Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
(Mark One)
| þ | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2006
OR
| o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number: 000-32883
WRIGHT MEDICAL GROUP, INC.
(Exact name of registrant as specified in its charter)
| Delaware | 13-4088127 | |
| (State or Other Jurisdiction of Incorporation or Organization) |
(I.R.S. Employer Identification No.) |
|
| 5677 Airline Road, Arlington, Tennessee (Address of Principal Executive Offices) |
38002 (Zip Code) |
Registrant’s telephone number, including area code: (901) 867-9971
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
Common Stock, par value $.01 per share
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of
the Securities Act.
þ Yes o No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or
Section 15(d) of the Act.
o Yes þ No
Note — Checking the box above will not relieve any registrant required to file reports
pursuant to Section 13 or 15(d) of the Exchange Act from their obligations under those
Sections.
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. þ Yes o 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 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. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,
or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in
Rule 12b-2 of the Exchange Act.
(Check one): Large accelerated filer þ Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act). o Yes þ No
The aggregate market value of the voting and non-voting common equity held by nonaffiliates
computed by reference to the price at which the common equity was last sold, or the average bid and
asked price of such common equity, as of the last
business day of the registrant’s most recently completed second fiscal quarter was
$904,421,006.
As of
February 23, 2007, there were 35,311,479 shares of common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III is incorporated by reference from portions of the definitive
proxy statement to be filed within 120 days after December 31, 2006, pursuant to Regulation 14A
under the Securities Exchange Act of 1934 in connection with the annual meeting of stockholders to
be held on May 17, 2007.
WRIGHT MEDICAL GROUP, INC.
ANNUAL REPORT ON FORM 10-K
ANNUAL REPORT ON FORM 10-K
Table of Contents
Safe-Harbor Statement
This annual report contains “forward-looking statements” within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended. All statements made in this annual report, other than statements of historical fact, are
forward-looking statements. Forward-looking statements reflect management’s current knowledge,
assumptions, beliefs, estimates, and expectations and express management’s current views of future
performance, results, and trends. We wish to caution readers that actual results might differ
materially from those described in the forward-looking statements. Forward-looking statements are
subject to a number of risks and uncertainties, including the factors discussed in our filings with
the Securities and Exchange Commission (including those described in “Risk Factors” and elsewhere
in this annual report), which could cause our actual results to differ materially from those
described in the forward-looking statements. Although we believe that the forward-looking
statements are accurate, there can be no assurance that any forward-looking statement will prove to
be accurate. A forward-looking statement should not be regarded as a representation by us
that the results described therein will be achieved. We wish to caution readers not to place undue
reliance on any forward-looking statement. The forward-looking statements are made as of the date
of this annual report, and we assume no obligation to update any forward-looking statement after
this date.
Table of Contents
PART I
Item 1. Business.
Overview
Wright Medical Group, Inc., through Wright Medical Technology, Inc. and other operating
subsidiaries, is a global orthopaedic medical device company specializing in the design,
manufacture and marketing of reconstructive joint devices and biologics products. Reconstructive
joint devices are used to replace knee, hip and other joints that have deteriorated through disease
or injury. Biologics are used to replace damaged or diseased bone, to stimulate bone growth, and to
provide other biological solutions for surgeons and their patients. Within these markets, we focus
on the higher-growth sectors of the orthopaedic industry, such as advanced bearing surfaces,
modular necks and bone conserving implants within the hip market, as well as on the integration of
our biologics products into reconstructive joint procedures and other orthopaedic applications.
For the year ended December 31, 2006, we had net sales of $338.9 million and net income of $14.4
million. As of December 31, 2006, we had total assets of $409.4 million. Detailed information on
our net sales by product line and our net sales, operating income and long-lived assets by
geographic region can be found in Note 15 to the consolidated financial statements contained in
“Financial Statements and Supplementary Data.”
History
We were incorporated in November 1999, as a Delaware corporation and had no operations until
December 1999 when we acquired majority ownership of our predecessor company, Wright Medical
Technology, Inc., in a recapitalization transaction, and immediately thereafter acquired Cremascoli
Ortho Holding, S.A., based in Toulon, France. The Cremascoli acquisition extended our product
offerings, enhanced our product development capabilities, and expanded our European presence. As a
result of combining Cremascoli’s strength in hip reconstruction with the predecessor company’s
historical expertise in knee reconstruction and biologics, we offer a broad range of reconstructive
joint devices and biologics to orthopaedic surgeons in over 60 countries.
In 2001, we sold 7,500,000 shares of common stock in our initial public offering, which generated
$84.8 million in net proceeds. In 2002, we sold 3,450,000 shares of common stock in a secondary
offering which generated $49.5 million in net proceeds.
Orthopaedic Industry
It is estimated that the worldwide orthopaedic industry generated sales of approximately $25
billion in 2006. We believe this figure will grow by approximately 10% annually over the next three
years. Seven multinational companies currently dominate the orthopaedic industry, each with
approximately $1.7 billion or more in annual sales. The size of these companies often leads them to
concentrate their marketing and research and development efforts on products that they believe will
have a relatively high minimum threshold level of sales. As a result, there is an opportunity for a
mid-sized orthopaedic company, such as us, to focus on smaller, higher-growth sectors of the
orthopaedic market, while still offering a comprehensive product line to address the needs of its
customers.
Orthopaedic devices are commonly divided into several primary sectors corresponding to the major
subspecialties within the orthopaedic field: reconstruction, trauma, arthroscopy, spine and
biologics. We specialize in reconstructive joint devices and biologics products.
1
Table of Contents
Reconstructive Joint Device Market
Most reconstructive joint devices are used to replace or repair joints that have deteriorated as a
result of disease or injury. Despite the availability of non-surgical treatment alternatives such
as oral medications, injections and joint fluid supplementation of the knee, severe cases of
disease or injury often require reconstructive joint surgery. Reconstructive joint surgery involves
the modification of the bone area surrounding the affected joint and the insertion of one or more
manufactured components, and may also involve the use of bone cement.
The reconstructive joint device market is generally divided into the areas of knees, hips and
extremities. It is estimated that the worldwide reconstructive joint device market had sales of
approximately $9 billion in 2006, with hip reconstruction and knee reconstruction representing two
of the largest sectors.
Knee Reconstruction. The knee joint involves the surfaces of three distinct bones: the lower end of
the femur, the upper end of the tibia or shin bone, and the patella or kneecap. Cartilage on any of
these surfaces can be damaged due to disease or injury, leading to pain and inflammation requiring
knee reconstruction. Knee reconstruction was the largest sector of the reconstructive joint device
market in 2006, with estimated sales of approximately $4.9 billion worldwide.
Major trends in knee reconstruction include the use of alternative surface materials to extend the
implant’s life and increase conservation of the patient’s bone to minimize surgical trauma and
accelerate recovery. Another significant trend in the knee reconstruction industry is the use of
more technologically advanced knees, called advanced kinematic knees, which more closely resemble
natural joint movement. Additionally, we believe that minimally invasive knee procedures, such as
those for unicompartmental repair, which replaces only one femoral condyle, as well as minimally
invasive surgical techniques and instrumentation are becoming more widely accepted.
Hip Reconstruction. The hip joint is a ball-and-socket joint which enables the wide range of motion
that the hip performs in daily life. The hip joint is most commonly replaced due to degeneration of
the cartilage between the head of the femur (the ball) and the acetabulum or hollow portion of the
pelvis (the socket). This degeneration causes pain, stiffness and a reduction in hip mobility. It
is estimated that the worldwide hip reconstruction market had sales of approximately $4.2 billion
in 2006.
Similar to the knee reconstruction market, major trends in hip replacement procedures and implants
are to extend implant life and to preserve bone stock for possible future procedures. New products
have been developed that incorporate advances in bearing surfaces from the traditional polyethylene
surface. These alternative bearing surfaces include metal-on-metal,
cross-linked polyethylene and
ceramic-on-ceramic combinations, which exhibit improved wear characteristics and lead to longer
implant life. In addition to advances in bearing surfaces, implants that preserve more natural bone
have been developed in order to minimize surgical trauma and recovery time for patients. These
implants, known as bone-conserving implants, leave more of the hip bones intact, which is
beneficial given the likelihood of future revision replacement procedures as the average patient’s
lifetime increases. Bone-conserving procedures are intended to enable patients to delay their first
total hip procedure and may significantly increase the time from the first procedure to the time
when a revision replacement implant is required.
Extremity Reconstruction. Extremity reconstruction involves implanting devices to replace or
reconstruct injured or diseased joints such as the finger, toe, wrist, elbow, foot, ankle and
shoulder. It is estimated that the extremity reconstruction market had sales of approximately $450
million worldwide in 2006. Major trends in extremity reconstruction include unique distal radius
(wrist) and foot and ankle fixation devices.
Biologics Market
The biologics market is one of the fastest growing sectors of the orthopaedic market. Biologics
products use both biological tissue-based and synthetic materials to regenerate damaged or diseased
bone and to repair damaged tissue. These products stimulate the body’s natural regenerative
capabilities to minimize or delay the need for invasive implant surgery, replace damaged or
diseased bone, and provide other biological solutions for surgeons and their patients.
2
Table of Contents
Biologics products are used in spinal fusions, trauma fractures, joint replacements, and
cranio-maxillofacial procedures and represent an alternative solution to autograft, a procedure
that involves harvesting a patient’s own bone or soft tissue. Currently, there are three main types
of biological bone grafting products, which are osteoconductive, osteoinductive and combined
osteoconductive/osteoinductive that refer to the way in which the materials affect bone growth.
Osteoconductive materials serve as a scaffold that supports the formation of bone but do not
trigger new bone growth, whereas osteoinductive materials induce bone growth. Other biologics
products enable the repair of soft tissue. These products provide favorable microenvironments for
quick revascularization and cell proliferation. It is estimated that the biologics market generated
sales of approximately
$1.3 billion worldwide in 2006.
Government Regulation
United States
Our products are strictly regulated by the United States Food and Drug Administration (FDA) under
the Food, Drug, and Cosmetic Act (FDC Act). Some of our products are also regulated by state
agencies. FDA regulations and the requirements of the FDC Act affect the pre-clinical and clinical
testing, design, manufacture, safety, efficacy, labeling, storage, recordkeeping, advertising and
promotion of our medical device products. Our tissue-based products are subject to FDA regulations,
the National Organ Transplant Act (NOTA), accreditation from the American Association of Tissue
Banks (AATB) and various state agency regulations.
Generally, before we can market a new medical device, marketing clearance from the FDA must be
obtained through either a premarket notification under Section 510(k) of the FDC Act or the
approval of a premarket approval (PMA) application. The FDA typically grants a 510(k) clearance if
the applicant can establish that the device is substantially equivalent to a predicate device. It
generally takes three months from the date of a 510(k) submission to obtain clearance, but it may
take longer, particularly if a clinical trial is required. The FDA may find that a 510(k) is not
appropriate or that substantial equivalence has not been shown and, as a result, will require a PMA
application.
PMA applications must be supported by valid scientific evidence to demonstrate the safety and
effectiveness of the device, typically including the results of human clinical trials, bench tests
and laboratory and animal studies. The PMA application must also contain a complete description of
the device and its components, and a detailed description of the methods, facilities and controls
used to manufacture the device. In addition, the submission must include the proposed labeling and
any training materials. The PMA application process can be expensive and generally takes
significantly longer than the 510(k) process. Additionally, the FDA may never approve the PMA
application. As part of the PMA application review process, the FDA generally will conduct an
inspection of the manufacturer’s facilities to ensure compliance with applicable quality system
regulatory requirements, which include quality control testing, control documentation and other
quality assurance procedures.
If human clinical trials of a medical device are required and the device presents a significant
risk, the sponsor of the trial must file an investigational device exemption (IDE) application
prior to commencing human clinical trials. The IDE application must be supported by data, typically
including the results of animal and/or laboratory testing. If the IDE application is approved by
the FDA and one or more institutional review boards (IRBs), human clinical trials may begin at a
specific number of investigational sites with a specific number of patients, as approved by the
FDA. If the device presents a nonsignificant risk to the patient, a sponsor may begin the clinical
trial after obtaining approval for the trial by one or more IRBs without separate approval from the
FDA. Submission of an IDE does not give assurance that the FDA will approve the IDE and, if it is
approved, there can be no assurance the FDA will determine that the data derived from the trials
support the safety and effectiveness of the device or warrant the continuation of clinical trials.
An IDE supplement must be submitted to and approved by the FDA before a sponsor or investigator may
make a change to the investigational plan that may affect its scientific soundness, study
indication or the rights, safety or welfare of human subjects. The trial must also comply with the
FDA’s IDE regulations and informed consent must be obtained from each subject.
If the FDA believes we are not in compliance with the law, it can institute proceedings to detain
or seize products, issue a market withdrawal, enjoin future violations and seek civil and criminal
penalties against us and our officers and employees. If we fail to comply with these regulatory
requirements, our business, financial condition and results of operations could be harmed.
3
Table of Contents
Most of our products are approved through the 510(k) premarket notification process. We have
conducted clinical trials to support many of our regulatory approvals. Regulations regarding the
manufacture and sale of our products are subject to change. We cannot predict the effect, if any,
that these changes might have on our business, financial condition and results of operations. In
particular, the FDA has statutory authority to regulate allograft-based products, processing and
materials. The FDA has been working to establish a more comprehensive regulatory framework for
allograft-based products, which are principally derived from human cadaveric tissue.
The framework developed by the FDA establishes criteria for determining whether a particular human
tissue-based product will be classified as human tissue, a medical device or a biologic drug
requiring premarket clearance or approval. All tissue-based products are subject to extensive FDA
regulation, including a requirement that ensures that diseases are not transmitted to tissue
recipients. The FDA has also proposed extensive additional regulations that would govern the
processing and distribution of all allograft products. Consent to use the donor’s tissue must also
be obtained. If a tissue-based product is considered human tissue, it does not require FDA
clearance or approval before being marketed. If it is considered a medical device, or a biologic
drug, then FDA clearance or approval may be required.
In addition to granting approvals for our products, the FDA and international regulatory
authorities periodically inspect us for compliance with regulatory requirements that apply to
medical devices marketed in the U.S. and internationally. These requirements include labeling
regulations, manufacturing regulations, quality system regulations, regulations governing
unapproved or off-label uses, and medical device regulations. Medical device regulations require a
manufacturer to report to the FDA serious adverse events or certain types of malfunctions involving
its products. The FDA periodically inspects device and drug manufacturing facilities in the U.S. in
order to assure compliance with applicable quality system regulations.
International
We obtain required regulatory approvals and comply with extensive regulations governing product
safety, quality, manufacturing and reimbursement processes in order to market our products in all
major foreign markets. These regulations vary significantly from country to country and with
respect to the nature of the particular medical device. The time required to obtain these foreign
approvals to market our products may be longer or shorter than that required in the U.S., and
requirements for such approval may differ from FDA requirements.
All of our products sold internationally are subject to certain foreign regulatory approvals. In
order to market our product devices in the member countries of the European Union (EU), we are
required to comply with the Medical Devices Directives and obtain CE mark certification. CE mark
certification is the European symbol of adherence to quality assurance standards and compliance
with applicable European Medical Devices Directives. Under the Medical Devices Directives, all
medical devices including active implants must qualify for CE marking. We also are required to
comply with other foreign regulations, such as obtaining MHLW (Ministry of Health Labor and
Welfare) approval in Japan, HPB (Health Protection Branch) approval in Canada, and TGA (Therapeutic
Goods Administration) approval in Australia as a few examples.
Products
We operate as one reportable segment, offering products in four primary market sectors: knee
reconstruction, hip reconstruction, extremity reconstruction, and biologics. Sales in each of these
markets represent greater than 10% of our consolidated revenue. Detailed information on our net
sales by product line can be found in Note 15 to the consolidated financial statements contained in
“Financial Statements and Supplementary Data.”
Knee Reconstruction
Our knee reconstruction product portfolio strategically positions us in the areas of total knee
reconstruction, revision replacement implants and limb preservation products. These products
provide the surgeon with a continuum of treatment options for improving patient care. We
differentiate our products through innovative design features that reproduce movement and
stability, resulting in products that more closely resemble a healthy knee. Additionally, we
provide a broad array of both open surgery and minimally invasive surgery (MIS) surgical
instrumentation to
4
Table of Contents
accommodate surgeon and patient preference. (MIS) or least invasive surgery has
gained momentum in recent history due to the smaller incision and minimal disruption of soft
tissues, which can significantly reduce recovery times. Faster recovery and rehabilitation times
are important to the growing market of younger, more active patients who want a quick return to
their active lifestyles. The MIS surgical instrumentation is not only tissue sparing but more
accurate and can perform traditional/open surgery procedures as well. This is important for
surgeons because not every patient clinically qualifies for the MIS surgical technique and they can
standardize with one set of instruments regardless of open surgery or MIS surgical technique.
Additionally, due to the difficulties of cementing techniques in small incisions, cementless
implants have also gained
momentum in MIS. We are utilizing our cementless implant history and expertise to provide surgical
solutions for this growing opportunity. Recently, certain industry participants have heightened
their focus on providing knee product offerings that offer better size-specificity to patients,
with the intent of improving patient outcomes longer-term as a result of improved implant fit. We
intend to expand the number of sizing options for our primary knee product line during 2007 as part
of a stature-specific approach to patient treatment.
The ADVANCE® Knee System is our primary knee product line offering. There are several
innovative product offerings within the ADVANCE® Knee System product line, one of which
is the ADVANCE® Medial Pivot Knee. The understanding of knee movement and function has
advanced significantly over the past several years, and we believe the ADVANCE® Medial
Pivot Knee is the first knee to be mass marketed that takes full advantage of the strides made in
understanding the knee joint. The ADVANCE® Medial Pivot Knee is designed to approximate
the movement and function of a healthy knee by using a unique spherical medial feature. Overall, we
believe the ADVANCE® Medial Pivot Knee more closely approximates natural knee motion,
improves clinical performance and provides excellent range of motion.
Our ADVANCE® Double-High Knee Tibial Insert is designed to address the needs of surgeons
who desire to retain the posterior cruciate ligament (PCL) and maintain medial-pivoting kinematics.
The insert design addresses an adverse phenomenon, known as paradoxical motion, that often occurs
with other PCL retaining knee systems. In general, total knee systems are designed to be used
either with or without the patient’s PCL. Most knee implant designs used with the PCL are based on
the theory that the ligament will provide stability and increased flexion. Due to the phenomenon of
paradoxical motion, however, small amounts of uncontrolled sliding can occur between the replaced
femoral and tibial surfaces. This movement prevents the prosthetic knee from flexing in a stable,
consistent manner like a normal knee and can result in abnormal gait and reduced flexion. The
ADVANCE® Double-High Knee component, like the ADVANCE® Medial-Pivot, is
designed to prevent paradoxical motion through medial-pivoting articulation designed to provide
stability and maximize PCL function.
Our REPIPHYSIS® Technology product grows with growing children without an operation. The
non-invasive expansion can be utilized for any long bone where lengthening is needed. This
technology, which we exclusively license, can be incorporated into a prosthetic implant and
subsequently adjusted non-invasively when lengthening of the implant is needed. The most common
application of this breakthrough technology is in the field of pediatric oncology, where growing
children can have the bones attached to their hip or knee implant lengthened non-invasively, thus
eliminating the need for more frequent surgeries and anesthesia.
Hip Reconstruction
We offer a comprehensive line of products for hip joint reconstruction. This product portfolio
provides offerings in the areas of bone-conserving implants, total hip reconstruction, revision
replacement implants and limb preservation. Additionally, our hip products offer a combination of
unique, innovative modular designs, a complete portfolio of advanced surface bearing materials,
including ceramic-on-ceramic and metal-on-metal articulations, and innovative technology in surface
replacement implants. We are therefore able to offer surgeons and their patients a full continuum
of treatment options.
The CONSERVE® family of products incorporates anatomically-replicating large diameter
bearings, led recently by the A-CLASS® advanced metal technology. This new
patent-pending metal-on-metal articulation has undergone extensive laboratory tests which suggest
that over the life of the implant, this advanced surface technology will result in significantly
less wear than traditional metal-on-metal hip implants. This new innovation is coupled with our
BFH® technology, which has demonstrated low rates of post-operative hip dislocation.
5
Table of Contents
We continue to invest in pioneering approaches to tissue sparing hip replacement. The
PATH® MIS technique offers patients quicker recovery due to a decrease of intraoperative
soft tissue trauma. The decreased soft tissue trauma results in less pain and blood loss for the
patient, as well as a lower risk of dislocation.
The PROFEMUR® patented modular neck systems allow surgeons to carefully adjust and
fine-tune implant positioning during surgery. If a surgeon requires a change in leg length, offset
or version, the PROFEMUR® system conveniently allows these options, without compromise.
All of these options can be changed after the hip stem is in place. Our principal PROFEMUR®
stem offerings which allow this innovative modularity include our
PROFEMUR® Z, PROFEMUR® Plasma Z, PROFEMUR® LX,
PROFEMUR® Tapered, PROFEMUR® RAZ, PROFEMUR® TL and the
PROFEMUR® RENAISSANCE® stems. These stems represent the vast majority of
popular stem designs in the current marketplace.
The DYNASTY™ Acetabular System offers surgeons the benefit of our BFH® technology both
in metal-on-metal and metal-on-cross-linked poly options with the added benefit of screw fixation.
Screw fixation of sockets is sometimes needed in the case of poor bone quality. The DYNASTY™ system
is based on the long track record of the LINEAGE® Acetabular System, which offers
ceramic, metal and cross-linked poly bearings.
Lastly, the GUARDIAN® Limb Salvage System offers options for patients with significant
bone loss due to cancer, trauma or previous surgical procedures. This modular system, with an array
of options in a multitude of sizes and complete inter-changeability, provides the surgeon with the
ability to meet a variety of patient needs. The GUARDIAN® Proximal Tibial Implant was
developed for patients with significant bone loss in the tibial bone. The GUARDIAN®
Revision Hinge Implant, another of the products offered within the system, was developed for use in
revision surgeries where both bone loss and ligament deficiencies are present. The GUARDIAN®
Total Femur is used in rare cases where the entire femur must be replaced.
Extremity Reconstruction
We offer extremity products for the hand, wrist, elbow, shoulder, foot and ankle in a number of
markets worldwide. Our extremity implants have many years of successful clinical history. We
believe we are one of the recognized leaders in radial head repair and finger and toe implants and
minimally invasive wrist fracture fixation.
Our EVOLVE® Modular Radial Head Replacement Prosthesis addresses the need for modularity
in this anatomically highly-variable joint, and is the market leading radial head prosthesis. The
EVOLVE® Modular Radial Head device provides 150 different combinations of heads and
stems allowing the surgeon to choose implant heads and stems to accommodate the unpredictable
anatomy of each patient. The smooth stem design allows for rotational motion at the implant/bone
interface and radiocapitellar articulation, potentially reducing capitellar wear. In the first
quarter of 2005, we released our EVOLVE® Radial Head Plating System for surgeons who
wish to repair rather than replace the damaged radial head. With prosthesis and plating, we believe
we have become the vendor of choice for repair of radial head fractures. Further strengthening our
position in the radial head market, in the first quarter of 2007, we introduced our
EVOLVE® Proline System, which adds additional size offerings and in-situ locking of the
implant, a favorable feature for surgeons treating patients with intact elbow ligaments.
Our CHARLOTTE™ Foot and Ankle System is a comprehensive offering of fixation products for foot and
ankle surgery, and includes six products that feature advanced design elements for simplicity,
versatility and high performance. The CHARLOTTE™ Foot and Ankle System offers a complete range of
options for the most common foot and ankle surgical needs. Adding to the CHARLOTTE™ portfolio, in
the third quarter of 2006, we introduced the first ever locking compressing plate designed for
corrective foot surgeries. The CLAW™ plate allows surgeons to dial in the length of screw and
amount of compression to the fusion site, a strong advantage over traditional staples.
The LOCON-T® and LOCON-VLS® Distal Radius Plating Systems provide surgeons
with anatomically designed, stainless steel plates used in the repair of distal radial fractures.
In designing both plating systems, we utilized thin, high-strength stainless steel with low profile
screws, which have been demonstrated clinically to lessen potential for
6
Table of Contents
tendon irritation and/or
rupture, which are complications that historically have resulted from this type of surgical repair.
Our MICRONAIL® intramedullary wrist fracture repair system is a next-generation, MIS
treatment for distal radius fractures that provides immediate fracture stabilization with minimal
soft tissue disruption. The result is rapid recovery of hand and wrist functions. Also, as the
product is implanted within the bone, it has no profile, thereby removing the potential for tendon
irritation or rupture.
The ORTHOSPHERE® Carpometacarpal Implant for the repair of the basal thumb joint is
constructed from implant-grade ceramic, which reduces wear and increases biocompatibility compared
to other implant materials. By providing an alternative to the harvesting of the patient’s own soft
tissues as a spacer for the repaired
carpometacarpal joint, the ORTHOSPHERE® Carpometacarpal Implant reduces morbidity and
operating time in appropriately selected patients. We have received FDA 510(k) clearance to also
market this device in foot and ankle procedures such as the tarso-metatarsal joint.
Biologics
We offer a broad line of biologics products that are used to replace and repair damaged or diseased
bone, tendons and soft tissues, and other biological solutions for surgeons and their patients.
These products focus on biological musculoskeletal repair by utilizing synthetic and human
tissue-based materials. Internationally, we offer bone graft products incorporating antibiotic
delivery and anti-adhesion products.
GRAFTJACKET® is a soft tissue graft designed for augmentation of tendon and ligament
repairs such as those of the rotator cuff (shoulder) and Achilles tendon in the ankle. By
augmenting the strength of the tendon repair and incorporating biologically,
GRAFTJACKET® Regenerative Tissue Matrix increases surgeons’ confidence in the surgical
outcome. GRAFTJACKET® Maxforce Extreme is a high strength form of GRAFTJACKET®
Matrix, which provides maximum suture holding power for the most challenging of tendon and
ligament repairs.
GRAFTJACKET® Ulcer Repair Matrix is designed to repair challenging diabetic ulcers of
the foot, the primary cause of hospital admissions for all individuals with diabetes. More than
two-thirds of the amputations administered each year are performed on individuals with diabetes,
often because of difficulties associated with diabetic foot ulcers. GRAFTJACKET® Ulcer
Repair Matrix appears to be the first chronic wound graft to demonstrate the ability to reliably
repair deep foot wounds, which have a much higher risk of leading to amputation. Unlike other
diabetic foot ulcer products, GRAFTJACKET® Ulcer Repair Matrix generally requires only
one application to treat the foot ulcer, reducing the time and cost of treatment.
Our OSTEOSET® bone graft substitute is a synthetic bone graft substitute made of
surgical grade calcium sulfate. OSTEOSET® bone graft provides an attractive alternative
to autograft, because it facilitates bone regeneration without requiring a painful, secondary
bone-harvesting procedure. Additionally, being purely synthetic, OSTEOSET® pellets are
cleared for use in infected sites, an advantage over tissue-based material. The human body resorbs
the OSTEOSET® material at a rate close to the rate that new bone grows. We offer
surgeons the option of custom-molding their own beads in the operating room using the
OSTEOSET® Resorbable Bead Kit, which is available in mixable powder form.
OSTEOSET® 2 DBM graft is a unique bone graft substitute incorporating demineralized bone
matrix (DBM) into OSTEOSET® surgical-grade calcium sulfate pellets. These two bone graft
materials, each with a long clinical history, provide an ideal combination of osteoinduction and
osteoconduction for guided bone regeneration. Our surgical grade calcium sulfate is manufactured
using proprietary processes that consistently produce a high quality product. Our
OSTEOSET® T medicated pellets, which contain tobramycin, are currently one of the few
resorbable bone void fillers available in international markets for the prevention and treatment of
osteomyelitis, an acute or chronic infection of the bone.
