-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, LQ8d8IK/wgeSVZf1jBIKfi1TCs0crogIGqdR5e29OugMP3pRYj82/l9TV5Z2uCJL 8L5Lxfmth+jseVN1AX1CZQ== 0000883322-99-000006.txt : 19990331 0000883322-99-000006.hdr.sgml : 19990331 ACCESSION NUMBER: 0000883322-99-000006 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PROTOCOL SYSTEMS INC/NEW CENTRAL INDEX KEY: 0000883322 STANDARD INDUSTRIAL CLASSIFICATION: ELECTROMEDICAL & ELECTROTHERAPEUTIC APPARATUS [3845] IRS NUMBER: 930913130 STATE OF INCORPORATION: OR FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-19943 FILM NUMBER: 99578345 BUSINESS ADDRESS: STREET 1: 8500 S W CREEKSIDE PLACE CITY: BEAVERTON STATE: OR ZIP: 97008 BUSINESS PHONE: 6126862500 MAIL ADDRESS: STREET 1: 8500 SW CREEKSIDE PLACE CITY: BEAVERTON STATE: OR ZIP: 97008 10-K405 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 Form 10-K (Mark One) [X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Fiscal Year Ended December 31, 1998 OR [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 Commission File Number: 0-19943 ------- PROTOCOL SYSTEMS, INC. (Exact name of registrant as specified in its charter) Oregon 93-0913130 ------------------------------- ------------------ (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 8500 SW Creekside Place, Beaverton, OR 97008 ---------------------------------------------- ---------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (503) 526-8500 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share -------------------------------------- (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] As of March 26, 1999 the aggregate market value of the voting stock held by non-affiliates of the registrant was $54,723,404. There were 8,272,507 shares of Common stock of the registrant outstanding at March 26, 1999. Documents Incorporated by Reference ----------------------------------- Part of Form 10-K Into Document Which Incorporated -------- ---------------------- Portions of the 1999 Proxy Statement Part III PART I ITEM 1. BUSINESS GENERAL Protocol Systems, Inc. was incorporated in Oregon in November 1985, and made its first commercial shipment of patient monitors in February 1988. Since that date, the Company has sold over 50,000 vital signs monitors. In March 1992, the Company completed its initial public offering. The Company's stock trades on the Nasdaq Stock Market under the symbol PCOL. The Company designs, manufactures and markets patient monitoring instruments and systems utilizing innovative design, advanced software concepts and leading electronic technology. The Company's products are designed to address hospitals' needs for more efficient and flexible utilization of patient monitoring equipment. The Company's Propaq monitors, including the Propaq monitors (100 Series) and the Propaq Encore (200 Series) monitors, combine multiple physiologic measurement and display capabilities in a single lightweight, rugged instrument, permitting the use of the monitor in a variety of patient care applications. The Company's Acuity central station further increases monitoring flexibility by allowing a clinician to observe and control up to 60 Propaq monitors from a dedicated Sun Microsystems UNIX-based workstation. In 1996 the Company acquired Pryon Corporation ("Pryon"), a supplier of capnography (CO2 monitoring) products to medical instrument manufacturers. In the third quarter of 1998, the Company relocated the operations of Pryon from Menomonee Falls, Wisconsin to its corporate headquarters in Beaverton, Oregon. Pryon was formally merged into Protocol Systems, Inc., effective December 31, 1998. The Company continues to supply capnography (CO2 monitoring) products to medical instrument manufacturers under the Pryon-tm- label. Capnography is the measurement and graphical display of carbon dioxide concentration, or partial pressure appearing at a patient's airway. Since 1989, over 35,000 CO2 systems have been sold. The Company operates in a single industry segment: the design, manufacture, sale and servicing of medical instruments and systems. Sales of the Company's products by geographic region are shown in the notes to the consolidated financial statements. MARKET FOR PATIENT MONITORING EQUIPMENT The principal purchasers of patient monitoring equipment are hospitals; other customers include outpatient surgery centers, subacute care centers, clinics, physician offices and emergency transportation units. Patient monitoring products measure, display and document physiologic information obtained from sensors attached to the patient. Measured parameters include electrocardiogram (ECG), invasive and non-invasive blood pressure, pulse rate, pulse oximetry, body temperature, respiration rate, end- tidal CO2 and other specialized parameters. Products vary from specialized single-parameter instruments to monitors with the ability to measure multiple parameters and interface with other instruments. PATIENT MONITORING MARKET SEGMENTS The patient monitoring market may be divided into five segments: portable bedside monitors, low-end systems, high-end systems, telemetry systems, and stand-alone monitors. The segments are distinguished by the intensity and duration of the monitoring, the acuity of the patient's condition and the level of nursing attention devoted to each patient. PORTABLE BEDSIDE MONITORS. Portable monitors are freestanding and movable and typically measure multiple parameters. They are carried or wheeled with the patient, often while he or she is being transported to or within the hospital. They may also be left at the patient's bedside, providing continuous longer- term monitoring when the patient's condition warrants. When monitoring is no longer required, the monitor can be easily moved to a new location or patient. The Company has been a leader in the development of the portable bedside monitoring segment since its introduction of the highly portable, multiple- parameter Propaq monitor in 1988. HIGH-END SYSTEMS. High-end systems monitors are normally large, permanently located adjacent to a particular hospital bed and connected to a central monitoring station for observing multiple patients. They are used most often in intensive care units (ICU's) where hospitals care for their more acutely ill patients, maintain the highest nurse-to-patient ratios and provide for constant patient monitoring. The Propaq Encore monitor and the Acuity central station allow the Company to compete in certain segments of the high-end systems market. The neonatal, impedance respiration and 5-lead ECG capabilities of the Propaq Encore monitor and the central monitoring capability of the Acuity central station provide a monitoring system which is suitable to neonatal, pediatric and adult respiratory ICU applications. LOW-END SYSTEMS. As medical monitoring manufacturers began to network their portable bedside monitors, the low-end systems market segment emerged. These systems allow for cost-effective, continuous monitoring of non-ICU patients. The Company's Acuity central station, with its central monitoring capability, is designed to meet the requirements of this market segment. Subsequent enhancements to the Acuity software, including arrhythmia detection, ST segment analysis, and 96-hour full disclosure capabilities, have expanded the potential applications for the Company's monitoring system. TELEMETRY SYSTEMS. A telemetry system typically consists of a small unit worn by the patient which transmits ECG data via telemetry to a central monitoring station. They are used in situations, such as post-coronary care, where the patient is allowed freedom of movement as part of the recovery process. The Company's Protocol Cordless-registered trademark- monitoring system provides such ECG telemetry monitoring for ambulating patients. STAND-ALONE MONITORS. This market segment includes stand-alone units which are not connected to a central monitoring station. They are often used in areas such as operating, emergency and recovery rooms as well as labor and delivery units. In these environments, the monitoring needs arise from specific procedures and the care giver is closely involved with the patient. While some stand-alone monitors include multiple physiologic capabilities, many measure only one parameter. The Company's QuikSigns-tm- monitor would be classified as a stand alone monitor. PRODUCTS The Company believes that its products presently address a significant portion of the worldwide patient vital sign monitoring market. The Company's highly portable multiple-parameter monitors and ECG telemetry transmitters networked to Acuity central workstations allow hospitals to realize the benefits of Flexible Monitoring-tm-. Flexible Monitoring allows hospitals to constantly reconfigure their monitoring capability in order to match vital signs monitoring with patient acuity levels in the most cost-effective way without compromising the quality of patient care. PROPAQ MONITORS AND OPTIONS. The Company's principal product line, Propaq portable patient monitors, is used in hospitals, outpatient surgery centers, clinics, physician offices and emergency transportation units to obtain and display current physiologic patient information. This information enables health care providers to continuously evaluate the patient's condition and to assist the clinician in determining the proper medication or treatment necessary to promote the patient's recovery. Propaq monitors lead the industry in terms of weight, durability and battery life for any comparably configured monitor. Propaq 100 Series monitors are available in multiple configurations and can measure ECG; blood pressure, both invasively and non- invasively; arterial blood oxygen saturation level (pulse oximetry); end-tidal CO2 (ETCO2); and body temperature. Propaq monitors are available in nine languages: English, German, French, Spanish, Japanese, Dutch, Swedish, Portugese and Italian. The Company introduced the second generation Propaq monitor, the Propaq Encore, in 1995. The Propaq Encore retains all of the monitoring capabilities and portability of the 100 Series Propaq monitor. In addition, the Propaq Encore monitor provides a brighter, higher resolution display, an enhanced user interface, respiration monitoring using impedance pneumography, diagnostic level 5-lead ECG monitoring capability and mainstream and/or sidestream Carbon Dioxide (CO2) monitoring. Propaq Encore monitors can be configured to monitor neonatal, pediatric or adult patients. In December 1998, the Company introduced Smartcuf-tm- technology that further increases the Propaq Encore's reliability and accuracy by filtering artifact for even more reliable non-invasive blood pressure (NIBP) measurements. The patented software synchronizes its NIBP readings with the patient's ECG which eliminates the "noise" affecting blood pressure measurement created by external stimuli such as patient motion or vibration, delivering more accurate blood pressure measurements. The Company introduced the Modem Propaq monitor in 1997. This monitor provides all the functionality of the Propaq 100 series and Propaq Encore monitors and is able to transmit multiple patient vital signs data via a simple telephone modem to the Acuity central station. The Modem propaq gives the health care provider the flexibility to remotely monitor patients located both inside and outside the hospital from a central nursing station. FLEXIBLE MONITORING SYSTEM. The Flexible Monitoring System is the product of a co-development effort with Massachusetts General Hospital and was introduced by the Company in 1991. The Flexible Monitoring System combines networked Propaq monitors, Modem Propaqs and Protocol Cordless transmitters with a Sun Microsystems, Inc. workstation and proprietary Protocol software to monitor the vital signs of up to 60 patients simultaneously. The Company's software controls the networked Propaq monitors and Protocol Cordless transmitters with an easy-to-understand graphical user interface display on a high-resolution color CRT screen. The Acuity central station utilizes a map to display the physical layout of the individual hospital floor. Remote diagnostic capabilities enable the Company's service and support personnel to evaluate system performance without user interruption and provide timely service response. Central station monitoring generally has been limited to intensive care environments in which systems monitors are permanently wired to a central station. Propaq monitors, however, can easily be connected to the Acuity central station as the hospital's needs dictate through the use of a simple snap-in modular plug similar to a telephone jack. The portability of Propaq monitors and ease with which they may be connected to the system reduces the number of monitors the hospital would otherwise need to cover a large number of beds. Full disclosure, arrythmia and ST segment analysis options are available with the Flexible Monitoring System. The full disclosure software version for the Acuity central station provides the ability to capture and later retrieve each second of patient vital signs data for the previous 96-hour period. The arrhythmia detection software option enables the system to detect various types of ventricular and life-threatening arrhythmias in a patient, classify the detected arrhythmias by category and provide an alarm when appropriate. Arrhythmia detection is often used in areas of the hospital such as emergency departments, cardiac telemetry units, step-down units and intermediate or transitional care units. The ST Segment Analysis software option analyzes the ST Segment of a patient's ECG for changes that may indicate myocardial ischemia or injury. The Company introduced Networked Acuity patient monitoring systems in February 1998. Networked Acuity systems operate as Vital Signs Servers-tm-, each capable of centrally monitoring local and remote groups of patients resident on multiple Networked Acuity systems. These systems, both inside and outside the hospital, connect smaller hospitals or clinics, or floors within a single hospital such as areas outside the ICU, providing a number of benefits to the user. Remote viewing and control of both real-time and historical full disclosure waveform information, for consultation on any patient's vital signs data, is easily accessible from any of the connected Acuity central stations. From admission to