10-Q 1 d10q.txt FORM 10-Q PERIOD ENDING 03/31/01 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2001 OR [_] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ________________ TO ________________. COMMISSION FILE NO. 000-23275 SOMNUS MEDICAL TECHNOLOGIES, INC. (Exact name of registrant as specified in its charter) Delaware 77-0423465 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 285 N. Wolfe Road Sunnyvale, California 94086 (address of principal executive offices, including zip code) (408) 773-9121 (Registrant's telephone number, including area code) 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. Yes X No ----- ____ As of May 11, 2001 17,355,986 shares of the Registrant's Common Stock were outstanding. 1 SOMNUS MEDICAL TECHNOLOGIES, INC. INDEX PART I. FINANCIAL INFORMATION Page ----------------------------- ---- Item 1. Financial Statements (unaudited) Condensed Consolidated Balance Sheets as of March 31, 2001 and December 31, 2000.................... 3 Condensed Consolidated Statements of Operations for the Three month periods ended March 31, 2001 and 2000....... 4 Condensed Consolidated Statements of Cash Flows for the Three month periods ended March 31, 2001 and 2000....... 5 Notes to Condensed Consolidated Financial Statements.... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........... 9 Item 3. Quantitative and Qualitative Disclosures of Market Risk............................................. 21 PART II. OTHER INFORMATION ----------------------------- Item 6. Exhibits and Reports on Form 8-K........................ 22 Signatures........................................................ 23 2 Item 1. Financial Statements SOMNUS MEDICAL TECHNOLOGIES, INC. Condensed Consolidated Balance Sheets (In thousands)

(*) Derived from audited financial statements See accompanying notes 3 SOMNUS MEDICAL TECHNOLOGIES, INC. Condensed Consolidated Statement of Operations (Unaudited) (In thousands, except per share data)

4 SOMNUS MEDICAL TECHNOLOGIES, INC. Condensed Consolidated Statements of Cash Flows (Unaudited, in thousands)

See accompanying notes 5 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 1 - Summary of Significant Accounting Policies --------------------------------------------------- Basis of Presentation The accompanying unaudited financial statements, have been prepared, in accordance with generally accepted accounting principles, for interim financial information and pursuant to instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not contain all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying unaudited, condensed financial statements reflect all adjustments (which include only normal recurring adjustments) considered necessary for a fair presentation of the company's interim financial information. These financial statements and notes should be read in conjunction with the audited consolidated financial statements as included in our Annual Report on Form 10-K for the year ended December 31, 2000, as filed with the Securities and Exchange Commission on March 29, 2001. The results of operations for the three month periods ended March 31, 2001 are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire fiscal year ending December 31, 2001. Revenue Recognition Somnus recognizes revenue at the time products are shipped or, for sales which are financed through third parties, upon acceptance from a third party leasing company of a customer lease and the related equipment. For product shipments to our international distributors made under agreements that do not provide for right of return or price protection, revenue is recognized upon shipment to the final customer. Allowances for product returns are provided at the time of revenue recognition. NOTE 2 - Inventories -------------------- (in thousands) March 31, 2001 December 31, 2000 Raw Materials $1,387 $1,204 Work in Process 93 290 Finished Goods 593 572 ----------------------------------- $2,073 $2,066 =================================== 6 NOTE 2 - Restructuring Expenses ------------------------------- In January 2001, the Company announced a restructuring plan that was implemented during the three months ended March 31, 2001. The plan resulted in the elimination of approximately ten percent of the Company's workforce. The plan encompassed the operational components of sales and marketing, manufacturing, certain ongoing clinical programs, and research development. The plan also included closing the European sales headquarters in the Netherlands and managing international distributors from the United States and the consolidation of domestic operations into one facility in Sunnyvale, California. As a result of this plan, the Company recorded a restructuring charge of $960,000. The restructuring charge is primarily made up severance costs for affected employees, costs related to the closing of the European headquarters and the consolidation of the United States facilities, including rent, lease termination costs, and the write off of leasehold improvements. The following table summarizes our 2001 restructuring charge activity for the three months ended March 31, 2001 (in thousands):

NOTE 3 - Comprehensive Loss -------------------------- There was no difference between net loss and comprehensive loss for the three months ended March 31, 2001 and 2000. NOTE 4 - Subsequent Events -------------------------- On April 26, 2001, an aggregate of 2,500,000 shares of the Company's Common Stock were issued pursuant to a private placement to certain investors for proceeds of $3,050,000, net of costs of $300,000. In connection with this issuance, warrants were issued to the same investors to purchase an aggregate of 625,000 shares of the Company's Common Stock, at a 7 price per share of $1.68 if exercised during the period from 91 days to 180 days following April 26, 2001 and at a price per share of $2.01 for the period from 181 days until their expiration. The announcement of a merger within 90 days of the issuance of the Warrants involving per share proceeds of at least $2.68 will result in the Warrants being unexercisable, provided such merger is consummated within 180 days from the date of the announcement. On May 4, 2001, we announced that we had reached an agreement on a merger with Gyrus PLC, a public limited company incorporated and existing under the laws of England and Wales, under which Gyrus will make a cash tender offer for all of our outstanding shares, at $3.11 per share. The completion of the merger is subject to the tender of a majority of the shares of our common stock in the tender offer and the receipt of certain U.S. and U.K. regulatory approvals. The consummation of the tender offer is also subject to the closing of Gryus' announced acquisition of the ear, nose and throat division of Smith & Nephew Inc. and the closing of firmly underwritten financing for both acquisitions. 