ALLOMATRIX® Injectable Putty combines a high content of DBM with our proprietary
surgical grade calcium sulfate carrier. The combination provides an injectable putty with the
osteoinductive properties of DBM as well as exceptional handling qualities. This product has been
well received by surgeons. Another combination we offer is ALLOMATRIX® C bone graft
putty, which includes the addition of cancellous bone granules. The addition of the bone granules
increases the stiffness of the material and thereby improves handling characteristics, increases
7
Table of Contents
osteoconductivity scaffold, and provides more structural support. Our ALLOMATRIX® Custom
bone graft putty allows surgeons to customize the amount of bone granules to add to the putty based
on its surgical application. Most recently, we introduced ALLOMATRIX® DR Graft, which is
ALLOMATRIX® putty that has been optimized for application in smaller fractures due to
the smaller particle size of its cancellous bone granules and the application-specific volume in
which it is marketed.
MIIG® 115 Minimally Invasive Injectable Graft is an injectable form of our surgical
grade calcium sulfate paste that hardens in the body. MIIG® 115 graft combines the
operative flexibility of an injectable substance with the clinically proven osteoconductive
properties of our OSTEOSET® material. MIIG® 115 graft is ideally suited for
use in non-loaded traumatic fractures such as the distal radius and tibial plateau.
MIIG® X3 High Strength Injectable Graft is an addition to the family of MIIG®
products for the minimally invasive
treatment of bone defects. It is an injectable calcium sulfate that hardens after placement,
provides intraoperative support and resorbs over time as it is replaced by new bone. Compared to
the MIIG® 115 graft, the principle advantages of the MIIG® X3 graft is that
it has 2.6 times greater compressive strength, easier injectability, and a longer working time.
MIIG® X3 graft has several competitive advantages over injectable calcium phosphate
products on the market, including its ability to be drilled or tapped for the placement of final
hardware. Additionally, it poses less risk of damage to the joint cartilage upon extravasation
(i.e., leakage into the joint space).
MIIG® X3 HiVisc Graft is an advanced formulation of MIIG® X3 graft specially
designed for management of complex compression fractures. The modified viscosity and extended
working time of MIIG® X3 HiVisc Graft reduces the potential for extravasation of
material into joint spaces and provides greater operative flexibility to the surgeon for very
challenging fractures.
PRO-DENSE™ Injectable Graft has recently become available on a limited basis in key U.S. centers.
PRO-DENSE™ Injectable Graft is a composite graft of surgical grade calcium sulfate and calcium
phosphate. In animal studies, this unique graft composite has demonstrated excellent bone
regenerative characteristics, forming new bone that is three times stronger than the natural
surrounding bone at a 13 week time point. Beyond 13 weeks, the regenerate bone gradually remodels
to natural bone strength.
IGNITEÒ Power Mix is a bone repair stimulus that combines calcium sulfate, DBM and
autologous bone marrow aspirate (BMA) for the treatment of problem fractures and delayed
non-unions. This combination of materials provides the surgeon and patient with all three critical
elements that a bone graft material can offer — an osteoconductive scaffold with both
osteoinductive and osteogenic capacity through the use of DBM and BMA, respectively. The
IGNITEÒ Power Mix kit also provides specially-designed instrumentation both to
procure BMA and to prepare the fracture site for the grafting procedure using a minimally invasive
technique. In 2006, we introduced Mini-Ignite® for stimulating repair of challenging
small bone fractures, such as those of the fifth metatarsal in the foot. We believe this product to
be highly synergistic with our CHARLOTTE™ fixation product line.
CELLPLEX® TCP Synthetic Cancellous Bone is an osteoconductive, resorbable tricalcium
phosphate (TCP) provided in granular form that simulates the structure of cancellous bone. It has
been engineered with a highly porous, interconnected structure to facilitate the ingrowth of new
bone throughout the material. Compared to other commercially available TCP products, its benefits
include a superior compressive strength and physical characteristics that more closely resemble
that of natural cancellous bone. It is an excellent carrier of BMA and is packaged in the
INFILTRATE® Marrow Infusion Chamber to provide surgeons a simple option for combining
BMA with the CELLPLEX® TCP, thereby adding an osteogenic component to the synthetic
graft.
In early 2007, we announced that we had signed a supply agreement with Regeneration Technologies,
Inc., to develop advanced zenograft implants for use in foot and ankle surgeries. During the second
quarter of 2007, we plan to launch our CANCELLO-PURE™ foot and ankle implant, which will provide
foot and ankle surgeons with an off-the-shelf, sterile graft that has handling characteristics
superior to allograft.
8
Table of Contents
Product Development
Our research and development staff focuses on developing new products in the knee, hip and
extremity reconstruction and biologics markets and on expanding our current product offerings and
the markets in which they are offered. Realizing that new product offerings are a key to future
success, we are committed to a strong research and development program. Research and development
expenses totaled $25.6 million, $22.3 million and $18.5 million in 2006, 2005 and 2004,
respectively.
We continue to collaborate with surgeon advisory panels that provide advice on market trends and
assist with the development and clinical testing of our products. We believe these surgeon advisors
are prominent in the field of orthopaedics. We also partner periodically with other industry
participants, particularly in the biologics area, to develop new products.
In the knee, hip and extremity reconstruction areas, our research and development activities focus
on expanding the continuum of products that span the life of implant patients, from early
intervention, such as bone-conserving
implants, to primary implants, revision replacement implants, and limb preservation implants. We
continue to explore and develop advanced bearing and fixation surfaces that improve the clinical
performance of reconstructive devices, including ceramic-on-ceramic and low-wear metal-on-metal
surfaces. Further, we provide minimally invasive tissue sparing techniques that allow patients to
quickly return to work and resume their daily activities. In 2004, we introduced the
ODYSSEY® Tissue Preserving Initiative, which is a minimally invasive surgery program for
hip and knee replacement procedures. In 2006, we launched two new innovative tissue sparing hip
replacement techniques, the PATH® MIS technique, which offers patients quicker mobility
and recovery after total hip replacement. The second new hip technique that we launched in 2006 was
the SUPERCAP™ MIS technique, which offers patients quicker recovery due to a decrease of
intraoperative soft tissue trauma. We anticipate that we will continue to focus on additional MIS
techniques and instrumentation for further surgical applications including the knee.
In the biologics area, we have a variety of research and development projects underway that are
designed to further expand our presence in this market. Such projects include developing materials
for new biologics applications as well as the integration of biologics products into reconstructive
joint procedures and other orthopaedic applications.
New products, procedures and techniques that we introduced across all product lines since 2004
include, but are not limited to, the OSTEOSET® 2 DBM surgical-grade calcium
sulfate pellets, the ADVANCE® Double-High Knee Tibial Insert, the MICRONAIL®
intramedullary distal radius implant, the ODYSSEY® Tissue Preserving Initiative for hip
and knee procedures, the PROFEMUR® Tapered Stem Total Hip System, the CHARLOTTE™ Foot
and Ankle System, the MIIG® HV Procedure Kit, the GRAFTJACKET® Regenerative
Tissue Matrix Maxforce Extreme, the ODYSSEY® Minimally Invasive Knee Instrument, the
CONSERVE® Total A-CLASS® Advanced Metal with BFH® Technology hip
system, the PROFEMUR® RENAISSANCE® hip stem, the CHARLOTTE™ CLAW™ Plate, the
PROFEMUR® RENAISSANCE® Total Hip System, the ODYSSEY® Distal Cut
First instruments, and the A-CLASS® Polyethylene Liner for the LINEAGE®
Acetabular Hip System.
Manufacturing and Supply
We operate manufacturing facilities in Arlington, Tennessee, and Toulon, France. These facilities
primarily produce orthopaedic implants and some of the related surgical instrumentation used to
prepare the bone surfaces and cavities during the surgical procedure. The majority of our surgical
instrumentation is produced to our specifications by qualified subcontractors who serve medical
device companies.
During the past year, we have continued to modernize both production facilities through changes to
the physical appearance and layout, and additions of new production and quality control equipment
to meet the evolving needs of our product specifications and designs. In seeking to optimize our
manufacturing operations, we have adopted many sophisticated manufacturing practices, such as lean
manufacturing and Six Sigma quality programs, which are designed to lower lead times, minimize
waste and reduce inventory. We have a wide breadth of manufacturing capabilities at both
facilities, including skilled manufacturing personnel.
9
Table of Contents
We rely on a limited number of suppliers for the components used in our products. Our
reconstructive joint devices are produced from various surgical grades of titanium, cobalt chrome,
stainless steel, various grades of high density polyethylenes, silicone elastomer and ceramics. We
rely on one source to supply us with a certain grade of cobalt chrome alloy and one supplier for the
silicone elastomer used in our extremity products. We are aware of only two suppliers of silicone
elastomer to the medical device industry for permanent implant usage. Additionally, we rely on one
supplier of ceramics for use in our hip products. In addition, for certain biologics products, we
depend on one supplier of DBM and cancellous bone matrix (CBM). Further, we rely on one supplier
for our GRAFTJACKET® family of soft tissue repair and graft containment products and one
supplier for our ADCON® Gel products. We maintain adequate stock from these sold
suppliers in order to meet production requirements.
We maintain a comprehensive quality assurance and quality control program, which includes
documentation of all material specifications, operating procedures, equipment maintenance and
quality control methods. Our U.S. and European quality systems are based on the requirements of
ISO13485 and the applicable regulations imposed by the FDA on medical device manufacturers. We are
accredited by the AATB, and we are registered with the FDA as a Tissue Bank and as a medical device
manufacturer. The FDA may audit our facilities at any time.
Our production facilities are adequate for our current requirements but we anticipate the need for
a modest expansion of our Arlington, Tennessee, facilities in the future as we continue to
introduce new products and processes and grow our business.
Sales and Marketing
Our sales and marketing efforts are focused primarily on orthopaedic surgeons, who typically are
the decision-makers in orthopaedic device purchases. We have established relationships with
surgeons who we believe are leaders in their chosen orthopaedic specialties. We involve these
surgeons and our marketing personnel in all stages of bringing a product to market -
from initial product development to product launch. As a result, we have a well educated,
highly involved marketing staff and an established, global base of well respected surgeons, who
serve as advocates to promote our products in the orthopaedic community.
In 2006,
we began working with tennis legend Jimmy Connors to educate patients about advances in products and
surgical techniques for treatment of chronic hip pain. Mr. Connors is a recipient of our
CONSERVE®
Total Hip with
BFH®
Technology, which was implanted using our PATH®
MIS surgical technique. As a focal point of our education outreach
program, Mr. Connors’ personal story of successful hip surgery is detailed on the website
www.jimmysnewhip.com, along with other resources for patients who may be exploring surgical options
for treatment of their hip pain.
We offer clinical symposia and seminars, publish advertisements and the results of clinical studies
in industry publications, and offer surgeon-to-surgeon education on our new products using our
surgeon advisors in an instructional capacity. Additionally, approximately 16,000 practicing
orthopaedic surgeons in the U.S. receive information on our latest products through our
distribution network, our website and brochure mailings.
We sell our products in the U.S. through a sales force of approximately 340 people as of December
31, 2006. This sales force primarily consists of independent, commission-based sales
representatives and distributors engaged principally in the business of supplying orthopaedic
products to hospitals in their geographic areas. Our U.S. field sales force is supported by our
Tennessee-based sales and marketing organization. Our independent distributors and sales
representatives are provided opportunities for product training throughout the year.
Our products are marketed internationally through a combination of direct sales offices in certain
key international markets and distributors in other markets. We have sales offices in France,
Italy, the United Kingdom, Belgium, Germany, Spain, the Netherlands, Japan and Canada that employ
direct sales employees and use independent sales representatives to sell our products in their
respective markets. Our products are sold in other countries in Europe, Asia, Africa, South America
and Australia using stocking distribution partners and other distribution arrangements. Stocking
distributors purchase products directly from us for resale to their local customers, with product
ownership generally passing to the distributor upon shipment. As of December 31, 2006, through a
combination of our direct sales offices and approximately 115 stocking distribution partners, we
had approximately 480 international sales representatives that sell our products in over 60
countries.
10
Table of Contents
Seasonal Nature of Business
We traditionally experience lower sales volumes in the third quarter than throughout the rest of
the year as a result of the European holiday schedule, typically resulting in selling, general and
administrative expenses and research and development expenses as a percentage of sales that are
higher than throughout the rest of the year. In addition, our first quarter selling, general and
administrative expenses include additional expenses that we incur in connection with the annual
meeting held by the American Academy of Orthopaedic Surgeons. This meeting, which is the largest
orthopaedic meeting in the world, features the presentation of scientific papers and instructional
courses for orthopaedic surgeons. During this 3-day event, we display our most recent and
innovative products for these surgeons.
Competition
Competition in the orthopaedic device industry is intense and is characterized by extensive
research efforts and rapid technological progress. Competitors include major companies in both the
orthopaedic and biologics industries,
as well as academic institutions and other public and private research organizations that continue
to conduct research, seek patent protection and establish arrangements for commercializing products
that will compete with our products.
The primary competitive factors facing us include price, quality, innovative design and technical
capability, breadth of product line, scale of operations and distribution capabilities. Our current
and future competitors may have greater resources, more widely accepted and innovative products,
less invasive therapies, greater technical capabilities and stronger name recognition than we do.
Our ability to compete is affected by our ability to:
| • | develop new products and innovative technologies; | ||
| • | obtain regulatory clearance and compliance for our products; | ||
| • | manufacture and sell our products cost-effectively; | ||
| • | meet all relevant quality standards for our products and their markets; | ||
| • | respond to competitive pressures specific to each of our geographic markets, including our ability to enforce non-compete agreements; | ||
| • | protect the proprietary technology of our products and manufacturing processes; | ||
| • | market our products; | ||
| • | attract and retain skilled employees and sales representatives; and | ||
| • | maintain and establish distribution relationships. |
Intellectual Property
We currently own or have licenses to use more than 200 patents and pending patent applications
throughout the world. We seek to aggressively protect technology, inventions and improvements that
are considered important through the use of patents and trade secrets in the U.S. and significant
foreign markets. We manufacture and market the products both under patents and license agreements
with other parties. These patents have a defined life, and expire from time to time.
Our knowledge and experience, creative product development, marketing staff and trade secret
information with respect to manufacturing processes, materials and product design, are as important
as our patents in maintaining our proprietary product lines. As a condition of employment, we
require all employees to execute a confidentiality agreement with us relating to proprietary
information and patent rights.
There can be no assurances that our patents will provide competitive advantages for our products,
or that
11
Table of Contents
competitors will not challenge or circumvent these rights. In addition, there can be no
assurances that the United States Patent and Trademark Office (USPTO) will issue any of our pending
patent applications. The USPTO may deny or require a significant narrowing of the claims in our
pending patent applications and the patents issuing from such applications. Any patents issuing
from the pending patent applications may not provide us with significant commercial protection. We
could incur substantial costs in proceedings before the USPTO. These proceedings could result in
adverse decisions as to the priority of our inventions and the narrowing or invalidation of claims
in issued patents. Additionally, the laws of some of the countries in which our products are or may
be sold may not protect our intellectual property to the same extent as the laws in the U.S. or at
all.
While we do not believe that any of our products infringe any valid claims of patents or other
proprietary rights held by others, there can be no assurances that we do not infringe any patents
or other proprietary rights held by them. If our products were found to infringe any proprietary
right of another party, we could be required to pay significant damages or license fees to such
party or cease production, marketing and distribution of those products. Litigation may also be
necessary to enforce patent rights we hold or to protect trade secrets or techniques we own. We are
currently involved in an intellectual property lawsuit with Howmedica Osteonics Corp., a subsidiary
of Stryker Corporation. See “Legal Proceedings” for an additional discussion of this lawsuit.
We also rely on trade secrets and other unpatented proprietary technology. There can be no
assurances that we can meaningfully protect our rights in our unpatented proprietary technology or
that others will not independently develop substantially equivalent proprietary products or
processes or otherwise gain access to our proprietary technology. We seek to protect our trade
secrets and proprietary know-how, in part, with confidentiality agreements with employees and
consultants. There can be no assurances, however, that the agreements will not be breached,
adequate remedies for any breach would be available, or competitors will not discover or
independently develop our trade secrets.
Third-Party Reimbursement
In the U.S., as well as in foreign countries, government-funded or private insurance programs,
commonly known as third-party payors, pay a significant portion of the cost of a patient’s medical
expenses. A uniform policy of reimbursement does not exist among all of these payors relative to
payment of claims or enforcement of guidelines established by the Centers for Medicare and Medicaid
Services (CMS). Therefore, reimbursement can be quite different from payor to payor as well as from
one region of the country to another. We believe that reimbursement is an important factor in the
success of any medical device. Consequently, we seek to obtain reimbursement for all of our
products.
Reimbursement in the U.S. depends on our ability to obtain FDA clearances and approvals to market
our products. Reimbursement also depends on our ability to demonstrate the short-term and long-term
clinical and cost-effectiveness of our products from the results obtained from our clinical
experience and formal clinical trials. We present these results at major scientific and medical
meetings and publish them in respected, peer-reviewed medical journals.
All U.S. and foreign third-party reimbursement programs, whether government funded or insured
commercially, are developing increasingly sophisticated methods of controlling health care costs
through prospective reimbursement and capitation programs, group purchasing, redesign of benefits,
second opinions required prior to major surgery, careful review of bills, encouragement of
healthier lifestyles and exploration of more cost-effective methods of delivering health care.
These types of programs can potentially limit the amount which health care providers may be willing
to pay for medical devices.
CMS has adopted prospective payment systems with respect to U.S. government funded patients for
services performed in hospital settings and all approved procedures performed in ambulatory surgery
centers. These prospective payment systems reimburse hospitals according to a system of groupings
that classify patients into clinically cohesive groups based on similar diagnosis and consumption
of hospital resources. The payment rate for each grouping is established by CMS based on the
national average cost associated with each category of treatment. The prospective payment is
intended to reimburse the facility for all costs associated with the patient’s care, including all
medical devices.
12
Table of Contents
The majority of non-government funded payors have adopted payment systems based on the prospective
payment methodology established by CMS. In some cases, however, particularly within the outpatient
surgery center setting, providers continue to issue payments based on each component of the
patient’s care. In these situations, facilities charge payors separately for any medical devices
used during treatment. Reimbursement is typically based on the cost of the device plus a small
administrative fee.
If adequate levels of reimbursement from third-party payors outside of the U.S. are not obtained,
international sales of our products may decline. Outside of the U.S., reimbursement systems vary
significantly by country. Many foreign markets have government-managed health care systems that
govern reimbursement for new medical devices and procedures. Canada and some European and Asian
countries, in particular France, Japan, Taiwan and Korea, have tightened reimbursement rates.
Additionally, some foreign reimbursement systems provide for limited payments in a given period
and, therefore, result in extended payment periods.
Employees
As of December 31, 2006, we employed approximately 1,060 people in the following areas: 440 in
manufacturing,
340 in sales and marketing, 150 in administration and 130 in research and development. We believe
that we have an excellent relationship with our employees.
Environmental
Our operations and properties are subject to extensive federal, state, local and foreign
environmental protection and health and safety laws and regulations. These laws and regulations
govern, among other things, the generation, storage, handling, use and transportation of hazardous
materials and the handling and disposal of hazardous waste generated at our facilities. Under such
laws and regulations, we are required to obtain permits from governmental authorities for some of
our operations. If we violate or fail to comply with these laws, regulations or permits, we could
be fined or otherwise sanctioned by regulators. Under some environmental laws and regulations, we
could also be held responsible for all of the costs relating to any contamination at our past or
present facilities and at third-party waste disposal sites.
We believe our costs of complying with current and future environmental laws, regulations and
permits, and our liabilities arising from past or future releases of, or exposure to, hazardous
substances will not materially adversely affect our business, results of operations or financial
condition, although there can be no assurances that they will not.
Available Information
Our website is located at www.wmt.com. We make available free of charge through this
website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K, and amendments to those reports filed with or furnished to the Securities and Exchange
Commission (SEC) pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as
amended, as soon as reasonably practicable after they are electronically filed with or furnished to
the SEC.
Item 1A. Risk Factors.
Our business and its future performance may be affected by various factors, the most significant of
which are discussed below.
We are subject to substantial government regulation that could have a material adverse effect on
our business.
The production and marketing of our products and our ongoing research and development, preclinical
testing and clinical trial activities are subject to extensive regulation and review by numerous
governmental authorities both in the U.S. and abroad. See “Business — Government Regulation” for
further details on this process. U.S. and foreign regulations govern the testing, marketing and
registration of new medical devices, in addition to regulating
13
Table of Contents
manufacturing practices, reporting,
labeling and recordkeeping procedures. The regulatory process requires significant time, effort and
expenditures to bring our products to market, and we cannot be assured that any of our products
will be approved. Our failure to comply with applicable regulatory requirements could result in
these governmental authorities:
| • | imposing fines and penalties on us; |
| • | preventing us from manufacturing or selling our products; |
| • | bringing civil or criminal charges against us; |
| • | delaying the introduction of our new products into the market; |
| • | recalling or seizing our products; or |
| • | withdrawing or denying approvals or clearances for our products. |
Even if regulatory approval or clearance of a product is granted, this could result in limitations
on the uses for which the product may be labeled and promoted. Further, for a marketed product, its
manufacturer and manufacturing facilities are subject to periodic review and inspection. Subsequent
discovery of problems with a product, manufacturer or facility may result in restrictions on the
product, manufacturer or facility, including withdrawal of the product from the market or other
enforcement actions.
We are currently conducting clinical studies of some of our products under an IDE. Clinical studies
must be conducted in compliance with FDA regulations, or the FDA may take enforcement action. The
data collected from these clinical studies will ultimately be used to support market clearance for
these products. There is no assurance that the FDA will accept the data from these clinical studies
or that it will ultimately allow market clearance for these products.
We are subject to various federal and state laws concerning health care fraud and abuse, including
false claims laws, anti-kickback laws, and physician self-referral laws. Violations of these laws
can result in criminal and/or civil punishment, including fines, imprisonment, and in the U.S.,
exclusion from participation in government health care programs. The scope of these laws and
related regulations are expanding and their interpretation is evolving. There is very little
precedent related to these laws and regulations. Increased funding for enforcement of these laws
and regulations has resulted in greater scrutiny of marketing practices in our industry and
resulted in several government investigations by various government authorities. If a governmental
authority were to determine that we do not comply with these laws and regulations, then we and our
officers and employees, could be subject to criminal and civil sanctions, including exclusion from
participation in federal health care reimbursement programs.
In order to market our product devices in the member countries of the EU, we are required to comply
with the Medical Devices Directive and obtain CE mark certification. CE mark certification is the
European symbol of adherence to quality assurance standards and compliance with applicable European
Medical Device Directives. Under the Medical Devices Directive, all medical devices including
active implants must qualify for CE marking. In August 2005, an EU Medical Devices Directive
changed the classification of hip, knee, and shoulder implants from class IIb to class III. The
transition period for these changes begins September 1, 2007. Upon reclassification to class III,
manufacturers will be required to assemble significantly more documentation and submit it to their
Notified Body for formal approval prior to affixing the CE mark to their product and packaging. We
intend to comply with the Medical Devices Directive for all of our products manufactured and sold
in the EU. However, there can be no assurance that our products will be approved for CE marking in
a timely manner or at all.
Modifications to our marketed devices may require FDA regulatory clearances or approvals or
require us to cease marketing or recall the modified devices until such clearances or approvals are
obtained.
When required, the products we market in the U.S. have obtained premarket notification under
Section 510(k) of the FDC Act or were exempt from the 510(k) clearance process. We have modified
some of our products and product labeling since obtaining 510(k) clearance, but we do not believe
these modifications require us to submit new 510(k) notifications. However, if the FDA disagrees
with us and requires us to submit a new 510(k) notification for modifications to our existing
products, we may be the subject of enforcement actions by the FDA and be required to stop marketing
the products while the FDA reviews the 510(k) notification. If the FDA requires us to go through a
lengthier, more rigorous examination than we had expected, our product introductions or
modifications could be delayed or canceled, which could cause our sales to decline. In addition,
the FDA may determine that future products will require the more costly, lengthy and uncertain PMA
application process. Products that are approved through a PMA application generally need FDA
approval before they can be modified. See “Business — Government Regulation.”
If market clearance is not obtained for launch of the CONSERVE® Plus implant in the
U.S., growth of our hip product line could be impacted.
Our CONSERVE® Plus Resurfacing Implant is available outside the U.S. There can be no
assurance that the sale of our CONSERVE® Plus product in the U.S. will be cleared by the
FDA in a timely manner or at all, which could have a significant impact on the future growth of our
hip product line.
Our biologics business is subject to emerging governmental regulations that can significantly
impact our business.
The FDA has statutory authority to regulate allograft-based products, processing and materials. The
FDA has been working to establish a more comprehensive regulatory framework for allograft-based
products, which are principally derived from cadaveric tissue. The framework developed by the FDA
establishes criteria for determining whether a particular human tissue-based product will be
classified as human tissue, a medical device or biologic drug requiring premarket clearance or
approval. All tissue-based products are subject to extensive FDA regulation, including a
requirement that ensures that diseases are not transmitted to tissue recipients. The FDA has also
proposed extensive additional regulations that would govern the processing and distribution of all
allograft products. Consent to use the donor’s tissue must also be obtained. The regulations for
allograft-based products are still developing. From time to time, the FDA reviews these products
and may informally suggest to us how these products should be classified. If a human tissue-based
product is considered human tissue, it does not require FDA clearance or approval before being
marketed. If it is considered a medical device or biologic drug, then FDA clearance or approval may
be required.
14
Table of Contents
Additionally, our biologics business involves the procurement and transplantation of allograft
tissue, which is subject to federal regulation under NOTA. NOTA prohibits the sale of human organs,
including bone and other human tissue, for valuable consideration within the meaning of NOTA. NOTA
permits the payment of reasonable expenses associated with the transportation, processing,
preservation, quality control and storage of human tissue. We currently charge our customers for
these expenses. In the future, if NOTA is amended or reinterpreted, we may not be able to charge
these expenses to our customers and, as a result, our business could be adversely affected.
Our principal allograft-based biologics offerings include ALLOMATRIX®,
GRAFTJACKET® and IGNITE® products.
If we fail to compete successfully in the future against our existing or potential competitors, our
sales and operating results may be negatively affected and we may not achieve future growth.
The markets for our products are highly competitive and dominated by a small number of large
companies. We may not be able to meet the prices offered by our competitors, or offer products
similar to or more desirable than those offered by our competitors. See “Business — Competition.”
If we lose one of our key suppliers, we may be unable to meet customer orders for our products in a
timely manner or within our budget.
We rely on a limited number of suppliers for the components used in our products. Our
reconstructive joint devices are produced from various surgical grades of titanium, cobalt chrome
and stainless steel, various grades of high-density polyethylenes, silicone elastomer and ceramics.
We rely on one source to supply us with a certain grade of cobalt chrome alloy and one supplier for
the silicone elastomer used in our extremity products. We are aware of only two suppliers of
silicone elastomer to the medical device industry for permanent implant usage. Additionally, we
rely on one supplier of ceramics for use in our hip products.
