UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2006
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from to
COMMISSION FILE NO. 0-26224
INTEGRA LIFESCIENCES HOLDINGS CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 51-0317849
--------------------------------------- -------------------------------
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
311 ENTERPRISE DRIVE
PLAINSBORO, NEW JERSEY 08536
--------------------------------------- --------------------------------
(ADDRESS OF PRINCIPAL (ZIP CODE)
EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (609) 275-0500
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
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 [ ] Accelerated filer [X] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
The number of shares of the registrant's Common Stock, $.01 par value,
outstanding as of November 6, 2006 was 27,771,327.
1
INTEGRA LIFESCIENCES HOLDINGS CORPORATION
INDEX
Page Number
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Statements of Operations for the three and
nine months ended September 30, 2006 and 2005 (Unaudited)......................3
Condensed Consolidated Balance Sheets as of September 30, 2006 and
December 31, 2005 (Unaudited)..................................................4
Condensed Consolidated Statements of Cash Flows for the nine
months ended September 30, 2006 and 2005 (Unaudited)...........................5
Notes to Unaudited Condensed Consolidated Financial Statements.................6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations............................................20
Item 3. Quantitative and Qualitative Disclosures About Market Risk...........35
Item 4. Controls and Procedures..............................................36
PART II. OTHER INFORMATION
Item 1. Legal Proceedings....................................................37
Item 1A. Risk Factors.........................................................38
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds..........41
Item 6. Exhibits.............................................................42
SIGNATURES....................................................................43
EXHIBITS......................................................................44
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(In thousands, except per share amounts)
Three Months Ended September 30, Nine Months Ended September 30,
2006 2005 2006 2005
---- ---- ---- ----
Total Revenue.................................. $116,647 $69,334 $293,903 $204,951
Costs and Expenses:
Cost of product revenues....................... 47,559 26,394 116,869 78,423
Research and development ...................... 10,991 3,110 20,518 9,256
Selling, general and administrative ........... 43,431 22,653 111,770 72,610
Intangible asset amortization ................. 2,852 1,085 6,150 3,470
------- ------- -------- ------
Total costs and expenses ................. 104,833 53,242 255,307 163,759
Operating income .............................. 11,814 16,092 38,596 41,192
Interest income ............................... 375 952 1,993 2,813
Interest expense .............................. (4,362) (1,345) (8,117) (3,094)
Other income (expense), net ................... (1,765) (4) (1,832) (638)
------- ------- -------- -------
Income before income taxes .................... 6,062 15,695 30,640 40,273
Income tax expense ............................ 3,468 5,213 11,364 13,693
------- ------- -------- -------
Net income..................................... $ 2,594 $10,482 $ 19,276 $ 26,580
======= ======= ======== ========
Basic net income per share .................... $ 0.09 $ 0.35 $ 0.65 $ 0.88
Diluted net income per share .................. $ 0.09 $ 0.33 $ 0.64 $ 0.82
Weighted average common
shares outstanding :
Basic .................................... 29,193 30,039 29,457 30,334
Diluted .................................. 29,867 34,297 30,162 34,727
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(In thousands)
September 30, 2006 December 31, 2005
ASSETS
Current Assets:
Cash and cash equivalents......................................... $ 24,322 $ 46,889
Short-term investments ........................................... -- 80,327
Accounts receivable, net of allowances of
$4,520 and $3,508 ............................................ 76,715 49,007
Inventories, net ................................................. 93,773 67,476
Deferred tax assets............................................... 11,337 10,842
Prepaid expenses and other current assets ........................ 13,352 11,411
--------- ---------
Total current assets ......................................... 219,499 265,952
Non-current investments................................................ -- 16,168
Property, plant, and equipment, net ................................... 40,659 27,451
Identifiable intangible assets, net ................................... 178,354 64,569
Goodwill............................................................... 158,243 68,364
Other assets .......................................................... 7,705 5,928
--------- ---------
Total assets .......................................................... $ 604,460 $ 448,432
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Borrowings under senior credit facility........................... 87,000 --
Convertible securities............................................ 115,205 --
Accounts payable, trade .......................................... 16,255 8,978
Income taxes payable ............................................. -- 715
Deferred revenue ................................................. 4,986 88
Accrued expenses and other current liabilities ................... 32,010 21,506
--------- ---------
Total current liabilities .................................... 255,456 31,287
Long-term debt ........................................................ 4,889 118,378
Deferred tax liabilities .............................................. 33,094 2,520
Other liabilities...................................................... 5,540 6,429
--------- ---------
Total liabilities ..................................................... 298,979 158,614
Commitments and contingencies (see Footnote 11) -- --
Stockholders' Equity:
Common stock; $0.01 par value; 60,000 authorized shares;