8 Item 2. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the attached condensed consolidated financial statements and notes thereto, and with our audited financial statements and notes thereto for the fiscal year ended December 31, 2000. The information set forth below contains forward-looking statements (designated by a *), and our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth below under "Factors That May Affect Future Results" and those set forth under "Item 1" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2000. Overview On May 4, 2001, we announced that we had reached agreement on a merger with Gyrus PLC, a public limited company incorporated and existing under the laws of England and Wales, under which Gyrus will make a cash tender offer for all of our outstanding shares, at $3.11 per share. The completion of the merger is subject to the tender of a majority of the shares of our common stock in the tender offer and the receipt of certain U.S. and U.K. regulatory approvals. The consummation of the tender offer is also subject to the closing of Gryus' announced acquisition of the ear, nose and throat division of Smith & Nephew Inc. and the closing of firmly underwritten financing for both acquisitions. Within the next few months, in the event the merger agreement is not consummated, we will need to either raise additional funds through the issuance of equity or debt securities in the public or private markets in order to continue operations, or sell the company to another acquiror.* To this end, we will continue to work with ING Barings as our exclusive financial advisor to provide us with investment banking services and financial advice on strategic opportunities, including raising capital through the sale of stock to the public or to private investors, as well as the sale of our company. We design, develop, manufacture and market innovative medical devices that utilize our proprietary temperature controlled radiofrequency technology for the treatment of upper airway disorders. Our Somnoplasty System provides physicians with a suite of products designed to offer minimally invasive, curative treatment alternatives for disorders of the upper airway, including obstructive sleep apnea syndrome, OSAS, chronic turbinate hypertrophy, and habitual snoring. Our operations in 1996 and 1997 consisted largely of research and development, product engineering, seeking clearance of our products from the Food & Drug Administration, development of a direct sales force in the United States and internationally, and training international distributor employees for distribution of the Somnoplasty System in the European Union, or EU, Australia, Southeast Asia and certain other areas. We commercially introduced the Somnoplasty System internationally, beginning in June 1997. One month later, after receiving 510(k) clearance from the FDA for the use of the Somnoplasty System to treat habitual snoring, we began direct sales of the Somnoplasty System in the United States. We received FDA clearance to treat chronic turbinate hypertrophy in December 1997 and OSAS in November 1998. During the third quarter of fiscal 1998 we established a European headquarters in the Netherlands. During 1999, we continued to build our direct sales force in the United States. During the fourth quarter of 1999, we hired a Director of International Sales to manage our distributors in 9 countries other than the United States and Europe. In May, 2000, we received 510(K) clearance for the Model 2420, (a dual needle device) in combination with the Somnus Control Unit for coagulation of tissue in the head and neck. In July 2000, we secured regulatory "shonin" approval to market our model 1010, 1100, and 1200 devices in Japan. We had previously secured regulatory "shonin" approval to market our S2 control unit in Japan on November 27, 1998. In January 2001, we announced a restructuring plan which included the closing of our European operations and managing international distributors from the United States. In April 2001, we announced the availability of our single channel Elypse control unit for the treatment of upper airway disorders. In addition, in April 2001, we announced plans to increase our sales force in the United States through the addition of independent distributors. To date, we have signed agreements with three regional organizations to distribute our products We have incurred significant operating losses since the commencement of our operations in 1996. As of March 31, 2001, we have an accumulated deficit of approximately $62 million. We expect those losses to continue based on our current and projected sales and marketing, general and administrative, and research and development expenses.* Despite the net proceeds of $3,050,000 received in an April 2001 private placement, we will either need to raise additional cash within the next few months or sell the company. We expect to attempt to raise additional funds through another issuance of equity or debt, but the consummation of an additional financing is uncertain.