discharge, a seamless patient flow record is automatically generated as the patient moves from one Networked Acuity system to another. Furthermore, the Networked Acuity system configured with an additional review station can provide "mission critical" back-up capability to another Networked Acuity system within the enterprise in the event of a hardware failure. In November 1998, the Company introduced the Data Critical StatView-tm- Patient Alarm Notification capability which provides wireless wide-area patient alarm notification and vital signs data from the Acuity central station to caregivers. The StatView device, about the size of a credit card, acquires patient alarm and vital signs data remotely from the Acuity System, and within 10 seconds of a patient alarm displays the six-second ECG waveform representing the data that caused the alarm, the patient's name and location. This device can also access other vital signs data including heart rate, CO2 and SpO2. PROTOCOL CORDLESS TELEMETRY SYSTEM. The telemetry option provides wireless communication of ECG signals by radio frequency (RF) waves from a portable transmitter, generally worn by an ambulating patient, to an Acuity central station and/or Propaq monitor. QUIKSIGNS MONITOR. In 1997, the Company entered into an agreement with Welch Allyn, Inc. under which Welch Allyn manufactures the QuikSigns monitor under the Company's name and provides the Company with exclusive U.S. hospital distribution and marketing rights. The QuikSigns product is a spot-check patient monitor that adds to the breadth of Protocol's product line, and is ideal for gathering routine and procedural vital signs data. The instrument quickly and non-invasively monitors blood pressure, blood oxygen and temperature, and features data storage and printing capabilities. OEM PRODUCTS. The Company manufactures solutions for CO2 monitoring applications under the Pryon label that include mainstream and sidestream CO2 sensors for OEM applications as well as stand-alone monitors. The sidestream CO2 sensor and related hardware and software are used with non-intubated patients in applications such as post-ventilator patient assessment, conscious sedation, acute asthma assessment in the emergency room, assessment of patient conditions on BiPAP and other applications. The mainstream CO2 sensors and related hardware and software are used in hospital venues for intubated patients. The Pryon label also includes a line of consumable products that are used in conjunction with its CO2 sensors. The stand-alone CO2 monitors include the SC-300 CO2 Monitor, an instrument containing both mainstream and sidestream CO2 monitoring modalities. A follow-up product, the SC-210 CO2 Monitor, was introduced in 1995. This device utilizes the SC-300 platform and provides sidestream monitoring. The Company plans to expand its OEM business under the Pryon label through the offering of a wider range of technologies currently under development. MARKETING AND DISTRIBUTION DOMESTIC. The Company markets its products domestically through both Company- employed sales representatives and independent distributors. The Company's domestic sales managers supervise its direct sales representatives and independent distributors, in a defined geographic area. The SC-210 and SC-300 monitors are sold through independent distributors while OEM subassemblies and accessories are sold directly to OEM customers. The Company intends to continue to use a combination of direct sales representatives and independent distributors based on the most effective sales approach for each territory. The Company's primary market in the United States consists of approximately 6,000 hospitals, where its products are purchased for use in emergency departments, operating rooms, post-anesthesia care units, step-down intensive care units, special procedure rooms such as cardiac catheterization and gastrointestinal endoscopy, labor and delivery, general-care floors, and for transport of patients between departments. In 1990, the General Services Administration approved the Company's Propaq monitors for purchase by United States government agencies, including the armed forces and Veterans' Administration hospitals. The Company's products were added to the U.S. Government's international supply schedule in 1992. In 1995, the Company received approval from the U. S. Air Force for in-flight use of the 100 Series Propaq monitor. In 1997, the Propaq Encore was approved for use during all phases of flight on all U.S. Air Force aircraft. The Company's national accounts managers negotiate and manage the Company's group contracts with organizations such as AmeriNet, MAGNET, Kaiser Permanente and others. In 1997, the Company was awarded a two-year contract with Shared Services Healthcare, Inc. to offer monitoring products to over 1,000 purchasing affiliates of the group. In February 1998, the Company signed an exclusive 3-year purchasing agreement with American Medical Response, the largest ambulance service and emergency physician practice manager in the U.S. The Company has group contracts which include more than half of the acute care hospitals in the U.S. The Company has developed a financial modeling tool called Proforma-tm- to help hospitals evaluate the financial impact of Flexible Monitoring on the institutions. Proforma facilitates sales of Flexible Monitoring systems by helping customers re-engineer their patient flow thereby helping the hospital lower patient care costs. INTERNATIONAL. The Company markets its products internationally through independent distributors covering all major European and Pacific Rim markets and has sold its products in over 90 countries. The agreements with these distributors generally provide the exclusive right to sell the Company's products in a specific geographic area or country subject to certain performance requirements. A team of international sales managers supervise, assist and train this network of international distributors. The Company believes that its ability to meet foreign regulatory requirements and provide monitors in nine foreign languages is an important international marketing advantage. During 1998, the Company provided direct sales and service through two wholly owned subsidiaries: Protocol Systems, S.A.R.L. and Protocol Systems, GmbH, operating in France and Germany, respectively. On December 31, 1998, the Company announced that these subsidiary offices and direct sales organizations would be shut-down. In February 1999, the Company announced that it has entered into a four-year marketing and representation agreement with Medtronic Physio-Control ("Physio"), that gives Physio exclusive marketing, distribution and service rights for the Company's Propaq and Acuity patient monitoring instruments and systems in France and most of Germany. OEM. The Company's marketing strategy is to establish and develop OEM customer relationships with U.S. and international patient monitoring systems manufacturers. OEM customers include Nellcor Puritan Bennett, SpaceLabs Medical, Medical Data Electronics, GE Marquette Medical Systems, Inc., Datex- Ohmeda, Marquette Hellige GmbH, Nihon Kohden, NEC Medical Equipment, G. Stemple GmbH, and others. CUSTOMER SUPPORT. The Company maintains a technical support group to provide clinical in-service, installation, repair and technical training services in support of both direct and distributor sales. Technical support offices are currently maintained in Beaverton, Oregon, the United Kingdom, and Asia/Pacific (New Zealand). The Company provides maintenance and repair classes for distributors and the biomedical engineering personnel of its hospital customers. In addition, Protocol has developed a "Partners in Care" program designed to provide clinical education and training to customers installing Flexible Monitoring systems. The services of Sun Microsystems and its third-party maintenance affiliates are available to support the Acuity central station. WARRANTIES. The Company warrants its products sold from one to three years depending on product category and geography (domestic vs. international). Optional extended warranty and service contracts are available for all Propaq products and the Acuity central stations. BACKLOG. The majority of customer orders are filled within 30 days of order receipt. As a result, the Company's order backlog is not significant and the Company does not believe backlog is an accurate indication of future sales. RESEARCH AND DEVELOPMENT The Company's research and development efforts focus on developing new products and expanding the capabilities of existing products. The Company's research and development staff consists of 63 individuals with collective expertise in analog and digital circuit design, software design, networking and communications, mechanical and packaging design, mathematics, medical and clinical sciences, and optics and display technology. During 1998, 1997 and 1996, research and development expenses, net of reimbursed expenditures, were $8.3 million, $8.7 million, and $8.7 million, respectively. MANUFACTURING The Company's manufacturing operations consist of procurement and inspection of components, final assembly of electronic components and extensive testing of finished products. The Company uses subcontractors for the fabrication and assembly of printed circuit boards. By using this approach, the Company reduces its capital and employee requirements and can more easily and rapidly adopt emerging manufacturing technologies. The Company currently procures all of its parts from outside suppliers and relies upon a number of single-source suppliers to provide certain parts for its products, including the pulse oximetry and EL display subassemblies. To date, the Company has been able to obtain the necessary parts to meet manufacturing requirements. There can be no assurance, however, that supply shortages or interruptions will not arise in the future, which could increase the cost or delay the shipment of the Company's products or cause the Company to incur costs to develop alternative sources, either of which could have a material adverse effect on the Company's results of operations. The Company typically purchases components pursuant to open purchase orders placed from time to time in the ordinary course of business. In order to reduce the risk of supply interruption, the Company maintains close working relationships with its suppliers and may choose to inventory selected components. Quality and reliability are emphasized in the design and manufacture of the Company's products. The Company believes it manufactures its products according to criteria that meet or exceed the requirements of all applicable domestic and foreign regulations and standards. The Company's products undergo thorough quality inspection and testing throughout the manufacturing process. In addition, the Company's quality assurance group inspects, operates and verifies calibration and conformance with the customer order of all products prior to shipment. The Company's Beaverton, Oregon manufacturing facility received ISO 9001 and EN 46001 certifications in January 1998 for its engineering and design practices, along with the ISO 9002 re-certification for the production of patient vital sign monitoring systems. In September 1998, the Company successfully completed an unannounced Good Manufacturing Practices (GMP) audit by the FDA. The audit was completed with no adverse observations and without the issuance of Form 483. In the third quarter of 1998, the Company moved its Pryon manufacturing facility from Menomonee Falls, Wisconsin to Beaverton, Oregon. Pryon's Menomonee Falls facility received ISO 9001 and EN 46001 certifications in 1995, and achieved self certification status per Annex II of the Medical Device Directive in 1996. In December 1998, Pryon's notified body completed an audit of the new Beaverton manufacturing line for SC-300 and SC-210 monitors with no adverse findings. COMPETITION The patient monitoring market is intensely competitive and characterized by rapidly evolving technology. Selling its products in multiple market segments, the Company faces a broad range of competitors, many of which have financial, technical, research and development and marketing resources significantly greater than those of the Company. The Company's principal competitors are Datascope Corporation, Hewlett-Packard Co., GE Marquette Medical Systems, Medical Data Electronics, Inc., Siemens Medical Electronics, and Spacelabs Medical, Inc. Principal OEM competitors include Novametrix, Andros and Oridion. In addition to the Company's existing competitors, other medical and electronic equipment companies could enter the markets in which the Company competes. The Company believes that the principal competitive factors in its market are product depth and breadth, individual product features, reliability, customer service, product reputation, price and effectiveness of marketing and sales efforts. In addition, the Company believes that the speed with which companies can identify medical needs and anticipate evolving standards of care, develop products to meet those needs and standards, and supply commercial quantities to the market are important competitive factors. The Company believes that it competes favorably with respect to these factors. PATENTS, TRADEMARKS AND COPYRIGHTS The Company owns or has rights to eleven U.S. patents, and has seven U.S. patent applications pending related to the design and manufacture of patient monitoring instruments. The Company owns or has the rights to six foreign patents. The Company also owns eleven U.S. registered trademarks, has three U.S. trademark registration applications pending, and owns eight registered trademarks in various countries. In addition, the Company holds copyrights with respect to its proprietary software. Under the Pryon product label, the Company owns or has the rights to two U.S. patents and has one U.S. patent application pending. Although the Company has such proprietary rights, it believes that its success depends more upon the innovative skills and technical competence of its management and employees in responding to customer needs and changing markets than upon ownership of such rights. GOVERNMENT REGULATION The manufacture and sale of the Company's products are subject to substantial regulation by numerous governmental