In addition, for our biologics products, we presently depend upon a single supplier as our source
for DBM and CBM, and any failure to obtain DBM and CBM from this source in a timely manner will
deplete levels of on-hand raw materials inventory and could interfere with our ability to process
and distribute allograft products. During 2007, we are expecting a single not-for-profit tissue
bank to meet all of our DBM and CBM order requirements, a key component in the allograft products
we currently produce, market and distribute. We cannot be sure that our supply of DBM and CBM will
continue to be available at current levels or will be sufficient to meet our needs, or that future
suppliers of DBM and CBM will be free from FDA regulatory action impacting their sale of DBM and
CBM. Since there is a small number of suppliers, if we cannot continue to obtain DBM and CBM from
our current source in volumes sufficient to meet our needs, we may not be able to locate
replacement sources of DBM and CBM on commercially reasonable terms, if at all. This could have the
effect of interrupting our business, which could adversely affect our sales. Further, we rely on
one supplier for our GRAFTJACKET® family of soft tissue repair and graft containment
products, as well as one supplier for our ADCON® Gel products. Sales of our
GRAFTJACKET® family of soft tissue repair products have grown to represent a significant
portion of our total consolidated net sales.
Suppliers of raw materials and components may decide, or be required, for reasons beyond our
control to cease supplying raw materials and components to us. FDA regulations may require
additional testing of any raw materials or components from new suppliers prior to our use of these
materials or components and in the case of a device with a PMA application, we may be required to
obtain prior FDA permission, either of which could delay or prevent our access to or use of such
raw materials or components.
We derive a significant portion of our sales from operations in international markets that are
subject to political, economic and social instability.
We derive a significant portion of our sales from operations in international markets. Our
international distribution system consists of nine direct sales offices and approximately 115
stocking distribution partners, which combined employ approximately 480 sales representatives who
sell in over 60 countries. Most of these countries are, to some degree, subject to political,
social and economic instability. For both of the years ended December 31, 2006, and 2005,
approximately 38% of our net sales were derived from our international operations. Our
international sales operations expose us and our representatives, agents and distributors to risks
inherent in operating in foreign jurisdictions. These risks include:
| • | the imposition of additional foreign governmental controls or regulations on orthopaedic implants and biologics products; |
15
Table of Contents
| • | new export license requirements, particularly related to our biologics products; | |
| • | economic instability, including currency risk between the U.S. dollar and foreign currencies, in our target markets; | |
| • | a shortage of high-quality international salespeople and distributors; | |
| • | loss of any key personnel who possess proprietary knowledge or are otherwise important to our success in international markets; | |
| • | changes in third-party reimbursement policy that may require some of the patients who receive our implant products to directly absorb medical costs or that may necessitate our reducing selling prices for our products; | |
| • | changes in tariffs and other trade restrictions, particularly related to the exportation of our biologics products; | |
| • | work stoppages or strikes in the health care industry, such as those that have previously affected our operations in France, Canada, Korea and Finland in the past; | |
| • | a shortage of nurses in some of our target markets, particularly affecting our operations in France; | |
| • | exposure to different legal and political standards due to our conducting business in over 60 countries; and | |
| • | work stoppages or strikes in the south of France, where we operate our European manufacturing and logistics facilities. |
Any material decrease in our foreign sales would negatively impact our profitability. Our
international sales are predominately generated in Europe. In Europe, health care regulation and
reimbursement for medical devices vary significantly from country to country. This changing
environment could adversely affect our ability to sell our products in some European countries.
Efforts to acquire and integrate other companies or product lines could adversely affect our
operations and financial results.
We may pursue acquisitions of other companies or product lines. Our ability to grow through
acquisitions depends upon our ability to identify, negotiate, complete and integrate suitable
acquisitions and to obtain any necessary financing. Even if we complete acquisitions, we may also
experience:
| • | difficulties in integrating any acquired companies, personnel and products into our existing business; | |
| • | delays in realizing the benefits of the acquired company or products; | |
| • | diversion of our management’s time and attention from other business concerns; | |
| • | limited or no direct prior experience in new markets or countries we may enter; | |
| • | higher costs of integration than we anticipated; or |
16
Table of Contents
| • | difficulties in retaining key employees of the acquired business who are necessary to manage these acquisitions. |
In addition, an acquisition could materially impair our operating results by causing us to incur
debt or requiring us to amortize acquisition expenses and acquired assets.
If our patents and other intellectual property rights do not adequately protect our products, we
may lose market share to our competitors and be unable to operate our business profitably.
We rely on patents, trade secrets, copyrights, know-how, trademarks, license agreements and
contractual provisions to establish our intellectual property rights and protect our products. See
“Business — Intellectual Property.” These legal means, however, afford only limited protection and
may not adequately protect our rights. In addition, we cannot be assured that any of our pending
patent applications will issue. The USPTO may deny or require a significant narrowing of the claims
in our pending patent applications and the patents issuing from such applications. Any patents
issuing from the pending patent applications may not provide us with significant commercial
protection. We could incur substantial costs in proceedings before the USPTO. These proceedings
could result in adverse decisions as to the priority of our inventions and the narrowing or
invalidation of claims in issued patents. In addition, the laws of some of the countries in which
our products are or may be sold may not protect our intellectual property to the same extent as
U.S. laws or at all. We also may be unable to protect our rights in trade secrets and unpatented
proprietary technology in these countries.
In addition, we hold licenses from third parties that are necessary to utilize certain technologies
used in the design and manufacturing of some of our products. The loss of such licenses would
prevent us from manufacturing, marketing and selling these products, which could harm our business.
We seek to protect our trade secrets, know-how and other unpatented proprietary technology, in
part, with confidentiality agreements with our employees, independent distributors and consultants.
We cannot be assured, however, that the agreements will not be breached, adequate remedies for any
breach would be available or our trade secrets, know-how, and other unpatented proprietary
technology will not otherwise become known to or independently developed by our competitors.
If we lose any existing or future intellectual property lawsuits, a court could require us to pay
significant damages or prevent us from selling our products.
The medical device industry is litigious with respect to patents and other intellectual property
rights. Companies in the medical device industry have used intellectual property litigation to gain
a competitive advantage. We are currently involved in an intellectual property lawsuit with
Howmedica Osteonics Corp., a subsidiary of Stryker Corporation, where it is alleged that our
ADVANCE® Knee product line infringes one of Howmedica’s patents. See “Legal Proceedings”
for more information regarding this lawsuit. If Howmedica were to succeed in obtaining the relief
it claims, the court could award damages to Howmedica and impose an injunction against further
sales of our product. If a monetary judgment is rendered against us, we may be forced to raise or
borrow funds, as a supplement to any available insurance claim proceeds, to pay the damages award.
In the future, we may become a party to other lawsuits involving patents or other intellectual
property. A legal proceeding, regardless of the outcome, could drain our financial resources and
divert the time and effort of our management. If we lose one of these proceedings, a court, or a
similar foreign governing body, could require us to pay significant damages to third parties,
require us to seek licenses from third parties and pay ongoing royalties, require us to redesign
our products, or prevent us from manufacturing, using or selling our products. In addition to being
costly, protracted litigation to defend or prosecute our intellectual property
17
Table of Contents
rights could result
in our customers or potential customers deferring or limiting their purchase or use of the affected
products until resolution of the litigation.
If product liability lawsuits are brought against us, our business may be harmed.
The manufacture and sale of medical devices exposes us to significant risk of product liability
claims. In the past, we have had a number of product liability claims relating to our products,
none of which either individually, or in the aggregate, have resulted in a material negative impact
on our business. In the future, we may be subject to additional product liability claims, some of
which may have a negative impact on our business. Additionally, we could experience a material
design or manufacturing failure in our products, a quality system failure, other safety issues, or
heightened regulatory scrutiny that would warrant a recall of some of our products. Our existing
product liability insurance coverage may be inadequate to protect us from any liabilities we might
incur. If a product liability claim or series of claims is brought against us for uninsured
liabilities or in excess of our insurance coverage, our business could suffer. In addition, a
recall of some of our products, whether or not the result of a product liability claim, could
result in significant costs and loss of customers.
Further, in 1993, our predecessor company, Wright Medical Technology, Inc. (the Predecessor
Company), acquired substantially all of the assets of the large joint orthopaedic implant business
from Dow Corning Corporation (DCC). DCC retains liability for matters arising from certain conduct
of DCC prior to June 30, 1993. As such, DCC has agreed to indemnify the Predecessor Company against
all liability for all products manufactured prior to the acquisition except for products provided
under the Predecessor Company’s 1993 agreement with DCC pursuant to which the Predecessor Company
purchased certain small joint orthopaedic implants for worldwide distribution. The Predecessor
Company was notified in 1995 that DCC, which filed for reorganization under Chapter 11 of the U.S.
Bankruptcy Code, would no longer defend the Predecessor Company in such matters until it received
further direction from the bankruptcy court. There are several appeals regarding the confirmed plan
of reorganization pending before the U.S. District Court in Detroit, Michigan, which have delayed
implementation of the plan. There can be no assurance that DCC will indemnify the Predecessor
Company or Wright on any claims in the future. Further, neither the Predecessor Company nor Wright
maintains insurance for claims arising on products sold by DCC.
If we are unable to continue to develop and market new products and technologies, we may experience
a decrease in demand for our products or our products could become obsolete, and our business would
suffer
We are continually engaged in product development and improvement programs, and new products
represent a significant component of our growth rate. We may be unable to compete effectively with
our competitors unless we can keep up with existing or new products and technologies in the
orthopaedic implant market. If we do not continue to introduce new products and technologies, or if
those products and technologies are not accepted, we may not be successful. Additionally, our
competitors’ new products and technologies may beat our products to market, may be more effective
or less expensive than our products or may render our products obsolete. See “Business —
Competition.”
Our business could suffer if the medical community does not continue to accept allograft
technology.
New allograft products, technologies and enhancements may never achieve broad market acceptance due
to numerous factors, including:
| • | lack of clinical acceptance of allograft products and related technologies; | |
| • | the introduction of competitive tissue repair treatment options that render allograft products and |
18
Table of Contents
| technologies too expensive and obsolete; | ||
| • | lack of available third-party reimbursement; | |
| • | the inability to train surgeons in the use of allograft products and technologies; | |
| • | the risk of disease transmission; and | |
| • | ethical concerns about the commercial aspects of harvesting cadaveric tissue. |
Market acceptance will also depend on the ability to demonstrate that existing and new allografts
and technologies are attractive alternatives to existing tissue repair treatment options. To
demonstrate this, we rely upon surgeon evaluations of the clinical safety, efficacy, ease of use,
reliability and cost effectiveness of our tissue repair options and technologies. Recommendations
and endorsements by influential surgeons are important to the commercial success of allograft
products and technologies. In addition, several countries, notably Japan, prohibit the use of
allografts. If allograft products and technologies are not broadly accepted in the marketplace, we
may not achieve a competitive position in the market.
If adequate levels of reimbursement from third-party payors for our products are not obtained,
surgeons and patients may be reluctant to use our products and our sales may decline.
In the U.S., health care providers that purchase our products generally rely on third-party payors,
principally federal Medicare, state Medicaid and private health insurance plans, to pay for all or
a portion of the cost of joint reconstructive procedures and products utilized in those procedures.
We may be unable to sell our products on a profitable basis if third-party payors deny coverage or
reduce their current levels of reimbursement. Our sales depend largely on governmental health care
programs and private health insurers reimbursing patients’ medical expenses. Surgeons, hospitals
and other health care providers may not purchase our products if they do not receive satisfactory
reimbursement from these third-party payors for the cost of the procedures using our products.
Payors continue to review their coverage policies carefully for existing and new therapies and can,
without notice, deny coverage for treatments that include the use of our products.
In addition, some health care providers in the U.S. have adopted or are considering a managed care
system in which the providers contract to provide comprehensive heath care for a fixed cost per
person. Health care providers may attempt to control costs by authorizing fewer elective surgical
procedures, including joint reconstructive surgeries, or by requiring the use of the least
expensive implant available.
If adequate levels of reimbursement from third-party payors outside of the U.S. are not obtained,
international sales of our products may decline. Outside of the U.S., reimbursement systems vary
significantly by country. Many foreign markets have government-managed health care systems that
govern reimbursement for medical devices and procedures. Canada, and some European and Asian
countries, in particular France, Japan, Taiwan and Korea, have tightened reimbursement rates.
Additionally, some foreign reimbursement systems provide for limited payments in a given period and
therefore result in extended payment periods. See “Business — Third-Party Reimbursement” for more
information regarding reimbursement in the U.S. and abroad.
If surgeons do not recommend and endorse our products, our sales may decline or we may be unable to
increase our sales and profits.
In order for us to sell our products, surgeons must recommend and endorse them. We may not obtain
the necessary recommendations or endorsements from surgeons. Acceptance of our products depends on
19
Table of Contents
educating the medical community as to the distinctive characteristics, perceived benefits, clinical
efficacy and cost-effectiveness of our products compared to products of our competitors and on
training surgeons in
the proper application of our products.
We rely on our independent sales distributors and sales representatives to market and sell our
products.
Our success depends largely upon marketing arrangements with independent sales distributors and
sales representatives, in particular their sales and service expertise and relationships with the
customers in the marketplace. Independent distributors and sales representatives may terminate
their relationships with us or devote insufficient sales efforts to our products. We do not control
our independent distributors and they may not be successful in implementing our marketing plans.
Our failure to maintain our existing relationships with our independent distributors and sales
representatives could have an adverse effect on our operations. Similarly, our failure to recruit
and retain additional skilled independent sales distributors and sales representatives could have
an adverse effect on our operations. We have experienced turnover with some of our independent
distributors in the past which adversely affected short-term financial results while we
transitioned to new independent distributors. While we believe these transitions have been managed
effectively, similar occurrences could happen in the future with different results which could have
a greater adverse effect on our operations than we have previously experienced.
Fluctuations in insurance cost and availability could adversely affect our profitability or our
risk management profile.
We hold a number of insurance policies, including product liability insurance, directors’ and
officers’ liability insurance, property insurance and workers’ compensation insurance. If the costs
of maintaining adequate insurance coverage should increase significantly in the future, our
operating results could be materially adversely impacted. Likewise, if the availability of any of
our current insurance coverage should become unavailable to us or economically impractical, we
would be required to operate our business without indemnity from commercial insurance providers.
If we cannot retain our key personnel, we will not be able to manage and operate successfully and
we may not be able to meet our strategic objectives.
Our continued success depends, in part, upon key managerial, scientific, sales and technical
personnel, as well as our ability to continue to attract and retain additional highly qualified
personnel. We compete for such personnel with other companies, academic institutions, governmental
entities and other organizations. There can be no assurance that we will be successful in retaining
our current personnel or in hiring or retaining qualified personnel in the future. Loss of key
personnel or the inability to hire or retain qualified personnel in the future could have a
material adverse effect on our ability to operate successfully. Further, any inability on our part
to enforce non-compete arrangements related to key personnel who have left the business could have
a material adverse effect on our business.
If a natural or man-made disaster strikes our manufacturing facilities, we could be unable to
manufacture our products for a substantial amount of time and our sales could decline.
We have principally relied to date on our manufacturing facilities in Arlington, Tennessee, and
Toulon, France. These facilities and the manufacturing equipment we use to produce our products
would be difficult to replace and could require substantial lead-time to repair or replace. Our
facilities may be affected by natural or man-made disasters. In the event one of our facilities was
affected by a disaster, we would be forced to rely on third-party manufacturers or shift production
to our other manufacturing facility. Although we believe we possess adequate insurance for damage
to our property and the disruption of our business
20
Table of Contents
from casualties, such insurance may not be
sufficient to cover all of our potential losses and may not continue to be available to us on
acceptable terms or at all.
Our business plan relies on certain assumptions about the market for our products, which, if
incorrect, may adversely affect our profitability.
We believe that the aging of the general population and increasingly active lifestyles will
continue and that these trends will increase the need for our orthopaedic implant products. The
projected demand for our products could materially differ from actual demand if our assumptions
regarding these trends and acceptance of our products by the medical community prove to be
incorrect or do not materialize, or if non-surgical treatments gain more widespread acceptance as a
viable alternative to orthopaedic implants.
Fluctuations in foreign currency exchange rates could result in declines in our reported sales and
earnings.
Since a majority of our international sales are denominated in local currencies and not in U.S.
dollars, our reported sales and earnings are subject to fluctuations in foreign exchange rates. Our
international net sales were unfavorably affected by the impact of foreign currency fluctuations
totaling approximately $300,000 in 2006 and favorably impacted by $400,000 in 2005. We currently
employ a derivative program using 30-day foreign currency forward contracts to mitigate the risk of
currency fluctuations on our intercompany receivable and payable balances that are denominated in
foreign currencies. These forward contracts are expected to offset the transactional gains and
losses on the related intercompany balances. These forward contracts are not designated as hedging
instruments under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.
Accordingly, the changes in the fair value and the settlement of the contracts are recognized in
the period incurred.
Our quarterly operating results are subject to substantial fluctuations and you should not rely on
them as an indication of our future results.
Our quarterly operating results may vary significantly due to a combination of factors, many of
which are beyond our control. These factors include:
| • | demand for products, which historically has been lowest in the third quarter; | |
| • | our ability to meet the demand for our products; | |
| • | increased competition; | |
| • | the number, timing and significance of new products and product introductions and enhancements by us and our competitors; | |
| • | our ability to develop, introduce and market new and enhanced versions of our products on a timely basis; | |
| • | changes in pricing policies by us and our competitors; | |
| • | changes in the treatment practices of orthopaedic surgeons; | |
| • | changes in distributor relationships and sales force size and composition; |
21
Table of Contents
| • | the timing of material expense- or income-generating events and the related recognition of their associated financial impact; | |
| • | the timing of significant orders and shipments; | |
| • | availability of raw materials; | |
| • | work stoppages or strikes in the health care industry; | |
| • | changes in FDA and foreign governmental regulatory policies, requirements and enforcement practices; | |
| • | changes in accounting policies, estimates, and treatments; and | |
| • | general economic factors. |
We believe that our quarterly sales and operating results may vary significantly in the future and
that period-to-period comparisons of our results of operations are not necessarily meaningful and
should not be relied upon as indications of future performance. We cannot assure you that our sales
will increase or be sustained in future periods or that we will be profitable in any future period.
Any shortfalls in sales or earnings from levels expected by securities or orthopaedic industry
analysts could have an immediate and significant adverse effect on the trading price of our common
stock in any given period.
Our business could be adversely impacted if we have deficiencies in our internal control over
financial reporting.
The design and effectiveness of our internal control over financial reporting may not prevent all
errors, misstatements or misrepresentations. As part of management’s review of our internal control
over financial reporting for the year ended December 31, 2006, pursuant to Section 404 of the
Sarbanes-Oxley Act of 2002, management concluded that, as of December 31, 2006, there was a
material weakness in our internal control over financial reporting related to our method of
calculating depreciation expense for our surgical instruments, as discussed in “Controls and
Procedures.”
We believe that the controls we have implemented have been designed to remediate this material
weakness as of the filing date of this annual report. While management will continue to review the
effectiveness of our internal control over financial reporting, we cannot assure you that our
internal control over financial reporting will be effective in accomplishing all control objectives
all of the time. Other deficiencies, particularly a material weakness in internal control over
financial reporting, which may occur in the future, could result in misstatements of our results of
operations, restatements of our financial statements, a decline in our stock price, or otherwise
materially adversely affect our business, reputation, results of operation, financial condition or
liquidity.
Item 1B. Unresolved Staff Comments.
None.
Item 2. Properties.
Our corporate headquarters and U.S. operations consist of a manufacturing facility, a warehouse,
and an administration building located on 31 acres in Arlington, Tennessee. We lease the
manufacturing facility from the Industrial Development Board of the Town of Arlington (IDB) under a
lease agreement which is automatically renewable through 2049. We may exercise an option to
purchase the manufacturing facility from the IDB at a nominal price at any time during the lease
term. We lease the warehouse from the IDB under a lease agreement which has no predetermined
expiration date. We may exercise an option to purchase the warehouse from the IDB at a nominal
price at any time during the lease term. We lease a portion of the administration building from the
IDB under a lease agreement that expires on July 8, 2008. We may exercise an option to purchase the
leased portion of the administration building from the IDB at a price of $101,000, which we have
pre-paid, at any time during the lease term. We own another portion of the administrative building
that was built in 2004.
Our production facilities are adequate for our current requirements, but we anticipate the need for
an expansion of our Arlington, Tennessee, facilities in the future as we continue to
introduce new products and processes and grow our business.
Our international operations include manufacturing, warehouse, sales, research and development, and
administrative facilities located in several countries. Our primary international warehouses are
located in leased facilities in Toulon, France and the Netherlands. Our primary international
research and development facility is located in leased
22
Table of Contents
facilities in Milan, Italy. Our sales
offices in France, Italy, the United Kingdom, Belgium, Japan and Canada also include warehouse and
administrative space.
Item 3. Legal Proceedings.
From time to time, we are subject to lawsuits and claims which arise out of our operations in the
normal course of business. We are the plaintiff or defendant in various litigation matters in the
ordinary course of business, some of which involve claims for damages that are substantial in
amount. We believe that the disposition of claims currently pending, including the matters
discussed below, will not have a material adverse effect on our financial position or ongoing
results of operations.
Howmedica Osteonics Corp. v. Wright Medical Technology, Inc.
In 2000, Howmedica Osteonics Corp., a subsidiary of Stryker Corporation, filed a lawsuit against us
in the United States District Court for the District of New Jersey alleging that we infringed
Howmedica’s U.S. Patent No. 5,824,100 related to our ADVANCE® Knee product line. The
lawsuit seeks an order of infringement, injunctive relief, unspecified damages and various other
costs and relief and could impact a substantial portion of our knee product line. We believe,
however, that we have strong defenses against Howmedica’s claims and thus are vigorously defending
this lawsuit. In November 2005, the court issued a Markman ruling on claim construction
holding that our products do not literally infringe the claims of Howmedica’s patent. No trial date
has been set in this matter. We are unable to estimate the potential liability, if any, with
respect to the claims, and accordingly, no provision has been made for this contingency as of
December 31, 2006. We believe that the claims are covered in part by our patent infringement
insurance. We do not believe that the outcome of this lawsuit will have a material adverse effect
on our financial position or ongoing results of operations.
Item 4. Submission of Matters to a Vote of Security Holders.
Not applicable.
23
Table of Contents
PART II
| Item 5. | Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. |
Market Information
Our common stock is traded on the Nasdaq Global Select Market under the symbol “WMGI.” The
following table sets forth, for the periods indicated, the high and low sales prices per share of
our common stock as reported on the Nasdaq Global Select Market.
| High | Low | |||||||
Fiscal Year 2006 |
||||||||
First Quarter |
$ | 22.69 | $ | 18.54 | ||||
Second Quarter |
$ | 24.80 | $ | 19.17 | ||||
Third Quarter |
$ | 24.79 | $ | 20.20 | ||||
Fourth Quarter |
$ | 25.09 | $ | 22.47 | ||||
Fiscal Year 2005 |
||||||||
First Quarter |
$ | 28.13 | $ | 23.51 | ||||
Second Quarter |
$ | 28.11 | $ | 22.44 | ||||
Third Quarter |
$ | 28.56 | $ | 23.65 | ||||
Fourth Quarter |
$ | 24.81 | $ | 18.27 | ||||
Holders
As of February 16, 2007, there were 203 stockholders of record and an estimated 7,205 beneficial
owners of our common stock.
Dividend Policy
We have never declared or paid cash dividends on our common stock. We currently intend to retain
all future earnings for the operation and expansion of our business. We do not anticipate declaring
or paying cash dividends on our common stock in the foreseeable future. Any payment of cash
dividends on our common stock will be at the discretion of our board of directors and will depend
upon our results of operations, earnings, capital requirements, contractual restrictions and other
factors deemed relevant by our board of directors. In addition, our current credit facility
prohibits us from paying any cash dividends without the lenders’ consent.
Equity Compensation Plan Information
The table below sets forth information regarding the shares of common stock to be issued upon the
exercise of the outstanding stock options granted under our equity compensation plans and the
shares of common stock remaining available for future issuance under our equity compensation plans
as of December 31, 2006 (in thousands):
| Shares of Common | ||||||||||||
| Shares of Common | Stock Remaining | |||||||||||
| Stock | Available for Future | |||||||||||
| to be Issued upon | Weighted-Average | Issuance under | ||||||||||
| Exercise | Exercise Price of | Equity | ||||||||||
| of Outstanding Options | Outstanding | Compensation Plans | ||||||||||
| Plan Category | (in thousands) | Options | (in thousands) | |||||||||
Equity compensation plans
approved by security holders |
5,711 | $ | 21.00 | 1,561 | ||||||||
Equity compensation plans
not approved by security
holders |
— | — | — | |||||||||
Total |
5,711 | $ | 21.00 | 1,561 | ||||||||
24
Table of Contents
Comparison of Total Stockholder Returns
The graph below compares the cumulative total stockholder returns for the period from December 31,
2001 to December 31, 2006, for our common stock, an index composed of U.S. companies whose stock is
listed on the Nasdaq Global Select Market (the Nasdaq U.S. Companies Index), and an index
consisting of Nasdaq-listed companies in the surgical, medical, and dental instruments and supplies
industry (the Nasdaq Medical Equipment Companies Index). The graph assumes that $100.00 was
invested on December 31, 2001, in our common stock, the Nasdaq U.S. Companies Index, and the Nasdaq
Medical Equipment Companies Index, and that all dividends were reinvested. Total returns for the
two Nasdaq indices are weighted based on the market capitalization of the companies included
therein. Historic stock price performance is not indicative of future stock price performance. We
do not make or endorse any prediction as to future stock price performance.
Cumulative Total Stockholder Returns
Based on Reinvestment of $100.00 Beginning on December 31, 2001
Based on Reinvestment of $100.00 Beginning on December 31, 2001
| 12/31/2001 | 12/31/2002 | 12/31/2003 | 12/31/2004 | 12/31/2005 | 12/31/2006 | |||||||||||||||||||
Wright Medical Group, Inc. |
$ | 100.00 | $ | 97.50 | $ | 169.80 | $ | 159.20 | $ | 114.00 | $ | 130.10 | ||||||||||||
Nasdaq U.S. Companies Index |
100.00 | 69.10 | 103.40 | 112.50 | 114.90 | 126.20 | ||||||||||||||||||
Nasdaq Medical Equipment
Companies Index |
100.00 | 81.70 | 119.50 | 139.60 | 153.90 | 162.90 | ||||||||||||||||||
Source: Center for Research in Security Prices, University of Chicago Graduate School of Business
25
Table of Contents
Item 6. Selected Financial Data.