* If we are unable to raise sufficient additional funds within the next few months, it is unlikely that we will be able to continue our operations. We may never generate sufficient revenue to sustain our business. Our ability to generate revenue depends on many factors, including our ability to achieve market acceptance for the Somnoplasty System, our ability to produce our products consistent with government and regulatory standards, and our ability to obtain reimbursement for both our products and the procedure from healthcare payors. The Company announced a restructuring plan in January 2001 which was implemented during the three months ended March 31, 2001. The plan resulted in a headcount reduction of approximately ten percent of our workforce. The plan encompassed the operational components of sales and marketing, manufacturing, certain ongoing clinical programs, and research and development. The plan also included the closing of European operations in the Netherlands and managing international distributors from the United States and the consolidation of domestic operations into one facility in Sunnyvale, California. Product shipments of control units and disposable devices are made directly from our facility in Sunnyvale, California to domestic customers and international distributors. As our installed base of control units has increased, we have continued to receive an increasing percentage of our sales revenue from the sale of disposable handpieces as opposed to the sales of control units. Our personnel, sales, and scope of operations place considerable strain on our management, financial, manufacturing, and other capabilities, procedures and controls. There can be no assurance that any existing or additional capabilities, procedures, or controls will be adequate to support our operations or that our capabilities, procedures or controls will be designed, implemented or improved in a timely and cost effective manner. Failure to implement and improve and expand such capabilities, procedures and controls in an efficient manner could have a material adverse effect on our business, financial condition and results of operations. 10 Future revenues and results of operations may fluctuate significantly from quarter to quarter or year to year and will depend upon numerous factors, including the extent to which our products gain market acceptance, the scale-up of manufacturing capabilities, the expansion of sales and marketing activities, competition, the timing and success of new product introductions by us or our competitors, the timing of regulatory clearances or approvals of those new products and our ability to market our products in the United States and internationally. Accordingly, interim period comparisons of our operating results are not necessarily meaningful and should not be relied upon as indicators of likely future performance or annual operating results. Our business and financial results could be materially adversely affected in the event that we are unable to market the Somnoplasty System effectively, anticipate customer demand accurately or effectively manage new product launches, pricing and cost containment pressures in health care. Our operations and financial results could also be significantly affected by international factors, including oversight by numerous regulatory agencies, changes in foreign currency exchange rates and foreign economic and political conditions. 11 Results of Operations Net Revenue. Our revenues for the three months ended March 31, 2001 were derived primarily from sales of our Somnoplasty system, consisting of control units and disposable devices to private practices, hospitals, clinics, and sleep clinics. Net revenues for the three months ended March 31, 2001 were $3,005,000 compared to $3,201,000 for the prior year quarter, a decrease of approximately $196,000 or 6 percent. The decrease for the three month period ended March 31, 2001 as compared to the prior year period is attributable to lower revenue from control units due to a decrease in the average selling price per unit partially offset by increased revenue from disposable handpieces due to the higher installed base. During the three month periods ended March 31, 2001 and 2000, 84.4 and 87.5 percent of our revenues, respectively were derived from sales to customers in the United States. As we have implemented sales programs that reduce the price of control units, the revenue from products shipped has shifted from a mix of approximately 26 percent control units and 74 percent disposable handpieces for the three month periods ended March 31, 2000 to a mix of approximately 14 percent control units and 86 percent disposable handpieces for the three month period ended March 31, 2001. Cost of sales and gross margin. Cost of sales consists of raw materials, subassemblies and completed electronics, quality assurance and warranty costs. Gross margin for the quarter increased to $1,420,000 or 47 percent of sales, from $1,322,000 or 41 percent of sales in the prior year quarter. The increase in gross margin as a percentage of sales for the three months ended March 31, 2001 as compared to the prior year period is due to an increase in manufacturing volume and the corresponding economy of scale offset by the lower average selling price of our control unit. We anticipate in the future as sales increase, cost of sales will increase but may fluctuate as a percentage of sales depending on volume and product mix. * Research and development expenses. Research and development expenses are comprised of salaries, prototype development costs, costs associated with clinical trials and regulatory approval costs. Research and development costs for the first quarter of 2001 were $1,179,000, a decrease over the prior year quarter of $329,000 or 22 percent. The decrease for the three months ended March 31, 2001 as compared to the prior year quarter was primarily attributable to decreased salaries and wages as we implemented our restructuring plan. The decrease in research and development expenses is also due to a reduction in prototype expenses and ongoing cost management efforts. Selling, general and administrative expenses. Selling, general and administrative expenses consist of executive salaries, professional fees, facilities overhead, accounting, human resources, and general office administration expenses such as rent and facility costs. Selling, general and administrative expenses for the first quarter of 2001 were $2,265,000, a decrease over the prior year period of $624,000 or 21.6 percent. The decrease in the three month period ended March 31, 2001 as compared to the prior year quarter is due to reduced costs due to the closing of our European sales headquarters and managing international distributors from the United States, reduced promotional and advertising costs, and ongoing cost management efforts. Restructuring expenses. Restructuring expenses of $960,000 relate to the restructuring