligament 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 of OrthoLogics
products; 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. 23




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OrthoLogic cannot predict whether it will successfully develop and
commercialize any of its product candidates. If it fails to do so, it will not
be able to generate revenue. OrthoLogics product candidates are all based on the same chemical
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. 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. OrthoLogics rights to the development, use and marketing of all of its
therapeutic products within the Chrysalin product platform are currently
governed by a series of sub-licensing agreements from Chrysalis. Upon the
consummation of the asset sale, the license agreements with Chrysalis will be
replaced by a direct license agreement with the University of Texas, which
OrthoLogic and Chrysalis negotiated in conjunction with the asset sale. Under
this direct license, OrthoLogic will expand 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 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 24




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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 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 and spine
fusions, none of OrthoLogics other Chrysalin product candidates have reached
clinical trial testing. OrthoLogics development of Chrysalin for the repair of
cartilage defects, ligaments and tendons 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. 25




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If OrthoLogic is unsuccessful in advancing its early stage product
candidates into and through clinical testing for any reason, its business
prospects will be harmed. The loss of OrthoLogics key scientific personnel may hinder its ability
to execute its business plan. As a small company with 34 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 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 maintains renewable one-year employment
contracts with its senior management, including Dr. Ryaby. OrthoLogic does not
believe resignation or retirement of other senior management is a current risk
that would materially negatively affect the companys business prospects. 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 it. 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 operating results;
    
    developments in litigation to which OrthoLogic or a competitor is subject;
    
    announcements and timing of potential acquisitions,
divestitures, and conversions of preferred stock; 26




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##### Table of Contents




    
    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
    
    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 two potential products and earlier preclinical testing phases for two
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 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 27




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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 Phase 3 human clinical trial on
Chrysalin for fracture repair indications. OrthoLogic expects to have
enrollment for the trial completed by the end of 2004. If it fails to achieve
the clinical benefits sought in this Phase 3 clinical trial or the results are
ambiguous, OrthoLogic will have to determine whether to redesign its Chrysalin
fracture repair product candidate and its 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. 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. 28




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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. 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 29




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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. 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 surgery, cartilage
defect repair and ligament and tendon 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: 30




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
    
    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., appears to have 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 one, InFuse
from Medtronic, a bone morphogenic protein (BMP), includes a
bioactive component. OrthoLogic believes others are in the
development stage, but none are yet in human clinical trials in
the United States.
    
    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 to begin human
clinical trials in the United States for this indication. 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 may depend
in part on the extent to which government health administration authorities,
private health insurers and other third party payors will reimburse consumers
for the cost of these products. Third party payors are increasingly challenging
both the need for, and the price of, novel therapeutic drugs and uncertainty
exists as to the reimbursement status of newly approved therapeutics. Adequate
third party reimbursement may not be available for 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 4   Submission of matters to a vote of security holders The annual meeting of the stockholders of the Company was held on June 7, 2004
to vote on:  
    
    Proposal 1: The election of three directors as Class I directors
to serve until the Annual Meeting of Stockholders to be held in the
year 2007 or until their respective successors are elected; 31




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
    
    Proposal 2: A proposal to amend the Companys 1997 Stock Option
Plan to increase the number of shares of Common Stock available for
grant thereunder by 1,000,000 shares; and
    
    Proposal 3: A proposal to ratify the appointment of Deloitte &
Touche LLP as independent auditors of the Company for the fiscal year
ending December 31, 2004. The results were as follows: WithheldFor
    
    Against
    
    Authority
    
    Abstained
    
    Broker Non-VotesProposal 1:Fredric J. Feldman,
Ph.D,
    
    
    30,041,501
    
    
    
    
    
    
    
    2,515,407Thomas R. Trotter,
    
    
    29,973,574
    
    
    
    
    
    
    
    2,583,334Michael D. Casey
    
    
    30,251,714
    
    
    
    
    
    
    
    2,305,194Proposal 2:Amendment to the
companys 1997
Stock Option Plan
to increase the
number of shares of
common stock
available for grant
under the plan by
1,000,000 shares
    
    
    17,085,921
    
    
    
    5,359,027
    
    
    
    
    
    
    
    516,326
    
    
    
    9,595,634Proposal 3:Ratify and approve
the appointment of
Deloitte & Touche
LLP
    
    
    31,118,213
    
    
    
    1,359,030
    
    
    
    
    
    
    
    79,665
 A more detailed discussion of each proposal is included in the OrthoLogic Corp.
Proxy Statement for the 2004 Annual Meeting of Stockholders. Directors continuing in office are Stuart H. Altman, Ph.D., Michael D. Casey,
Fredric J. Feldman, Ph.D, Elwood D. Howse, Jr., Augustus A. White III, M.D.,
Ph.D., John M. Holliman III and Thomas R. Trotter. 
 Item 6.  Exhibits and Reports  (a)
    
    Exhibit IndexSee Exhibit List following this report(b)
    
    Reports on Form 8-K
None 32




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. ORTHOLOGIC CORP.
(Registrant) Signature
    
    Title
    
    Date/s/ Thomas R. Trotter
Thomas R. Trotter
    
    President and Chief Executive Officer
(Principal Executive Officer)
    
    August 9, 2004/s/ Sherry A. Sturman
Sherry A. Sturman
    
    Senior Vice-President and Chief
Financial Officer
(Principal Financial and Accounting
Officer)
    
    August 9, 2004
 33




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##### Table of Contents



OrthoLogic Corp.
Exhibit Index to Quarterly Report on Form 10-Q
For the Quarterly Period Ended June 30, 2004 Exhibit No
    
    Description
    
    Incorporated by
    
    FiledReference to:
    
    Herewith31.1
    
    Certification of CEO pursuant to
Securities Exchange Act Rule 13a -
14 (a).
    
    
    
    X31.2
    
    Certification of CFO pursuant to
Securities Exchange Act Rule 13a -
14 (a).
    
    
    
    X32
    
    Certification pursuant to the Security
Exchange Act Rule 13a  14(b) and
18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 Thomas R. Trotter
 Sherry A. Sturman
    
    
    
    X