authorities, principally the FDA and corresponding foreign agencies. The Company is subject to FDA regulations, standards and procedures with respect to registration of the Company's manufacturing facilities and the manufacture of its medical devices and to periodic FDA inspection for compliance therewith. The FDA also has broad regulatory powers with respect to pre-clinical and clinical testing of new medical devices and the manufacturing, marketing and advertising of medical devices. The Company is also subject to regulation in the foreign countries in which it markets its products. Many of the regulations applicable to the Company's products in such countries are similar to those of the FDA. However, certain foreign regulatory agencies establish product standards and qualification requirements for medical devices which are different from, and in some cases more stringent than, those in the United States. The Company has received certification that the 100 Series Propaq monitor, the Propaq Encore monitor and the SC-300 and SC-210 stand alone CO2 monitors meet the essential requirements of the Medical Device Directive of the European Union. This certification authorizes the Company to display the CE mark on its monitors and to sell monitors in the various countries of the European Union. Prior to obtaining this certification, the Company was required to obtain product approvals from each of the pertinent regulatory agencies of the individual countries of the European Union. Federal and foreign regulations regarding manufacture and sale of products such as those of the Company, as well as regulations and practices regarding the reimbursement of hospitals and other health care providers for the cost of service rendered, are subject to change. Although the Company cannot predict what impact, if any, such changes might have on its business, it is possible that any such changes could adversely affect the Company's business. EMPLOYEES As of December 31, 1998, the Company had 353 employees, including 63 in research and development, 131 in manufacturing, 127 in marketing and sales and 32 in administration. The Company's future success will depend, in part, on its continued ability to attract and retain qualified personnel. None of the Company's employees are represented by collective bargaining groups and the Company considers its relationships with employees to be good. ITEM 2. PROPERTIES The Company's principal office is located in Beaverton, Oregon. The Company leases approximately 85,000 square feet at the Beaverton, Oregon location under a lease that expires in December 2005. The primary manufacturing, warehousing, research and development, sales, marketing and administrative activities of the Company are conducted from this facility which is nearly fully utilized and maintained in good condition. The Company believes that the properties subject to the lease and additional office space available under lease options will be sufficient to accommodate its operations for the near term. ITEM 3. LEGAL PROCEEDINGS In 1990, the Company entered into a development and supply agreement with Gensia, Inc. to develop and supply a closed-loop drug delivery and monitoring device ("GenESA device"), which was amended in December 1997. In April 1998, the Company was informed that Gensia plans no additional purchases of the GenESA device under the supply agreement with the Company which provided for the purchase of devices through the year 2002. On July 15, 1998, the Company commenced litigation against Gensia Sicor, Inc. and Gensia Automedics alleging that they have breached the supply agreement and is seeking damages of approximately $10 million. This case was filed with the U.S. District Court for the District of Oregon (Case No. CV98-1006-AA). ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1998. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock began trading on the Nasdaq Stock Market under the symbol PCOL on March 24, 1992 following the Company's initial public offering. As of March 26, 1999, there were 158 stockholders of record of Protocol common stock and approximately 2,800 beneficial owners of common stock. No cash dividends have been paid on the common stock and the Company does not anticipate paying any cash dividends in the foreseeable future. Following are the range of the high and low sales prices for the Company's common stock as reported by Nasdaq: 1998 -- QUARTER ENDED: HIGH LOW - ------------------------------ ------ ------ December 31, 1998.................... $ 8.50 $ 6.13 September 30, 1998................... 9.63 7.88 June 30, 1998........................ 10.38 7.69 March 31, 1998....................... 10.25 6.75 1997 -- QUARTER ENDED: HIGH LOW - ------------------------------ ------ ------ December 31, 1997.................... $12.81 $9.88 September 30, 1997................... 12.75 7.63 June 30, 1997........................ 8.94 7.00 March 31, 1997....................... 14.50 8.88 During the fourth quarter of 1998, the Company sold securities without registration under the Securities Act of 1933, as amended (the "Securities Act") upon the exercise of certain stock options granted under the Company's stock option plans. An aggregate of 19,084 shares of Common Stock were issued at exercise prices ranging from $1.32 to $2.55. These transactions were effected in reliance upon the exemption from registration under the Securities Act provided by Rule 701 promulgated by the Securities and Exchange Commission pursuant to authority granted under Section 3 (b) of the Securities Act. ITEM 6. SELECTED FINANCIAL DATA
Year Ended December 31, (in thousands, except ----------------------- per share amounts) 1998 1997 1996 1995 1994 - --------------------------- ------- ------- ------- ------- -------- OPERATIONS DATA Sales $67,323 $64,094 $66,894 $59,602 $48,158 Income from operations before special charges 3,252 3,316 7,377 6,010 4,098 Income (loss) from operations (2,182) 3,316 5,005 6,010 4,098 Net income (loss) (675) 3,356 4,078 5,398 3,434 PER SHARE DATA Basic earnings (loss) per share $(0.08) $.38 $.47 $.64 $.42 Diluted earnings (loss) per share $(0.08) .36 .44 .60 .40 Weighted average number of shares used in the computation of earnings (loss) per share: Basic 8,487 8,859 8,672 8,460 8,201 Diluted 8,487 9,253 9,373 9,004 8,639 Dividends declared -- -- -- -- -- BALANCE SHEET DATA Cash and investments $18,748 $25,570 $22,703 $24,267 $23,719 Working capital 39,296 42,475 43,783 30,853 33,352 Total assets 55,851 63,755 59,045 57,220 48,196 Long-term debt and capital lease obligations, excluding current maturities -- -- -- 1,795 156 Shareholders' equity 47,746 55,678 51,309 46,793 39,426
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS RESULTS OF OPERATIONS 1998 COMPARED TO 1997 - --------------------- SALES. Sales increased 5.0% to $67.3 million in 1998 from $64.1 million in 1997. The increase in sales was primarily attributable to an increase in instrument sales (including the Propaq and Propaq Encore monitors and monitor options) in 1998 largely due to an increase in unit sales of Propaq Encore monitors to the U.S. military. Sales of the QuikSigns monitor, accessories, and systems, including the Acuity central workstation, also increased in 1998. Domestic sales, excluding military revenues and Original Equipment Manufacturer (OEM) sales of Pryon OEM products and GenESA devices, decreased 0.8% to $34.5 million (51.3% of total sales) in 1998 from $34.8 million (54.3% of total sales) in 1997. U.S. military revenues increased 207.2% to $10.4 million (15.5% of total sales) in 1998 from $3.4 million (5.3% of total sales) in 1997. The Company attributes the increase in its military revenues in 1998 to the unpredictable size and timing of military patient monitoring equipment procurements. International sales, excluding international OEM sales of Pryon OEM products and GenESA devices, decreased 7.4% to $16.2 million (24.1% of total sales) in 1998 from $17.5 million (27.3% of total sales) in 1997. This decline in international sales was principally due to the continued strength of the U.S. dollar against foreign currencies and soft international markets, particularly in Europe and Asia. OEM sales of Pryon OEM products and GenESA devices decreased 26.5% to $6.1 million (9.1% of total sales) in 1998 from $8.4 million (13.1% of total sales) in 1997 primarily due to a $2.1 million decrease in sales to certain of the Company's OEM customers. Additionally, there was a slight decrease in sales of GenESA devices to Gensia Automedics. Gensia began shipments of GenESA devices to Europe in early 1995 and in 1997 Gensia received clearance from the Food and Drug Administration (FDA) to market the GenESA device in the United States. In April 1998, the Company was informed that Gensia planned no additional purchases of the GenESA device under a supply agreement with the Company which provided for the purchase of devices through the year 2002. In July 1998, the Company commenced litigation against Gensia Sicor, Inc. and Gensia Automedics alleging that they have breached the supply agreement and seeking damages of approximately $10 million. Domestic sales, excluding OEM and U.S. military revenues, are expected to increase in 1999 as compared to 1998 primarily due to new sales automation processes and the introduction of new instrumentation products. Domestic system sales are expected to soften in 1999. Pryon OEM sales are expected to increase in 1999 as compared to 1998 primarily due to new OEM customers, increased demand from existing OEM customers and the introduction of new products. GROSS PROFIT. Gross profit as a percentage of sales decreased to 50.9% in 1998 from 51.3% in 1997. The decrease in gross profit as a percentage of sales was primarily due to manufacturing inefficiencies that resulted from the relocation of the Pryon operations from Menomonee Falls, Wisconsin to the Company's Beaverton, Oregon facility in 1998. RESEARCH AND DEVELOPMENT. Research and development expenses decreased 4.3% to $8.3 million in 1998 compared to $8.7 million in 1997. This decrease was primarily the result of the relocation of the Pryon operations from Menomonee Falls, Wisconsin to the Company's Beaverton, Oregon facility in 1998 which resulted in a reduction in the total number of research and development employees. As a percentage of sales, research and development expenses were 12.3% in 1998 and 13.5% in 1997. SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses increased 8.8% to $22.7 million in 1998 from $20.9 million in 1997. This increase resulted primarily from the establishment of direct sales organizations in Germany and France in 1998 and an increase in the number of direct sales representatives and clinical application specialists employed by the Company to expand the field sales and service operations. As a percentage of sales, selling, general and administrative expenses were 33.8% in 1998 and 32.6% in 1997. SPECIAL CHARGES. The Company incurred special charges of $5.4 million during 1998. These special charges included $3.2 million related to the restructuring of the Company's worldwide operations, which was comprised of a $1.6 million write-down of the Universal Defibrillator Module (UDM) purchased in 1995 as part of the acquisition of Omeara Limited, $933,000 costs related to the closure of the direct sales organizations in Germany and France which include termination costs for 16 employees, lease termination costs and write- down of assets of direct sales organizations to net realizable value, and $644,000 of severance costs for 14 terminated domestic employees and a severance package for the founder and Chief Technical Officer who resigned in 1998. Additionally, special charges of $2.2 million were incurred to relocate the operations of the Company's Pryon subsidiary from Wisconsin to Oregon. These costs include employee severance, write-off of assets that will not be utilized in Oregon, lease and other contract terminations, and costs to relocate key employees as well as inventory and equipment. The relocation resulted in a reduction of 56 employees from manufacturing, engineering and administrative functions. OTHER INCOME. Other income (net) decreased to $982,000 in 1998 from $1.1 million in 1997 primarily due to a reduction in the cash and investments balance as the Company utilized $8.9 million of its available cash to repurchase common stock in 1998. PROVISION FOR (BENEFIT FROM) INCOME TAXES. The benefit from income taxes was $525,000 in 1998 compared to a provision for income taxes of $1.0 million in 1997, producing annual effective tax rates of (43.7%) and 23.5%, respectively. The difference in the effective taxes rates between 1998 and 1997 was primarily due to the significant change in pretax income (loss) caused by the special charges incurred in 1998. NET INCOME (LOSS). The net loss in 1998 was $675,000 or $0.08 per diluted share compared to net income of $3.4 million or $0.36 per diluted share in 1997. Excluding special charges associated with the worldwide restructuring and the relocation of Pryon, net income for 1998 would have been $3.3 million or $0.39 per diluted share. Net income exclusive of special charges is a non-GAAP measure and investors should not rely on it as a substitute for GAAP measures. Because the worldwide restructuring and relocation of the Pryon subsidiary were unusual in nature, management believes that a measure of net income excluding the special charges is meaningful and useful to investors as it provides an alternative basis with which management and investors can assess the profitability of the Company's core operations. 