plan that was completed during the three month period ended March 31, 2001. The restructuring charge is primarily made up of severance costs for affected employees, costs related to the shutdown of the European headquarters and consolidation of the United States facilities, including rent, lease termination costs, and the write off of leasehold improvements. The plan 12 resulted in the elimination of approximately ten percent of the Company's workforce. The plan encompassed the operational components of sales and marketing, manufacturing, certain ongoing clinical programs, and research development. The plan also included closing the European sales headquarters in the Netherlands and managing international distributors from the United States and the consolidation of domestic operations into one facility in Sunnyvale, California. Interest and other income. Interest and other income for the first quarter of 2001 was $47,000 compared to $265,000 for the prior year quarter. The decrease in the three month period ended March 31, 2001 as compared to the prior year quarter is attributable to the reduction in interest income earned on a decreasing balance of cash, cash equivalents, and short-term investments. Liquidity and Capital Resources Since inception through March 31, 2001, Somnus has financed its operations primarily through the private placement of equity securities, bank loans, credit lease lines of credit, stockholder loans and our November 1997 Initial Public Offering. From inception, we raised approximately $19,545,000 in net proceeds from private equity financing which includes $3,050,000 raised in our recently concluded April 26, 2001 private placement. We raised an additional $43,800,000 from our Initial Public Offering, net of costs of $4,500,000. Cash and cash equivalents at March 31, 2001 were $2,031,000 compared to $5,396,000 at December 31, 2000. Net cash used in operating activities was $3,019,000 for the three months ended March 31, 2001, compared to $3,083,000 million for the prior year quarter Net cash used in investing activities was approximately $454,000 for the three months ended March 31, 2001, compared to net cash provided by investing activities of $4,691,000 for the prior year quarter. The decrease from the prior year period is attributable to the maturity of short-term investments in the prior year period partially offset by an increase in capital expenditures for the three months ended March 31, 2001. Net cash provided by financing activities was approximately $108,000 for the three months ended March 31, 2001 as compared to $153,000 for the prior year quarter. At March 31, 2001, our principal sources of liquidity consisted of cash and cash equivalents. There were no other material unused sources of liquid assets at March 31, 2001. We currently anticipate that our capital expenditure requirements will be between $2,500,000 to $4,000,000 for the next twelve months.* We expect capital expenditures of $500,000 to $1,000,000 related to day-to-day operating needs, including an anticipated facility move in the first quarter of 2002.* In addition, we expect to capitalize between $2,000,000 to $3,000,000 of fixed assets for Company owned control units.* The Company owned control units will consist primarily of units placed at customer sites and demonstration units for our direct and independent sales force. The level of capital expenditure shown above reflects an expansion of our customer installed base. The expansion of our installed base is dependent on acceptance of our products by new customers and the successful implementation of our independent sales representative strategy. There can be no assurance that new customers will accept our products at a rapid 13 rate or that we will be able to successfully implement our independent sales representative strategy. Our existing resources will only be sufficient capital to support our operations for a few months.* We have incurred cumulative operating losses of $62 million, including a net loss of $2.9 million for the three month period ending March 31, 2001. In addition, our cash, cash equivalents, and short-term investments decreased from $5.4 million at December 31, 2000 to $2.0 million at March 31, 2001. On April 26, 2001, an aggregate of 2,500,000 shares of the Company's Common Stock were issued pursuant a to private placement to certain investors for proceeds of $3,050,000. Despite this additional funding, our current cash position still raises substantial doubt about our ability to continue as a going concern. FACTORS THAT MAY AFFECT FUTURE RESULTS Our operating results may vary significantly depending on certain factors, including market acceptance of products, the ability to anticipate and meet customer demand, delays in the introduction or shipment of new products, increased competition, delays in ongoing research and development programs, litigation costs should we be involved in litigation, adverse changes in the economic conditions in any of the several counties in which we do business, a slower growth rate in our target markets, and the factors set forth in our annual report on Form 10-K for the fiscal year ended December 31, 2000. The consummation of the merger agreement we signed with Gyrus Group PLC may never occur. On May 4, 2001, we announced that we had signed an agreement to merge with Gyrus Group, PLC, a public limited company incorporated and existing under the laws of England and Wales, under which Gyrus will make a cash tender offer for all of our outstanding shares, at $3.11 per share. The completion of the merger is subject to the tender of a majority of the shares of our common stock in the tender offer and receipt of certain U.S. and U.K. regulatory approvals. The consummation of the tender offer is also subject to the closing of Gryus' announced acquisition of the ears, nose, and throat division of Smith & Nephew, Inc. and the closing of the firmly underwritten financing for both acquisitions. We can provide no assurance that a sufficient number of shares will be tendered to allow the merger to occur. In the event an in sufficient number of shares are tendered, Gyrus may undertake additional efforts to acquire the necessary shares or abandon the merger altogether. If the merger is not completed, our stock price may