The following tables set forth certain of our selected consolidated financial data as of the dates
and for the years indicated. The selected consolidated financial data as of December 31, 2006,
2005, 2004, 2003 and 2002, and for the years then ended, was derived from our consolidated
financial statements audited by KPMG LLP. The audited consolidated financial statements as of
December 31, 2006, 2005 and 2004, and for the years then ended, are included elsewhere in this
annual report. The audited consolidated financial statements as of December 31, 2003 and 2002, and
for the years then ended, are not included in this filing. Historical results are not necessarily
indicative of the results to be expected for any future period. These tables are presented in
thousands, except per share data.
| Year Ended December 31, | ||||||||||||||||||||
| 2006 | 2005 | 2004 | 2003 | 2002 | ||||||||||||||||
Statement of Operations: |
||||||||||||||||||||
Net sales |
$ | 338,938 | $ | 319,137 | $ | 297,539 | $ | 248,932 | $ | 200,873 | ||||||||||
Cost of sales (1) |
97,234 | 91,752 | 84,251 | 67,922 | 55,724 | |||||||||||||||
Gross profit |
241,704 | 227,385 | 213,288 | 181,010 | 145,149 | |||||||||||||||
Operating expenses: |
||||||||||||||||||||
Selling, general and administrative (1) |
192,573 | 167,365 | 152,508 | 129,487 | 108,381 | |||||||||||||||
Research and development (1) |
25,551 | 22,289 | 18,478 | 16,237 | 10,467 | |||||||||||||||
Amortization of intangible assets |
4,149 | 4,250 | 3,889 | 3,562 | 3,946 | |||||||||||||||
Acquired in-process research and development costs |
— | — | — | 4,558 | — | |||||||||||||||
Arbitration settlement award |
— | — | — | — | (4,200 | ) | ||||||||||||||
Total operating expenses |
222,273 | 193,904 | 174,875 | 153,844 | 118,594 | |||||||||||||||
Operating income |
19,431 | 33,481 | 38,413 | 27,166 | 26,555 | |||||||||||||||
Interest (income) expense, net |
(1,127 | ) | (176 | ) | 1,064 | 1,107 | 938 | |||||||||||||
Other (income) expense, net |
(1,643 | ) | 237 | (74 | ) | (1,060 | ) | (1,277 | ) | |||||||||||
Income before income taxes |
22,201 | 33,420 | 37,423 | 27,119 | 26,894 | |||||||||||||||
Provision for income taxes |
7,790 | 12,355 | 13,401 | 9,722 | 1,834 | |||||||||||||||
Net income |
$ | 14,411 | $ | 21,065 | $ | 24,022 | $ | 17,397 | $ | 25,060 | ||||||||||
Net income per share: |
||||||||||||||||||||
Basic |
$ | 0.42 | $ | 0.62 | $ | 0.72 | $ | 0.53 | $ | 0.79 | ||||||||||
Diluted |
$ | 0.41 | $ | 0.60 | $ | 0.68 | $ | 0.50 | $ | 0.75 | ||||||||||
Weighted-average number of common shares outstanding
— basic |
34,434 | 33,959 | 33,391 | 32,857 | 31,870 | |||||||||||||||
Weighted-average number of common shares outstanding
— diluted |
35,439 | 35,199 | 35,317 | 34,561 | 33,550 | |||||||||||||||
26
Table of Contents
| As of December 31, | ||||||||||||||||||||
| 2006 | 2005 | 2004 | 2003 | 2002 | ||||||||||||||||
Consolidated Balance Sheet Data: |
||||||||||||||||||||
Cash and cash equivalents |
$ | 57,939 | $ | 51,277 | $ | 83,470 | $ | 66,571 | $ | 51,373 | ||||||||||
Marketable securities |
30,325 | 25,000 | — | — | — | |||||||||||||||
Working capital |
220,306 | 196,126 | 189,803 | 147,255 | 127,557 | |||||||||||||||
Total assets |
409,402 | 371,810 | 361,158 | 322,103 | 276,370 | |||||||||||||||
Long-term liabilities |
14,162 | 15,547 | 19,870 | 20,516 | 25,939 | |||||||||||||||
Stockholders’ equity |
$ | 335,824 | $ | 292,008 | $ | 276,069 | $ | 238,318 | $ | 204,999 | ||||||||||
| Year Ended December 31, | ||||||||||||||||||||
| 2006 | 2005 | 2004 | 2003 | 2002 | ||||||||||||||||
Other Data: |
||||||||||||||||||||
Cash flow provided by operating activities |
$ | 29,975 | $ | 5,291 | $ | 37,365 | $ | 40,065 | $ | 21,950 | ||||||||||
Cash flow used in investing activities |
(28,349 | ) | (31,583 | ) | (18,428 | ) | (25,844 | ) | (22,430 | ) | ||||||||||
Cash flow provided by (used in) financing
activities |
4,646 | (5,379 | ) | (2,305 | ) | 514 | 48,384 | |||||||||||||
Depreciation |
21,361 | 17,895 | 17,278 | 13,948 | 13,553 | |||||||||||||||
Stock-based compensation expense (2) |
13,840 | 467 | 1,489 | 2,068 | 1,724 | |||||||||||||||
Amortization of intangible assets |
4,149 | 4,250 | 3,889 | 3,562 | 3,946 | |||||||||||||||
Capital expenditures |
$ | 29,643 | $ | 30,356 | $ | 18,316 | $ | 18,116 | $ | 17,974 | ||||||||||
| (1) | These line items include the following amounts of non-cash stock-based compensation expense for the periods indicated: |
| Year Ended December 31, | ||||||||||||||||||||
| 2006 | 2005 | 2004 | 2003 | 2002 | ||||||||||||||||
Cost of sales |
$ | 854 | $ | 12 | $ | 68 | $ | 107 | $ | 108 | ||||||||||
Selling, general and administrative |
10,766 | 449 | 1,364 | 1,875 | 1,506 | |||||||||||||||
Research and development |
2,220 | 6 | 57 | 86 | 110 | |||||||||||||||
| (2) | Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004), Share-Based Payment, which requires stock-based compensation costs to be measured using the grant date fair value and recognized as expense over the vesting period. The Company elected the modified prospective method of transition, under which prior periods are not revised for comparative purposes. As a result, 2006 amounts are not comparable to prior years. |
27
Table of Contents
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of
Operations.
The following management’s discussion and analysis of financial condition and results of operations
(MD&A) describes the principal factors affecting the results of our operations, financial
condition, and changes in financial condition, as well as our critical accounting estimates. MD&A
is organized as follows:
| • | Executive overview. This section provides a general description and history of our business, a brief discussion of our principal product lines, significant developments in our business, and the opportunities, challenges and risks we focus on in the operation of our business. |
| • | Net sales and expense components. This section provides a description of the significant line items in our consolidated statement of operations. |
| • | Results of operations. This section provides our analysis of and outlook for the significant line items in our consolidated statement of operations. |
| • | Seasonal nature of business. This section describes the effects of seasonal fluctuations in our business. |
| • | Liquidity and capital resources. This section provides an analysis of our liquidity and cash flow and a discussion of our outstanding debt and commitments. |
| • | Critical accounting estimates. This section discusses the accounting estimates that are considered important to our financial condition and results of operations and require us to exercise subjective or complex judgments in their application. All of our significant accounting policies, including our critical accounting estimates, are summarized in Note 2 to our consolidated financial statements in “Financial Statements and Supplementary Data.” |
Executive Overview
Company Description. We are a global orthopaedic medical device company specializing in the design,
manufacture and marketing of reconstructive joint devices and biologics products. Reconstructive
joint devices are used to replace knee, hip and other joints that have deteriorated through disease
or injury. Biologics are used to replace damaged or diseased bone, to stimulate bone growth and to
provide other biological solutions for surgeons and their patients. We have been in business for
over 50 years and have built a well-known and respected brand name and strong relationships with
orthopaedic surgeons.
Our corporate headquarters and U.S. operations are located in Arlington, Tennessee, where we
conduct our domestic research and development, manufacturing, warehousing and administrative
activities. Outside the U.S., we have research and development, manufacturing and administrative
facilities in Toulon, France; research, distribution and administrative facilities in Milan, Italy;
distribution and administrative facilities in Amsterdam, the Netherlands; and sales and
distribution offices in Canada, Japan and throughout Europe. We market our products in over 60
countries through a global distribution system that consists of a sales force of approximately 820
individuals who promote our products to orthopaedic surgeons and hospitals. At the end of 2006, we
had approximately 340 independent distributors and sales associates in the U.S., and approximately
480 sales representatives internationally who were employed through a combination of our stocking
distribution partners and direct sales offices.
Company History. We were incorporated in November 1999, as a Delaware corporation, and had no
operations until December 1999, when we acquired majority ownership of our predecessor company,
Wright Medical Technology, Inc. in a recapitalization, and immediately thereafter acquired
Cremascoli Ortho Holding, S.A., an orthopaedic medical device company headquartered in Toulon,
France.
In 2001, we sold 7,500,000 shares of common stock in our initial public offering, which generated
$84.8 million in net proceeds. In 2002, we sold 3,450,000 shares of common stock in a secondary
offering which generated $49.5 million in net proceeds.
28
Table of Contents
Principal Products. We primarily sell reconstructive joint devices and biologics products. Our
reconstructive joint device sales are derived from three primary product lines: knees and hips,
collectively referred to as our reconstructive large joint business, and extremities. Our biologics
sales are derived from a broad portfolio of products designed to stimulate and augment the natural
regenerative capabilities of the human body. We also sell orthopaedic products not considered to be
part of our knee, hip, extremity or biologics product lines.
Our hip joint reconstruction product portfolio provides offerings in the areas of bone-conserving
implants, total hip reconstruction, revision replacement implants and limb preservation. Our hip
joint products include the CONSERVE® family of products, the PROFEMUR® Hip
System, the LINEAGE® Acetabular System, the ANCA-FIT™ Hip System,
and the PERFECTA® Hip System.
Our knee reconstruction products position us well in the areas of total knee reconstruction,
revision replacement implants and limb preservation products. Our principal knee product is the
ADVANCE® Knee System.
We offer extremity products for the hand, wrist, elbow, shoulder, foot and ankle in a number of
markets worldwide. Our principal extremity products include the EVOLVE® Modular Radial
Head system, the CHARLOTTE™ Foot and Ankle System, the LOCON-T® and
LOCON-VLS® Distal Radius Plating Systems, and the MICRONAIL® intramedullary
wrist fracture repair system. We also sell the Swanson line of finger and toe joint replacement
products and the ORTHOSPHERE® Carpometacarpal Implant for repair of the basal thumb
joint.
Our biologics products focus on biological musculoskeletal repair and include synthetic and human
tissue-based materials. Our principal biologics products include the GRAFTJACKET® soft
tissue repair and containment membranes, the ALLOMATRIX® line of injectable tissue-based
bone graft substitutes, the OSTEOSET® synthetic bone graft substitute, and the
MIIG® family of minimally invasive injectable synthetic bone grafts.
Significant Business Developments. Net sales grew 6% in 2006, totaling $338.9 million, compared to
$319.1 million in 2005. Our hip and extremity product lines contributed significantly to our
performance in 2006, achieving 12% and 11% growth rates, respectively. Our net income decreased to
$14.4 million in 2006 from $21.1 million in 2005, primarily as a result of the recognition of $13.8
million ($10.9 million net of taxes) of non-cash stock-based compensation expense in accordance
with the provisions of Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004),
Share-Based Payment (FAS 123R), partially offset by a $1.5 million gain recognized upon the sale of
an investment and a $1.1 million income tax benefit resulting from the resolution of certain
foreign tax matters in 2006.
During 2006, our domestic biologics business returned to year-over-year growth, totaling 2% for the
full year, as the sales growth in our GRAFTJACKET® soft tissue repair and containment
membranes offset the continued declining sales of our DBM (demineralized bone matrix) containing
ALLOMATRIX® family of products. We anticipate that growth within our domestic biologics
business will continue to increase, as sales of our GRAFTJACKET® products continue to
increase, and as we expand our biologics product offerings.
Our international sales increased by 5% during 2006 as compared to 2005. Increased sales are
attributable to growth in Japan and certain geographic regions within our European operations, most
significantly in the Middle East and Africa region and Germany. Also of note is the turnaround in
our Italian operations, where after experiencing declining sales since the fourth quarter of 2004,
we achieved sales growth during the last three quarters of 2006. Further, while we continued to
experience sales declines in our French market this year, we anticipate that we will see sales
growth in this region in the latter half of 2007.
Significant Industry Factors. Our industry is impacted by numerous competitive, regulatory and
other significant factors. The growth of our business relies on our ability to continue to develop
new products and innovative technologies, obtain regulatory clearance and compliance for our
products, protect the proprietary technology of our products and our manufacturing processes,
manufacture our products cost-effectively, respond to competitive pressures specific to each of our
geographic markets, including our ability to enforce non-compete agreements,
and
29
Table of Contents
successfully market and distribute our products in a profitable manner. We, and the entire
industry, are subject to extensive governmental regulation, primarily by the FDA. Failure to comply
with regulatory requirements could have a material adverse effect on our business. Additionally,
our industry is highly competitive and has recently experienced increased pricing pressures,
specifically in the areas of reconstructive joints. We devote significant resources to assessing
and analyzing competitive, regulatory and economic risks and opportunities. A detailed discussion
of these and other factors is provided in “Risk Factors.”
In addition to the factors noted above, in 2005 and 2006, as part of a governmental inquiry into
the orthopaedic industry, several of our competitors received subpoenas from the United States
Department of Justice (the “DOJ”). Based on publicly available information, we believe that these
subpoenas requested information related to antitrust issues in regard to these companies’
relationships with orthopaedic surgeons. As of the date of this report, we have not been contacted
by the DOJ or received a subpoena from the DOJ relating to this investigation.
Net Sales and Expense Components
Net sales. We derive our net sales primarily from the sale of reconstructive joint devices and
biologics products. An overview of our principal product lines is provided in “MD&A — Executive
Overview.”
Cost of sales. Our cost of sales consists primarily of direct labor, allocated manufacturing
overhead, raw materials and components, non-cash stock-based compensation, charges incurred for
excess and obsolete inventories, royalty expenses associated with licensing technologies used in
our products or processes, and certain other period expenses.
Selling, general and administrative. Our selling, general and administrative expenses consist
primarily of salaries, sales commissions, royalty and consulting expenses associated with our
medical advisors, marketing costs, facility costs, legal costs, non-cash stock-based compensation,
other general business and administrative expenses and depreciation expense associated with
reusable surgical instruments that are used to implant our products.
Research and development. Research and development expense includes costs associated with the
design, development, testing, deployment, enhancement and regulatory approval of our products.
Amortization of intangible assets. Our intangible assets consist of purchased intangibles related
to completed technology, distribution channels and trademarks primarily resulting from our 1999
acquisition of Cremascoli, as well as distribution and product licenses, and non-compete
agreements. We amortize intangible assets over periods ranging from one to 15 years.
Interest (income) expense, net. Interest (income) expense, net, consists primarily of interest on
borrowings outstanding under our previous senior credit facility, capital lease agreements, and
certain of our factoring agreements, as well as non-cash expenses associated with the amortization
of deferred financing costs resulting from the origination of our current and previous senior
credit facilities. These expenses are offset by income generated by our invested cash balances and
investments in marketable securities.
Provision for income taxes. We record provisions for income taxes on earnings generated by both our
domestic and international operations. Historically, our effective tax rates have varied from our
statutory tax rates primarily due to research and development credits, changes in estimates related
to our valuation allowances recorded against our net deferred tax assets, and, in 2006, the
recognition of non-cash stock-based compensation expense, a significant portion of which may not be
deductible under U.S. and foreign tax regulations.
Results of Operations
Introduction. Effective January 1, 2006, we adopted the provisions of FAS 123R. We elected the
modified-
prospective method of transition, under which prior periods are not revised for comparative
purposes. As a result, our results of operations during 2006 will not be comparable to our prior
year results. We recorded approximately
30
Table of Contents
$13.8 million ($10.9 million net of taxes) of non-cash
stock-based compensation expense during the year ended December 31, 2006. See Note 12 to our
consolidated financial statements in “Financial Statements and Supplementary Data” for further
information regarding our stock-based compensation assumptions and expenses, including pro forma
disclosures for prior periods as if we had applied the fair value recognition provisions of SFAS
No. 123 to stock-based employee compensation expense. We also discuss the effect of stock-based
compensation on certain individual line items in our consolidated statement of operations in
“Comparison of the year ended December 31, 2006 to the year ended December 31, 2005.”
Comparison of the year ended December 31, 2006 to the year ended December 31, 2005
The following table sets forth, for the periods indicated, our results of operations expressed as
dollar amounts (in thousands) and as percentages of net sales:
| Year Ended December 31, | ||||||||||||||||
| 2006 | 2005 | |||||||||||||||
| % of | % of | |||||||||||||||
| Amount | Sales | Amount | Sales | |||||||||||||
Net sales |
$ | 338,938 | 100.0 | % | $ | 319,137 | 100.0 | % | ||||||||
Cost of sales |
97,234 | 28.7 | % | 91,752 | 28.8 | % | ||||||||||
Gross profit |
241,704 | 71.3 | % | 227,385 | 71.2 | % | ||||||||||
Operating expenses: |
||||||||||||||||
Selling, general and administrative |
192,573 | 56.8 | % | 167,365 | 52.4 | % | ||||||||||
Research and development |
25,551 | 7.5 | % | 22,289 | 7.0 | % | ||||||||||
Amortization of intangible assets |
4,149 | 1.2 | % | 4,250 | 1.3 | % | ||||||||||
Total operating expenses |
222,273 | 65.6 | % | 193,904 | 60.8 | % | ||||||||||
Operating income |
19,431 | 5.7 | % | 33,481 | 10.5 | % | ||||||||||
Interest income, net |
(1,127 | ) | (0.3 | )% | (176 | ) | (0.1 | )% | ||||||||
Other (income) expense, net |
(1,643 | ) | (0.5 | )% | 237 | 0.1 | % | |||||||||
Income before income taxes |
22,201 | 6.6 | % | 33,420 | 10.5 | % | ||||||||||
Provision for income taxes |
7,790 | 2.3 | % | 12,355 | 3.9 | % | ||||||||||
Net income |
$ | 14,411 | 4.3 | % | $ | 21,065 | 6.6 | % | ||||||||
The following table sets forth our net sales by product line for the periods indicated (in
thousands) and the percentage of year-over-year change:
| Year Ended | Year Ended | |||||||||||
| December 31, | December 31, | % | ||||||||||
| 2006 | 2005 | Change | ||||||||||
Hip products |
$ | 122,073 | $ | 109,267 | 11.7 | % | ||||||
Knee products |
94,079 | 94,073 | 0.0 | % | ||||||||
Biologics products |
65,455 | 62,358 | 5.0 | % | ||||||||
Extremity products |
45,044 | 40,594 | 11.0 | % | ||||||||
Other |
12,287 | 12,845 | (4.3 | )% | ||||||||
Total net sales |
$ | 338,938 | $ | 319,137 | 6.2 | % | ||||||
31
Table of Contents
The following graphs illustrate our product line sales as a percentage of total net sales for
the years ended December 31, 2006 and 2005:
|
|
|||
Net sales. Our net sales growth in 2006 was primarily attributable to the continued growth in our
hip product line, which grew 12% over 2005, as well as increases in our extremities and biologics
product lines, which grew 11% and 5%, respectively. Geographically, our domestic net sales totaled
$211.0 million in 2006 and $197.5 million in 2005, representing approximately 62% of total net
sales in both years, and growth of 7%. Our international net sales totaled $127.9 million in 2006,
a 5% increase as compared to net sales of $121.6 million in 2005. This increase in international
sales is attributable to continued growth in Japan and successful market expansion initiatives in
certain regions within our European operations, which were partially offset by continued declines
in France.
Our hip product sales totaled $122.1 million in 2006, representing a 12% increase over 2005.
Domestic hip sales in 2006 grew 14% as compared to prior year, driven primarily by the continued
successes of our CONSERVE® Total Implant with BFH® Technology and our
PROFEMUR® line of primary stems featuring our innovative neck modularity. These
increased sales are attributable to volume increases, as well as favorable shifts within our
CONSERVE® product mix to our higher-priced A-CLASS® Advanced Metal products.
Our international markets further contributed to the success of our hip product line in 2006,
posting 9% growth over 2005. Our international growth was led by Japan, due to increased sales
within our PROFEMUR® line of primary stems and our ANCA-FIT™ Hip System. Also
contributing to the international growth in 2006 were our European operations, particularly in
those areas where we successfully initiated our market expansion programs.
Our extremity product sales increased to $45.0 million in 2006, representing growth of 11% over
2005. This year-over-year growth was primarily driven by performance in our domestic markets, where
we achieved 10% growth, as well as expansion within our European operations. This growth is mainly
attributable to increased unit sales of our CHARLOTTE™ Foot and Ankle system, as well as the
continued success of our MICRONAIL® intramedullary wrist fracture repair system.
Net sales of our biologics products totaled $65.5 million in 2006, which represents a 5% increase
over 2005. This increase was driven primarily by our international business, which grew 15% over
prior year, due to the market expansions within our European operations. In the U.S., biologics
sales grew 2% over prior year, as a result of continued unit sales growth of our higher-priced
GRAFTJACKET® tissue repair and containment membranes, which was mostly offset by the
continued decline of our DBM containing products.
Sales of our knee products totaled $94.1 million in 2006, which was relatively static as compared
to 2005. Year-over-year growth in our ADVANCE® knee systems in both our international
and domestic markets, which totaled
8% and 5%, respectively, was offset by declines across our other, more mature knee product
offerings.
32
Table of Contents
Looking ahead to 2007, we anticipate that our international markets may grow at a higher rate than
our domestic business, as we continue to see the positive results of our market expansion
initiatives in Europe, and as we see a recovery in our France markets. We expect that our U.S.
business will continue to expand in all product lines, as the strength of our current product
portfolio combines with our anticipated product launches in 2007.
Cost of sales. In 2006, our cost of sales as a percentage of net sales decreased from 28.8% in 2005
to 28.7% in 2006. Our 2006 cost of sales included approximately 0.3 percentage points of non-cash
stock-based compensation expense recorded pursuant to FAS 123R. Cost of sales in 2005 included $1.5
million (0.5% of net sales) of charges to write down inventory to its net realizable value due to
the termination of an agreement to distribute certain third party spinal products in Europe. Our
cost of sales and corresponding gross profit percentages can be expected to fluctuate in future
periods depending upon changes in our product sales mix and prices, distribution channels and
geographies, manufacturing yields, period expenses and levels of production volume.
Selling, general and administrative. Our selling, general and administrative expenses as a
percentage of net sales totaled 56.8% in 2006, a 4.4 percentage point increase from 52.4% in 2005.
Our 2006 selling, general and administrative expenses include approximately $10.8 million (3.2% of
net sales) of non-cash stock-based compensation recorded pursuant to FAS 123R, as compared to
approximately $449,000 (0.1% of net sales) of non-cash stock-based compensation recognized in 2005.
Our 2005 selling, general and administrative expenses included severance charges of approximately
$1.6 million (0.5% of net sales) related to the transition of management in our U.S. and European
operations, and charges of approximately $1.5 million (0.5% of net sales) related to a European
distributor transition and the related legal dispute. The remaining increase in selling, general
and administrative expenses in 2006 is attributable to increased investments in sales and marketing
initiatives, higher levels of cash incentive compensation, and increased depreciation expense.
We anticipate that our selling, general and administrative expenses will increase in absolute
dollars to the extent that any additional growth in net sales results in increases in sales
commissions and royalty expense associated with those sales and requires us to expand our
infrastructure. However, we expect our selling, general and administrative expenses as a percentage
of net sales will decrease in future periods as we manage the growth of our existing infrastructure
while continuing to expand our business.
Research and development. Our investment in research and development activities represented
approximately 7.5% of net sales in 2006, as compared to 7.0% in 2005. The increase was driven by
$2.2 million (0.7% of net sales) of non-cash stock-based compensation recorded in 2006 pursuant to
FAS 123R. Our remaining investment in research and development in 2006 was relatively static as a
percentage of net sales as compared to 2005, as our investment increased in absolute dollars for
higher levels of spending in clinical and regulatory and pre-clinical studies, while our business
expanded at the same rate.
We anticipate that our research and development expenditures may increase as a percentage of net
sales and will increase in absolute dollars as we increase our product development initiatives and
clinical studies to support regulatory approvals and provide expanded proof of the efficacy of our
products.
Amortization of intangible assets. Non-cash charges associated with amortization of intangible
assets totaled $4.1 million in 2006, as compared to $4.3 million in 2005. Based on the intangible
assets held at December 31, 2006, we expect to amortize approximately $3.2 million in 2007, $2.9
million in 2008, $2.6 million in 2009, $350,000 in 2010 and $130,000 in 2011.
Interest income, net. Interest income, net, totaled approximately $1.1 million and $176,000 during
2006 and 2005, respectively. Interest income, net, consisted of interest expense of $1.6 million
and $1.9 million during 2006 and 2005, respectively, primarily from borrowings under our capital
lease agreements, certain of our factoring agreements, our previous senior credit facility, and, in
2006, approximately $600,000 of interest related to an unfavorable judgment rendered on a 13-year old legal dispute, offset by interest income of
$2.7 million and $2.0 million during 2006 and 2005, respectively,
33
Table of Contents
generated by our invested cash balances and investments in marketable securities. The increase in
interest income was driven by a full year of investments in marketable securities in 2006.
Other (income) expense, net. Other (income) expense, net, totaled $1.6 million of income during
2006, including a gain of approximately $1.5 million upon the sale of an investment, as compared to
$237,000 of expense during 2005.
Provision for income taxes. We recorded tax provisions of $7.8 million and $12.4 million in 2006
and 2005, respectively. Our effective tax rate for 2006 and 2005 was approximately 35.1% and 37.0%,
respectively. Our 2006 effective tax rate includes a $1.1 million benefit that was realized upon
the resolution of certain foreign tax matters. Our 2006 effective tax rate also includes the
unfavorable impact of non-cash stock-based compensation expenses recorded under the provisions of
FAS 123R, a significant portion of which may not be deductible under U.S. and foreign tax
regulations and therefore, pursuant to FAS 123R, do not benefit our current period tax provision.
The remaining decrease was primarily driven by increased interest income generated from our
tax-free investments.
We expect our effective tax rate to range from approximately 43% to 45% during 2007. This estimated
effective tax rate is higher than our 2006 effective tax rate as a result of the 2006 favorable
resolution of certain foreign tax matters.
Comparison of the year ended December 31, 2005 to the year ended December 31, 2004
The following table sets forth, for the periods indicated, our results of operations expressed as
dollar amounts (in thousands) and as percentages of net sales:
| Year Ended December 31, | ||||||||||||||||
| 2005 | 2004 | |||||||||||||||
| % of | % of | |||||||||||||||
| Amount | Sales | Amount | Sales | |||||||||||||
Net sales |
$ | 319,137 | 100.0 | % | $ | 297,539 | 100.0 | % | ||||||||
Cost of sales |
91,752 | 28.8 | % | 84,251 | 28.3 | % | ||||||||||
Gross profit |
227,385 | 71.2 | % | 213,288 | 71.7 | % | ||||||||||
Operating expenses: |
||||||||||||||||
Selling, general and administrative |
167,365 | 52.4 | % | 152,508 | 51.3 | % | ||||||||||
Research and development |
22,289 | 7.0 | % | 18,478 | 6.2 | % | ||||||||||
Amortization of intangible assets |
4,250 | 1.3 | % | 3,889 | 1.3 | % | ||||||||||
Total operating expenses |
193,904 | 60.8 | % | 174,875 | 58.8 | % | ||||||||||
Operating income |
33,481 | 10.5 | % | 38,413 | 12.9 | % | ||||||||||
Interest (income) expense, net |
(176 | ) | (0.1 | )% | 1,064 | 0.4 | % | |||||||||
Other expense (income), net |
237 | 0.1 | % | (74 | ) | 0.0 | % | |||||||||
Income before income taxes |
33,420 | 10.5 | % | 37,423 | 12.6 | % | ||||||||||
Provision for income taxes |
12,355 | 3.9 | % | 13,401 | 4.5 | % | ||||||||||
Net income |
$ | 21,065 | 6.6 | % | $ | 24,022 | 8.1 | % | ||||||||
34
Table of Contents
The following table sets forth our net sales by product line for the periods indicated (in
thousands) and the percentage of year-over-year change:
| Year Ended | Year Ended | |||||||||||
| December 31, | December 31, | % | ||||||||||
| 2005 | 2004 | Change | ||||||||||
Hip products |
$ | 109,267 | $ | 99,133 | 10.2 | % | ||||||
Knee products |
94,073 | 87,408 | 7.6 | % | ||||||||
Biologics products |
62,358 | 62,070 | 0.5 | % | ||||||||
Extremity products |
40,594 | 36,433 | 11.4 | % | ||||||||
Other |
12,845 | 12,495 | 2.8 | % | ||||||||
Total net sales |
$ | 319,137 | $ | 297,539 | 7.3 | % | ||||||
The following graphs illustrate our product line sales as a percentage of total net sales for
the years ended December 31, 2005 and 2004:
|
|
|||
Net sales. Our net sales growth in 2005 was primarily attributable to the success of our domestic
reconstructive joint business, as our domestic hip, extremity and knee product lines grew by 18%,
12%, and 11%, respectively. Geographically, domestic net sales totaled $197.5 million in 2005 and
$180.4 million in 2004, representing approximately 62% and 61% of total net sales, respectively,
and growth of 10%. International net sales totaled $121.6 million in 2005, a 4% increase as
compared to net sales of $117.2 million in 2004. This increase in international sales was
attributable to growth in our Asian markets, which was partially offset by declines in our Italian
and French markets due to the transition of management and distribution personnel in Southern
Europe.