1997 COMPARED TO 1996 - ---------------------- SALES. Sales decreased 4.2% to $64.1 million in 1997 from $66.9 million in 1996. Instrument sales (including the Propaq and Propaq Encore monitors and monitor options) decreased by $5.8 million or 12.4% from 1996. The decline in instrument sales resulted from a decrease in the unit sales of Propaq monitors, the older monitor model sold, and higher sales discounts. Sales of the Propaq Encore monitor increased from the prior year in both units and total dollars. Sales of GenESA devices to Gensia Automedics, Inc. decreased $1.8 million or 76.1% in 1997. These decreases were partially offset by an increase in sales of Acuity systems, service, accessories, and the introduction of the QuikSigns monitor in 1997. Acuity system sales increased $2.3 million or 86.7% in 1997 as a result of an increase in the number of systems sold as well as higher average selling prices due to an increase in the size and scale of individual system sales. Domestic sales, excluding military revenues and Original Equipment Manufacturer (OEM) sales of GenESA devices and Pryon OEM products, increased 19.5% to $34.8 million (54.3% of total sales) in 1997 from $29.2 million (43.6% of total sales) in 1996. The growth in domestic sales was primarily attributable to an increase in the sales of Acuity systems and related instruments. U.S. military revenues decreased 60.2% to $3.4 million (5.3% of total sales) in 1997 from $8.5 million (12.7% of total sales) in 1996. The Company attributes the decrease in its military revenues in 1997 to the unpredictable size and timing of military patient monitoring equipment procurements. International sales, excluding international OEM sales of GenESA devices and Pryon OEM products, decreased 8.0% to $17.5 million (27.3% of total sales) in 1997 from $19.0 million (28.5% of total sales) in 1996. This decline in international sales was principally due to the increased strength of the U.S. dollar against foreign currencies and soft economic conditions in international markets, particularly in Europe and Asia. OEM sales of GenESA devices and Pryon OEM products decreased 17.9% to $8.4 million (13.1% of total sales) in 1997 from $10.2 million (15.2% of total sales) in 1996 due to decreased sales of GenESA devices to Gensia Automedics, Inc. GROSS PROFIT. Gross profit as a percentage of sales decreased to 51.3% in 1997 from 54.4% in 1996. The decrease in gross profit as a percentage of sales was partially due to increased sales discounts, including discounts related to sales of refurbished instruments and an enterprise-wide upgrade of Massachusetts General Hospital's monitoring systems. As a co-developer of the Company's Acuity central monitoring system, Massachusetts General Hospital had the right to purchase certain monitoring equipment for a small markup over cost. This right expired in October 1997. Gross profit was also negatively impacted by additional warranty expenses incurred as a result of the Company's voluntary decision to replace a defective component in certain Propaq Encore monitors in 1997, as well as an increase in the percentage of sales of lower margin products including service, accessories and QuikSigns monitors. RESEARCH AND DEVELOPMENT. Research and development expenses remained consistent at $8.7 million in 1997 compared to $8.8 million in 1996. As a percentage of sales, research and development expenses were 13.5% in 1997 and 13.1% in 1996. SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses increased 3.0% to $20.9 million in 1997 from $20.3 million in 1996. This increase resulted primarily from rising payroll and related costs associated with the growth of the sales organization and higher commission expense related to the increase in domestic sales. As a percentage of sales, selling, general and administrative expenses were 32.6% in 1997 and 30.3% in 1996. SPECIAL CHARGES. In 1996, the Company incurred expenses of $2.1 million in connection with the acquisition of Pryon. Additionally, the Company incurred $275,000 in expenses in connection with the settlement of litigation regarding the 1991 termination of the Company's former Canadian distributor. No such charges were incurred in 1997. OTHER INCOME. Other income (net) increased to $1.1 million in 1997 from $999,000 in 1996 primarily due to an increase in interest income on higher cash and investments balances as well as a slightly higher rate of return on investments. PROVISION FOR INCOME TAXES. The provision for income taxes decreased to $1.0 million in 1997 from $1.9 million in 1996, representing effective tax rates of 23.5% and 32.1%, respectively. The decrease in the effective tax rate resulted primarily from the effect in 1996 of nondeductible charges related to the acquisition of Pryon. Other factors that affect the tax rate comparison include lower 1997 state taxes and increased research and experimentation tax credits created by the extension of the federal credit provisions, offset by greater tax benefits in 1996 of deferred tax valuation reserve adjustments and utilization of net operating loss carryovers. NET INCOME. Net income in 1997 was $3.3 million or $0.36 per diluted share compared to $4.1 million or $0.44 per diluted share in 1996. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 1998, the Company's financial position remained strong as cash and investment balances totaling $18.7 million continued to provide the Company with a substantial source of capital and liquidity. Working capital balances decreased to $39.3 million at December 31, 1998 from $42.5 million at December 31, 1997 primarily due to the decrease in the cash and investments balances as the Company repurchased 956,000 shares of common stock at a weighted average purchase price of $9.35 per share. The repurchase of common stock by the Company also resulted in a decrease in the current ratio to 5.9:1 at December 31, 1998 from 6.5:1 at December 31, 1997. Operating activities generated positive cash flows of $3.1 million in 1998 primarily due to income from operations before special charges of $3.3 million as well as a decrease in inventory balances. Cash of $2.1 million was used for the acquisition of property and equipment in 1998. Proceeds from stock option and stock purchase plans and related tax benefits were $1.3 million in 1998. No significant commitments for capital expenditures have been entered into as of December 31, 1998. However, management will continue to explore opportunities for strategic relationships with other companies and the possible acquisition of technologies or businesses, all of which may require significant future outlays of cash. Management believes that the combination of current cash and investment balances and cash flows from operations will be sufficient to meet the Company's liquidity and capital needs for 1999 and the foreseeable future. YEAR 2000 ISSUES The Company is in the process of assessing its computer software programs and operating systems used in its internal operations, including applications used in its financial, manufacturing equipment, and engineering design tools to determine its readiness for the Year 2000. The inability of computer software programs and operating systems to accurately recognize, interpret and process date codes designating the Year 2000 and beyond could result in a system failure or miscalculations which could have a material impact on the Company's ability to conduct its business. The Company estimates that its internal assessment of its computer software programs and operating systems will be completed by the end of the first quarter of 1999. Costs incurred by the Company to date in its assessment of internal systems have not been material, and future costs to complete this assessment are not anticipated to be material. The Company has completed its assessment of Year 2000 compliance of each of its product lines. All configurations of instruments (instruments include Propaq and Propaq Encore monitors and all options) and their component parts have been tested and are Year 2000 compliant. Acuity software versions 3.15.05 and all Networked Acuity software versions have been tested and are Year 2000 compliant. Acuity software versions prior to 3.15.05 have a minor connectivity issue related to the Year 2000 between the Acuity central station and the monitors that can be fixed through an upgrade to the Acuity central station provided by the Company. The operation of the Acuity central station and the Propaq monitors in the Year 2000 and beyond should not be adversely affected by this connectivity issue. The Company has also contacted most critical suppliers of products and services to determine that the suppliers' operations and the products and services they provide are Year 2000 compliant. The Company has received responses from approximately 65% of the suppliers contacted, all of which have indicated that their products and operations either are, or expect to be, Year 2000 compliant. The Company will continue to follow up with suppliers who have not yet responded to determine if there are any critical suppliers who may not be Year 2000 compliant. Based on its assessments to date, the Company believes it will not experience any material disruption as a result of Year 2000 issues in its computer software programs and other systems used in its operations. However, there can be no assurances that unanticipated Year 2000 issues will not have a material adverse effect on the Company's business, financial condition or results of operations. Furthermore, there can be no assurance that Year 2000 issues of certain critical third party suppliers, including those supplying electricity, water or telephone service will not experience difficulties resulting in the disruption of service or delivery of supplies to the Company, which could adversely affect the Company's business, financial condition or results of operations. The Company will develop contingency plans for dealing with the most reasonably likely worst case scenario that would occur in the event that the Company and critical third parties fail to complete efforts to achieve Year 2000 compliance on a timely basis by the end of the third quarter of 1999. FORWARD-LOOKING STATEMENTS This Management's Discussion and Analysis of Financial Condition and Results of Operations and other sections of the Annual Report contain statements, including statements regarding the Company's expectation that domestic sales, excluding OEM and U.S. military revenues, and Pryon OEM sales will return to growth in 1999, and the anticipated effects of the Year 2000 issue, that are forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995 that are based on current expectations, estimates and projections about the Company's business, management's beliefs and assumptions made by management. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements due to numerous factors, including, but not limited to factors that could cause unforeseen increases or decreases in the expenses expected to be incurred in connection with the operations of the Pryon subsidiary in Oregon, the closure of direct sales organizations in France and Germany, the timely introduction of new products, the Company's ability to identify and remediate Year 2000 issues or the reliability of third party assessments and certifications relating to Year 2000 issues. In addition, such statements could be affected by other factors discussed elsewhere in this Annual Report and from time to time in the Company's other Securities and Exchange Commission filings and reports, including the Company's Annual Report on Form 10-K, and by general industry and market conditions and growth rates, and general domestic and international economic conditions. Such forward-looking statements speak only as of the date on which they are made and the Company does not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of this Report. If the Company does update or correct one or more forward-looking statements, investors and others should not conclude that the Company will make additional updates or corrections with respect thereto or with respect to other forward-looking statements. The Company's quarterly operating results have fluctuated in the past and may continue to fluctuate in the future depending on factors such as increased competition, timing of new product announcements, pricing changes by the Company or its competitors, length of sales cycles, market acceptance or delays in the introduction of new products or enhanced versions of existing products, timing of significant orders, regulatory approval requirements, product mix and economic factors and conditions generally and in the market for the Company's products specifically. In particular, the Company's quarterly operating results have fluctuated as a result of the unpredictable size and timing of military patient monitoring equipment procurements, and seasonal or other changes in customer buying patterns. A substantial portion of the Company's revenue in each quarter results from orders booked in that quarter. Accordingly, revenue from quarter to quarter is difficult to forecast. The Company's expense levels are based, in part, on its expectations as to future revenue. If revenue levels are below expectations, operating results are likely to be adversely affected. In particular, net income may be disproportionately affected by a reduction in revenue because only a small portion of expenses vary with revenue. Results of operations in any period should not be considered indicative of the result to be expected for any future period, and fluctuations in operating results may also result in fluctuations in the price of the Company's common stock. No assurance can be given that the Company will be able to grow in future periods or that its operations will remain profitable. NEW ACCOUNTING PRONOUNCEMENTS In March 1998, the AICPA issued Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" which provides guidance on accounting for the costs of computer software developed or obtained for internal use. SOP 98-1 is effective for fiscal years beginning December 15, 1998. The Company has adopted SOP 98-1 during 1998. This SOP did not have a material impact on its Consolidated Financial Statements. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 also requires that changes in the derivative's fair value be recognized currently in results of operations unless specific hedge accounting criteria are met. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. The Company does not expect SFAS No. 133 to have a material impact on its Consolidated Financial Statements. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to the impact of foreign currency fluctuations due to a small portion of its international sales. The Company minimizes its risk to foreign currency fluctuations as international sales through independent distributors are made in U.S. dollars which has helped reduce any foreign currency risk. On December 31, 1998, the Company announced that it is closing its foreign subsidiaries and direct sales operations in France and Germany which will further limit exposure to foreign exchange risk in those countries. As of December 31, 1998, the Company had an investment portfolio of fixed income securities, including those classified as cash equivalents, short-term investments and long-term investments of $16.8 million. These securities are subject to interest rate fluctuations. An increase in interest rates could adversely affect the market value of the Company's fixed income securities. The Company does not use derivative financial instruments in its investment portfolio to manage interest rate risk. The Company does, however, limit its exposure to interest rate and credit risk by establishing and strictly monitoring clear policies and guidelines for its investment portfolio. The weighted average maturity of the investment portfolio may not exceed 360 days and no single investment may have a maturity date of greater than two years. The guidelines also establish credit quality standards and limit the exposure to one issue, issuer, or type of instrument. Due to these factors the exposure to market and credit risk is not expected to be material. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENTS - -------------------- REPORT OF MANAGEMENT The management of Protocol Systems, Inc. is responsible for the accompanying consolidated financial statements. These consolidated financial statements were prepared by management in conformity with generally accepted accounting principles and necessarily include amounts which are based on management's best estimates and judgment. Management is also responsible for maintaining systems of internal control to provide reasonable assurance that assets are safeguarded, business activities are executed in accordance with management authorization and transactions are properly recorded. The Audit Committee of the Board of Directors is composed of two outside directors who are not officers or employees of the Company. These directors meet regularly with management and with the independent auditors to review matters related to accounting, financial reporting and the Company's systems of internal control. The independent auditors have free access to the Audit Committee, without management present, to discuss these matters. /s/ David F. Bolender /s/ Craig M. Swanson Chief Executive Officer, President Vice-President Finance, Chief and Chairman of the Board Financial Officer and Secretary INDEPENDENT AUDITORS' REPORT To the Shareholders and Board of Directors of Protocol Systems, Inc.: We have audited the accompanying consolidated balance sheets of Protocol Systems, Inc. and subsidiaries as of December 31, 1998 and 1997 and the related consolidated statements of operations and comprehensive income, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Protocol Systems, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998 in conformity with generally accepted accounting principles. /s/ KPMG Peat Marwick, LLP Portland, Oregon January 22, 1999 PROTOCOL SYSTEMS, INC. Consolidated Statements of Operations and Comprehensive Income (in thousands except per share amounts)
Year ended December 31, ----------------------------- 1998 1997 1996 ------- ------- ------- Sales $67,323 $64,094 $66,894 Cost of sales 33,029 31,212 30,471 ------ ------ ------ Gross profit 34,294 32,882 36,423 Operating expenses: Research and development expenses 8,304 8,675 8,754 Selling, general and administrative expenses 22,738 20,891 20,292 Special charges 5,434 -- 2,372 ------- ------- ------- Total operating expenses 36,476 29,566 31,418 ------- ------- ------- Income (loss) from operations (2,182) 3,316 5,005 Other income (expense): Interest income 1,016 1,104 1,156 Interest expense -- -- (110) Other (34) (32) (47) ------- ------- ------- Total other income (expense) 982 1,072 999 ------- ------- ------- Income (loss) before income taxes (1,200) 4,388 6,004 Provision for (benefit from) income taxes (525) 1,032 1,926 ------- ------- ------- Net income (loss) (675) 3,356 4,078 ------- ------- ------- Other comprehensive income (loss), net of tax: Foreign currency translation adjustment 87 (41) 140 Unrealized holding gain (loss) arising during the period 20 1 (14) ------- ------- ------- Other comprehensive income (loss) 107 (40) 126 ------- ------- ------- Comprehensive income (loss) $ (568) $ 3,316 $ 4,204 ------- ------- ------- Earnings (loss) per share: Basic $(0.08) $ 0.38 $ 0.47 ------- ------- ------- Diluted $(0.08) $ 0.36 $ 0.44 ------- ------- ------- Weighted average number of shares used in the computation of earnings (loss) per share: Basic 8,487 8,859 8,672 Diluted 8,487 9,253 9,373
See accompanying notes to consolidated financial statements. PROTOCOL SYSTEMS, INC. Consolidated Balance Sheets (in thousands)
December 31, --------------------- ASSETS 1998 1997 -------- -------- Current assets: Cash and cash equivalents $ 8,023 $12,257 Short-term investments 6,680 6,524 Accounts receivable: Trade, less allowance for doubtful accounts of $420 and $358 at 1998 and 1997, respectively 17,654 15,746 Other 317 360 Inventories 12,218 13,507 Prepaid expenses and other current assets 2,469 1,750 ------- ------- Total current assets 47,361 50,144 Long-term investments 4,045 6,789 Property and equipment, net 4,041 4,575 Other assets 404 2,247 ------- ------- $55,851 $63,755 ------- ------- LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $2,584 $ 2,806 Accrued liabilities 5,383 4,741 Deferred revenue and customer deposits 98 122 ------- ------- Total current liabilities 8,065 7,669 Deferred income taxes 40 408 Commitments and contingencies Shareholders' equity: Preferred stock, $.01 par value. Authorized 10,000 shares; none issued and outstanding at 1998 and 1997 -- -- Common stock, $.01 par value. Authorized 30,000 shares; issued and outstanding 8,207 at 1998 and 8,935 at 1997 82 89 Additional paid-in capital 28,105 35,414 Unearned compensation (48) -- Accumulated other comprehensive income 205 98 Retained earnings 19,402 20,077 ------- ------- Total shareholders' equity 47,746 55,678 ------- ------- $55,851 $63,755 ------- -------
See accompanying notes to consolidated financial statements. PROTOCOL SYSTEMS, INC. Consolidated Statements of Shareholders' Equity (in thousands)
Accumulated Total Common stock Additional other share- ----------------- paid-in Unearned comprehensive Retained holders' Shares Par value capital compensation income earnings equity ------ --------- --------- ----------- -------- ----------- --------- Balance at December 31, 1995 8,612 $86 $34,052 $-- $12 $12,643 $46,793 Common stock issued under stock purchase and stock option plans 189 2 948 -- -- -- 950 Tax benefit from stock option incentive plans -- -- 531 -- -- -- 531 Vesting of shares issued for purchase of subsidiary -- -- 92 -- -- -- 92 Repurchase of common stock (57) (1) (1,260) -- -- -- (1,261) Other comprehensive income -- -- -- -- 126 -- 126 Net income -- -- -- -- -- 4,078 4,078 ------ --------- --------- ----------- -------- ----------- --------- Balance at December 31, 1996 8,744 87 34,363 -- 138 16,721 51,309 Common stock issued under stock purchase and stock option plans 191 2 879 -- -- -- 881 Tax benefit from stock option incentive plans -- -- 81 -- -- -- 81 Vesting of shares issued for purchase of subsidiary -- -- 91 -- -- -- 91 Other comprehensive loss -- -- -- -- (40) -- (40) Net income -- -- -- -- -- 3,356 3,356 ------ --------- --------- ----------- -------- ----------- --------- Balance at December 31, 1997 8,935 89 35,414 -- 98 20,077 55,678 Common stock issued under stock purchase and stock option plans 213 2 1,183 -- -- -- 1,185 Tax benefit from stock option incentive plans -- -- 147 -- -- -- 147 Repurchase of common stock (956) (9) (8,922) -- -- -- (8,931) Issuance of common stock under restricted stock award agreement 20 -- 192 (192) -- -- -- Amortization of unearned compensation -- -- -- 144 -- -- 144 Vesting of shares issued for purchase of subsidiary -- -- 91 -- -- -- 91 Cancellation of shares issued for purchase of subsidiary (5) -- -- -- -- -- -- Other comprehensive income -- -- -- -- 107 -- 107 Net loss -- -- -- -- -- (675) (675) ------ --------- --------- ------------ -------- ----------- --------- Balance at December 31, 1998 8,207 $82 $28,105 $(48) $205 $19,402 $47,746 ------ --------- --------- ------------ -------- ----------- ---------
See accompanying notes to consolidated financial statements. PROTOCOL SYSTEMS, INC. Consolidated Statements of Cash Flows (in thousands)
Year ended December 31, ------------------------------- 1998 1997 1996 ------------------------------- Cash flows from operating activities: Net income (loss) $ (675) $ 3,356 $4,078 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 2,353 2,365 2,196 Asset impairment 2,466 -- -- Amortization of bond premium 186 312 398 Provision for deferred income taxes (562) (250) (125) Other non-cash items 144 -- -- Increase (decrease) in cash resulting from changes in: Accounts receivable (1,808) (653) 34 Inventories 1,331 (1,098) (2,530) Prepaid expenses and other assets (120) (130) 148 Accounts payable and accrued liabilities (169) 569 (773) Deferred revenue and customer deposits (24) (20) (6) -------- -------- ------- Net cash provided by operating activities 3,122 4,451 3,420 Cash flows from investing activities: Purchase of investments (10,871) (14,539) (9,683) Proceeds from maturity of investments 13,292 16,715 13,764 Acquisition of property and equipment (2,090) (2,198) (2,528) Expenditures for other assets (264) (36) (405) -------- -------- -------- Net cash provided by (used in) investing activities 67 (58) 1,148 Cash flows from financing activities: Proceeds from stock option and stock purchase plans and related tax benefits 1,332 962 1,481 Repurchase of common stock (8,931) -- (1,261) Principal payments on long-term debt -- -- (1,894) -------- -------- -------- Net cash provided by (used in) financing activities (7,599) 962 (1,674) Effect of exchange rates on cash and cash equivalents 176 (1) 35 -------- -------- -------- Net increase (decrease) in cash and cash equivalents (4,234) 5,354 2,929 Cash and cash equivalents at beginning of year 12,257 6,903 3,974 -------- -------- -------- Cash and cash equivalents at end of year $8,023 $12,257 $6,903 -------- -------- -------- Supplemental disclosures of cash flow information: Cash paid for interest -- -- $ 119 -------- -------- -------- Cash paid for income taxes $ 989 $ 933 $2,364 -------- -------- -------- Supplemental schedule of noncash financing activities: Increase in investment due to release of escrowed shares of common stock $ 91 $ 91 $ 92
See accompanying notes to consolidated financial statements. PROTOCOL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Protocol Systems, Inc. and its wholly owned subsidiaries (the "Company"). All material intercompany balances and transactions have been eliminated in consolidation. CASH AND CASH EQUIVALENTS For purposes of these consolidated financial statements, the Company considers all highly liquid securities purchased with an original or effective maturity of three months or less to be cash equivalents. INVESTMENTS In accordance with the provisions of Statement of Financial Accounting Standards No. 115 (SFAS 115), "Accounting for Certain Investments in Debt and Equity Securities", all investments in marketable securities are classified as available-for-sale and are reported at their fair market value. Short-term investments consist of highly liquid securities with maturities of less than one year. Long-term investments consist of highly-rated notes and bonds from a variety of issuers with maturities of greater than one year and less than two years. At December 31, 1998, the fair market value of short-term and long-term investments was $10,725,000 while short-term and long-term investments stated at amortized cost were $10,672,000 resulting in an unrealized holding gain of $53,000. At December 31, 1997, the fair market value of short-term and long- term investments was $13,313,000 while short-term and long-term investments stated at amortized cost were $13,280,000 resulting in an unrealized holding gain of $33,000. Unrealized holding gains and losses on available-for-sale securities are reported as a separate component of shareholders' equity until realized. INVENTORIES Inventories consist primarily of raw materials, work in process, finished goods and demonstration instruments and are valued at the lower of cost or market. Cost is determined on the first-in, first-out basis (FIFO). PROPERTY AND EQUIPMENT Property and equipment is stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the various assets, generally three to five years. Leasehold improvements are amortized using the straight-line method over a period of five years or the life of the lease, whichever is shorter. Depreciation expense, including amortization of capital leases, totaled $2,203,000, $2,058,000, and $1,860,000, for 1998, 1997, and 1996, respectively. SOFTWARE DEVELOPMENT COSTS The Company capitalizes certain software development costs incurred in accordance with the provisions of Statement of Financial Accounting Standards No. 86. These capitalized costs are amortized using the straight-line method over the estimated economic life of the software, which is not anticipated to exceed three years. The Company capitalized software development costs of $190,000, $26,000, and $205,000 in 1998, 1997, and 1996, respectively. Amortization expense related to capitalized software development costs of $148,000, $202,000, and $244,000 was recorded in 1998, 1997, and 1996, respectively. Amortization of capitalized software costs is included in cost of sales in the consolidated statements of operations. Accumulated amortization at December 31, 1998 and 1997 was $1,063,000 and $1,314,000, respectively. INTANGIBLE ASSETS Intangible assets, which are classified as other non-current assets, are stated at historical cost less accumulated amortization. The Company's intangible assets consist primarily of patents and technology rights. The patents are amortized using the straight-line method over their estimated economic lives of ten years. Amortization of the technology rights will commence upon the initial sale of the related product. FOREIGN CURRENCY TRANSLATION The functional currency of the Company's foreign subsidiaries is the local currency. Assets and liabilities of the foreign subsidiaries are translated into U.S. dollars at the current exchange rate as of the balance sheet date. Revenues and expenses are translated using a weighted average exchange rate for the period presented. Adjustments resulting from the translation of the financial statements of the foreign subsidiaries are included as a separate component of consolidated shareholders' equity. Cash flows from the foreign subsidiaries are calculated using its functional currency. As a result, changes in assets and liabilities reported on the consolidated statements of cash flows will not necessarily agree to changes in the corresponding items on the consolidated balance sheets. The effect of exchange rate changes on cash balances held in foreign currencies is reported as a separate line item in the consolidated statements of cash flows. REVENUE RECOGNITION Revenue is recognized and all related costs, including warranty, are recorded upon transfer of title and risk of loss to the customer which generally occurs upon product shipment. BASIC AND DILUTED EARNINGS PER SHARE The Company reports earnings per share in accordance with Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per Share" which requires the presentation of both basic earnings per share and diluted earnings per share. Basic earnings per share is computed using the weighted average number of common shares outstanding and diluted earnings per share is computed using the weighted average number of common shares outstanding and dilutive potential common shares assumed to be outstanding during the period using the treasury stock method. Dilutive potential common shares consist of options to purchase common stock. FINANCIAL INSTRUMENTS The carrying amounts of cash and cash equivalents, accounts receivable and accounts payable approximate fair value due to the short-term nature of these instruments. Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument when available. These estimates are subjective in nature and involve uncertainties and matters of significant judgement and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. USE OF ESTIMATES These consolidated financial statements were prepared by management in conformity with generally accepted accounting principles and necessarily include amounts which are based on management's best estimates and judgment. Actual results could differ from those estimates. RECLASSIFICATIONS Certain reclassifications were made to the fiscal 1997 and 1996 consolidated financial statements to conform to the fiscal 1998 presentation. STOCK-BASED COMPENSATION PLANS The Company accounts for its stock plans in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," which establishes a fair value method of accounting for stock plans. As allowed under SFAS No. 123, the Company has elected to continue to apply the provisions of Accounting Principles Board (APB) Opinion No. 25 to its plans covering employees and non-employee directors, and to provide pro-forma disclosures of the effects of SFAS No. 123 on net income (loss) and earnings (loss) per share. NOTE 2. BALANCE SHEET COMPONENTS (IN THOUSANDS)
The components of inventories, net of reserve are as follows: December 31, 1998 1997 ------- ------- Raw materials $4,939 $5,521 Work in process 2,838 2,460 Finished goods 2,207 3,569 Demonstration instruments 2,234 1,957 ------- ------- Total inventories $12,218 $13,507 ------- ------- The components of property and equipment are as follows: Equipment $12,111 $11,732 Furniture and fixtures 1,910 1,757 Leasehold improvements 551 683 ------- ------- 14,572 14,172 Less accumulated depreciation and amortization 10,531 9,597 ------- ------- Net property and equipment $ 4,041 $ 4,575 ------- ------- The components of accrued liabilities are as follows: Accrued salaries, wages and related liabilities $2,588 $2,375 Accrual for special charges 1,642 -- Reserve for warranties 915 1,084 Income taxes payable -- 676 Other liabilities 238 606 ------ ------ Total accrued liabilities $5,383 $4,741 ------ ------ The components of accumulated other comprehensive income are as follows: Unrealized holding gain on investments $ 53 $33 Foreign currency translation adjustment 152 65 ----- --- Total accumulated other comprehensive income $205 $98 ---- ---
NOTE 3. SHAREHOLDERS' EQUITY PREFERRED STOCK The Company is authorized to issue 10,000,000 shares of $.01 par value preferred stock. At December 31, 1998, no preferred shares were issued; however, 100,000 shares of Series D Junior Participating Preferred Stock had been designated and reserved. Additional series of preferred stock may be designated and the related rights and preferences fixed by action of the Board of Directors. COMMON STOCK OPTIONS Pursuant to the Company's 1998, 1992 and 1987 stock option plans, the Board of Directors has the authority to grant incentive stock options. The incentive stock options generally vest at a rate of 25% per year, with the Board having authority to accelerate the vesting schedules. The options expire ten years from the date of grant. The incentive stock option price is determined by the Board of Directors, but may not be less than the fair market value of the Company's common stock on the date of grant. Non-statutory stock options may also be granted pursuant to the 1998 and 1992 stock option plans. The option price for the non-statutory stock options is determined by the Board of Directors on the date of grant, but generally is not less than the fair market value of the Company's common stock on the grant date. The outstanding options vest at a rate of 25% per year, with the Board having authority to accelerate the vesting schedules. Non-statutory options expire ten years from the date of grant. On March 6, 1998, the Company's Board of Directors granted 80,000 non- statutory stock options to its newly appointed Chief Executive Officer in lieu of cash compensation. These options were not pursuant to any of the Company's stock option plans. These options vest ratably over a one year period following the grant date and expire ten years from the date of grant. These options were issued at the fair market value of the Company's common stock on the date of grant. Under the Company's 1993 Stock Option Plan for Nonemployee Directors, each nonemployee director receives an initial option to purchase 10,000 shares of common stock immediately following the annual meeting of shareholders at which such director is first elected to the Board of Directors. The initial option grant vests ratably over a three year period. Following each subsequent annual meeting of shareholders, each nonemployee director receives an additional option, which is immediately exercisable, to purchase 3,000 shares of common stock. The option price for the non-statutory stock options granted pursuant to the plan may not be less than the fair market value of the Company's common stock at the date of grant. Each option expires ten years from the date of grant. As of December 31, 1998, there were 300,000, 122,266 and 0 stock options available under the 1998, 1992 and 1987 option plans, respectively and 237,000 non-statutory stock options available for grant under the 1993 option plan for nonemployee directors. The Company has reserved 2,095,204 shares of common stock for future issuance pursuant to these plans. SHAREHOLDER RIGHTS PLAN In March 1992, the Board of Directors approved a shareholder rights plan and declared a dividend of one preferred share purchase right for each outstanding common share. Each right represents the right to purchase one one-hundredth of a share of Series D Junior Participating Preferred Stock, par value $.01 per share, at an exercise price of $40, subject to adjustment. The rights are only exercisable ten days after a person or group acquires, or commences a tender or exchange offer to acquire, beneficial ownership of 20% or more of the Company's outstanding common shares. Subject to the terms of the shareholder rights plan and upon the occurrence of certain events, each right would entitle the holder to purchase common shares of the Company, or of an acquiring company in certain circumstances, having a market value of two times the exercise price of the right. The rights expire in March 2002, but may be redeemed by action of the Board of Directors prior to that time at $.01 per right. EMPLOYEE STOCK PURCHASE PLAN The 1994 Employee Stock Purchase Plan allows employees of the Company to accumulate funds of up to 10% of their cash compensation to purchase shares of the Company's common stock. Under the plan, 101,289 , 91,736, and 45,972 shares of common stock were issued in 1998, 1997, and 1996, respectively. The Company has reserved 85,234 shares of common stock for future issuance under this plan. RESTRICTED STOCK AWARD On April 3, 1998, the Company's Board of Directors awarded a stock grant of 20,000 common shares with weighted average per share fair value of $9.63 to the newly appointed Chief Executive Officer. These shares, together with 80,000 non-statutory stock options, were granted in lieu of any cash compensation to the Chief Executive Officer. This stock award is subject to vesting ratably over a one year period and other terms as specified at the time of issuance by a committee of the Board of Directors. Unearned compensation expense is recognized ratably over the vesting period. STOCK REPURCHASE PLAN On January 7, 1998, the Board of Directors authorized the repurchase of up to 1,000,000 shares of the Company's currently outstanding shares of common stock over a 12 month period. As of December 31, 1998, the Company has repurchased 956,000 shares of common stock. NOTE 4. STOCK-BASED COMPENSATION At December 31, 1998, the Company had five plans providing for stock compensation; four fixed option plans under which options are granted to acquire company stock at exercise prices equal to 100% of the fair value of the stock as of the date the option is granted, and an employee stock purchase plan, which provides for six-month enrollment periods under which shares may be purchased at 85% of the lesser of the fair value at the beginning or end of the enrollment period. Additionally, the Company issued 80,000 options in 1998 that were not pursuant to any of the Company's stock option plans. The Company applies APB No. 25 in accounting for these options and, accordingly, no compensation cost has been recognized with respect thereto. Had compensation cost for these options been determined consistent with SFAS No. 123, the Company's net income (loss) and basic and diluted earnings (loss) per share would have been reduced to the proforma amounts shown in the following table:
1998 1997 1996 ------- ------ ------ Net income (loss) (in thousands) As reported $ (675) $3,356 $4,078 Pro forma $(2,420) $1,811 $3,155 Basic earnings (loss) per share As reported $(0.08) $ 0.38 $ 0.47 Proforma $(0.29) $ 0.20 $ 0.36 Diluted earnings (loss) per share As reported $(0.08) $ 0.36 $ 0.44 Proforma $(0.29) $ 0.20 $ 0.35
The pro forma information presented above includes only the effects of applying SFAS No. 123 to options granted after 1994. Because options generally vest over a number of years and additional awards are made each year, the pro forma 1998, 1997 and 1996 amounts are not representative of the effect SFAS No. 123 would have had on net income (loss) and earnings (loss) per share had it been applied to options granted prior to 1995. Similarly, the resulting pro forma compensation costs may not be representative of that expected in future years. The fair value of compensation costs reflected in the above pro forma amounts were determined using the Black-Scholes option pricing model and the following weighted-average assumptions: Year ended December 31, 1998 1997 1996 - ------------------------ ----- ----- ----- Risk-free interest rate 5.19% 6.18% 6.14% Expected dividend yield 0% 0% 0% Expected life (in years) 5 5 5 Expected volatility 61% 60% 60%
Under the Black-Scholes option pricing model the weighted-average grant date fair value of options granted during 1998, 1997 and 1996 was $4.91, $4.80, and $8.33, respectively. Information with respect to the Company's options for 1998, 1997 and 1996 is provided below:
Weighted-average Number of shares exercise price per share ---------------- ------------------------ Balance at December 31, 1995 1,076,111 $ 6.01 Granted 459,340 14.64 Exercised (142,871) 3.49 Cancelled (33,277) 14.66 Expired -- -- --------- Balance at December 31, 1996 1,359,303 8.51 Granted 535,154 8.38 Exercised (108,408) 2.02 Cancelled (408,426) 12.93 Expired -- -- --------- Balance at December 31, 1997 1,377,623 7.66 Granted 278,620 8.76 Exercised (112,083) 3.98 Cancelled (108,222) 8.66 Expired -- -- --------- Balance at December 31, 1998 1,435,938 $ 8.09 ---------
Additional information regarding options as of December 31, 1998 is as follows:
Options outstanding Options exercisable - ------------- ------------------------------------- ------------------------ Weighted- Weighted- Weighted- Range of average average average exercise Number remaining exercise Number exercise prices outstanding life price exercisable price - ------------- ------------------------------------- ------------------------ $ 0.35-$ 6.00 297,841 3.14 years $ 3.84 297,841 $ 3.84 6.25- 7.75 412,097 7.46 years 7.01 207,968 7.03 7.88- 9.50 420,457 7.71 years 8.74 224,708 8.97 9.63- 20.75 305,543 7.88 years 12.78 152,688 13.23 ----------- ----------- $ 0.35-$20.75 1,435,938 6.72 years $ 8.09 883,205 $ 7.52 ----------- -----------
NOTE 5. 401(K) RETIREMENT INVESTMENT PLAN The Company has a Retirement Investment Plan (the Plan) that qualifies as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the Plan, participating U.S. employees may defer a portion of their pretax earnings, up to the Internal Revenue Service annual contribution limit. The Company currently matches 25% of eligible employee's contributions on the first 5% of employee's earnings deferred. Employer matching contributions vest over 5 years, 20% for each year of service completed. The Company's matching contributions to the Plan were $169,000, $170,000, and $114,000 for 1998, 1997 and 1996, respectively. NOTE 6. EARNINGS PER SHARE The following is a reconciliation of the denominators of the basic and diluted computations of earnings (loss) per share. There are no reconciling items for the numerators, which consist of net income (loss) for all periods presented.
