Certain statements included in this report, including without limitation statements in Management's Discussion and Analysis of Financial Condition and Results of Operations, which are not historical facts, are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, both as amended. These forward-looking statements represent the Company's current expectations regarding future events. The Company cautions that such statements are qualified by important factors that could cause actual results to differ materially from expected results which may be contained in the forward-looking statements. All forward-looking statements involve risks and uncertainties, including, but not limited to, the following: regulations and other economic and political factors which affect the Company's ability to market its products internationally, changes in economic conditions that adversely affect demand for the Company's products, potential liquidity constraints, new product introductions or other actions taken by the Company's competitors, such as limiting market access for the Company's products through exclusive contracting arrangements, increased price competition, foreign currency fluctuations, rapid technological changes, dependence upon significant customers, availability and cost of components for the Company's products, the impact of any product liability or other adverse litigation, marketplace acceptance for the Company's new products, FDA and other governmental regulatory and enforcement actions, changes in reimbursement levels from third-party payers, and other factors described in greater detail in the Company's Annual Report on Form 10-K for the year ended December 31, 2017 and subsequent filings with the SEC.
Total sales from continuing operations were $5,382,000 for the three months ended September 30, 2018, an increase of $856,000, or 19%, from sales of $4,526,000 for the same three months of the prior year. Worldwide tissue oximetry product sales of $5,256,000 for the three months ended September 30, 2018, were $881,000, or 20%, above the $4,375,000 reported for the same period in the prior year. Worldwide sensor sales increased 22%, or $851,000, to $4,753,000, and monitor and accessories sales increased $30,000, or 6%, to $503,000 for the three months ended September 30, 2018, compared to the same period of the prior year.
Service and Other sales were $126,000 for the three months ended September 30, 2018, compared to $151,000 for the same prior-year period.
Sales of all products to U.S. customers accounted for $4,523,000, or 84%, of the total sales reported for the three months ended September 30, 2018, and increased $552,000, or 14%, from the $3,971,000 of U.S. sales reported for the three months ended September 30, 2017. U.S. tissue oximetry product sales, per the following table, increased 15%, or $567,000, to $4,410,000, due to an increase of $690,000, or 20%, in disposable sensor sales and a decrease of $124,000 in monitor and accessories sales.
International sales of all products accounted for $859,000, or 16%, of the total sales reported for the three months ended September 30, 2018, and increased $304,000, or 55%, from the $555,000 reported for the same period of the prior year. The increase was due to higher monitor sales as depicted in the following table.
The Company shipped a net of 78 FORE-SIGHT monitors to customers in the third quarter, compared to 73 units shipped in the third quarter of 2017. A net 28 monitors were shipped to U.S. customers, bringing the installed base to 1,398 units, a 21% increase over the adjusted base of 1,158 at September 30, 2017. (The adjusted base reflects the removal of first-generation FORE-SIGHT monitors for all periods reported.)
Gross profit was $3,140,000, or 58.3% of sales, for the three months ended September 30, 2018, compared to $2,644,000, or 58.4% of sales, for the three months ended September 30, 2017. Lower disposable sensor manufacturing costs were offset by increased U.S. tariff charges effective July 2018. The additional tariff costs negatively impacted overall gross profit margins by approximately 190 basis points for the third quarter of 2018. Gross profit was $9,407,000, or 58.4% of sales, for the nine months ended September 30, 2018, compared to $7,504,000, or 55.0% of sales, for the same period of the prior year. The improvement in gross profit margin, for the nine months ended September 30, 2018, was related to lower disposable sensor costs, higher gross margins on monitor sales, and lower, primarily fixed, manufacturing and service repair costs as a percentage of sales.
Operating expenses for the three months ended September 30, 2018, increased $179,000, or 5%, to $4,116,000, from $3,937,000, for the three months ended September 30, 2017. Operating expenses for the first nine months of 2018 were relatively flat at $12,656,000, from $12,659,000 for the same period of the prior year. Management expects operating expenses to remain at or slightly above current levels of spending for the remainder of 2018.
R&D expenses decreased $92,000, or 11%, for the three months ended September 30, 2018, to $712,000, from $804,000, for the three months ended September 30, 2017. R&D expenses decreased $101,000, or 4%, to $2,348,000 for the nine months ended September 30, 2018, compared to $2,449,000 for the same period of the prior year. Higher clinical evaluation costs were more than offset by lower salaries and related fringe benefits for both the three- and nine-month periods ended September 30, 2018.