From a product line perspective, our net sales growth for 2005 was attributable to increases in
sales across three of our four principal product lines. For 2005, we experienced growth of 11%, 10%
and 8% in our extremity, hip and knee product lines, respectively. Our biologics product line sales
were flat in 2005 as compared to 2004. During 2005, our hip sales growth was attributable primarily
to success in domestic markets, specifically driven by our CONSERVE® Total Implant with
BFH® Technology and our PROFEMUR® line of primary stems featuring our
innovative neck modularity. The growth of our extremity business in 2005 was primarily attributable
to increased unit sales of our EVOLVE® Modular Radial Head System and the successful
mid-February 2005 launch of our CHARLOTTE™ Foot and Ankle system.
Cost of sales. In 2005, our cost of sales as a percentage of net sales increased to 28.8% as
compared to 28.3% in 2004. Cost of sales in 2005 included charges of approximately $1.5 million
(0.5% of net sales) to write down inventory to its net realizable value due to the termination of
an agreement to distribute certain third party spinal
35
Table of Contents
products in Europe. Cost of sales in 2004 included charges of approximately $2.4 million (0.8% of
net sales) to write down certain foot and ankle inventory to its net realizable value as a result
of the transition to our CHARLOTTE™ foot and ankle system. The remaining increase in cost of sales
as a percentage of net sales is attributable to increased levels of fixed manufacturing costs and
distribution costs, as well as shifts in our product line sales.
Operating expenses. Our total operating expenses increased, as a percentage of net sales, by 2
percentage points to 60.8% in 2005. Operating expenses include selling, general and administrative
expenses, research and development expenses, and amortization of intangibles. The increase in
operating expenses was attributed to higher selling, general and administrative expenses, which
increased as a percentage of net sales by 1.1 percentage points, driven by approximately $1.6
million (0.5% of net sales) of severance charges and $1.5 million (0.5% of net sales) of charges
related to the European distributor transition, partially offset by lower levels of stock-based
compensation related to options issued prior to our IPO in 2001. Also contributing to the increase
in operating expenses was higher levels of R&D spending for product development and clinical and
regulatory costs.
Interest (income) expense, net. Interest (income) expense, net, totaled $1.1 million of expense in
2004, as compared to $176,000 of income in 2005. This variance was driven by lower levels of
interest expense related to our senior credit facility, as we paid down a significant portion of
debt during 2005, as well as higher levels of interest income generated from our investment in
marketable securities during 2005.
Provision for income taxes. Our effective tax rate for 2005 and 2004 was 37.0% and 35.8%,
respectively, which reflects the impact of research and development credits, changes in estimates
related to the valuation allowances recorded against our deferred tax assets and, in 2005, the
impact of the domestic manufacturers’ deduction included within the American Jobs Creation Act of
2004.
Seasonal Nature of Business
We traditionally experience lower sales volumes in the third quarter than throughout the rest of
the year as a result of the European holiday schedule, typically resulting in selling, general and
administrative expenses and research and development expenses as a percentage of sales that are
higher than throughout the rest of the year. In addition, our first quarter selling, general and
administrative expenses include additional expenses that we incur in connection with the annual
meeting held by the American Academy of Orthopaedic Surgeons. This meeting, which is the largest
orthopaedic meeting in the world, features the presentation of scientific papers and instructional
courses for orthopaedic surgeons. During this 3-day event, we display our most recent and
innovative products to these surgeons.
Liquidity and Capital Resources
The following table sets forth, for the periods indicated, certain liquidity measures (in
thousands):
| As of December 31, | ||||||||
| 2006 | 2005 | |||||||
Cash and cash equivalents |
$ | 57,939 | $ | 51,277 | ||||
Short-term marketable securities |
30,325 | 25,000 | ||||||
Working capital |
220,306 | 196,126 | ||||||
Line of credit availability |
100,000 | 59,878 | ||||||
At December 31, 2006, we have invested $30.3 million of our excess cash balance in short-term
marketable debt securities in order to increase our rate of return. Specifically, our investments
in marketable securities at December 31, 2006, are available for redemption through an auction
process every 21 or 49 days from initial purchase, and are considered trading securities. While
these investments are not considered cash equivalents for financial reporting
36
Table of Contents
purposes, due to the
short-term nature of these investments, we do not believe that these investments will have an
impact on our overall liquidity position.
Operating Activities. Cash provided by operating activities totaled $30.0 million in 2006, as
compared to $5.3 million in 2005 and $37.4 million in 2004. The increase in cash provided by
operating activities in 2006 is primarily attributable to $25 million of cash used as a result of
net changes in our marketable securities balances during 2005, as compared to $5.3 million used in
2006. Lower levels of cash tax payments for U.S. federal income taxes further contributed to the
increase in operating cash flow for 2006 compared to 2005. The decrease in 2005, as compared to
2004, was attributable to the $25 million investment in marketable securities, as well as higher
levels of cash tax payments for estimated U.S. federal income taxes.
Investing Activities. Our capital expenditures totaled approximately $29.6 million in 2006, $30.4
million in 2005, and $18.3 million in 2004. The increase in 2006 and 2005 from 2004 is primarily
related to investments in minimally invasive surgical instrumentation for our hip and knee
businesses. Our industry is capital intensive, particularly as it relates to surgical
instrumentation. Historically, our capital expenditures have consisted of purchased manufacturing
equipment, research and testing equipment, computer systems, office furniture and equipment, and
surgical instruments. We expect to incur capital expenditures of approximately $35 million in total
for 2007 for routine capital expenditures, as well as approximately $8 million for the planned
expansion of facilities in Arlington, TN.
We invested approximately $705,000 in intellectual property during 2006. We are continuously
evaluating opportunities to purchase technology and other forms of intellectual property and are,
therefore, unable to predict the timing of future purchases.
Financing Activities. During 2006, we made approximately $2.0 million in principal payments related
to our long-term capital lease obligations. In addition, our operating subsidiary in Italy
continues to factor portions of its accounts receivable balances under factoring agreements, which
are considered financing transactions for financial reporting. The cash proceeds received from
these factoring agreements, net of the amount of factored receivables collected, are reflected as
cash flows from financing activities in our consolidated statements of cash flows. The proceeds
received under these agreements in 2006, 2005 and 2004 totaled approximately $5.6 million, $8.0
million, and $10.7 million, respectively. These proceeds were offset by payments for factored
receivables collected of approximately $5.7 million, $9.2 million and $10.8 million in 2006, 2005
and 2004, respectively. We recorded obligations of $3.9 million and $3.5 million for the amount of
receivables factored under these agreements as of December 31, 2006 and 2005, respectively, which
are included within “Accrued expenses and other current liabilities” in our consolidated balance
sheet.
On June 30, 2006, we paid $3.8 million to retire all remaining indebtedness under our then existing
credit facility, cancelled the credit facility, and terminated the related credit agreement. At the
same time, we entered into a credit agreement with a group of banks led by Bank of America, N.A.
The new credit agreement provides for a $100 million revolving credit facility, which can be
increased by up to an additional $50 million at our request and subject to the agreement of the
lenders. We currently have no borrowings outstanding under the new credit facility. Borrowings
under the new credit facility will bear interest at the sum of a base annual rate plus an
applicable annual rate that ranges from 1.125% to 4.55% depending on the type of loan and our
consolidated leverage ratio, with a current annual rate of 8.25%.
Those financing payments were offset by proceeds of $5.9 million from the issuances of common stock
under our stock-based compensation plans.
In 2007, we will make continued payments under our long-term capital leases, including interest, of
approximately $1.1 million in 2007. We anticipate that our factoring program in Italy will
continue; however, the level and extent of the amounts factored under the agreement and the
ultimate amount of proceeds received under the program cannot be predicted.
37
Table of Contents
Contractual Cash Obligations. At December 31, 2006, we had contractual cash obligations and
commercial commitments as follows (in thousands):
| Payments Due by Periods | ||||||||||||||||||||
| 2010 – | ||||||||||||||||||||
| Total | 2007 | 2008-2009 | 2011 | After 2011 | ||||||||||||||||
Amounts reflected in balance sheet: |
||||||||||||||||||||
Capital lease obligations (1) |
1,853 | 1,085 | 656 | 112 | — | |||||||||||||||
Amounts not reflected in balance sheet: |
||||||||||||||||||||
Operating leases |
17,923 | 7,738 | 7,022 | 1,824 | 1,339 | |||||||||||||||
Purchase obligations |
2,535 | 2,535 | — | — | — | |||||||||||||||
Royalty and consulting agreements |
5,638 | 970 | 1,400 | 1,200 | 2,068 | |||||||||||||||
Total contractual cash obligations |
$ | 27,949 | $ | 12,328 | $ | 9,078 | $ | 3,136 | $ | 3,407 | ||||||||||
| (1) | Payments include amounts representing interest |
The amounts reflected in the table above for capital lease obligations represent future
minimum lease payments under our capital lease agreements, which are primarily for certain property
and equipment. The present value of the minimum lease payments are recorded in our balance sheet at
December 31, 2006. The minimum lease payments related to these leases are discussed further in Note
7 to our consolidated financial statements contained in “Financial Statements and Supplementary
Data.”
The amounts reflected in the table above for operating leases represent future minimum lease
payments under non-cancelable operating leases primarily for certain equipment and office space.
Portions of these payments are denominated in foreign currencies and were translated in the table
above based on their respective U.S. dollar exchange rates at December 31, 2006. These future
payments are subject to foreign currency exchange rate risk. In accordance with accounting
principles generally accepted in the U.S., our operating leases are not recognized in our
consolidated balance sheet; however, the minimum lease payments related to these agreements are
disclosed in Note 14 to our consolidated financial statements contained in “Financial Statements
and Supplementary Data.”
Our purchase obligations reflected in the table above consist of minimum purchase obligations
related to certain supply agreements. The royalty and consulting agreements in the above table
represent minimum payments to consultants that are contingent upon future services. Portions of
these payments are denominated in foreign currencies and were translated in the table above based
on their respective U.S. dollar exchange rates at December 31, 2006. These future payments are
subject to foreign currency exchange rate risk. Our purchase obligations and royalty and consulting
agreements are disclosed in Note 14 to our consolidated financial statements contained in
“Financial Statements and Supplementary Data.”
In addition to the contractual cash obligations discussed above, all of our domestic sales and a
portion of our international sales are subject to commissions based on net sales, and a substantial
portion of our global sales are subject to other royalties earned based on product sales. Further,
under our factoring agreement in Italy, our liability for cash proceeds received of $3.9 million
discussed in “Financing Activities” may be subject to repayment upon 15 days notice. None of these
amounts are included in the table above.
Other Liquidity Information. We have funded our cash needs since 2000 through various equity and
debt issuances and through cash flow from operations. In 2001, we completed our IPO of 7,500,000
shares of common stock which generated $84.8 million in net proceeds. In 2002, we completed a
secondary offering of 3,450,000 shares of common stock which generated $49.5 million in net
proceeds.
Although it is difficult for us to predict our future liquidity requirements, we believe that our
current cash balance of approximately $57.9 million, our marketable securities balance of $30.3
million, our existing available credit line of
38
Table of Contents
$100 million and our expected cash flow from our
2007 operations will be sufficient for the foreseeable
future to fund our working capital requirements and operations, permit anticipated capital
expenditures in 2007 of approximately $43 million and meet our contractual cash obligations in
2007.
Critical Accounting Estimates
All of our significant accounting policies and estimates are described in Note 2 to our
consolidated financial statements contained in “Financial Statements and Supplementary Data.”
However, certain of our more critical accounting estimates require the application of significant
judgment by management in selecting the appropriate assumptions in determining the estimate. By
their nature, these judgments are subject to an inherent degree of uncertainty. We develop these
judgments based on our historical experience, terms of existing contracts, our observance of trends
in the industry, information provided by our customers, and information available from other
outside sources, as appropriate. Different, reasonable estimates could have been used in the
current period. Additionally, changes in accounting estimates are reasonably likely to occur from
period to period. Both of these factors could have a material impact on the presentation of our
financial condition, changes in financial condition or results of operations.
We believe that the following financial estimates are both important to the portrayal of our
financial condition and results of operations and require subjective or complex judgments. Further,
we believe that the items discussed below are properly recorded in the financial statements for all
periods presented. Our management has discussed the development, selection, and disclosure of our
most critical financial estimates with the audit committee of our Board of Directors and with our
independent auditors. The judgments about those financial estimates are based on information
available as of the date of the financial statements. Those financial estimates include:
Revenue recognition. Our revenues are primarily generated through two types of customers, hospitals
and stocking distributors, with the majority of our revenue derived from sales to hospitals. Our
products are primarily sold through a network of independent sales representatives in the U.S. and
by a combination of employee sales representatives, independent sales representatives, and stocking
distributors outside the U.S. We record revenues from sales to hospitals when the hospital takes
title to the product, which is generally when the product is surgically implanted in a patient.
We record revenues from sales to our stocking distributors at the time the product is shipped to
the distributor. Our stocking distributors, who sell the products to their customers, take title to
the products and assume all risks of ownership. Our distributors are obligated to pay us within
specified terms regardless of when, if ever, they sell the products. In general, our distributors
do not have any rights of return or exchange; however, in limited situations we have repurchase
agreements with certain stocking distributors. Those certain agreements require us to repurchase a
specified percentage of the inventory purchased by the distributor within a specified period of
time prior to the expiration of the contract. During those specified periods, we defer the
applicable percentage of the sales. Approximately $175,000 and $170,000 of sales related to these
types of agreements were deferred and not yet recognized as revenue as of December 31, 2006 and
2005, respectively.
We must make estimates of potential future product returns related to current period product
revenue. To do so, we analyze our historical experience related to product returns when evaluating
the adequacy of the allowance for sales returns. Judgment must be used and estimates made in
connection with establishing the allowance for product returns in any accounting period. Our
allowances for product returns of approximately $350,000 and $430,000 are included as a reduction
of accounts receivable at December 31, 2006 and 2005, respectively. Should actual future returns
vary significantly from our historical averages, our operating results could be affected.
Allowances for doubtful accounts. We experience some credit loss on our accounts receivable and
accordingly we must make estimates related to the ultimate collection of our accounts receivable.
Specifically, we analyze our accounts receivable, historical bad debt experience, customer
concentrations, customer creditworthiness, and current economic trends when evaluating the adequacy
of our allowance for doubtful accounts.
39
Table of Contents
The majority of the Company’s receivables are from hospitals, many of which are government funded.
Accordingly, the Company’s collection history with this class of customer has been favorable.
Historically, the Company has experienced minimal bad debts from its hospital customers and more
significant bad debts from certain international distributors, typically as a result of specific
financial difficulty or geo-political factors. The Company writes off receivables when it
determines that the receivables are uncollectible, typically upon customer bankruptcy or the
customer’s non-response to continuous collection efforts.
We believe that the amount included in our allowance for doubtful accounts has been a historically
accurate estimate of the amount of accounts receivable that are ultimately collected. While we
believe that our allowance for doubtful accounts is adequate, the financial condition of our
customers and the geo-political factors that impact reimbursement under individual countries’
healthcare systems can change rapidly and as such, additional allowances may be required in future
periods. Our accounts receivable balance for 2006 and 2005 was $72.5 million and $61.7 million, net
of allowances for doubtful accounts of $2.9 million and $2.0 million, at December 31, 2006 and
2005, respectively.
Excess and obsolete inventories. We value our inventory at the lower of the actual cost to purchase
and/or manufacture the inventory or its net realizable value. We regularly review inventory
quantities on hand for excess and obsolete inventory and, when circumstances indicate, we incur
charges to write down inventories to their net realizable value. Our review of inventory for excess
and obsolete quantities is based primarily on our forecast of product demand and production
requirements for the next twenty-four months. A significant decrease in demand could result in an
increase in the amount of excess inventory quantities on hand. Additionally, our industry is
characterized by regular new product development that could result in an increase in the amount of
obsolete inventory quantities on hand due to cannibalization of existing products. Also, our
estimates of future product demand may prove to be inaccurate, in which case we may be required to
incur charges for excess and obsolete inventory. In the future, if additional inventory write-downs
are required, we would recognize additional cost of goods sold at the time of such determination.
Regardless of changes in our estimates of future product demand, we do not increase the value of
our inventory above its adjusted cost basis. Therefore, although we make every effort to ensure the
accuracy of our forecasts of future product demand, significant unanticipated decreases in demand
or technological developments could have a significant impact on the value of our inventory and our
reported operating results.
Charges incurred for excess and obsolete inventory were $6.5 million, $6.9 million and $5.8 million
for the years ended December 31, 2006, 2005 and 2004, respectively. In 2005, we incurred
approximately $1.5 million in charges within cost of sales to write down inventory to its net
realizable value due to the termination of an agreement to distribute certain third party spinal
products in Europe. In 2004, charges incurred for excess and obsolete inventory included $2.4
million recorded to write down certain foot and ankle implant inventory to its net realizable value
as a result of our transition to our CHARLOTTE™ Foot and Ankle System.
Goodwill and long-lived assets. We have approximately $8.5 million of goodwill recorded as a result
of the acquisition of businesses. Goodwill is tested for impairment annually, or more frequently if
changes in circumstances or the occurrence of events suggest that impairment exists. Based on our
single business approach to decision-making, planning, and resource allocation, we have determined
that we have only one reporting unit for purposes of evaluating goodwill for impairment. The annual
evaluation of goodwill impairment may require the use of estimates and assumptions to determine the
fair value of our reporting unit using projections of future cash flows. We performed our annual
impairment test during the fourth quarter of 2006 and determined that the fair value of our
reporting unit exceeded its carrying value and, therefore, no impairment charge was necessary.
Our business is capital intensive, particularly as it relates to surgical instrumentation. We
depreciate our property, plant and equipment and amortize our intangible assets based upon our
estimate of the respective asset’s useful life. Our estimate of the useful life of an asset
requires us to make judgments about future events, such as product life cycles, new product
development, product cannibalization and technological obsolescence, as well as other
40
Table of Contents
competitive factors beyond our control. We account for the impairment of long-lived assets in accordance SFAS
No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Accordingly, we evaluate
impairments of our property, plant and equipment based upon an analysis of estimated undiscounted
future cash flows. If we determine that a change is required in the useful life of an asset, future
depreciation/amortization is adjusted accordingly. Alternatively, should we determine that an asset
has been impaired, an adjustment would be charged to income based on its fair market value, or
discounted cash flows if the fair market value is not readily determinable, reducing income in that
period.
Product liability claims and other litigation. Periodically, claims arise involving the use of our
products. We make provisions for claims specifically identified for which we believe the likelihood
of an unfavorable outcome is probable and an estimate of the amount of loss has been developed. We
have recorded at least the minimum estimated liability related to those claims where a range of
loss has been established. As additional information becomes available, we reassess the estimated
liability related to our pending claims and make revisions as necessary. Future revisions in our
estimates of the liability could materially impact our results of operation and financial position.
We maintain insurance coverage that limits the severity of any single claim as well as total
amounts incurred per policy year, and we believe our insurance coverage is adequate. We use the
best information available to us in determining the level of accrued product liabilities and we
believe our accruals are adequate. Our accrual for product liability claims was approximately
$330,000 and $850,000 at December 31, 2006 and 2005, respectively. During 2006, we paid
approximately $375,000 for claims which had been accrued as of December 31, 2005, and we reduced
our accrual for specific claims for which we have met our insurance deductible.
We are also involved in legal proceedings as a plaintiff involving contract, patent protection and
other matters. We make provisions for claims specifically identified for which we believe the
likelihood of an unfavorable outcome is probable and an estimate of the amount of loss has been
developed.
Accounting for income taxes. Our effective tax rate is based on income by tax jurisdiction,
statutory rates and tax saving initiatives available to us in the various jurisdictions in which we
operate. Significant judgment is required in determining our effective tax rate and evaluating our
tax positions. This process includes assessing temporary differences resulting from differing
recognition of items for income tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within our consolidated balance sheet. Realization
of deferred tax assets in each taxable jurisdiction is dependent on our ability to generate future
taxable income sufficient to realize the benefits. Management evaluates deferred tax assets on an
ongoing basis and provides valuation allowances to reduce net deferred tax assets to the amount
that is more likely than not to be realized.
We have recorded valuation allowances of $5.7 million and $6.0 million as of December 31, 2006 and
2005, respectively, due to uncertainties related to our ability to realize, before expiration, some
of our deferred tax assets for both U.S. and foreign income tax purposes. These deferred tax assets
primarily consist of the carry forward of certain net operating losses and general business tax
credits.
We operate within numerous taxing jurisdictions. We are subject to regulatory review or audit in
virtually all of those jurisdictions and those reviews and audits may require extended periods of
time to resolve. Management makes use of all available information and makes reasoned judgments
regarding matters requiring interpretation in establishing tax expense, liabilities and reserves.
We believe adequate provisions exist for income taxes for all periods and jurisdictions subject to
review or audit.
Stock-Based Compensation. We currently use the Black-Scholes option pricing model to determine the
fair value of stock options and employee stock purchase plan shares. The determination of the fair
value of stock-based payment awards on the date of grant using an option-pricing model is affected
by our stock price as well as assumptions regarding a number of complex and subjective variables,
which include the expected life of the award, the expected stock price volatility over the expected
life of the awards, expected dividend yield, and risk-free interest rate.
41
Table of Contents
We estimate the expected life of options by calculating the average of the vesting period and the
contractual term
of the option, as allowed by SEC Staff Accounting Bulletin No. 107 (SAB 107). We estimated expected
stock price volatility based upon historical volatility of our common stock. The risk-free interest
rate was determined using U.S. Treasury rates where the term is consistent with the expected life
of the stock options. Expected dividend yield is not considered as we have never paid dividends and
have no plans of doing so in the future.
We are required to estimate forfeitures at the time of grant and revise those estimates in
subsequent periods if actual forfeitures differ from those estimates. We use historical data to
estimate pre-vesting option forfeitures and record stock-based compensation expense only for those
awards that are expected to vest. All stock options are amortized on a straight-line basis over
their respective requisite service periods, which are generally the vesting periods.
If factors change and we employ different assumptions for estimating stock-based compensation
expense in future periods, the future periods may differ significantly from what we have recorded
in the current period and could materially affect our operating income, net income and net income
per share. It may also result in a lack of comparability with other companies that use different
models, methods and assumptions.
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded
options that have no vesting restrictions and are fully transferable, characteristics not present
in our option grants and employee stock purchase plan shares. Existing valuation models, including
the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values
of our stock-based compensation. Consequently, there is a risk that our estimates of the fair
values of our stock-based compensation awards on the grant dates may bear little resemblance to the
actual values realized upon the exercise, expiration, early termination or forfeiture of those
stock-based payments in the future. Certain stock-based payments, such as employee stock options,
may expire worthless or otherwise result in zero intrinsic value as compared to the fair values
originally estimated on the grant date and reported in our financial statements. Alternatively,
value may be realized from these instruments that is significantly higher than the fair values
originally estimated on the grant date and reported in our financial statements. There is not
currently a market-based mechanism or other practical application to verify the reliability and
accuracy of the estimates stemming from these valuation models.
See Note 12 to our consolidated financial statements contained in “Financial Statements and
Supplementary Data” for further information regarding our FAS 123R disclosures.
Impact of Recently Issued Accounting Pronouncements
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48,
Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109, (FIN 48).
FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial
statements in accordance with FASB Statement No. 109, Accounting for Income Taxes, by defining the
criterion that an individual tax position must meet in order to be recognized in the financial
statements. FIN 48 requires that the tax effects of a position be recognized only if it is
“more-likely-than-not” to be sustained based solely on the technical merits as of the reporting
date. FIN 48 further requires that interest that the tax law requires to be paid on the
underpayment of taxes should be accrued on the difference between the amount claimed or expected to
be claimed on the return and the tax benefit recognized in the financial statements, which may be
recorded as either income taxes or interest expense. Management has made the policy election to
record this interest as interest expense. FIN 48 also requires additional disclosures of
unrecognized tax benefits, including a reconciliation of the beginning and ending balance. We will
comply with the provisions of FIN 48 effective January 1, 2007. We are currently assessing the
impact that the adoption of FIN 48 will have on our results of operations and financial position.
As a result of the adoption of FIN 48, the balance of certain of our liabilities for uncertain tax
positions may change, which would be recorded as an adjustment to opening retained earnings as a
cumulative effect of a change in accounting principle.
42
Table of Contents
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Foreign Currency Exchange Rate Fluctuations
Fluctuations in the rate of exchange between the U.S. dollar and foreign currencies could adversely
affect our financial results. Approximately 30% of our total net sales were denominated in foreign
currencies during both of the years ended December 31, 2006 and 2005, and we expect that foreign
currencies will continue to represent a similarly significant percentage of our net sales in the
future. Costs related to these sales are largely denominated in the same respective currencies,
thereby limiting our transaction risk exposure. However, for sales not denominated in U.S. dollars,
if there is an increase in the rate at which a foreign currency is exchanged for U.S. dollars, it
will require more of the foreign currency to equal a specified amount of U.S. dollars than before
the rate increase. In such cases, if we price our products in the foreign currency, we will receive
less in U.S. dollars than we did before the rate increase went into effect. If we price our
products in U.S. dollars and competitors price their products in local currency, an increase in the
relative strength of the U.S. dollar could result in our prices not being competitive in a market
where business is transacted in the local currency.
A substantial majority of our sales denominated in foreign currencies are derived from EU countries
and are denominated in the euro. Additionally, we have significant intercompany receivables from
our foreign subsidiaries which are denominated in foreign currencies, principally the euro and the
Japanese yen. Our principal exchange rate risk, therefore, exists between the U.S. dollar and the
euro and the U.S. dollar and the yen. Fluctuations from the beginning to the end of any given
reporting period result in the revaluation of our foreign currency-denominated intercompany
receivables and payables, generating currency translation gains or losses that impact our
non-operating income and expense levels in the respective period.
As discussed in Note 2 to our consolidated financial statements in “Financial Statements and
Supplementary Data,” we enter into certain short-term derivative financial instruments in the form
of foreign currency forward contracts. These forward contracts are designed to mitigate our
exposure to currency fluctuations in our intercompany balances denominated in euros, Japanese yen,
British pounds and Canadian dollars. Any change in the fair value of these forward contracts as a
result of a fluctuation in a currency exchange rate is expected to be offset by a change in the
value of the intercompany balance. These contracts are effectively closed at the end of each
reporting period.
43
Table of Contents
Item 8. Financial Statements and Supplementary Data.
Wright Medical Group, Inc.