be adversely affected. On Thursday, May 3, 2001, the closing price for our stock was $1.65. Upon the announcement of the merger with Gyrus, our stock price increased 74% to a closing price of $2.87 on May 4, 2001. If the merger is not completed, the price of our stock may drop significantly. In the event the merger is not consummated, our funds available for operations are low and we will need to either raise additional funds soon which will cause dilution to existing investors, or sell the company to another acquiror. We have incurred cumulative operating losses of $62 million, including a net loss of $2.9 million for the three month period ending March 31, 2001. In addition, our cash and cash equivalents decreased from $5.4 million at December 31, 2000 to $2.0 million at March 31, 2001. On April 26, 2001, an aggregate of 2,500,000 shares of the Company's Common Stock 14 were issued pursuant to a private placement to certain investors for net proceeds of $3,050,000. Despite this additional funding our current cash position raises substantial doubt about our ability to continue as a going concern. Within the next few months, if the merger with Gyrus is not consummated, we expect we will raise additional funds through the issuance of equity or debt securities in the public or private markets in order to continue operations, or sell the company to another acquiror.* To this end, we will continue to work with ING Barings as our exclusive financial advisor to provide us with investment banking services and financial advice on strategic opportunities, including raising capital through the sale of stock to the public or to private investors, as well as the sale of our company. Additional financing and merger opportunities may not be available, or if available, may not be on favorable terms. The availability of financing or merger opportunities will depend, in part, on market conditions, which have been depressed as of late. If we cannot raise sufficient new capital we may be unable to successfully promote or produce products, continue supplying our services, or pay our employees, or vendors any of which could seriously harm our business. Any future equity financing would result in substantial dilution to our stockholders. If we raise additional funds by issuing debt, we may be subject to limitations on our operations, through debt covenants or other restrictions. We may fail to meet continued Nasdaq listing standards which would result in a listing on a lesser known market within Nasdaq or a delisting altogether. Any change in market listing may adversely affect our ability to raise capital. Under the continued listing standards for inclusion of our stock on the Nasdaq National Market we are required to maintain net tangible assets of $4.0 million. As of March 31, 2001, our net tangible assets were $3.7 million. Due to our financing on April 26, 2001, we are currently in compliance with Nasdaq National Market continued listing requirements. We expect that our additional funding received of $3,050,000, net of costs of $300,000 will enable us to maintain net tangible assets in excess of $4.0 million for the next few months. We are not certain that we will be able to raise additional capital or otherwise increase the assets we own by acquiring cash from the sale of our products or purchasing assets to continue to maintain minimum net tangible assets beyond the next few months. There are other Nasdaq maintenance standards as well, including a requirement that our stock cannot close below $1.00 for 30 consecutive trading days. We can give no assurance that our stock will continue to trade above $1.00. If we cannot maintain Nasdaq maintenance standards we may be transferred from the Nasdaq National Market to the Nasdaq Small cap or the pink sheets or delisted altogether. If our stock is removed from the Nasdaq National Market, the liquidity and price of our stock may be adversely affected. As a result, there may be less demand for our stock and we may be unable to raise sufficient capital to funds our operations. We have limited experience in selling and marketing our Somnoplasty System. We may be unable to generate significant revenue from the sale or our generators and the revenue resulting from sales of our handpieces may not be significant enough to make us profitable. We have only limited experience selling and marketing the Somnoplasty System for the treatment of turbinate hypertrophy (chronic nasal obstruction), soft palate/uvula (habitual snoring), and base of tongue (obstructive sleep apnea syndrome/upper airway resistance syndrome). The sale of our disposable handpieces may not provide substantial revenue and we may ultimately prove unsuccessful in selling the Somnoplasty System on a direct basis in the United States in sufficient quantities for us to become profitable. Market acceptance of the 15 Somnoplasty System will require us to demonstrate that the cost of our products and procedures are competitive with currently available alternatives. There can be no assurance that we will successfully generate sufficient demand for the Somnoplasty System at the prices at which we currently offer our control units and disposable devices. In the event the required investments were to preclude us from placing sufficient quantities of control units, our ability to sell disposable devices would be limited, which would have a material effect on our business, financial condition and results of operations. We have a history of operating losses and we expect those losses to continue. We have had significant operating losses since the commencement of our operations in 1996. As of March 31, 2001, we have an accumulated deficit of approximately $62 million. Despite our restructuring plan, we expect those losses to continue based on our current and projected sales and marketing, general and administrative, and research and development expenses.