S,G&A expenses of $3,403,000 for the three months ended September 30, 2018, were $270,000 higher than the $3,133,000 of S,G&A expenses incurred for the same period of the prior year. S,G&A expenses for the nine months ended September 30, 2018, were $10,308,000, compared to $10,211,000 for the nine months ended September 30, 2017, an increase of $97,000, or 1%. Increases in marketing, international sales, and G&A expenses were partially offset by decreases in sales administration and customer support costs for both of the three- and nine-month periods.
Interest expense of $308,000 and $1,168,000 for the three- and nine-month periods ended September 30, 2018, increased $33,000 and $369,000, respectively, reflecting the borrowing costs associated with the Company's bank loans, including interest, and amortization of debt issuance costs, including $265,000 related to the prior debt facility that was terminated on May 8, 2018. Those debt issuance costs were charged to interest expense during the second quarter of 2018.
The Company's operating loss decreased $317,000, or 25%, to $976,000, from $1,293,000, for the three months ended September 30, 2017. The operating loss of $3,248,000 for the first nine months of 2018 represents a reduction of $1,907,000, or 37%, from $5,155,000 for the first nine months of the prior year. The improvement resulted from increased sales and higher gross profit margins combined with largely unchanged operating expenses.
The Company does not expect to generate taxable income for its 2018 fiscal year. Income tax benefits that may be generated during 2018 would be offset by a deferred income tax asset valuation allowance. Management established the valuation allowance as a result of cumulative pre-tax losses and its estimates of future taxable income. Management has continued to perform the required analysis regarding the realization of our deferred income tax assets, concluding that a full valuation allowance is warranted.
Financial Condition, Liquidity and Capital Resources
As of September 30, 2018, the Company's cash and cash equivalents totaled $3,862,000, compared to $5,653,000 as of December 31, 2017. At September 30, 2018, the Company had cash and cash equivalents plus available borrowings under its revolving loan totaling $5,862,000. Working capital increased $1,107,000 to $5,910,000 as of September 30, 2018, from $4,803,000 as of December 31, 2017, supported by the proceeds from the Company's debt refinancing in May 2018.
Cash used in operating activities of continuing operations for the nine months ended September 30, 2018, was $2,325,000, compared to $3,574,000 for the same period in the prior year. The decrease in cash used from operations of $1,249,000 resulted primarily from reduced losses from continuing operations before income taxes as well as from increases in accounts payable and accrued expenses.
Cash used in investing activities of continuing operations was $625,000 for the nine months ended September 30, 2018, compared to cash provided of $3,947,000 for the same period in the prior year, which included $4,527,000 of proceeds from the sale of discontinued operations. Expenditures for property and equipment increased by $46,000 in 2018, compared to 2017, and reflect $118,000 of leasehold improvements associated with the consolidation of the Company's operations into one facility. The Company had been utilizing space for its R&D activities under a lease which expired during May 2018.
Cash provided by financing activities of continuing operations was $1,193,000 for the nine months ended September 30, 2018, primarily related to the refinancing of the Company's bank agreements in May 2018. The refinancing provided expanded borrowings under a term loan agreement with a new lender and an extended period of interest-only payments. The Company used $139,000 for financing activities for the nine months ended September 30, 2017, largely to repay its insurance notes payable.
On May 8, 2018, the Company consummated a Loan and Security Agreement (the "Loan Agreement") with East West Bank (the "Bank"). Pursuant to the Loan Agreement, the Bank has provided a 48-month term loan (the "Term Loan") in the amount of $10,000,000 and a revolving loan (the "Revolver") in the maximum of $2,000,000, each of which expires May 8, 2022. The obligations under the Loan Agreement are secured by a lien on substantially all of the non-intellectual property assets of the Company. As of September 30, 2018, there was no outstanding balance under the Revolver. Available borrowings under the Revolver were $2,000,000 as of that date.
The Term Loan bears interest at a floating rate equal to the Bank's prime rate (not less than 4.75%) plus 3.65% (8.90% as of September 30, 2018). Under the Term Loan, 30 equal payments of $333,333 are scheduled to commence on December 1, 2019, following an 18-month period during which the Company shall make interest-only payments. The interest-only period may be extended to 21 months or 24 months under certain circumstances.