Consolidated Financial Statements
for the Years Ended December 31, 2006, 2005, and 2004
Index to Financial Statements
Consolidated Financial Statements
for the Years Ended December 31, 2006, 2005, and 2004
Index to Financial Statements
| Page | ||||
| 45 | ||||
| 48 | ||||
| 49 | ||||
| 50 | ||||
| 51 | ||||
| 52 | ||||
44
Table of Contents
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Wright Medical Group, Inc.:
Wright Medical Group, Inc.:
We have audited the accompanying consolidated balance sheets of Wright Medical Group, Inc. and
subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of
operations, changes in stockholders’ equity and comprehensive income, and cash flows for each of
the years in the three-year period ended December 31, 2006. 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 the standards of the Public Company Accounting
Oversight Board (United States). 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 Wright Medical Group, Inc. and subsidiaries as of
December 31, 2006 and 2005, and the results of their operations and their cash flows for each of
the years in the three-year period ended December 31, 2006, in conformity with U.S. generally
accepted accounting principles.
As discussed in the Notes 2 and 12 to the consolidated financial statements, effective January 1,
2006, the Company adopted the fair value method of accounting for stock-based compensation as
required by Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based
Payment. Also as discussed in Note 2 to the consolidated financial statements, the Company changed
its method of quantifying errors in 2006.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the effectiveness of internal control over financial reporting of Wright
Medical Group, Inc. and subsidiaries as of December 31, 2006, based on criteria established in
Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), and our report dated February 27, 2007 expressed an unqualified opinion
on management’s assessment of, and an adverse opinion on the effective operation of, internal
control over financial reporting.
/s/ KPMG LLP
Memphis, Tennessee
February 27, 2007
February 27, 2007
45
Table of Contents
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Wright Medical Group, Inc.:
Wright Medical Group, Inc.:
We have audited management’s assessment, included in Management’s Annual Report on
Internal Control Over Financial Reporting under item 9A(b), that Wright Medical Group, Inc. and subsidiaries did not
maintain effective internal control over financial reporting as of December 31, 2006, because of
the effect of the material weakness identified in management’s assessment, based on criteria
established in Internal Control — Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). The Company’s management is responsible for
maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express an
opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal
control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management’s assessment, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles. A
company’s internal control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company; (2) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the company
are being made only in accordance with authorizations of management and directors of the company;
and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company’s assets that could have a material effect on the
financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or
detect misstatements. Also, projections of any evaluation of effectiveness to future periods are
subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control deficiencies, that
results in more than a remote likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. The following material weakness has been
identified and included in management’s assessment:
As of December 31, 2006, the Company had
ineffective policies and procedures relating to the calculation of depreciation expense for its
surgical instruments. Specifically, the Company did not have policies and procedures in place to
ensure that depreciation expense was calculated based on the appropriate cost basis of these
assets, resulting in an error in depreciation expense and accumulated
depreciation. This deficiency
resulted in a more than remote likelihood that a material misstatement of the Company’s annual or
interim financial statements would not be prevented or detected.
We also have audited, in
accordance with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheets of Wright Medical Group, Inc. and subsidiaries as of December 31, 2006
and 2005, and the related consolidated statements of operations, changes in stockholders’ equity
and comprehensive income, and cash flows for each of the years in the three-year period ended
December 31, 2006. This material
46
Table of Contents
weakness was considered in determining the nature, timing and extent of
audit tests applied in our audit of the 2006 consolidated financial statements, and this report
does not affect our report dated February 27, 2007, which expressed an unqualified opinion on those
consolidated financial statements.
In our opinion, management’s assessment that Wright Medical Group, Inc. and subsidiaries did not
maintain effective internal control over financial reporting as of December 31, 2006, is fairly
stated, in all material respects, based on criteria established in Internal Control — Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Also, in our opinion, because of the effect of the material weakness described above on the
achievement of the objectives of the control criteria, Wright Medical Group, Inc. and subsidiaries
has not maintained effective internal control over financial reporting as of December 31, 2006,
based on criteria established in Internal Control — Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO).
/s/ KPMG LLP
Memphis, Tennessee
February 27, 2007
February 27, 2007
47
Table of Contents
Wright Medical Group, Inc.
Consolidated Balance Sheets
(In thousands, except share data)
(In thousands, except share data)
| December 31, | ||||||||
| 2006 | 2005 | |||||||
Assets: |
||||||||
Current assets: |
||||||||
Cash and cash equivalents |
$ | 57,939 | $ | 51,277 | ||||
Marketable securities |
30,325 | 25,000 | ||||||
Accounts receivable, net |
72,476 | 61,729 | ||||||
Inventories |
86,157 | 82,381 | ||||||
Prepaid expenses |
6,646 | 11,025 | ||||||
Deferred income taxes |
21,871 | 24,218 | ||||||
Other current assets |
4,308 | 4,751 | ||||||
Total current assets |
279,722 | 260,381 | ||||||
Property, plant and equipment, net |
86,265 | 81,206 | ||||||
Goodwill |
8,486 | 7,829 | ||||||
Intangible assets, net |
9,309 | 12,724 | ||||||
Deferred income taxes |
22,732 | 8,217 | ||||||
Other assets |
2,888 | 1,453 | ||||||
Total assets |
$ | 409,402 | $ | 371,810 | ||||
Liabilities and Stockholders’ Equity: |
||||||||
Current liabilities: |
||||||||
Accounts payable |
$ | 17,049 | $ | 13,572 | ||||
Accrued expenses and other current liabilities |
41,366 | 45,055 | ||||||
Current portion of long-term obligations |
1,001 | 5,628 | ||||||
Total current liabilities |
59,416 | 64,255 | ||||||
Long-term obligations |
723 | 1,728 | ||||||
Deferred income taxes |
6 | 151 | ||||||
Other liabilities |
13,433 | 13,668 | ||||||
Total liabilities |
73,578 | 79,802 | ||||||
Commitments and contingencies (Note 14) |
||||||||
Stockholders’ equity: |
||||||||
Common stock, voting, $.01 par value, shares
authorized - 100,000,000; shares issued and
outstanding - 35,143,800 in 2006 and 34,175,696 in 2005 |
351 | 342 | ||||||
Additional paid-in capital |
300,648 | 274,312 | ||||||
Accumulated other comprehensive income |
17,878 | 11,957 | ||||||
Retained earnings |
16,947 | 5,397 | ||||||
Total stockholders’ equity |
335,824 | 292,008 | ||||||
| $ | 409,402 | $ | 371,810 | |||||
The accompanying notes are an integral part of these consolidated financial statements.
48
Table of Contents
Wright Medical Group, Inc.
Consolidated Statements of Operations
(In thousands, except per share data)
(In thousands, except per share data)
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Net sales |
$ | 338,938 | $ | 319,137 | $ | 297,539 | ||||||
Cost of sales1 |
97,234 | 91,752 | 84,251 | |||||||||
Gross profit |
241,704 | 227,385 | 213,288 | |||||||||
Operating expenses: |
||||||||||||
Selling, general and administrative1 |
192,573 | 167,365 | 152,508 | |||||||||
Research and development 1 |
25,551 | 22,289 | 18,478 | |||||||||
Amortization of intangible assets |
4,149 | 4,250 | 3,889 | |||||||||
Total operating expenses |
222,273 | 193,904 | 174,875 | |||||||||
Operating income |
19,431 | 33,481 | 38,413 | |||||||||
Interest (income) expense, net |
(1,127 | ) | (176 | ) | 1,064 | |||||||
Other (income) expense, net |
(1,643 | ) | 237 | (74 | ) | |||||||
Income before income taxes |
22,201 | 33,420 | 37,423 | |||||||||
Provision for income taxes |
7,790 | 12,355 | 13,401 | |||||||||
Net income |
$ | 14,411 | $ | 21,065 | $ | 24,022 | ||||||
Net income per share (Note 10): |
||||||||||||
Basic |
$ | 0.42 | $ | 0.62 | $ | 0.72 | ||||||
Diluted |
$ | 0.41 | $ | 0.60 | $ | 0.68 | ||||||
Weighted-average number of shares outstanding – basic |
34,434 | 33,959 | 33,391 | |||||||||
Weighted-average number of shares outstanding – diluted |
35,439 | 35,199 | 35,317 | |||||||||
| 1 | These line items include the following amounts of non-cash stock-based compensation expense for the periods indicated: |
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Cost of sales |
$ | 854 | $ | 12 | $ | 68 | ||||||
Selling, general and administrative |
10,766 | 449 | 1,364 | |||||||||
Research and development |
2,220 | 6 | 57 | |||||||||
The accompanying notes are an integral part of these consolidated
financial statements.
49
Table of Contents
Wright Medical Group, Inc.
Consolidated Statements of Cash Flows
(In thousands)
(In thousands)
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Operating activities: |
||||||||||||
Net income |
$ | 14,411 | $ | 21,065 | $ | 24,022 | ||||||
Adjustments to reconcile net income to net cash
provided by operating activities: |
||||||||||||
Depreciation |
21,361 | 17,895 | 17,278 | |||||||||
Stock-based compensation expense |
13,840 | 467 | 1,489 | |||||||||
Amortization of intangible assets |
4,149 | 4,250 | 3,889 | |||||||||
Deferred income taxes |
(8,852 | ) | (329 | ) | 5,068 | |||||||
Gain on sale of investment |
(1,499 | ) | — | — | ||||||||
Excess tax benefits from stock-based
compensation arrangements |
(4,908 | ) | — | — | ||||||||
Other |
1,340 | 1,648 | 884 | |||||||||
Changes in assets and liabilities: |
||||||||||||
Accounts receivable |
(8,555 | ) | (5,177 | ) | (3,811 | ) | ||||||
Inventories |
(867 | ) | (9,364 | ) | (7,861 | ) | ||||||
Marketable securities |
(5,325 | ) | (25,000 | ) | — | |||||||
Other current assets |
4,600 | (6,062 | ) | (3,223 | ) | |||||||
Accounts payable |
2,504 | 647 | (849 | ) | ||||||||
Accrued expenses and other liabilities |
(2,224 | ) | 5,251 | 479 | ||||||||
Net cash provided by operating activities |
29,975 | 5,291 | 37,365 | |||||||||
Investing activities: |
||||||||||||
Capital expenditures |
(29,643 | ) | (30,356 | ) | (18,316 | ) | ||||||
Purchase of intangible assets |
(705 | ) | (1,227 | ) | (161 | ) | ||||||
Proceeds from sale of investment |
1,499 | — | — | |||||||||
Other |
500 | — | 49 | |||||||||
Net cash used in investing activities |
(28,349 | ) | (31,583 | ) | (18,428 | ) | ||||||
Financing activities: |
||||||||||||
Issuance of common stock |
5,915 | 2,930 | 4,056 | |||||||||
Financing under factoring agreements, net |
(54 | ) | (1,208 | ) | (29 | ) | ||||||
Principal payments of bank and other financing |
(6,123 | ) | (7,101 | ) | (6,332 | ) | ||||||
Excess tax benefits from stock-based compensation
arrangements |
4,908 | — | — | |||||||||
Net cash provided by (used in) financing activities |
4,646 | (5,379 | ) | (2,305 | ) | |||||||
Effect of exchange rates on cash and cash equivalents |
390 | (522 | ) | 267 | ||||||||
Net increase (decrease) in cash and cash equivalents |
6,662 | (32,193 | ) | 16,899 | ||||||||
Cash and cash equivalents, beginning of period |
51,277 | 83,470 | 66,571 | |||||||||
Cash and cash equivalents, end of period |
$ | 57,939 | $ | 51,277 | $ | 83,470 | ||||||
The accompanying notes are an integral part of these consolidated financial statements.
50
Table of Contents
Wright Medical Group, Inc.
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income
For the Years Ended December 31, 2004, 2005 and 2006
(In thousands, except share data)
For the Years Ended December 31, 2004, 2005 and 2006
(In thousands, except share data)
| Common Stock, Voting | Retained | Accumulated | ||||||||||||||||||||||||||
| Additional | Earnings | Other | Total | |||||||||||||||||||||||||
| Number of | Paid-in | (Accumulated | Deferred | Comprehensive | Stockholders’ | |||||||||||||||||||||||
| Shares | Amount | Capital | Deficit) | Compensation | Income | Equity | ||||||||||||||||||||||
Balance at December 31, 2003 |
33,040,747 | $ | 330 | $ | 263,455 | $ | (39,690 | ) | $ | (1,452 | ) | $ | 15,675 | $ | 238,318 | |||||||||||||
2004 Activity: |
||||||||||||||||||||||||||||
Net income |
— | — | — | 24,022 | — | — | 24,022 | |||||||||||||||||||||
Foreign currency translation |
— | — | — | — | — | 5,967 | 5,967 | |||||||||||||||||||||
Total comprehensive income |
29,989 | |||||||||||||||||||||||||||
Issuances of common stock |
809,455 | 9 | 4,047 | — | — | — | 4,056 | |||||||||||||||||||||
Tax benefit of employee
stock option exercises |
— | — | 2,217 | — | — | — | 2,217 | |||||||||||||||||||||
Stock-based compensation |
— | — | 331 | — | 1,158 | — | 1,489 | |||||||||||||||||||||
Forfeiture of stock options |
— | — | (106 | ) | — | 106 | — | — | ||||||||||||||||||||
Balance at December 31, 2004 |
33,850,202 | $ | 339 | $ | 269,944 | $ | (15,668 | ) | $ | (188 | ) | $ | 21,642 | $ | 276,069 | |||||||||||||
2005 Activity: |
||||||||||||||||||||||||||||
Net income |
— | — | — | 21,065 | — | — | 21,065 | |||||||||||||||||||||
Foreign currency translation |
— | — | — | — | — | (9,685 | ) | (9,685 | ) | |||||||||||||||||||
Total comprehensive income |
11,380 | |||||||||||||||||||||||||||
Issuances of common stock |
325,494 | 3 | 2,927 | — | — | — | 2,930 | |||||||||||||||||||||
Tax benefit of employee
stock option exercises |
— | — | 1,162 | — | — | — | 1,162 | |||||||||||||||||||||
Stock-based compensation |
— | — | 288 | — | 179 | — | 467 | |||||||||||||||||||||
Forfeiture of stock options |
— | — | (9 | ) | — | 9 | — | — | ||||||||||||||||||||
Balance at December 31, 2005 |
34,175,696 | $ | 342 | $ | 274,312 | $ | 5,397 | $ | — | $ | 11,957 | $ | 292,008 | |||||||||||||||
2006 Activity: |
||||||||||||||||||||||||||||
Net income |
— | — | — | 14,411 | — | — | 14,411 | |||||||||||||||||||||
Foreign currency translation |
— | — | — | — | — | 5,921 | 5,921 | |||||||||||||||||||||
Total comprehensive income |
— | — | — | — | 20,332 | |||||||||||||||||||||||
SAB 108 adjustment to
opening balance (See Note
2) |
— | — | — | (2,861 | ) | — | — | (2,861 | ) | |||||||||||||||||||
Issuances of common stock |
968,104 | 9 | 5,906 | — | — | — | 5,915 | |||||||||||||||||||||
Tax benefit of employee
stock option exercises |
— | — | 5,585 | — | — | — | 5,585 | |||||||||||||||||||||
Stock-based compensation |
— | — | 14,845 | — | — | — | 14,845 | |||||||||||||||||||||
Balance at December 31, 2006 |
35,143,800 | $ | 351 | $ | 300,648 | $ | 16,947 | $ | — | $ | 17,878 | $ | 335,824 | |||||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
51
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Description of Business:
Wright Medical Group, Inc. (the “Company”), through Wright Medical Technology, Inc. and other
operating subsidiaries, is a global medical device company specializing in the design, manufacture
and marketing of reconstructive joint devices and biologics products. The Company’s products are
sold primarily through a network of independent sales representatives in the United States (“U.S.”)
and by a combination of employee sales representatives, independent sales representatives, and
stocking distributors outside the U.S. The Company promotes its products in over 60 countries with
principal markets in the U.S., Europe, and Japan. The Company is headquartered in suburban Memphis,
Tennessee.
The Company was incorporated in November 1999 as a Delaware corporation, and had no operations
until an investment group acquired majority ownership of Wright Medical Technology, Inc. (the
“Predecessor Company”) on December 7, 1999. This transaction, which represents a recapitalization
of the Predecessor Company and the inception of the Company in its present form, was accounted for
using the purchase method of accounting.
On December 22, 1999 the Company acquired all of the outstanding common stock of Cremascoli Ortho
Holding, S.A. (“Cremascoli”), an orthopaedic medical device company headquartered in Toulon,
France. The acquisition was accounted for using the purchase method of accounting and, accordingly,
the results of operations of Cremascoli have been included in the Company’s consolidated financial
statements from the date of acquisition.
On July 18, 2001, the Company completed its initial public offering (“IPO”), issuing 7,500,000
shares of common stock which generated net proceeds of $84.8 million. On March 6, 2002, the Company
and certain selling stockholders completed a secondary offering which generated net proceeds of
$49.5 million.
2. Summary of Significant Accounting Policies:
Principles of Consolidation. The accompanying consolidated financial statements include the
accounts of the Company and its wholly owned domestic and international subsidiaries. All
significant intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates. The preparation of financial statements in conformity with accounting principles
generally accepted in the U.S. requires management to make estimates and assumptions that affect
the amounts reported in the financial statements and accompanying notes. Actual results could
differ from those estimates. The most significant areas requiring the use of management estimates
relate to revenue recognition, the determination of allowances for doubtful accounts and excess and
obsolete inventories, the evaluation of goodwill and long-lived assets, product liability claims
and other litigation, accounting for income taxes, and accounting for stock-based compensation.
Cash and Cash Equivalents. Cash and cash equivalents include all cash balances and short-term
investments with original maturities of three months or less.
Marketable Securities. The Company’s investment in marketable securities represents debt
securities, which are classified as trading securities in accordance with Statement of Financial
Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity
Securities. The Company recognizes realized and unrealized gains or losses on the purchase or sale
of these securities in the period incurred in the accompanying consolidated statement of
operations. For the years ended December 31, 2006 and 2005, the Company did not incur any realized
or unrealized gains or losses related to these securities.
52
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
Inventories. The Company’s inventories are valued at the lower of cost or market on a first-in,
first-out (“FIFO”) basis. Inventory costs include material, labor costs and manufacturing overhead.
The Company regularly reviews inventory quantities on hand for excess and obsolete inventory and,
when circumstances indicate, the Company incurs charges to write down inventories to their net
realizable value. The Company’s review of inventory for excess and obsolete quantities is based
primarily on its estimated forecast of product demand and production requirements for the next
twenty-four months. Charges incurred for excess and obsolete inventory were $6.5 million, $6.9
million and $5.8 million for the years ended December 31, 2006, 2005 and 2004, respectively. In
2005, charges incurred for excess and obsolete inventory included $1.5 million recorded to write
down certain inventory to its net realizable value due to the termination of an agreement to
distribute certain third party spinal products in Europe. In 2004, charges incurred for excess and
obsolete inventory included $2.4 million recorded to write down certain foot and ankle implant
inventory to its net realizable value as a result of the Company’s transition to the CHARLOTTE™
Foot and Ankle System from a line of products supplied by a third party vendor pursuant to a
distribution agreement that expired in the first quarter of 2005.
Product Liability Claims and Other Litigation. The Company makes provisions for claims specifically
identified for which it believes the likelihood of an unfavorable outcome is probable and an
estimate of the amount of loss has been developed. The Company has recorded at least the minimum
estimated liability related to those claims where a range of loss has been established. The
Company’s accrual for product liability claims was approximately $330,000 and $850,000 at December
31, 2006 and 2005, respectively. During 2006, payments of approximately $375,000 were made for
claims which were included in the accrual as of December 31, 2005. Additionally, during 2006, the
accrual was reduced for specific claims for which the Company has met its insurance deductible.
Property, Plant and Equipment. The Company’s property, plant and equipment is stated at cost.
Depreciation, which includes amortization of assets under capital lease, is provided on a
straight-line basis over the estimated useful lives based on the following categories:
Land improvements |
15 to 25 years | |||
Buildings |
10 to 45 years | |||
Machinery and equipment |
3 to 20 years | |||
Furniture, fixtures and office equipment |
1 to 14 years | |||
Surgical instruments |
6 years | |||
Expenditures for major renewals and betterments, including leasehold improvements, that extend the
useful life of the assets are capitalized and depreciated over the remaining life of the asset or
lease term, if shorter. Maintenance and repair costs are charged to expense as incurred. Upon sale
or retirement, the asset cost and related accumulated depreciation are eliminated from the
respective accounts and any resulting gain or loss is included in income.
Intangible Assets and Goodwill. Goodwill is recognized for the excess of the purchase price over
the fair value of assets of businesses acquired. Goodwill is required to be tested for impairment
at least annually. Unless circumstances otherwise dictate, the annual impairment test is performed
in the fourth quarter. Accordingly, during the fourth quarter of 2006, the Company evaluated
goodwill for impairment and determined that the fair value of its reporting unit exceeded its
carrying value, indicating that goodwill was not impaired. Based on the Company’s single business
approach to decision-making, planning, and resource allocation, management has determined that the
Company has only one reporting unit for purposes of evaluating goodwill for impairment.
The Company’s intangible assets with estimable useful lives are amortized on a straight line basis
over their respective estimated useful lives to their estimated residual values, and are reviewed
for impairment in
53
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets. The
weighted average amortization periods for completed technology, distribution channels, trademarks
and licenses are 8 years, 10 years, 9 years, and 6 years, respectively. The weighted average
amortization period of the Company’s intangible assets on a combined basis is 9 years.
Valuation of Long-Lived Assets. Management periodically evaluates carrying values of long-lived
assets, including property, plant and equipment and intangible assets, when events and
circumstances indicate that these assets may have been impaired. The Company accounts for the
impairment of long-lived assets in accordance SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. Accordingly, the Company evaluates impairment of its property, plant
and equipment based upon an analysis of estimated undiscounted future cash flows. If it is
determined that a change is required in the useful life of an asset, future
depreciation/amortization is adjusted accordingly. Alternatively, should the Company determine that
an asset is impaired, an adjustment would be charged to income based on its fair market value, or
discounted cash flows if the fair market value is not readily determinable, reducing income in that
period.
Allowances for Doubtful Accounts. The Company experiences some credit loss on its accounts
receivable and, accordingly, it must make estimates related to the ultimate collection of its
accounts receivable. Specifically, management analyzes the Company’s accounts receivable,
historical bad debt experience, customer concentrations, customer credit-worthiness, and current
economic trends, when evaluating the adequacy of its allowance for doubtful accounts.
The majority of the Company’s receivables are from hospitals, many of which are government funded.
Accordingly, the Company’s collection history with this class of customer has been favorable.
Historically, the Company has experienced minimal bad debts from its hospital customers and more
significant bad debts from certain international distributors, typically as a result of specific
financial difficulty or geo-political factors. The Company writes off receivables when it
determines that the receivables are uncollectible, typically upon customer bankruptcy or the
customer’s non-response to continued collection efforts. The Company’s allowance for doubtful
accounts totaled $2.9 million and $2.0 million at December 31, 2006 and 2005, respectively.
Concentrations of Supply of Raw Material. The Company relies on a limited number of suppliers for
the components used in the Company’s products. The Company’s reconstructive joint devices are
produced from various surgical grades of titanium, cobalt chrome and stainless steel, various
grades of high-density polyethylenes, silicone elastomer and ceramics. The Company relies on one
source for a certain grade of cobalt chrome alloy and one supplier for the silicone elastomer used in
certain of the Company’s extremity products. The Company is aware of only two suppliers of silicone
elastomer to the medical device industry for permanent implant usage. Further, the Company relies
on one supplier of ceramics for use in the Company’s hip products. In addition, for the Company’s
biologics products, it presently depends on a single source for demineralized bone matrix (“DBM”)
and cancellous bone matrix (“CBM”) materials. Further, the Company relies on one supplier for its
GRAFTJACKET® family of soft tissue repair and graft containment products, as well as one
supplier for its ADCON® Gel products.
Income Taxes. Income taxes are accounted for pursuant to the provisions of SFAS No. 109, Accounting
for Income Taxes. The Company’s effective tax rate is based on income by tax jurisdiction,
statutory rates and tax saving initiatives available to it in the various jurisdictions in which it
operates. Significant judgment is required in determining the Company’s effective tax rate and
evaluating its tax positions. This process includes assessing temporary differences resulting from
differing recognition of items for income tax and financial accounting purposes. These differences
result in deferred tax assets and liabilities, which are included within the Company’s consolidated
balance sheet.
54
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
Revenue Recognition. The Company’s revenues are primarily generated through two types of customers,
hospitals and stocking distributors, with the majority of the Company’s revenue derived from sales
to hospitals. The Company’s products are primarily sold through a network of independent sales
representatives in the U.S. and by a combination of employee sales representatives, independent
sales representatives, and stocking distributors outside the U.S. Revenues from sales to hospitals
are recorded when the hospital takes title to the product, which is generally when the product is
surgically implanted in a patient.
The Company records revenues from sales to its stocking distributors outside the U.S. at the time
the product is shipped to the distributor. Stocking distributors, who sell the products to their
customers, take title to the products and assume all risks of ownership. The Company’s distributors
are obligated to pay within specified terms regardless of when, if ever, they sell the products. In
general, the distributors do not have any rights of return or exchange; however, in limited
situations the Company has repurchase agreements with certain stocking distributors. Those certain
agreements require the Company to repurchase a specified percentage of the inventory purchased by
the distributor within a specified period of time prior to the expiration of the contract. During
those specified periods, the Company defers the applicable percentage of the sales. Approximately
$175,000 and $170,000 of deferred revenue related to these types of agreements was recorded at
December 31, 2006 and 2005, respectively.
The Company must make estimates of potential future product returns related to current period
product revenue. The Company develops these estimates by analyzing historical experience related to
product returns. Judgment must be used and estimates made in connection with establishing the
allowance for sales returns in any accounting period. An allowance for sales returns of
approximately $350,000 and $430,000 is included as a reduction of accounts receivable at December
31, 2006 and 2005, respectively.
Shipping and Handling Costs. The Company incurs shipping and handling costs associated with the
shipment of goods to customers, independent distributors and its subsidiaries. All shipping and
handling amounts billed to customers are included in net sales. All shipping and handling costs
associated with the shipment of goods to customers are included in cost of sales. All other
shipping and handling costs are included in selling, general and administrative expenses.
Research and Development Costs. Research and development costs are charged to expense as incurred.
Foreign Currency Translation. The financial statements of the Company’s international subsidiaries
are translated into U.S. dollars using the exchange rate at the balance sheet date for assets and
liabilities and the weighted average exchange rate for the applicable period for revenues,
expenses, gains and losses. Translation adjustments are recorded as a separate component of
comprehensive income. Gains and losses resulting from transactions denominated in a currency other
than the local functional currency are included in “Other (income) expense, net.”
Comprehensive Income. Comprehensive income is defined as the change in equity during a period
related to transactions and other events and circumstances from non-owner sources. It includes all
changes in equity during a period except those resulting from investments by owners and
distributions to owners. The difference between the Company’s net income and its comprehensive
income is wholly attributable to foreign currency translation.
Stock-Based Compensation. Effective January 1, 2006, the Company adopted the provisions of, and
accounts for stock-based compensation in accordance with, Statement of Financial Accounting
Standards (“SFAS”) No. 123 (Revised 2004), Share-Based Payment (“FAS 123R”), which replaced SFAS
No. 123, Accounting for Stock-Based Compensation, and supersedes Accounting Principles Board
(“APB”) Opinion No. 25, Accounting for Stock Issued to Employees. Under the fair value recognition
provisions of FAS
55
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
123R, stock-based compensation cost is measured at the grant date based on the
fair value of the award and is recognized as expense on a straight-line basis over the requisite
service period, which is the vesting period. The determination of the fair value of stock-based
payment awards on the date of grant using an option-pricing model is affected by the Company’s
stock price as well as assumptions regarding a number of complex and subjective variables, which
include the expected life of the award, the expected stock price volatility over the expected life
of the awards, expected dividend yield, and risk-free interest
rate. The Company elected the modified prospective method of transition, under which prior periods
are not revised for comparative purposes.
