SANUWAVE Health, Inc. annual report, FY2017

SANUWAVE Health, Inc. — 2017 Form 10-K

Business context and reporting period. This annual report covers the fiscal year ended December 31, 2017; the filing text provided does not give standalone fourth-quarter financial results. SANUWAVE develops acoustic shock-wave devices, with dermaPACE as its lead product for diabetic foot ulcers. On December 28, 2017, the FDA granted de novo clearance classifying dermaPACE as a Class II device and permitting U.S. marketing for that indication. The company planned a U.S. launch in 2018; existing sales were primarily international.

Financial results and liquidity

Metric	2017	2016
Revenue	$738,527	$1,376,063
Cost of revenue	$241,970	$565,129
Gross margin	67%	59%
Operating loss	$3,824,446	$3,316,499
Net loss	$5,537,936	$6,439,040
Net cash used in operating activities	$1,528,971	$3,199,453

Revenue declined 46%, mainly from lower orthoPACE sales in Asia/Pacific and Europe and lower applicator sales. 2017 revenue also included an upfront distribution fee from the MundiMed arrangement.
Gross margin improved, partly because refurbishment and upfront distribution-fee revenue had little or no associated cost. Excluding those items, the filing says gross margin declined due to lower refurbishment pricing and higher shipping costs.
Operating expenses were $4.321 million. Research and development expense rose 15% to $1.293 million. The filing reports general and administrative expense as $3,004,803 in MD&A and $3,004,403 in the financial statements.
Other expense was $1.713 million, including a $568,729 noncash warrant-valuation loss and $1.140 million of net interest expense. The prior-year warrant-valuation loss was $2.224 million.
At year-end, cash was $730,184; current assets were $1.205 million; current liabilities were $11.160 million; and working capital was negative $9.955 million. Total liabilities were $11.160 million and stockholders’ deficit was $9.881 million.
Operating cash use improved year over year, but cash flow benefited from increases in accounts payable and accrued expenses. Financing provided $2.117 million in 2017, principally from convertible notes, related-party credit and advances, and warrant exercises.
Reported debt and financing obligations included $5.222 million of related-party notes payable, net, $685,907 of related-party interest payable, $455,606 of convertible promissory notes, net, and a $370,179 related-party line of credit. The related-party notes were in default for missed interest payments, bore 10% interest, were callable, and were due December 31, 2018 under the latest amendment.

Material changes and outlook

Net loss narrowed 14%, chiefly because the prior-year warrant-valuation loss was larger. Operating loss increased despite lower revenue; lower amortization expense partly offset higher research and administrative costs.
Management estimated operating cash use of $225,000–$300,000 per month in first-quarter 2018 and $275,000–$350,000 per month in second-quarter 2018, reflecting launch preparations, international expansion and continued development work.
Management said additional capital would be needed during second-quarter 2018 and potentially into 2019. Potential sources included strategic partners, licensing, warrant conversion, equity, convertible securities or debt; financing might materially dilute shareholders. Management warned that failure to obtain financing could force a bankruptcy filing.
The independent auditor issued an unmodified opinion on the financial statements but highlighted substantial doubt about the company’s ability to continue as a going concern. The statements include no adjustments that might result if the company cannot continue as a going concern.
Commercialization and reimbursement remain uncertain. The company had applied for two wound-care CPT Category III codes, anticipated for publication for use beginning in 2020; the filing notes that coding or an APC classification does not guarantee payer reimbursement.

Risks, contingencies and unusual items

Three material weaknesses in internal control over financial reporting were identified: insufficient expertise and resources for complex financial instruments and derivatives; accounting for equity components of service agreements; and completeness and accuracy of GAAP disclosures. Management said it would develop a remediation plan, potentially using outside consultants. Disclosure controls were also deemed ineffective.
A South Korean distributor represented 69% of year-end accounts receivable. The company reserved 38% of the total outstanding receivable balance for bad debt and was pursuing a payment plan. Distributor concentration also exposed revenue and collections to counterparty risk.
HealthTronics held a first security interest in company assets under the amended related-party notes. The company was required to prepay 20% of proceeds from equity issuance or licensing of intellectual property toward those notes.
In February 2018, the company entered into a related-party distribution agreement with entities owned by director and shareholder A. Michael Stolarski. It provides for a minimum purchase of 100 dermaPACE systems over three years, limited exclusive distribution to certain government facilities, royalties, and change-of-control purchase options that could affect a transaction or dilute shareholders.
Other subsequent financing included additional 10% convertible notes and warrants issued in January and February 2018. A January 2018 equipment lease provided a line of up to $1 million, secured by accounts receivable and other assets.
Potential dilution is substantial: at December 31, 2017, the filing listed 21.6 million options and 97.98 million warrants, plus another 14.64 million warrants in its anti-dilutive securities disclosure. Common shares outstanding were 139.3 million at year-end; the cover page reported 140.97 million as of March 28, 2018.
Management said ordinary-course legal matters were not expected to have a material adverse effect; it also disclosed no material proceedings known to be contemplated by a governmental authority.

Most important facts for investors to verify

Whether the company raised enough capital to meet near-term cash needs, and on what dilution, security and repayment terms.
Whether the HealthTronics defaults were cured or amended, whether the callable secured debt was repaid or extended, and how much interest continued to accrue.
Collections from the South Korean distributor, the adequacy of the bad-debt reserve, and whether customer and distributor concentration changed.
Actual dermaPACE launch volumes, realized revenue and margins, reimbursement progress, and whether the stated 100-unit distribution commitment is met.
Reconciliation of the filing’s two 2017 general and administrative expense figures, and the status of remediation of the three material weaknesses.
Updated fully diluted share count, including convertible notes, warrants, options and any subsequent issuances.