* We may never generate sufficient revenue to sustain our business. The ability to generate revenue depends on many factors, including our ability to achieve market acceptance for the Somnoplasty System, our ability to produce our products consistent with government and regulatory standards, and our ability to obtain reimbursement for both our products and the procedure from healthcare payors. We are dependent upon the Somnoplasty System, which has not been available for sufficient time for us to know if it is effective on a long term basis. Our success depends upon the market acceptance of the Somnoplasty System for the treatment of turbinate hypertrophy (chronic nasal obstruction), soft palate/uvula (habitual snoring), and base of tongue (obstructive sleep apnea syndrome/upper airway resistance syndrome). Market acceptance will depend, in the large part, upon the effectiveness of the Somnoplasty System over time. There can be no assurance that the procedure will provide a permanent, curative treatment for patients. Independent factors, such as aging and weight gain, may, over time, lead to the enlargement of tissue in areas previously treated by our procedure. This could result in the need for further treatments, making the procedure a potentially less attractive alternative to existing surgical and non-surgical procedures, which could have a material adverse effect upon our business, financial condition and results of operations. We rely on a third party manufacturer as our only supplier of the S-2 control unit and may experience design or production problems and delays as a result. The third party manufacturer of our S-2 control unit is our only supplier for this product. The inability of this manufacturer to successfully produce our S-2 control unit consistent with our quality standards and/or on a timely basis may have a material adverse affect on our financial condition and results of operations. In the event this supplier fails to fulfill our product needs, we will be forced to locate alternative suppliers. We can give no assurance that we will be able to locate suitable replacement suppliers. If we are unable to secure adequate manufacturing capacity to meet our supply requirements, our business will be materially harmed. We may experience problems with regard to our disposable devices which we manufacture ourselves. We currently manufacture our disposable devices in their entirety. We have in the past experienced and we may in the future experience design or production problems and delays as 16 we manufacture these units. In addition, certain parts may be discontinued or placed on allocation by their manufacturers. We have had to qualify alternative vendors when parts could no longer be obtained by the vendor we had been using. We may have to redesign our products to use alternative parts when we switch vendors. These transfers to new vendors can cause delays in our manufacturing operations. Additionally, there can be no assurance that in the future we will be able to have parts specifically manufactured, redesign our products to use other available parts or, qualify alternative vendors, at all or without interrupting our ability to meet customer demand. The inability to react to design or production issues through the manufacturing of special parts, redesign of our products, and the qualification of new vendors could have a material adverse effect on, financial condition and results of operations. We are dependent on single-source suppliers for components. We purchase certain key components of our products from single-source suppliers. We have in the past and may in the future encounter shortages from one of our single source suppliers. * In such a situation, we have had to identify and qualify one or more substitute suppliers for these component needs. There can be no assurance that in the future components obtained from the single-source suppliers will continue to be available in adequate quantities or, if required, that we will be able to locate alternative sources of such components on a timely and cost-effective basis. To date, we have not experienced significant adverse effects resulting from any shortage of components. However, there can be no assurance that the single-source suppliers will meet our future requirements for timely delivery of components of sufficient quality and in sufficient quantity. The components may take several months to procure, and a significant increase of orders could lead to significant delays and control unit or device shortages. Such delays or shortages, particularly as we scale up our manufacturing activities in support of sales and distributor orders, would have a material adverse effect on our business, financial condition and results of operations. If our vendors are unable to satisfy our manufacturing requirements our business will be materially harmed. The S2 control unit and our disposable devices use electronic components. Our vendors supply the electronic components we require to much larger customers, with whom we have to compete for the limited supply. If we or our third party manufacturer are not able to obtain such components in a timely manner or in quantities necessary to meet our requirements, we may be unable to fulfill orders and may lose customers. We have in the past and may in the future have vendors who are unable to supply us with adequate quantities of components. In such a situation, we have to identify and qualify one or more substitute suppliers for these components needs. Incorporating new components or transferring existing components needs to new vendors requires significant time and can cause products shipment delays. In addition, the costs associated with manufacturing our products may increase if we are required to use third party vendors. If we fail to satisfy our manufacturing requirements, our business would be materially harmed. Several factors will impact our ability to achieve market acceptance. Temperature Controlled Radiofrequency tissue volume reduction in the upper airway is a new and novel development. Market acceptance of this procedure for the treatment of turbinate hypertrophy (chronic nasal obstruction), soft palate/uvula (habitual snoring), and base of tongue 17 (obstructive sleep apnea syndrome/upper airway resistance syndrome) could be adversely affected by numerous factors, including: . the lack of availability of third-party reimbursement, . cost of the procedure, . clinical acceptance, . differentiation of our temperature control feature, and . effective physician training and patient acceptance. Third party reimbursement. Patients do not receive third-party reimbursement for use of the Somnoplasty System