For years ended December 31, ---------------------------- 1998 1997 1996 -------------- -------------- -------------- Per Per Per (in thousands except share share share per share amounts) Shares Amount Shares Amount Shares Amount ------ ------ ------ ------ ------ ------ Basic earnings (loss) per share: 8,487 ($0.08) 8,859 $0.38 8,672 $0.47 Effect of dilutive stock options -- 394 701 Diluted earnings (loss) ----- ----- ----- per share: 8,487 ($0.08) 9,253 $0.36 9,373 $0.44 ----- ------ ----- ----- ----- -----
The number of options to purchase shares of common stock that were outstanding but were not included in the computation of diluted earnings per share were 1,414,000, 414,000, and 54,000 for 1998, 1997, and 1996, respectively. These options were not included in the diluted loss per share calculation in 1998 because the Company incurred a net loss for the year, whereas they were not included in the diluted earnings per share calculation in 1997 and 1996 because the options' exercise prices were greater than the average market prices of the shares. NOTE 7. SPECIAL CHARGES On December 31, 1998, the Company discontinued the development of the Universal Defibrillator Module (UDM) obtained as part of its 1995 acquisition of Omeara Limited, a defibrillator design and engineering firm located in Northern Ireland, and announced a restructuring of its worldwide operations which includes the closure of its subsidiary offices and direct sales organizations in France and Germany and the elimination of 14 positions at the Company's headquarters in Beaverton, Oregon. The Company incurred $3,188,000 of charges related to the restructuring, including a $1,610,000 write-down of the Universal Defibrillator Module (UDM), $664,000 of severance costs for terminated domestic employees and the founder and Chief Technical Officer who resigned on December 31, 1998, and $933,000 of costs to close the French and German subsidiaries. Costs to close these subsidiaries include $656,000 of employee severance benefits for 16 terminated employees, $140,000 of lease termination costs and a $137,000 write-down of the assets of the subsidiaries to net realizable value. The Company anticipates the restructuring will be completed in the first quarter of 1999. During the third quarter of 1998, the Company relocated its wholly-owned subsidiary, Pryon Corporation, from Menomonee Falls, Wisconsin to the Company's Beaverton, Oregon facility in order to improve operating efficiencies. This relocation included moving all Pryon operations including key management personnel and was complete by the end of the third quarter of 1998. The relocation resulted in a reduction of 56 employees from manufacturing, engineering and administrative functions. The Company incurred $2,246,000 in relocation costs in the third quarter of 1998. These costs include employee severance benefits, lease and other contract terminations, key employee, inventory and equipment relocation costs as well as a write-off of $482,000 of fixed assets and capitalized software development costs related to assets that will not be utilized by the Company's Beaverton facility. At December 31, 1998, special charges relating primarily to employee terminations as well as lease and other contract terminations of $1,642,000 were not disbursed. The Company anticipates that these remaining balances will be expended by the end of 1999. During 1996, the Company incurred special charges of $2,372,000 in connection with the acquisition of Pryon Corporation and the settlement of litigation regarding the 1991 termination of the Company's former Canadian distributor. NOTE 8. CONTINGENCIES In 1990, the Company entered into a development and supply agreement with Gensia, Inc. to develop and supply a closed-loop drug delivery and monitoring device ("GenESA device"). This agreement was amended in December 1997. Gensia began shipments of the GenESA device to Europe in 1995 and received FDA clearance to market the product in the United States in the third quarter of 1997. In April 1998, the Company was informed that Gensia planned no additional purchases of the GenESA device under the supply agreement with the Company which provided for the purchase of devices through the year 2002. In July 1998, the Company commenced litigation against Gensia Sicor, Inc. and Gensia Automedics alleging that they have breached the supply agreement and is seeking damages of approximately $10 million. NOTE 9. LEASES The Company leases its primary office and manufacturing facilities in Beaverton, Oregon under a long-term operating lease which expires in December 2005. Other operating leases have been entered into in connection with the lease of additional office space and capital equipment. Minimum future rental payments under all operating leases are as follows:
Year ending December 31, (in thousands) ----------- -------------- 1999 $ 888 2000 1,034 2001 1,116 2002 1,076 2003 1,127 Thereafter 2,340 ------ Total future minimum lease payments $7,581 ------
Total rental expense for all operating leases was $886,000, $767,000, and $868,000, for the years ended December 31, 1998, 1997, and 1996, respectively. NOTE 10. INCOME TAXES Domestic and foreign pre-tax income (loss) consists of the following:
For the year ended December 31, ------------------------------- (in thousands) 1998 1997 1996 - -------------- ------- -------- ------- Domestic $ 1,786 $4,587 $6,078 Foreign (2,986) (199) (74) -------- ------- ------- Total $(1,200) $4,388 $6,004 -------- ------- -------
The provision for income taxes consists of the following:
For the year ended December 31, ------------------------------- (in thousands) 1998 1997 1996 ----- ----- ----- Current: Federal $ (40) $1,080 $1,707 Foreign 5 4 28 State 72 198 316 ------ ------ ------ 37 1,282 2,051 Deferred: Federal (74) (156) (85) Foreign (482) (65) (51) State (6) (29) 11 ------ ------ ------ (562) (250) (125) ------ ------ ------ Total $ (525) $1,032 $1,926 ------ ------ ------
A reconciliation showing the reasons for the difference between the Company's effective tax rate and the statutory Federal income tax rate of 34% is as follows:
For the year ended December 31, ------------------------------- 1998 1997 1996 ----- ----- ----- Federal statutory rate (34.0%) 34.0% 34.0% State taxes, net of federal benefit 2.3 2.5 4.0 Research and experimentation credits (27.5) (7.6) (3.4) Tax benefit of foreign sales corporation (3.1) (2.3) (3.3) Tax benefit of exempt interest income (18.8) (5.6) (4.4) Increase (decrease) in valuation allowance 34.4 -- (2.7) Net operating loss carryovers utilized -- -- (3.0) Non-deductible acquisition related charges -- -- 11.3 Other, net 3.0 2.5 (.4) ----- ----- ----- Effective tax rate (43.7%) 23.5% 32.1% ----- ----- -----
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1998 and 1997 are presented below:
(in thousands) 1998 1997 ----- ----- Deferred tax assets: Inventory valuation adjustments $ 513 $ 615 Other non-deductible accruals 717 770 Net operating loss carryovers 322 422 Tax credit carryovers 632 414 Other 684 330 ----- ----- Gross deferred tax assets 2,868 2,551 Valuation allowance (1,172) (987) ----- ----- Deferred tax assets 1,696 1,564 Deferred tax liabilities: Depreciation (40) (65) Intangible technology rights 55 (405) Software development costs (84) (28) ----- ----- Deferred tax liabilities (69) (498) ----- ----- Net deferred taxes $1,627 $1,066 ----- ----- Net current deferred taxes - asset $1,667 $1,474 Net long-term deferred taxes - liability ($40) ($408)
The Company has established a valuation allowance for certain deferred tax assets of $1,172,000 at December 31, 1998. The valuation allowance was $987,000 and $878,000 at December 31, 1997 and 1996, respectively. The 1998 net increase of $185,000 was mainly the result of increases of $330,000 and $82,000 for excess research credits arising in 1998 and non-deductible foreign asset write-downs, respectively, offset by deletion of $232,000 of fully reserved state operating loss and tax credit carryovers. Management believes that it is more likely than not that the results of future operations will generate sufficient income to realize the deferred tax assets. At December 31, 1998, the Company had available federal net operating loss carryovers of $947,000, expiring in years 2007 through 2009, and federal research and experimentation tax credit carryovers of $289,000, expiring in the years 2003 through 2010. NOTE 11. SEGMENT INFORMATION The Company adopted SFAS 131 "Disclosures about Segments of an Enterprise and Related Information" during 1998. In accordance with SFAS 131 the Company has identified a single operating segment: the design, manufacture, sale and servicing of medical instruments and systems. Sales are made primarily to hospitals and other health-care related customers. Credit risk with respect to accounts receivable is limited due to the large number and geographical dispersion (both domestically and internationally) of entities which comprise the Company's customer base. Sales to the U.S. Government were $10,410,000, $3,388,000, and $8,515,000 in 1998, 1997 and 1996, respectively. No other customer or country constituted more than 5% of total sales. Sales by geographic region were as follows for the years ended December 31:
(in thousands) 1998 1997 1996 ------- ------- ------- United States $49,306 $45,365 $41,588 International 18,017 18,729 25,306 ------- ------- ------- Total Sales $67,323 $64,094 $66,894 ------- ------- -------
SUPPLEMENTARY DATA - ------------------ QUARTERLY FINANCIAL SUMMARY (UNAUDITED DATA)
(in thousands except common stock Quarters ended prices and per share amounts) ------------------------------------------------ March 31 June 30 September 30 December 31 --------- -------- ------------ ------------ 1998 Sales $14,920 $16,960 $17,530 $17,913 Gross profit 6,913 8,967 9,478 8,936 Income (loss) from operations 39 721 (1,041) (1,901) Net income (loss) 230 673 (557) (1,021) Basic earnings (loss) per share .03 .08 (.07) (.12) Diluted earnings (loss) per share .03 .08 (.07) (.12) Weighted average number of shares used in the computation of earnings (loss) per share: Basic 8,794 8,501 8,389 8,267 Diluted 9,134 8,845 8,389 8,267 1997 Sales $13,193 $16,110 $17,158 $17,633 Gross profit 6,496 8,077 9,063 9,246 Income (loss) from operations (153) 696 1,527 1,246 Net income 55 694 1,377 1,230 Basic earnings per share .01 .08 .15 .14 Diluted earnings per share .01 .08 .15 .13 Weighted average number of shares used in the computation of earnings per share: Basic 8,780 8,846 8,888 8,920 Diluted 9,202 9,102 9,337 9,387
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is included under the captions "Election of Directors", "Management" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's 1999 Proxy Statement and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is included under the caption "Executive Compensation" in the Company's 1999 Proxy Statement and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is included under the caption "Stock Owned By Management and Principal Shareholders" in the Company's 1999 Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) (1) FINANCIAL STATEMENTS The following financial statements listed are included on pages indicated in the Company's 1998 Annual Report to Shareholders:
Page # ------ Report of Management 11 Report of Independent Accountants for the fiscal years ended December 31, 1998 and 1997 11 Consolidated Statements of Operations and Comprehensive Income - Years ended December 31, 1998, 1997 and 1996 12 Consolidated Balance Sheets - As of December 31, 1998 and 1997 13 Consolidated Statements of Stockholders' Equity - Years ended December 31, 1998, 1997 and 1996 14 Consolidated Statements of Cash Flows - Years ended December 31, 1998, 1997 and 1996 15 (A) (2) FINANCIAL STATEMENT SCHEDULE Schedule II - Valuation and Qualifying Accounts S-1 Report of Independent Accountants on Financial Statement Schedules S-2
Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is included in the Consolidated Financial Statements or notes thereto. (A) (3) EXHIBITS
Exhibit Number Description - ------- ----------- 3.1 Fourth Restated Articles of Incorporation of Protocol Systems, Inc. (1) 3.2 Restated Bylaws of Protocol Systems, Inc. (1) 4.0 Rights Agreement dated March 20, 1992 between Protocol Systems, Inc. and First Interstate Bank of Oregon, N.A. (1) 10.1 Original Equipment Manufacturer Agreement for Purchase and Sale of Pulse Oximeter Modules dated October 23, 1989 between Protocol Systems, Inc. and Nellcor, Incorporated, and addendum thereto dated January 21, 1992. (1) 10.2 Development and Supply Agreement dated January 26, 1990 between Protocol Systems, Inc. and Gensia Pharmaceuticals, Inc. (1) 10.3 Form of Indemnity Agreements between Protocol Systems, Inc. and its Executive Officers and Directors. (1) 10.4 Protocol Systems, Inc. 1987 Key Employee's Incentive Stock Option Plan, as amended on January 21, 1992. (1) 10.5 Protocol Systems, Inc. 1987 Non-Statutory Stock Option Plan, as amended on January 21, 1992. (1) 10.6 Protocol Systems, Inc. 1992 Stock Incentive Plan as amended on January 24, 1995 (4) 10.7 Business Park Lease dated October 26, 1990 By and Among Protocol Systems, Inc., Koll-Copley Partners and Petula Associates and amendments thereto dated October 16,1991 and November 6, 1991. (1) 10.8 Amendment to Business Park Lease between Protocol Systems, Inc., Koll -Copley Partners and Petula Associates dated October 6, 1993. (3) 10.9 Amendment to Original Equipment Manufacturer Agreement for Purchase and Sale of Pulse Oximeter Modules dated February 25, 1993 between Protocol Systems, Inc. and Nellcor, Incorporated. (3) 10.10 Protocol Systems, Inc. 1993 Stock Option Plan for Nonemployee Directors. (4) 10.11 Protocol Systems, Inc. 1994 Employee Stock Purchase Plan. (2) 10.12 Amendment to the Development and Supply Agreement between Protocol Systems, Inc. and Gensia Automatics, Inc. dated December 23, 1997 (5) 10.13 Amendment to Business Park Lease between Protocol Systems, Inc., Koll- Copley Partners and Petula Associates dated December 24, 1997 (5) 10.14 Sublease between NIKE, Inc. and Protocol Systems, Inc. dated August 13, 1998 (10) 10.15 Protocol Systems, Inc. 1994 Employee Stock Purchase Plan as amended on May 19,1998 (7) 10.16 Protocol Systems, Inc. 1998 Stock Incentive Plan (8) 10.17 Protocol Systems, Inc. Non-Qualified Stock Option Agreement dated March 6, 1998 (9) 10.18 Protocol Systems, Inc. Restricted Stock Award Agreement dated April 3, 1998 (6) 10.19 Executive Employment Agreement between Protocol Systems, Inc. and Allen L. Oyler dated July 1, 1998 (10) 10.20 Executive Employment Agreement between Protocol Systems, Inc. and Carl P. Hollstein dated July 1, 1998 (10) 10.21 Executive Employment Agreement between Protocol Systems, Inc. and Craig M. Swanson dated July 1, 1998 (10) 10.22 Executive Employment Agreement between Protocol Systems, Inc. and James P. Fee dated July 1, 1998 (10) 10.23 Executive Employment Agreement between Protocol Systems, Inc. and James B. Moon dated July 1, 1998 (10) 10.24 Executive Employment Agreement between Protocol Systems, Inc. and James P. Welch dated July 1, 1998 (10) 10.25 Executive Employment Agreement between Protocol Systems, Inc. and Richard L. Roa dated July 1, 1998 (10) 10.26 Executive Employment Agreement between Protocol Systems, Inc. and Donald M. Abbey dated July 1, 1998 (10) 22.0 Subsidiaries of the Registrant 23.0 Consent of Accountants 27.1 Financial Data Schedule for the year ended December 31, 1998 (1) Incorporated herein by reference to the Company's Registration Statement on Form S-1 dated January 22, 1992, File No. 33-45067. (2) Incorporated herein by reference to the Company's Registration Statement on Form S-8 dated January 24, 1994, File No. 33-74384. (3) Incorporated herein by reference to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993. (4) Incorporated herein by reference to the Company's Registration Statement on Form S-4 dated April 9, 1996, File No. 333-03316. (5) Incorporated herein by reference to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. (6) Incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998. (7) Incorporated herein by reference to the Company's Registration Statement on S-8 dated August 13, 1998, File No. 333-61423. (8) Incorporated herein by reference to the Company's Registration Statement on S-8 dated August 13, 1998, File No. 333-61419. (9) Incorporated herein by reference to the Company's Registration Statement on S-8 dated August 13, 1998, File No. 333-61415. (10) Incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998.
(b) No reports on Form 8-K were filed during the quarter ended December 31, 1998. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. PROTOCOL SYSTEMS, INC. ----------------------- (Registrant) Date: March 29, 1999 By: /s/ David F. Bolender ----------------------- David F. Bolender President, Chief Executive Officer and Chairman of the Board of Directors Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ----- /s/ David F. Bolender President, Chief Executive - ---------------------- Officer and Chairman of the David F. Bolender Board of Directors March 29, 1999 (Principal Executive Officer) -------------- /s/ Craig M. Swanson Vice-President, Chief Financial - ---------------------- Officer and Secretary (Principal Craig M. Swanson Financial and Accounting Officer) March 29, 1999 -------------- /s/ Steven E. Wynne Director March 29, 1999 - ---------------------- -------------- Steven E. Wynne /s/ Ronald S. Newbower, Ph.D. Director March 29, 1999 - ------------------------------- -------------- Ronald S. Newbower, Ph.D. /s/ Frank E. Samuel, Jr. Director March 29, 1999 - --------------------------- -------------- Frank E. Samuel, Jr. /s/ Curtis M. Stevens Director March 29, 1999 - ---------------------------- -------------- Curtis M. Stevens
S-1 PROTOCOL SYSTEMS, INC. Schedule II Valuation and Qualifying Accounts (in thousands)
Additions Additions Balance at charged to charged to Balance at beginning costs and other end of Description period expenses accounts Deductions period ---------- ---------- --------- ---------- ---------- Year ended December 31, 1996: Allowance for doubtful accounts $ 212 $ 111 -- $ 71(1) $ 252 Allowance for sales returns 100 -- -- -- 100 Inventory obsolescence and valuation reserves 1,063 319 -- 597(2) 785 Reserve for warranties 1,053 620 -- 688(3) 985 Reserve for product upgrades 190 54 -- 241(4) 3 Year ended December 31, 1997: Allowance for doubtful accounts $ 252 $ 147 -- $ 41(1) $ 358 Allowance for sales returns 100 187 -- -- 287 Inventory obsolescence and valuation reserves 785 530 -- 313(2) 1,002 Reserve for warranties 985 1,177 -- 1,078(3) 1,084 Reserve for product upgrades 3 245 -- 56(4) 192 Year ended December 31, 1998: Allowance for doubtful accounts $ 358 $ 114 -- $ 52(1) $ 420 Allowance for sales returns 287 134 -- 181(5) 240 Inventory obsolescence and valuation reserves 1,002 329 -- 605(2) 726 Reserve for warranties 1,084 511 -- 680(3) 915 Reserve for product upgrades 192 (98) -- 68(4) 26
(1) Deductions primarily represent write-offs of accounts receivable during the period. (2) Deductions primarily represent inventory scrapped, sold or upgraded during the period. (3) Deductions primarily represent inventory and labor costs incurred repairing products under warranty. (4) Deductions primarily represent inventory and labor costs incurred for product upgrades performed during the period. (5) Deductions primarily represent product returns and recognition of deferred revenue for upgrades performed during the period. S-2 INDEPENDENT AUDITORS' REPORT To the Shareholders and Board of Directors of Protocol Systems, Inc.: Under the date of January 22, 1999, we reported on the consolidated balance sheets of Protocol Systems, Inc. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations and comprehensive income, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1998, which are included in the 1998 annual report to shareholders. These consolidated financial statements and our report thereon are included in the annual report on Form 10-K for the year 1998. In connection with our audit of the aforementioned consolidated financial statements, we also have audited the related financial statement schedule as listed in the accompanying index. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ KPMG Peat Marwick LLP Portland, Oregon January 22, 1999 EX-22.0 2 EXHIBIT 22.0 SUBSIDIARIES OF THE REGISTRANT Jurisdiction of Subsidiary Incorporation - ---------- ---------------- Protocol Medical Systems Limited Northern Ireland Protocol U.K. Limited Oregon Protocol Systems Foreign Sales Corporation Guam Protocol Systems, S.A.R.L. France Protocol Systems, GmbH Germany EX-23.0 3 Exhibit 23.0 Consent of Independent Accountants - -------------------------------------------- The Board of Directors Protocol Systems, Inc. We consent to incorporation by reference in the Registration Statements (Nos. 33-94912, 33-53992,33-66272, 33-74384, 33-81104, 333-17703, 333- 17705, 333-61423, 333-61419 and 333-61415) on Form S-8 of Protocol Systems, Inc. of our reports dated January 22, 1999, relating to the consolidated balance sheets of Protocol Systems, Inc. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations and comprehensive income, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1998, and all related financial statement schedules, which reports appear in the December 31, 1998 annual report on Form 10- K of Protocol Systems, Inc. /s/ KPMG Peat Marwick LLP March 26, 1999 EX-27.1 4
5 This schedule contains summary financial information extracted from Protocol Systems, Inc. Consolidated Balance Sheets as of December 31, 1998 and Consolidated Statements of Operations and Comprehensive Income for the Year Ended December 31, 1998 and is qualified in its entirety by reference to such financial statements. 1,000 YEAR DEC-31-1998 JAN-01-1998 DEC-31-1998 8,023 10,725 17,654 420 12,218 47,361 14,572 10,531 55,851 8,065 0 0 0 82 47,664 55,851 67,323 67,323 33,029 33,029 35,494 0 0 (1,200) (525) (675) 0 0 0 (675) (0.08) (0.08) Net of allowance The amount of the loss provision is not significant and has been included in other expenses
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