The Company recorded approximately $13.8 million of stock-based compensation expense during the
year ended December 31, 2006. See Note 12 for further information regarding our stock-based
compensation assumptions and expenses, including pro forma disclosures for prior periods as if the
Company had applied the fair value recognition provisions of SFAS No. 123 to non-cash stock-based
employee compensation expense.
Fair Value of Financial Instruments. The carrying value of cash and cash equivalents, marketable
securities, accounts receivable, accounts payable and notes payable approximates the fair value of
these financial instruments at December 31, 2006 and 2005 due to their short maturities or variable
rates.
Derivative Instruments. The Company accounts for derivative instruments and hedging
activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as
amended by SFAS No. 138. Accordingly, all of the Company’s derivative instruments are recorded on
the balance sheet as either an asset or liability and measured at fair value. The changes in the
derivative’s fair value are recognized currently in earnings unless specific hedge accounting
criteria are met.
The Company employs a derivative program, which began in 2004, using 30-day foreign currency
forward contracts to mitigate the risk of currency fluctuations on its intercompany receivable and
payable balances that are denominated in foreign currencies. These forward contracts are expected
to offset the transactional gains and losses on the related intercompany balances. These forward
contracts are not designated as hedging instruments under SFAS No. 133. Accordingly, the changes in
the fair value and the settlement of the contracts are recognized in the period incurred in the
accompanying consolidated statements of operations.
The Company recorded net losses of approximately $1.9 million, net gains of approximately $1.5
million, and net losses of approximately $790,000 for the years ended December 31, 2006, 2005, and
2004 respectively, on foreign currency contracts, which are included in “Other (income) expense,
net” in the Company’s consolidated statements of operations. These gains and losses substantially
offset translation losses and gains recorded on the Company’s intercompany receivable and payable
balances, also included in “Other (income) expense, net.” At December 31, 2006 and 2005, the
Company had no foreign currency contracts outstanding.
Supplemental Cash Flow Information. Cash paid for interest and income taxes was as follows (in
thousands):
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Interest |
$ | 1,298 | $ | 1,420 | $ | 717 | ||||||
Income taxes |
$ | 9,663 | $ | 17,057 | $ | 8,289 | ||||||
During 2004 and 2006, the Company favorably resolved certain income tax contingencies associated
with the Company’s acquisition of Cremascoli, resulting in decreases in goodwill of approximately
$3.0 million
56
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
and $140,000, respectively. Additionally, the Company entered into capital leases of
approximately $1.6 million and $1.1 million during 2005 and 2004, respectively. The Company entered
into an insignificant amount of capital leases during 2006.
Reclassifications. Certain prior year amounts have been reclassified to conform to the 2006
presentation.
Adoption of SAB 108. In September 2006, the SEC issued Staff Accounting Bulletin No. 108,
Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year
Financial Statements (“SAB 108”), to address diversity in practice in quantifying financial
statement misstatements.
SAB 108 requires registrants to consider both the “rollover” method which focuses on the income
statement impact of misstatements and the “iron curtain” method which focuses on the balance sheet
impact of misstatements to define materiality. The transition provisions of SAB 108 allow a
registrant to adjust opening retained earnings for the cumulative effect of immaterial errors
relating to prior years. The Company adopted SAB 108 during the year ended December 31, 2006.
During 2006, the Company concluded there was an error in its method of calculating depreciation
expense for its surgical instruments, resulting in an understatement of depreciation expense for
the years 2000 through 2005. Under SAB 108, the Company must assess materiality of errors
originating in prior years using both the rollover method and the iron-curtain method. Management
has concluded that the impact of this error was immaterial for each of the prior years under the
rollover method, which was the method used by the Company prior to the adoption of SAB 108.
However, under the iron curtain method, the cumulative effect of the balance sheet adjustment is
material to the Company’s current year statement of operations. Therefore, an adjustment was
recorded to the 2006 opening retained earnings in accordance with the implementation guidance in
SAB 108. The total cumulative impact is as follows:
| Increase/ | ||||
| (Decrease) | ||||
Accumulated depreciation |
$ | 4,721 | ||
Deferred tax asset |
1,860 | |||
Retained earnings |
(2,861 | ) | ||
Recently Issued Accounting Pronouncements. In July 2006, the Financial Accounting Standards Board
(“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – An
Interpretation of FASB Statement No. 109, (“FIN 48”). FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in a company’s financial statements in accordance with FASB
Statement No. 109, Accounting for Income Taxes, by defining the criterion that an individual tax
position must meet in order to be recognized in the financial statements. FIN 48 requires that the
tax effects of a position be recognized only if it is “more-likely-than-not” to be sustained based
solely on the technical merits as of the reporting date. FIN 48 further requires that interest that
the tax law requires to be paid on the underpayment of taxes should be accrued on the difference
between the amount claimed or expected to be claimed on the return and the tax benefit recognized
in the financial statements. Management has made the policy election to record this interest as
interest expense. FIN 48 also requires additional disclosures of unrecognized tax benefits,
including a reconciliation of the beginning and ending balance. The Company will comply with the
provisions of FIN 48 effective January 1, 2007. The Company is currently assessing the impact that
the adoption of FIN 48 will have on its results of operations and financial position. As a result
of the adoption of FIN 48, the balance of certain of the Company’s liabilities for uncertain tax
positions may change, which would be recorded as an adjustment to opening retained earnings as a
cumulative effect of a change in accounting principle.
57
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
3. Inventories:
Inventories consist of the following (in thousands):
| December 31, | ||||||||
| 2006 | 2005 | |||||||
Raw materials |
$ | 4,204 | $ | 4,186 | ||||
Work-in-process |
12,078 | 14,417 | ||||||
Finished goods |
69,875 | 63,778 | ||||||
| $ | 86,157 | $ | 82,381 | |||||
4. Property, Plant and Equipment:
Property, plant and equipment consists of the following (in thousands):
| December 31, | ||||||||
| 2006 | 2005 | |||||||
Land and land improvements |
$ | 3,882 | $ | 2,329 | ||||
Buildings |
8,992 | 8,458 | ||||||
Machinery and equipment |
35,557 | 33,530 | ||||||
Furniture, fixtures and office equipment |
33,003 | 29,193 | ||||||
Construction in progress |
4,573 | 2,654 | ||||||
Surgical instruments |
90,092 | 72,088 | ||||||
| 176,099 | 148,252 | |||||||
Less: Accumulated depreciation |
(89,834 | ) | (67,046 | ) | ||||
| $ | 86,265 | $ | 81,206 | |||||
The components of property, plant and equipment recorded under capital leases consist of the
following (in thousands):
| December 31, | ||||||||
| 2006 | 2005 | |||||||
Buildings |
$ | 1,448 | $ | 1,448 | ||||
Machinery and equipment |
4,789 | 5,717 | ||||||
Furniture, fixtures and office equipment |
1,909 | 2,309 | ||||||
| 8,146 | 9,474 | |||||||
Less: Accumulated depreciation |
(5,553 | ) | (4,619 | ) | ||||
| $ | 2,593 | $ | 4,855 | |||||
Depreciation expense approximated $21.4 million, $17.9 million, and $17.3 million for the years
ended December 31, 2006, 2005, and 2004, respectively, and included amortization of assets under
capital leases.
58
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
5. Goodwill and Intangible Assets:
Changes in the carrying amount of goodwill occurring during the year ended December 31, 2006, are
as follows (in thousands):
Goodwill, at December 31, 2005 |
$ | 7,829 | ||
Less: Resolution of pre-acquisition foreign income tax contingencies |
(140 | ) | ||
Foreign currency translation |
797 | |||
Goodwill, at December 31, 2006 |
$ | 8,486 | ||
The components of the Company’s identifiable intangible assets are as follows (in thousands):
| December 31, 2006 | December 31, 2005 | |||||||||||||||
| Accumulated | Accumulated | |||||||||||||||
| Cost | Amortization | Cost | Amortization | |||||||||||||
Distribution channels |
$ | 20,241 | $ | 14,185 | $ | 18,173 | $ | 10,908 | ||||||||
Completed technology |
5,233 | 3,076 | 5,243 | 2,353 | ||||||||||||
Licenses |
2,741 | 2,314 | 2,756 | 1,847 | ||||||||||||
Trademarks |
657 | 307 | 657 | 230 | ||||||||||||
Other |
4,218 | 3,899 | 4,014 | 2,781 | ||||||||||||
| 33,090 | $ | 23,781 | 30,843 | $ | 18,119 | |||||||||||
Less: Accumulated
amortization |
(23,781 | ) | (18,119 | ) | ||||||||||||
Intangible assets, net |
$ | 9,309 | $ | 12,724 | ||||||||||||
Based on the intangible assets held at December 31, 2006, we expect to amortize approximately $3.2
million in 2007, $2.9 million in 2008, $2.6 million in 2009, $350,000 in 2010, and $130,000 in
2011.
6. Accrued Expenses and Other Current Liabilities:
Accrued expenses and other current liabilities consist of the following (in thousands):
| December 31, | ||||||||
| 2006 | 2005 | |||||||
Employee benefits |
$ | 9,661 | $ | 11,287 | ||||
Advances from factoring arrangement |
3,912 | 3,547 | ||||||
Royalties |
5,203 | 4,455 | ||||||
Taxes other than income |
4,476 | 5,604 | ||||||
Commissions |
4,096 | 3,982 | ||||||
Professional and legal fees |
5,744 | 5,009 | ||||||
Purchased technology |
— | 1,500 | ||||||
Other |
8,274 | 9,671 | ||||||
| $ | 41,366 | $ | 45,055 | |||||
59
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
7. Long-Term Obligations:
Long-term obligations consist of the following (in thousands):
| December 31, | ||||||||
| 2006 | 2005 | |||||||
Capital lease obligations |
$ | 1,724 | $ | 3,606 | ||||
Notes payable |
— | 3,750 | ||||||
| 1,724 | 7,356 | |||||||
Less: current portion |
(1,001 | ) | (5,628 | ) | ||||
| $ | 723 | $ | 1,728 | |||||
On June 30, 2006, the Company paid $3.8 million to retire all indebtedness under its then existing
credit facility, cancelled the credit facility, and terminated the related credit agreement. At the
same time, the Company entered into a new credit agreement with a group of banks led by Bank of
America, N.A. The new credit agreement provides for a $100 million revolving credit facility, which
can be increased by up to $50 million at the Company’s request and subject to the agreement of the
lenders. The Company currently has no borrowings outstanding under the new credit facility.
Borrowings under the new credit facility will bear interest at the sum of a base rate plus an
applicable rate that ranges from 1.125% to 4.55% depending on the type of loan and our consolidated
leverage ratio, with a current annual rate of 8.25%. The term of the new credit facility extends
through June 30, 2011.
As discussed in Note 4, the Company has acquired certain property and equipment pursuant to capital
leases. These leases have various terms ranging from two to seven years with interest rates ranging
from 2.9% to 6.8%. At December 31, 2006, future minimum lease payments under capital lease
obligations, together with the present value of the net minimum lease payments, are as follows (in
thousands):
2007 |
$ | 1,085 | ||
2008 |
459 | |||
2009 |
197 | |||
2010 |
105 | |||
2011 |
7 | |||
Thereafter |
— | |||
Total minimum payments |
1,853 | |||
Less amount representing interest |
(129 | ) | ||
Present value of minimum lease payments |
1,724 | |||
Current portion |
(1,001 | ) | ||
Long-term portion |
$ | 723 | ||
8. Other Long-Term Liabilities:
Other long-term liabilities consist of the following (in thousands):
| December 31, | ||||||||
| 2006 | 2005 | |||||||
Accrued income taxes payable |
$ | 12,663 | $ | 13,045 | ||||
Other |
770 | 623 | ||||||
| $ | 13,433 | $ | 13,668 | |||||
60
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
9. Income Taxes:
The components of the Company’s income before income taxes are as follows (in thousands):
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Domestic |
$ | 34,624 | $ | 43,588 | $ | 40,437 | ||||||
Foreign |
(12,423 | ) | (10,168 | ) | (3,014 | ) | ||||||
Income before income taxes |
$ | 22,201 | $ | 33,420 | $ | 37,423 | ||||||
The components of the Company’s provision for income taxes are as follows (in thousands):
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Current provision: |
||||||||||||
Domestic: |
||||||||||||
Federal |
$ | 13,257 | $ | 9,777 | $ | 12,815 | ||||||
State |
1,841 | 1,709 | 811 | |||||||||
Foreign |
2,234 | 1,385 | 4,401 | |||||||||
Deferred (benefit) provision: |
||||||||||||
Domestic: |
||||||||||||
Federal |
(2,915 | ) | 3,013 | (197 | ) | |||||||
State |
(361 | ) | 605 | 803 | ||||||||
Foreign |
(6,266 | ) | (4,134 | ) | (5,232 | ) | ||||||
Total provision for income taxes |
$ | 7,790 | $ | 12,355 | $ | 13,401 | ||||||
A reconciliation of the statutory U.S. federal income tax rate to the Company’s effective income
tax rate is as follows:
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Income tax provision at statutory rate |
35.0 | % | 35.0 | % | 35.0 | % | ||||||
State tax provision |
5.3 | % | 5.3 | % | 4.8 | % | ||||||
Stock-based compensation expense |
11.3 | % | 0.2 | % | 0.3 | % | ||||||
Change in valuation allowance |
(2.8 | %) | (1.2 | %) | (3.1 | %) | ||||||
Research and development credit |
(4.2 | %) | (2.8 | %) | (3.3 | %) | ||||||
Foreign income taxes |
(4.5 | %) | (2.5 | %) | (1.9 | %) | ||||||
Non-taxable differences and other, net |
(5.0 | %) | 3.0 | % | 4.0 | % | ||||||
Total |
35.1 | % | 37.0 | % | 35.8 | % | ||||||
61
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
The significant components of the Company’s deferred income taxes as of December 31, 2006 and 2005
are as follows (in thousands):
| December 31, | ||||||||
| 2006 | 2005 | |||||||
Deferred tax assets: |
||||||||
Net operating loss carryforwards |
$ | 23,140 | $ | 13,924 | ||||
General business credit carryforward |
2,262 | 2,341 | ||||||
Reserves and allowances |
21,175 | 18,031 | ||||||
Amortization |
5,484 | 5,230 | ||||||
Other |
10,337 | 11,856 | ||||||
Valuation allowance |
(5,738 | ) | (5,964 | ) | ||||
Total deferred tax assets |
56,660 | 45,418 | ||||||
Deferred tax liabilities: |
||||||||
Depreciation |
3,845 | 6,205 | ||||||
Acquired intangible assets |
2,252 | 2,661 | ||||||
Other |
5,966 | 4,297 | ||||||
Total deferred tax liabilities |
12,063 | 13,163 | ||||||
Net deferred tax assets |
$ | 44,597 | $ | 32,255 | ||||
Provisions for federal income taxes are not made on the undistributed earnings of foreign
subsidiaries when earnings are considered permanently invested. Deferred taxes are not provided for
temporary differences related to earnings of non-U.S. subsidiaries that are intended to be
permanently reinvested. At December 31, 2006, the Company did not have undistributed earnings of
foreign subsidiaries, as total earnings from these subsidiaries have been offset by losses.
At December 31, 2006, the Company had net operating loss carryforwards for U.S. federal income tax
purposes of approximately $13.7 million, which expire in 2017 and 2018. Additionally, the Company
had general business credit carryforwards of approximately $2.3 million, which expire beginning in
2007 and extending through 2016. At December 31, 2006, the Company had foreign net operating loss
carryforwards of approximately $54.5 million, of which $5.0 million expires beginning in 2009 and
extending through 2015.
Certain of the Company’s U.S. and foreign net operating losses and general business credit
carryforwards are subject to various limitations. The Company maintains valuation allowances for
these net operating losses and tax credit carryforwards that are expected to expire unused due to
these limitations.
10. Earnings Per Share:
SFAS No. 128, Earnings Per Share, requires the presentation of basic and diluted earnings per
share. Basic earnings per share is calculated based on the weighted-average shares of common stock
outstanding during the period. Diluted earnings per share is calculated to include any dilutive
effect of the Company’s common stock equivalents. The Company’s common stock equivalents consist of
stock options and non-vested shares of common stock. The dilutive effect of such instruments is
calculated using the treasury-stock method.
62
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
The weighted-average number of common shares outstanding for basic and diluted earnings per share
purposes is as follows (in thousands):
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Weighted-average number of common
shares outstanding — basic |
34,434 | 33,959 | 33,391 | |||||||||
Common stock equivalents |
1,005 | 1,240 | 1,926 | |||||||||
Weighted-average number of common
shares outstanding — diluted |
35,439 | 35,199 | 35,317 | |||||||||
The Company has excluded from the calculation of diluted earnings per share approximately 4.4
million, 2.7 million and 1.7 million antidilutive options for the years ended December 31, 2006,
2005, and 2004 respectively.
11. Capital Stock:
Common Stock. The Company is authorized to issue up to 100,000,000 shares of voting common stock.
The Company has 64,856,200 shares of voting common stock available for future issuance at December
31, 2006.
Warrants. In connection with the December 1999 recapitalization, the Company issued warrants to
stockholders and certain employees to purchase an aggregate of 727,276 shares of the Company’s
common stock at an exercise price of $4.35 per share. The warrants were exercisable at any time
after issuance and, unless exercised, expired five years from the date of issuance. During the year
ended December 31, 2004, warrants for 353,209 shares were exercised. All warrants had been
exercised as of December 31, 2004.
12. Stock Option Plans:
Effective January 1, 2006, the Company adopted FAS 123R, which replaced SFAS No. 123 and supersedes
APB Opinion No. 25. FAS 123R requires recognition of the fair value of an award of equity
instruments granted in exchange for employee services as a cost of those services. Prior to the
adoption of FAS 123R, as permitted by SFAS No. 123, the Company accounted for similar transactions
in accordance with APB Opinion No. 25, which employed the intrinsic value method of measuring
compensation cost. Accordingly, compensation cost related to stock option grants to employees was
recognized only to the extent that the fair market value of the stock exceeded the exercise price
of the stock option at the date of grant.
The Company adopted FAS 123R using the modified prospective method. Accordingly, prior year amounts
have not been restated. Under the modified prospective method, the provisions of FAS 123R are to be
applied to new awards granted after January 1, 2006. For unvested options granted prior to January
1, 2006, the Company is required to recognize, over the remaining vesting period, non-cash
stock-based compensation expense for the grant date fair value of the options. FAS 123R did not
change the accounting for non-cash stock-based compensation related to non-employees with
equity-based incentive arrangements.
The Company has two stock-based employee compensation plans which are described below.
Equity Incentive Plan. On December 7, 1999, the Company adopted the 1999 Equity Incentive Plan (the
“Plan”), which was subsequently amended and restated on July 6, 2001, May 13, 2003, May 13, 2004,
and May 12, 2005. The Plan authorizes the Company to grant stock options and other stock-based
awards with respect to up to 9,767,051 shares of common stock. Under the Plan, options to purchase
common stock generally are exercisable in increments of 25% annually on each of the first through
fourth anniversaries of
63
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
the date of grant. Options to purchase Series A Preferred Stock that were outstanding at the time
the Company completed its IPO in July 2001 became options to purchase the Company’s common stock.
Those options were immediately exercisable upon their issuance. All the options issued under the
Plan expire after ten years.
The Company recognized approximately $13.8 million ($10.9 million net of taxes) in non-cash
stock-based compensation expense during 2006, which reduced both basic and diluted earnings per
share by $0.31 during the year ended December 31, 2006. Further, approximately $690,000 and
$315,000 of non-cash stock-based compensation was capitalized as part of the cost of inventory and
an intangible asset, respectively, as of December 31, 2006. During 2005 and 2004, the Company
incurred approximately $467,000 ($287,000 net of taxes) and $1.5 million ($1.0 million net of
taxes), respectively, of non-cash stock-based compensation expense for the fair value of stock
options granted to independent distributors and for certain stock options granted to employees
where the fair value of the Company’s stock exceeded the exercise price of the stock option at the
date of grant.
The following table illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation
in 2005 and 2004 (in thousands, except per share amounts):
| Year Ended | Year Ended | |||||||
| December 31, | December 31, | |||||||
| 2005 | 2004 | |||||||
Net income, as reported |
$ | 21,065 | $ | 24,022 | ||||
Add: Stock-based employee compensation cost
recognized under intrinsic value method,
net of tax |
151 | 681 | ||||||
Less: Stock-based employee compensation expense
determined under fair value based method,
net of tax |
(12,972 | ) | (8,626 | ) | ||||
Pro forma net income |
$ | 8,244 | $ | 16,077 | ||||
Income per share: |
||||||||
Basic, as reported |
$ | 0.62 | $ | 0.72 | ||||
Basic, pro forma |
$ | 0.24 | $ | 0.48 | ||||
Diluted, as reported |
$ | 0.60 | $ | 0.68 | ||||
Diluted, pro forma |
$ | 0.24 | $ | 0.47 | ||||
The Company estimates the fair value of stock options using the Black-Scholes valuation model. The
Black-Scholes option-pricing model requires the input of estimates, including the expected life of
stock options, expected stock price volatility, the risk-free interest rate, and the expected
dividend yield. The expected life of options was estimated by calculating the average of the
vesting term and the contractual term of the option, as allowed in SEC Staff Accounting Bulletin
No. 107 (“SAB 107”). The expected stock price volatility assumption was estimated based upon
historical volatility of the Company’s common stock. The risk-free interest rate was determined
using U.S. Treasury rates where the term is consistent with the expected life of the stock options.
Expected dividend yield is not considered as the Company has never paid dividends and has no plans
of doing so in the future. The Company is required to estimate forfeitures at the time of grant and
revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The
Company uses historical data to estimate pre-vesting option forfeitures and records stock-based
compensation expense only for those awards that are expected to vest. All stock options are
amortized
64
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
on a straight-line basis over their respective requisite service periods, which are generally the
vesting periods.
The weighted-average fair value of the Company’s options granted to employees in 2006, 2005 and
2004 was $9.97 per share, $11.62 per share, and $17.39 per share, respectively. The fair value of
each option grant is estimated on the date of grant using the Black-Scholes option valuation model
using the following assumptions:
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Risk-free interest rate |
4.3% - 5.1 | % | 4.0% - 4.5 | % | 4.0% – 4.8 | % | ||||||
Expected option life |
6 years | 7 years | 7 years | |||||||||
Expected price volatility |
40 | % | 40 | % | 50 | % | ||||||
As of December 31, 2006, the Company had $27.6 million of total unrecognized compensation cost
related to unvested stock-based compensation arrangements granted to employees under the Plan. That
cost is expected to be recognized over a weighted-average period of 2.3 years.
During 2006, 2005 and 2004, the Company granted certain independent distributors common stock
options of 66,700, 41,900 and 18,200 shares, respectively, under the Plan. These options are
exercisable in 25% increments on the first through fourth anniversaries of the date of grant at a
weighted-average exercise price of $22.43, $25.08 and $33.48 per share, respectively. The options
expire after ten years.
A summary of the Company’s stock option activity is as follows:
| Weighted- | Aggregate | |||||||||||||||
| Weighted- | Average | Intrinsic | ||||||||||||||
| Shares | Average | Remaining | Value* | |||||||||||||
| (000’s) | Exercise Price | Contractual Life | ($000’s) | |||||||||||||
Outstanding at December 31, 2003 |
4,234 | $ | 12.28 | |||||||||||||
Granted |
2,458 | 30.61 | ||||||||||||||
Exercised |
(505 | ) | 7.53 | |||||||||||||
Forfeited or expired |
(359 | ) | 24.34 | |||||||||||||
Outstanding at December 31, 2004 |
5,828 | 19.68 | ||||||||||||||
Granted |
1,819 | 23.82 | ||||||||||||||
Exercised |
(314 | ) | 8.61 | |||||||||||||
Forfeited or expired |
(1,145 | ) | 30.01 | |||||||||||||
Outstanding at December 31, 2005 |
6,188 | 19.55 | ||||||||||||||
Granted |
1,219 | 20.92 | ||||||||||||||
Exercised |
(899 | ) | 6.35 | |||||||||||||
Forfeited or expired |
(797 | ) | 26.06 | |||||||||||||
Outstanding at December 31, 2006 |
5,711 | $ | 21.00 | 7.2 years | $ | 23,163 | ||||||||||
Exercisable at December 31, 2006 |
2,828 | $ | 18.31 | 5.9 years | $ | 19,026 | ||||||||||
| * | The aggregate intrinsic value is calculated as the difference between the market value of the Company’s common stock as of December 31, 2006, and the exercise price of the shares. The market value as of December 31, 2006, is deemed to have been $23.28 per share, which is the closing sale price of the common stock reported for transactions effected on the Nasdaq Global Select Market on December 29, 2006. |
65
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
The total intrinsic value of options exercised during 2006, 2005 and 2004 was approximately $15.2
million, $4.3 million and $12.0 million, respectively. As of December 31, 2006, there were
1,411,120 shares available for future issuance.
A summary of the company’s stock options outstanding and exercisable at December 31, 2006, is as
follows (shares in thousands):
| Options Outstanding | Options Exercisable | |||||||||||||||||||
| Weighted- | Weighted- | |||||||||||||||||||
| Weighted-Average | Average | Average | ||||||||||||||||||
| Number | Remaining | Exercise | Number | Exercise | ||||||||||||||||
| Range of Exercise Prices | Outstanding | Contractual Life | Price | Exercisable | Price | |||||||||||||||
$0.00 – $8.50 |
823 | 3.7 | $ | 5.33 | 823 | $ | 5.33 | |||||||||||||
$8.51 – $16.00 |
74 | 5.7 | 15.14 | 61 | 15.14 | |||||||||||||||
$16.01 – $24.00 |
2,572 | 8.1 | 20.31 | 910 | 19.17 | |||||||||||||||
$24.01 – $32.00 |
2,160 | 7.5 | 27.49 | 993 | 27.82 | |||||||||||||||
$32.01 – $35.87 |
82 | 7.1 | 34.03 | 41 | 34.03 | |||||||||||||||
| 5,711 | 7.2 | $ | 21.00 | 2,828 | $ | 18.31 | ||||||||||||||
During
2006, the Company issued approximately 7,000 non-vested shares of common stock to
employees with a weighted-average fair value of $23.37 per share. The fair value of these
shares will be recognized on a straight-line basis over four years, the requisite service
period. The forfeiture restrictions on these shares lapse in increments of 25% annually on
each of the first through fourth anniversaries of the date of grant.
During
2006, the Company issued 50,000 non-vested shares of common stock with a grant date fair
value of $1.2 million to a third party in exchange for certain rights and services. The
expense related to those shares will be recognized over 28 months, the life of the contract.
The forfeiture restrictions lapsed on 16,667 of these shares on the grant date. The forfeiture
restrictions on the remaining shares lapse on January 1, 2007, and January 1, 2008.
Employee Stock Purchase Plan. On May 30, 2002, the Company and its shareholders approved and
adopted the 2002 Employee Stock Purchase Plan (the “ESPP”). The ESPP authorizes the Company to
issue up to 200,000 shares of common stock to its employees who work at least 20 hours per week.
Under the ESPP, there are two six-month plan periods during each calendar year, one beginning
January 1 and ending on June 30, and the other beginning July 1 and ending on December 31. Under
the terms of the ESPP, employees can choose each plan period to have up to 5% of their annual base
earnings, limited to $5,000, withheld to purchase the Company’s common stock. The purchase price of
the stock is 85 percent of the lower of its beginning-of-period or end-of-period market price.