in the treatment of habitual snoring. Market acceptance of the Somnoplasty System for the treatment of turbinate hypertrophy (chronic nasal obstruction), and base of tongue (obstructive sleep apnea syndrome/upper airway resistance syndrome) depends, in large part, upon the availability and receipt of an acceptable level of third- party reimbursement for each of those indications, which has not yet been established on a consistent basis. Reimbursement for the treatment of habitual snoring, turbinate hypertrophy (chronic nasal obstruction), and base of tongue (obstructive sleep apnea syndrome/upper airway resistance syndrome) varies significantly depending on the third party payor involved, the region in the United States and type of medical facility where the procedure is performed. Cost of the procedure and clinical acceptance. Market acceptance also is impacted by our ability to demonstrate that the Somnoplasty System is an attractive alternative to other procedures, which depends upon physicians' evaluations of the clinical safety and efficacy, ease of use, reliability and cost-effectiveness of the Somnoplasty System. Recommendations and endorsements by influential physicians have been and we believe, will continue to be, essential to market acceptance. * There can be no assurance that such recommendations or endorsements will continue to be obtained. Competition and differentiation of our technology. There can be no assurance that we will be able to successfully differentiate our technology from competing products. In the treatment of habitual snoring, the Somnoplasty System is subject to intense competition from existing products, such as nasal dilators and oral appliances, and surgical procedures, such as LAUP. The U.S. market for products for the treatment of OSAS is currently dominated by CPAP products produced by Healthdyne Technologies Inc, Nellcor Puritan Bennett, Inc., a wholly owned subsidiary of Mallinckrodt Inc., ResMed Inc. and Respironics, Inc. There can be no assurance that the Somnoplasty System will successfully compete with or replace any existing products for these or other indications. Other companies offer products which use radiofrequency for the treatment of upper airway disorders, including Elmed, Ellman, and Entec, a division of Arthrocare, Inc. There can be no assurance of our ability to differentiate our products with temperature control feature from these products. Physician training. Broad adoption of the Somnoplasty System will require us to train physicians on how to perform the Somnoplasty procedure and educating physicians regarding the advantages of the Somnoplasty System over currently available surgical and non-surgical approaches. The time required to complete such training and education could extend the sales cycle for our products and delay or preclude commercial sales and market acceptance. If we are 18 unable to achieve broad market acceptance of the Somnoplasty System for our current and anticipated indications, our business, financial condition and results of operations would be materially adversely affected. Patient acceptance. Patient acceptance has been and we believe will continue to be affected by numerous factors, including the possibility that the Somnoplasty procedure may require multiple treatments, which would be not only inconvenient for the patient, but also more costly if not covered by insurance. Patient acceptance of the Somnoplasty System for the treatment of turbinate hypertrophy (chronic nasal obstruction), soft palate/uvula (habitual snoring), and base of tongue (obstructive sleep apnea syndrome/upper airway resistance syndrome) also depend in part upon physician recommendations as well as other factors, including the effectiveness and reliability of the procedure as compared to existing surgical and non-surgical procedures. We have not yet obtained broad acceptance of the Somnoplasty System by the patient community, and there can be assurance that we will achieve such broad acceptance, or that market demand for our system will be sufficient to allow us to achieve profitable operations. In addition, publicity arising from any adverse outcome or other problem occurring in the treatment of a Somnoplasty patient for any reason could materially adversely affect patient demand for the procedure. Failure of the Somnoplasty System, for whatever reason, to achieve significant patient acceptance would have a material adverse effect on our business, financial condition and results of operations. Our products could infringe the intellectual property rights of others and lead to costly litigation and/or substantial royalty payments. Our competitors or licensors may assert that our products infringe upon their intellectual property. We may be forced to arbitrate or litigate to protect our products from claims of infringement. One of our former licensors has claimed royalty rights on our control unit. We do not believe this claim is valid but cannot assure you that we will not have to pay retroactive and future royalties as a result. We may have to litigate or arbitrate to protect our interests in this matter. Litigation and arbitration are costly pursuits and they consume time that management would otherwise dedicate to building our business. In the event that our products infringe on the intellectual property of others we may be required to pay significant damages. We need to develop successful distributor relationships for international sales. Our future success will depend, in part, on our ability to enter into and successfully develop strategic and distributor relationships with other parties with respect to the marketing and distribution of our products. Following implementation of our restructuring plan, our distributors worldwide are managed out of our headquarters in Sunnyvale, California. We may add additional distributors as necessary to further penetrate markets around the world. * The success of our future strategic or distributor relationships will depend on the other parties' ability to perform the role contemplated by us. We may have limited or no control over the resources that any particular strategic party or distributor devotes to our relationship with us. There can be no assurance that we will be successful in locating or finalizing agreements