Revolver advances will bear interest at a floating rate equal to the Bank's prime rate (not less than 4.75%) plus 2.40% (7.65% as of September 30, 2018). Maximum borrowings under the Revolver are based upon the Company's eligible accounts receivable, as defined in the Loan Agreement, and subject to other terms and conditions.
The Company has the right to prepay the loan under the Loan Agreement in full at any time; however, if the Term Loan is prepaid prior to the first or second anniversaries of the Loan Agreement or prior to maturity, a fee of 3%, 2%, or 1%, respectively, of the Term Loan amount is due. Amounts prepaid under the Term Loan may not be re-borrowed. Upon repayment of the Term Loan at any time, the Bank is entitled to an additional fee equal to 4% of the Term Loan amount.
The Loan Agreement contains customary affirmative covenants, including covenants regarding the payment of taxes and other obligations, maintenance of insurance, reporting requirements, and compliance with applicable laws and regulations. Further, the Loan Agreement contains customary negative covenants limiting the ability of the Company and its subsidiaries, among other things, to grant liens on the pledged collateral or the Company's intellectual property, incur additional indebtedness, make certain investments and acquisitions, and dispose of assets outside the ordinary course of business. The Loan Agreement also contains financial covenants requiring the Company to achieve certain sales results and to maintain a continuing level of cash plus available borrowing capacity based on a formula. Management believes the Company was in compliance with all covenants under the Loan Agreement as of September 30, 2018.
Upon an event of default, the Bank may declare all outstanding principal and accrued but unpaid interest under the Loan Agreement immediately due and payable and may exercise the other rights and remedies provided under the Loan Agreement. The events of default under the Loan Agreement include payment defaults, breaches of covenants or representations and warranties, a material adverse change, certain adverse regulatory events, specified change of control events, and bankruptcy events.
The Company has also financed various insurance premiums with notes payable. The balance of $67,814 at September 30, 2018, will be repaid by December 2018.
Management believes its cash balances and available borrowings are sufficient to support operations through at least November 1, 2019. The Company expects to continue to require cash for its operations during this period and may seek reductions in planned operating expenses and/or may pursue additional capital funding to support its operations should the need arise. Management believes that it can execute on one or more of these initiatives or obtain additional capital; however, there can be no assurance that such actions can be consummated or additional capital can be obtained on acceptable terms or at all.
Critical Accounting Policies and Estimates
The Company's discussion and analysis of financial condition and results of operations are based on the consolidated financial statements. The preparation of these financial statements requires the Company to make estimates and judgments that affect the amounts reported in them. The Company's critical accounting policies and estimates include those related to revenue recognition, the valuations of inventories and deferred income tax assets, measuring stock compensation and warranty costs, determining useful lives of intangible assets, and making asset impairment valuations. The Company bases its estimates on historical experience and on various other assumptions that management believes to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. For additional information about the Company's critical accounting policies and estimates, see the financial statements included in the Company's Form 10-K for the year ended December 31, 2017. There were no significant changes in critical accounting policies and estimates during the nine months ended September 30, 2018.
In February 2016, the Financial Accounting Standards Board (the "FASB") issued Accounting Standards Update ("ASU") 2016-02,
Leases - Topic 842.
ASU 2016-02
requires the recognition by lessees on the balance sheet of lease assets and lease liabilities for those long-term leases classified as operating leases. The Company will adopt the new standard effective January 1, 2019, using a modified retrospective transition approach to all annual and interim periods presented. The Company is evaluating the impact that this standard will have on its financial statements and results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company at times has certain exposures to market risk related to changes in interest rates and exchange rates. The Company holds no derivative securities for trading or other purposes and is not subject in any material respect to commodity risk. Although the Company sells its products worldwide in U.S. dollars and has only limited currency risks, changes in foreign currency exchange rates could make our products less price competitive in our international markets.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company's Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms and that such information is accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure based on the definition of "disclosure controls and procedures" in Rule 13a-15(e). In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
The Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and the Company's Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of September 30, 2018. Based upon the foregoing evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective as of that date.
There have been no changes in the Company's internal control over financial reporting during the quarter ended September 30, 2018, that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
Reference is made to the Certifications of the Chief Executive Officer and the Chief Financial Officer about these and other matters attached as Exhibits 31.1, 31.2, and 32.1 to this quarterly report on Form 10-Q.