Under the ESPP, the Company sold to employees 11,465, 11,530 and 8,792 shares in 2006, 2005 and
2004, respectively, with weighted-average fair values of $6.88, $6.93 and $9.04 per share,
respectively. As of December 31, 2006, there were 149,754 shares available for future issuance
under the ESPP. During 2006, 2005, and 2004, the Company recorded nominal amounts of stock-based
compensation expense related to the ESPP.
In applying the Black-Scholes methodology to the purchase rights granted under the ESPP, the
Company used the following assumptions:
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Risk-free interest rate |
4.6% - 4.8 | % | 3.0% - 3.6 | % | 1.9% - 2.8 | % | ||||||
Expected option life |
6 months | 6 months | 6 months | |||||||||
Expected price volatility |
40 | % | 40 | % | 50 | % | ||||||
66
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
13. Employee Benefit Plans:
The Company sponsors a defined contribution plan under Section 401(k) of the Internal Revenue Code,
which covers U.S. employees who are 21 years of age and over. Under this plan, the Company matches
voluntary employee contributions at a rate of 100% for the first 2% of an employee’s annual
compensation and at a rate of 50% for the next 2% of an employee’s annual compensation. Employees
vest in the Company’s contributions after three years of service with the Company. The Company’s
expense related to the plan was approximately $1.0 million, $940,000, and $830,000 in 2006, 2005,
and 2004, respectively.
14. Commitments and Contingencies:
Operating Leases. The Company leases certain equipment and office space under non-cancelable
operating leases. Rental expense under operating leases approximated $8.5 million, $7.7 million and
$6.2 million for the years ended December 31, 2006, 2005, and 2004, respectively. Future minimum
payments, by year and in the aggregate, under non-cancelable operating leases with initial or
remaining lease terms of one year or more, are as follows at December 31, 2006 (in thousands):
2007 |
$ | 7,738 | ||
2008 |
4,830 | |||
2009 |
2,192 | |||
2010 |
1,162 | |||
2011 |
662 | |||
Thereafter |
1,339 | |||
| $ | 17,923 | |||
Royalty and Consulting Agreements. The Company has entered into various royalty and other
consulting agreements with third party consultants. The Company incurred royalty and consulting
expenses of $1.0 million, $3.2 million and $5.2 million during the years ended December 31, 2006,
2005, and 2004, respectively, under minimum contractual obligations that were contingent upon
services. The amounts in the table below represent minimum payments to consultants that are
contingent upon future services. These fees are accrued when it is deemed probable that the
performance thresholds are met. Payments under these agreements for which the Company has not
recorded a liability, are as follows at December 31, 2006 (in thousands):
2007 |
$ | 970 | ||
2008 |
700 | |||
2009 |
700 | |||
2010 |
600 | |||
2011 |
600 | |||
Thereafter |
2,068 | |||
| $ | 5,638 | |||
Portions of the Company’s payments for operating leases and royalty agreements are denominated in
foreign currencies and were translated in the tables above based on their respective U.S. dollar
exchange rates at December 31, 2006. These future payments are subject to foreign currency exchange
rate risk.
Purchase Obligations. The Company has entered into certain supply agreements for its products,
which include minimum purchase obligations. During the years ended December 31, 2006, 2005, and
2004, the Company paid approximately $3.8 million, $6.4 million, and $6.4 million, respectively,
under those supply agreements. The Company’s remaining purchase obligations under those supply
agreements are approximately $2.5 million in 2007.
67
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
Portions of these payments are denominated in foreign currencies and were translated based on their
respective U.S. dollar exchange rates at December 31, 2006. These future payments are subject to
foreign currency exchange rate risk.
Legal Proceedings. In 2000, Howmedica Osteonics Corp. (“Howmedica”) sued the Company alleging
patent infringement. The lawsuit seeks an order of infringement, injunctive relief, unspecified
damages and various other costs and relief and could impact a substantial portion of the Company’s
knee product line. The Company believes, however, that it has strong defenses against Howmedica’s
claims and is vigorously defending this lawsuit. In November 2005, the court issued a Markman
ruling on claim construction holding that the Company’s products do not literally infringe the
claims of Howmedica’s patent. No trial date has been set in this matter. Management is unable to
estimate the potential liability, if any, with respect to the claims and accordingly, no provision
has been made for this contingency as of December 31, 2006. Management believes that the claims are
covered in part by our patent infringement insurance. Management does not believe that the outcome
of this lawsuit will have a material adverse effect on the Company’s financial position or ongoing
results of operations.
The Company is involved in separate disputes in Italy with a former agent and two former employees.
Management believes that it has meritorious defenses to the claims related to these disputes. The
payment of any amount related to these disputes is not probable and cannot be estimated at this
time. Accordingly, no provisions have been made for these matters as of December 31, 2006.
The Company is involved in a dispute with a former consultant who is demanding payment of royalties
on the sales of certain knee products as well as punitive damages. The Company contends that the
plaintiff breached his agreement, and therefore it owes no royalties to the plaintiff. In April
2006, the U.S. District Court for the Eastern District of Massachusetts granted partial summary
judgment in favor of the plaintiff, ruling that the plaintiff did not breach his contract; however,
the claim for punitive damages was dismissed. A damages hearing has been scheduled to be held in
March 2007 to determine the amount of the judgment. Discovery for the damages hearing is ongoing,
and the plaintiff is currently demanding approximately $3.4 million of royalties. This does not
include interest on these royalties. Both parties have the right to appeal this ruling and the
Company intends to appeal the portion of the judgment issued in favor of the plaintiff. The Company
believes that an ultimate unfavorable resolution to this matter is not probable; therefore, it has
not accrued any amounts related to this matter as of December 31, 2006.
The Company is involved in a dispute with a former consultant who is demanding approximately $3.6
million for consulting payments under a contract that the Company terminated in 2005. This dispute
will be heard in binding arbitration, which is anticipated to be scheduled during the second
quarter of 2007. The Company believes that it has meritorious defenses in this dispute and does not
believe that an unfavorable ruling is probable. Therefore, the Company has not accrued any amounts
related to this matter as of December 31, 2006.
In addition to those noted above, the Company is subject to various other legal proceedings,
product liability claims and other matters which arise in the ordinary course of business. In the
opinion of management, the amount of liability, if any, with respect to these matters, will not
have a material adverse effect on the results of operations or financial position of the Company.
Legal costs are generally expensed as incurred.
15. Segment Data:
The Company has one reportable segment, orthopaedic products, which includes the design,
manufacture and marketing of reconstructive joint devices and biologics products. The Company’s
geographic regions
consist of the United States, Europe (which includes the Middle East and Africa) and Other (which
68
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
principally represents Asia and Canada). Long-lived assets are those assets located in each region.
Revenues attributed to each region are based on the location in which the products were sold.
Net sales of orthopaedic products by category and information by geographic region are as follows
(in thousands):
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Net sales by product line: |
||||||||||||
Hips products |
$ | 122,073 | $ | 109,267 | $ | 99,133 | ||||||
Knee products |
94,079 | 94,073 | 87,408 | |||||||||
Biologics products |
65,455 | 62,358 | 62,070 | |||||||||
Extremity products |
45,044 | 40,594 | 36,433 | |||||||||
Other |
12,287 | 12,845 | 12,495 | |||||||||
Total |
$ | 338,938 | $ | 319,137 | $ | 297,539 | ||||||
Net sales by geographic region: |
||||||||||||
United States |
$ | 211,015 | $ | 197,548 | $ | 180,380 | ||||||
Europe |
82,197 | 80,374 | 84,726 | |||||||||
Other |
45,726 | 41,215 | 32,433 | |||||||||
Total |
$ | 338,938 | $ | 319,137 | $ | 297,539 | ||||||
Operating income (loss) by
geographic region: |
||||||||||||
United States |
$ | 18,752 | $ | 32,464 | $ | 31,209 | ||||||
Europe |
(7,563 | ) | (5,633 | ) | 3,535 | |||||||
Other |
8,242 | 6,650 | 3,669 | |||||||||
Total |
$ | 19,431 | $ | 33,481 | $ | 38,413 | ||||||
| December 31, | ||||||||
| 2006 | 2005 | |||||||
Long-lived assets: |
||||||||
United States |
$ | 59,709 | $ | 58,237 | ||||
Europe |
20,055 | 18,012 | ||||||
Other |
6,501 | 4,957 | ||||||
Total |
$ | 86,265 | $ | 81,206 | ||||
No single foreign country accounted for more than 10% of the Company’s total net sales during 2006,
2005 or 2004; however, the largest single foreign country represented approximately 7%, 6%, and 9%
of the Company’s total net sales in 2006, 2005, and 2004, respectively.
Effective January 1, 2006, the Company adopted FAS 123R, which replaced SFAS No. 123 and supersedes
APB Opinion No. 25, and requires recognition of the fair value of an award of equity instruments
granted in exchange for employee services as a cost of those services. The Company elected the
modified prospective method of transition, under which prior periods are not revised for
comparative purposes. As a result, 2006 amounts are not comparable to prior years. The
Company’s U.S. region recognized non-cash stock-based compensation expense within operating income
of $11.7 million in 2006, compared to $467,000 in 2005 and $1.5 million in 2004. The Company’s
European geographic region recognized $1.4 million of non-cash stock-based compensation expense
within operating income in 2006. Stock-based compensation expense was not recognized in the
Company’s European geographic region in
prior years.
69
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
During the year ended December 31, 2005, the Company’s European geographic region incurred charges
of approximately $1.5 million related to the write down of certain inventory due to the termination of an
agreement to distribute certain third party spinal products in Europe, charges of approximately
$1.5 million associated with a European distributor transition and the associated legal dispute,
and charges of approximately $800,000 for severance costs associated with management changes.
16. Quarterly Results of Operations (unaudited):
The following table presents a summary of the Company’s unaudited quarterly operating results for
each of the four quarters in 2006 and 2005, respectively (in thousands). This information was
derived from unaudited interim financial statements that, in the opinion of management, have been
prepared on a basis consistent with the financial statements contained elsewhere in this filing and
include all adjustments, consisting only of normal recurring adjustments, necessary for a fair
statement of such information when read in conjunction with our audited financial statements and
related notes. The operating results for any quarter are not necessarily indicative of results for
any future period.
| 2006 | ||||||||||||||||
| First | Second | Third | Fourth | |||||||||||||
| Quarter | Quarter | Quarter | Quarter | |||||||||||||
Net sales |
$ | 86,256 | $ | 87,492 | $ | 78,637 | $ | 86,553 | ||||||||
Cost of sales |
23,393 | 26,335 | 22,517 | 24,989 | ||||||||||||
Gross profit |
62,863 | 61,157 | 56,120 | 61,564 | ||||||||||||
Operating expenses: |
||||||||||||||||
Selling, general and administrative |
49,486 | 48,416 | 45,494 | 49,177 | ||||||||||||
Research and development |
7,343 | 6,476 | 6,175 | 5,557 | ||||||||||||
Amortization of intangible assets |
1,146 | 1,121 | 987 | 895 | ||||||||||||
Total operating expenses |
57,975 | 56,013 | 52,656 | 55,629 | ||||||||||||
Operating income |
$ | 4,888 | $ | 5,144 | $ | 3,464 | $ | 5,935 | ||||||||
Net income |
$ | 2,309 | $ | 2,750 | $ | 3,605 | $ | 5,747 | ||||||||
Net income per share, basic |
$ | 0.07 | $ | 0.08 | $ | 0.10 | $ | 0.16 | ||||||||
Net income per share, diluted |
$ | 0.07 | $ | 0.08 | $ | 0.10 | $ | 0.16 | ||||||||
70
Table of Contents
WRIGHT MEDICAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(continued)
| 2005 | ||||||||||||||||
| First | Second | Third | Fourth | |||||||||||||
| Quarter | Quarter | Quarter | Quarter | |||||||||||||
Net sales |
$ | 82,601 | $ | 82,789 | $ | 73,479 | $ | 80,268 | ||||||||
Cost of sales |
22,788 | 24,358 | 20,263 | 24,343 | ||||||||||||
Gross profit |
59,813 | 58,431 | 53,216 | 55,925 | ||||||||||||
Operating expenses: |
||||||||||||||||
Selling, general and administrative |
41,869 | 39,297 | 40,110 | 46,089 | ||||||||||||
Research and development |
4,897 | 5,704 | 5,904 | 5,784 | ||||||||||||
Amortization of intangible assets |
1,059 | 1,040 | 1,020 | 1,131 | ||||||||||||
Total operating expenses |
47,825 | 46,041 | 47,034 | 53,004 | ||||||||||||
Operating income |
$ | 11,988 | $ | 12,390 | $ | 6,182 | $ | 2,921 | ||||||||
Net income |
$ | 7,269 | $ | 7,767 | $ | 3,986 | $ | 2,043 | ||||||||
Net income per share, basic |
$ | 0.21 | $ | 0.23 | $ | 0.12 | $ | 0.06 | ||||||||
Net income per share, diluted |
$ | 0.21 | $ | 0.22 | $ | 0.11 | $ | 0.06 | ||||||||
Effective January 1, 2006, the Company adopted the provisions of FAS 123R, electing the
modified-prospective method of transition, under which prior periods are not revised for
comparative purposes. As a result, the results of operations during 2006 are not comparable to
prior year results. The Company recorded approximately $13.8 million ($10.9 million net of taxes)
of non-cash stock-based compensation expense during the year ended December 31, 2006, respectively.
See Note 12 for further information regarding the Company’s stock-based compensation assumptions
and expenses, including pro forma disclosures for prior periods as if it had applied the fair value
recognition provisions of SFAS No. 123 to stock-based employee compensation expense in 2005 and
2004.
The Company’s net income for the third quarter of 2006 included a $1.5 million gain recognized on
the sale of an investment and a $1.4 million tax benefit recognized upon the resolution of foreign
tax circumstances. The Company’s net income for the fourth quarter of 2005 included the after-tax
effects of approximately $1.7 million of costs incurred related to management changes in the
Company’s U.S. and European operations, approximately $1.6 million of charges related to the
termination of an agreement to distribute certain third party spinal products in Europe,
approximately $1.5 million of charges related to a European distributor transition and the
associated legal dispute, and approximately $700,000 of charges to write-down a long-lived asset to
its fair value.
71
Table of Contents
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
Not applicable.
Item 9A. Controls and Procedures.
(a) Evaluation of Disclosure Controls and Procedures
We have established disclosure controls and procedures that are designed to ensure that material
information required to be disclosed by us in the reports that we file or submit under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time
periods specified in the SEC’s rules and forms, and that such information is made known to our
principal executive officer and principal financial officer as appropriate, to allow timely
decisions regarding required disclosure.
Under the supervision and with the participation of our management, including our principal
executive officer and principal financial officer, we conducted an evaluation of the effectiveness
of the design and operation of our disclosure controls and procedures as of the end of the period
covered by this Annual Report. As a result of the material weakness in internal control over
financial reporting discussed below, our principal executive officer and principal financial
officer concluded that our disclosure controls and procedures were not effective as of December 31,
2006. We have since taken corrective actions that have been designed to remediate this material
weakness as of the filing date of this Annual Report.
We believe our financial statements included in this annual report present fairly in all material
respects the financial position, results of operations and cash flows for each of the periods presented herein.
(b) Management’s Annual Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over
financial reporting. Under the supervision of our management, including our principal executive
officer and principal financial officer, we conducted an evaluation of the effectiveness of our
internal control over financial reporting as of December 31, 2006, based on the criteria
established in Internal Control – Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO).
Based on this evaluation, we have identified a material weakness in internal control over financial
reporting described below, and as such, and based upon the criteria issued by COSO, our management
has concluded that our internal control over financial reporting was not effective as of December
31, 2006. A material weakness is a control deficiency, or combination of deficiencies, that results
in more than a remote likelihood that a material misstatement of the annual or interim financial
statements will not be prevented or detected. Management’s assessment of the effectiveness of our
internal control over financial reporting as of December 31, 2006, has been audited by KPMG LLP, an
independent registered public accounting firm, as stated in their report included within this
Annual Report.
Inadequate Controls over the Calculation of Depreciation Expense
As of December 31, 2006, the Company had ineffective policies and procedures relating to the
calculation of depreciation expense for its surgical instruments. Specifically, we did not have
policies and procedures in place to ensure that depreciation expense was calculated based on the
appropriate cost basis of these assets, resulting in an error in depreciation expense and
accumulated depreciation, which was corrected in our 2006 financial statements. Management has
determined that this deficiency resulted in a more than remote
likelihood that a material misstatement of our annual or interim
financial statements would not be prevented or detected.
(c) Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during the
quarter ended December 31, 2006, that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.
72
Table of Contents
(d) Remediation of Controls over the Calculation of Depreciation Expense
In response to the material weakness noted above, we performed an in-depth review of the Company’s
policies and procedures for determining depreciation expense and adjusted the calculation to
include the correct cost basis for the surgical instruments. Additionally, the method for capturing
the proper cost basis of these assets has been revised to appropriately calculate depreciation
expense in the future. The calculation of depreciation expense will continue to be reviewed on a
monthly basis as part of our internal control over financial reporting.
Based upon the corrective actions identified above, we believe that the controls we have
implemented have been designed to remediate the material weakness as of the filing date of this
Annual Report.
Item 9B. Other Information.
Not applicable.
73
Table of Contents
PART III
Item 10. Directors, Executive Officers, and Corporate Governance
The information required by this item is incorporated by reference from the definitive proxy
statement to be filed within 120 days after December 31, 2006, pursuant to Regulation 14A under the
Securities Exchange Act of 1934 in connection with the annual meeting of stockholders to be held on
May 17, 2007.
Item 11. Executive Compensation.
The information required by this item is incorporated by reference from the definitive proxy
statement to be filed within 120 days after December 31, 2006, pursuant to Regulation 14A under the
Securities Exchange Act of 1934 in connection with the annual meeting of stockholders to be held on
May 17, 2007.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters.
The information required by this item is incorporated by reference from the definitive proxy
statement to be filed within 120 days after December 31, 2006, pursuant to Regulation 14A under the
Securities Exchange Act of 1934 in connection with the annual meeting of stockholders to be held on
May 17, 2007.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The information required by this item is incorporated by reference from the definitive proxy
statement to be filed within 120 days after December 31, 2006, pursuant to Regulation 14A under the
Securities Exchange Act of 1934 in connection with the annual meeting of stockholders to be held on
May 17, 2007.
Item 14. Principal Accounting Fees and Services.
The information required by this item is incorporated by reference from the definitive proxy
statement to be filed within 120 days after December 31, 2006, pursuant to Regulation 14A under the
Securities Exchange Act of 1934 in connection with the annual meeting of stockholders to be held on
May 17, 2007.
74
Table of Contents
PART IV
Item 15. Exhibits and Financial Statement Schedules.
Financial Statements
See Index to Consolidated Financial Statements in “Financial Statements and Supplementary Data.”
Financial Statement Schedules
See Schedule II — Valuation and Qualifying Accounts on page S-2 of this report.
Index to Exhibits
| Exhibit | ||
| No. | Description | |
3.1
|
Fourth Amended and Restated Certificate of Incorporation of Wright Medical Group, Inc., (1) as amended by Certificate of Amendment of Fourth Amended and Restated Certificate of Incorporation of Wright Medical Group, Inc. (2) | |
3.2
|
Amended and Restated By-laws of Wright Medical Group, Inc. (3) | |
4.1
|
Form of Common Stock certificate. (1) | |
10.1
|
Credit Agreement dated as of June 30, 2006, among Wright Medical Group, Inc., its domestic subsidiaries, the lenders named therein, Bank of America, N.A., and SunTrust Bank.(4) | |
10.2
|
Fourth Amended and Restated 1999 Equity Incentive Plan (the “1999 Plan”). (5) | |
10.3
|
Form of Incentive Stock Option Agreement, as amended by form of Amendment No. 1 to Incentive Stock Option Agreement, pursuant to the 1999 Plan. (1) | |
10.4
|
Form of Non-Qualified Stock Option Agreement pursuant to the 1999 Plan. (1) | |
10.5
|
Form of Executive Stock Option Agreement pursuant to the 1999 Plan. (6) | |
10.6
|
Form of Non-Employee Director Stock Option Agreement pursuant to the 1999 Plan. (6) | |
10.7
|
Wright Medical Group, Inc. Executive Performance Incentive Plan. (7) | |
10.8
|
Form of Indemnification Agreement between Wright Medical Group, Inc. and its directors and executive officers. (1) | |
10.9
|
Employment Agreement dated as of July 1, 2004, between Wright Medical Technology, Inc. and Laurence Y. Fairey, (8) as amended by First Amendment to Employment Agreement dated as of April 4, 2005. (9) | |
10.10
|
Employment Agreement dated as of April 25, 2005, between Wright Medical Technology, Inc. and R. Glen Coleman. (6) | |
10.11
|
Employment Agreement dated as of November 22, 2005, between Wright Medical Technology, Inc. and F. Barry Bays. (10) | |
10.12
|
Employment Agreement dated as of November 22, 2005, between Wright Medical Technology, Inc. and Jeffrey G. Roberts. (10) | |
10.13
|
Employment Agreement dated as of November 22, 2005, between Wright Medical Technology, Inc. and John K. Bakewell. (10) | |
10.14
|
Employment Agreement dated as of November 22, 2005, between Wright Medical Technology, Inc. and John R. Treace.(10) | |
10.15
|
Employment Agreement dated as of November 22, 2005, between Wright Medical Technology, Inc. and Jason P. Hood (11). | |
10.16
|
Employment Agreement dated as of April 4, 2006, between Wright Medical Technology, Inc. and Gary D. Henley. (12) |
75
Table of Contents
| Exhibit | ||
| No. | Description | |
10.17
|
Severance and Release Agreement dated as of April 1, 2005, between Wright Medical Technology, Inc. and Brian T. Ennis. (7) | |
10.18
|
Severance and Release Agreement dated as of October 5, 2005, between Wright Medical Technology, Inc. and Laurence Y. Fairey. (13) | |
10.19
|
Severance and Release Agreement dated as of October 17, 2005, between Wright Medical Technology, Inc. and R. Glen Coleman. (14) | |
11
|
Computation of earnings per share (included in Note 10 of the Notes to Consolidated Financial Statements in “Financial Statements and Supplementary Data”). | |
21
|
Subsidiaries of Wright Medical Group, Inc. | |
23
|
Consent of KPMG LLP | |
31.1
|
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) Under the Securities Exchange Act of 1934. | |
31.2
|
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) Under the Securities Exchange Act of 1934. | |
32
|
Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Rule 13a-14(b) Under the Securities Exchange Act of 1934 and Section 1350 of Chapter 63 of Title 18 of the United States Code. |
| (1) | Incorporated by reference to the Company’s Registration Statement on Form S-1 (Registration No. 333-59732), as amended. | |
| (2) | Incorporated by reference to the Company’s Registration Statement on Form S-8 filed on May 14, 2004. | |
| (3) | Incorporated by reference to the Company’s current report on Form 8-K filed on March 31, 2004. | |
| (4) | Incorporated by reference to the Company’s current report on Form 8-K filed on July 7, 2006. | |
| (5) | Incorporated by reference to the Company’s definitive Proxy Statement filed on April 13, 2005. | |
| (6) | Incorporated by reference to the Company’s current report on Form 8-K filed on April 27, 2005. | |
| (7) | Incorporated by reference to the Company’s current report on Form 8-K filed on February 10, 2005. | |
| (8) | Incorporated by reference to the Company’s quarterly report on Form 10-Q for the quarter ended June 30, 2004. | |
| (9) | Incorporated by reference to the Company’s current report on Form 8-K filed on April 7, 2005. | |
| (10) | Incorporated by reference to the Company’s current report on Form 8-K filed on November 22, 2005. | |
| (11) | Incorporated by reference to the Company’s quarterly report on Form 10-Q filed on May 2, 2006. | |
| (12) | Incorporated by reference to the Company’s current report on Form 8-K filed on March 22, 2006. | |
| (13) | Incorporated by reference to the Company’s current report on Form 8-K filed on October 6, 2005. | |
| (14) | Incorporated by reference to the Company’s current report on Form 8-K filed on October 20, 2005. |
76
Table of Contents
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.
February 27, 2007
| Wright Medical Group, Inc. |
||||
| By: | /s/ Gary D. Henley | |||
| Gary D. Henley | ||||
| President and Chief Executive Officer | ||||
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the capacities and on the
dates indicated.
| Signature | Title | Date | ||
/s/ Gary D. Henley
|
President, Chief Executive Officer and Director (Principal Executive Officer) | February 27, 2007 | ||
/s/ John K. Bakewell
|
Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) | February 27, 2007 | ||
/s/ F. Barry Bays
|
Executive Chairman of the Board and Former President and Chief Executive Office | February 27, 2007 | ||
/s/ Martin J. Emerson
|
Director | February 27, 2007 | ||
/s/ Lawrence W. Hamilton
|
Director | February 27, 2007 | ||
/s/ Beverly A. Huss
|
Director | February 27, 2007 | ||
/s/ Robert J. Quillinan
|
Director | February 27, 2007 | ||
/s/ David D. Stevens
|
Director | February 27, 2007 | ||
/s/ Thomas E. Timbie
|
Director | February 27, 2007 | ||
/s/ James T. Treace
|
Director | February 27, 2007 |
77
Table of Contents
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Wright Medical Group, Inc.:
Wright Medical Group, Inc.:
Under date of February 27, 2007, we reported on the consolidated balance sheets of Wright Medical
Group, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated
statements of operations, changes in stockholders’ equity and comprehensive income, and cash flows
for each of the years in the three-year period ended December 31, 2006. These consolidated
financial statements, and our report thereon, are included in the annual report on Form 10–K for
the year 2006. In connection with our audits of the aforementioned consolidated financial
statements, we also audited the related consolidated financial statement schedule listed in Item 15
in the annual report on Form 10–K. The financial statement schedule is the responsibility of the
Company’s management. Our responsibility is to express an opinion on the financial statement
schedule based on our audit.
In our opinion, the financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, present fairly, in all material respects, the
information set forth therein.
As discussed in the Notes 2 and 12 to the consolidated financial statements, effective January 1,
2006, the Company adopted the fair value method of accounting for stock-based compensation as
required by Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based
Payment. Also as discussed in Note 2 to the consolidated financial statements, the Company changed
its method of quantifying errors in 2006.
/s/ KPMG LLP
Memphis, Tennessee
February 27, 2007
February 27, 2007
S- 1
Table of Contents
Wright Medical Group, Inc.
Schedule II-Valuation and Qualifying Accounts
(In thousands)
Schedule II-Valuation and Qualifying Accounts
(In thousands)
| Balance at | Charged to | Balance at | ||||||||||||||
| Beginning | Cost and | Deductions | End of | |||||||||||||
| of Period | Expenses | and Other | Period | |||||||||||||
Allowance for doubtful accounts: |
||||||||||||||||
For the period ended: |
||||||||||||||||
December 31, 2006 |
$ | 1,997 | $ | 820 | $ | (33 | ) | $ | 2,850 | |||||||
December 31, 2005 |
$ | 1,820 | $ | 510 | $ | 333 | $ | 1,997 | ||||||||
December 31, 2004 |
$ | 1,489 | $ | 268 | $ | (63 | ) | $ | 1,820 | |||||||
Sales returns and allowance: |
||||||||||||||||
For the period ended: |
||||||||||||||||
December 31, 2006 |
$ | 434 | $ | (84 | ) | $ | — | $ | 350 | |||||||
December 31, 2005 |
$ | 395 | $ | 39 | $ | — | $ | 434 | ||||||||
December 31, 2004 |
$ | 412 | $ | (17 | ) | $ | — | $ | 395 | |||||||
S- 2