with further qualified parties with whom we could enter into additional strategic or distributor relationships or that any such relationships can be maintained or will ultimately prove beneficial 19 to us. In the event we are not successful in developing such additional relationships, or if such relationships do not prove to be successful, our business, financial condition and results of operations would be materially adversely affected. International sales of the Somnoplasty System are subject to numerous risks. Distribution, pricing and marketing structures, as well a regulatory requirements, vary significantly from country to country. Additionally, such sales can be adversely affected by: . limitations or disruptions caused by the imposition of government controls, . difficulty in obtaining export licenses, . political instability, . trade restrictions, . changes in foreign tax laws or tariffs or other trade regulations, . difficulties coordinating communications among and managing international operations, . the risk that distributors will fail to effectively promote our products, . the risk of financial instability of distributors, . fluctuations in overseas economic conditions and international currency exchange rates, . increase in duty rates and . competition. There can be no assurance that we will be able to successfully commercialize the Somnoplasty System or any of our future products in any international market, which would have a material adverse effect on our business, financial condition and results of operations. Compliance with Quality System regulations is costly and time consuming and our failure to comply could lead to delays in filling product orders and loss of sales revenues. Our facilities are subject to inspection by regulatory authorities, including the FDA, for compliance with Quality System regulations. The FDA completed an inspection of our manufacturing facility in April 2000 and the FDA inspector provided a list of observations indicating he believed were not in full compliance with applicable Quality System regulations. In addition, in July 2000, the FDA issued us a formal warning letter, which stated that the methods used in, or the facilities or controls used for the manufacture, packaging, storage, or installation of our devices are not in conformance with applicable Quality System regulations. The issuance of a formal warning letter may materially impact our business, because: . Federal agencies are advised of the issuance and may take this information into account when considering the award of contracts; 20 . The FDA will not clear pre-market submission for devices to which Quality System violations are reasonably related until the violations have been corrected; and . The FDA will not approve a request for Certificate for Products to Export which will prevent us from exporting to new foreign markets until the violations have been corrected. We implemented a plan to take corrective actions to address the FDA's observations and submitted a written response to the FDA Warning Letter. In August 2000, we commissioned an audit of the Quality System regulations as required by the FDA. The findings of this audit were submitted to the FDA. The FDA reinspected our facility in March 2001. The FDA inspector provided a list of three observations, none of which were identified in the warning letter. We responded to these observations in writing in March 2001. In addition, we have addressed the observations identified by the FDA. We have been advised by the FDA that the March 2001 inspection and the companies status has been reclassified since items in the July 2000 Warning Letter have been satisfactorily discharged and that the conditions stated above no longer apply to us. The FDA could initiate another inspection to verify that we have corrected the observations. Failure to achieve and maintain compliance with Quality System regulations could have a significant adverse effect on our ability to continue to manufacture and sell our products, and in the most serious cases could result in the seizure or recall of products, and injunction and/or civil fines. We are dependent upon key personnel. Our future success depends in significant part upon the continued service of certain key scientific, technical and management personnel and our continuing ability to attract and retain highly qualified scientific, technical and managerial personnel. Competition for such personnel is intense, and there can be no assurance that we can retain our key scientific, technical and managerial personnel or that we can attract, assimilate or retain other highly qualified scientific, technical and managerial personnel in the future. We have taken steps to retain our key employees including the granting of stock options that vest over time. The loss of key personnel, especially if without advanced notice, or the inability to hire or retain qualified personnel could have a material adverse effect upon our business, financial condition and results of operations. Due to the factors noted above, our future earnings and stock price may be subject to significant volatility, particularly on a quarterly basis. Any shortfall in revenues or earnings from levels expected by security analysts could have an immediate and significant adverse effect on the trading price of our common stock. Item 3: Quantitative and Qualitative Disclosures of Market Risk There have been no material changes in the reported market risks since December 31, 2000. 21 PART II- OTHER INFORMATION --------------------------- Item 6: Exhibits and Reports on Form 8-K (a) There were no reports on Form 8-K during the quarter ended March 31, 2001. Exhibit 99.1 Schedule 14d-9, filed on May 7, 2001 (File No. 005- 53019) and incorporated by reference herein. 22 SOMNUS MEDICAL TECHNOLOGIES, INC -------------------------------- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SOMNUS MEDICAL TECHNOLOGIES, INC. (Registrant) Date: May 11, 2001 By: /s/ John G. Schulte --------------------------------- John G. Schulte President and Chief Executive Officer By: /s/ Robert D. McCulloch --------------------------------- Robert D. McCulloch Vice President of Finance Chief Financial Officer (principal financial and accounting officer) 23

SOMNUS MEDICAL TECHNOLOGIES INC 10-Q