31,190 and 29,823 issued at September 30, 2006 and
December 31, 2005, respectively .............................. 312 298
Additional paid-in capital ....................................... 353,415 333,179
Treasury stock, at cost; 3,226 and 2,368 shares at
September 30, 2006 and December 31, 2005, respectively ....... (107,640) (75,815)
Accumulated other comprehensive income (loss):
Unrealized loss on available-for-sale securities, net of tax . -- (801)
Foreign currency translation adjustment ...................... 5,010 (2,300)
Minimum pension liability adjustment, net of tax ............. (1,821) (1,672)
Retained earnings................................................. 56,205 36,929
--------- ---------
Total stockholders' equity ................................... 305,481 289,818
--------- ---------
Total liabilities and stockholders' equity ............................ $ 604,460 $ 448,432
========= =========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(In thousands)
Nine Months Ended September 30,
2006 2005
---- ----
OPERATING ACTIVITIES:
Net income ............................................................ $ 19,276 $ 26,580
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization ................................ 13,181 8,488
Deferred income tax provision (benefit) ...................... (7,821) 10,004
Amortization of discount/premium on investments .............. 364 1,543
Loss of sale of assets/ investments .......................... 1,112 --
Amortization of bond issuance costs........................... 1,910 611
Share-based compensation ..................................... 10,499 77
Excess tax benefits from stock-based compensation arrangements (730) --
In-process research and development........................... 5,600 500
Other, net ................................................... 200 40
Changes in assets and liabilities, net of business acquisitions:..
Accounts receivable .......................................... (18,373) 2,975
Inventories .................................................. (527) (11,505)
Prepaid expenses and other current assets .................... (460) (5,139)
Other non-current assets ..................................... (114) 144
Accounts payable accrued expenses and other liabilities....... 4,215 (1,337)
Income taxes payable ......................................... (316) (869)
Deferred revenue ............................................. 4,776 (72)
Other accrued expenses and current liabilities................ 7,781 9,677
Deferred tax liabilities...................................... 10,409 --
Other non-current liabilities................................. (214) 170
--------- --------
Net cash provided by operating activities ............................. 50,768 41,887
--------- --------
INVESTING ACTIVITIES:
Cash used in business acquisition, net of cash acquired ............... (227,114) (50,527)
Proceeds from sales/maturities of investments.......................... 109,872 39,477
Purchases of available-for-sale investments ........................... (13,074) (36,724)
Purchases of property and equipment ................................... (7,236) (6,632)
--------- ---------
Net cash used in investing activities ................................. (137,552) (54,406)
--------- ---------
FINANCING ACTIVITIES:
Borrowings under senior credit facility................................ 140,000 --
Repayment of loans .................................................... (54,463) (270)
Proceeds from exercised stock options.................................. 9,155 5,368
Excess tax benefits from stock-based compensation arrangements ........ 730 --
Purchases of treasury stock ........................................... (31,825) (24,650)
--------- ---------
Net cash provided by (used in) financing activities ................... 63,597 (19,552)
-------- ---------
Effect of exchange rate changes on cash and cash equivalents........... 620 (432)
-------- --------
Net decrease in cash and cash equivalents ............................. (22,567) (32,503)
Cash and cash equivalents at beginning of period ...................... 46,889 69,855
-------- --------
Cash and cash equivalents at end of period ............................ $ 24,322 $ 37,352
======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
General
In the opinion of management, the September 30, 2006 unaudited condensed
consolidated financial statements contain all adjustments (consisting only of
normal recurring adjustments) necessary for a fair statement of the financial
position, results of operations and cash flows of the Company. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted in accordance with the instructions to Form 10-Q and Rule
10-01 of Regulation S-X. These unaudited condensed consolidated financial
statements should be read in conjunction with the Company's consolidated
financial statements for the year ended December 31, 2005 included in the
Company's Annual Report on Form 10-K. The December 31, 2005 condensed
consolidated balance sheet was derived from audited financial statements but
does not include all disclosures required by accounting principles generally
accepted in the United States. Operating results for the three- and nine-month
periods ended September 30, 2006 are not necessarily indicative of the results
to be expected for the entire year.
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the reported amount of
assets and liabilities, the disclosure of contingent liabilities, and the
reported amounts of revenues and expenses. Significant estimates affecting
amounts reported or disclosed in the consolidated financial statements include
allowances for doubtful accounts receivable and sales returns, net realizable
value of inventories, estimates of future cash flows associated with long-lived
asset valuations, depreciation and amortization periods for long-lived assets,
fair value estimates of stock-based compensation awards, valuation allowances
recorded against deferred tax assets, estimates of amounts to be paid to
employees and other exit costs to be incurred in connection with the
restructuring of our operations and loss contingencies. These estimates are
based on historical experience and on various other assumptions that are
believed to be reasonable under the current circumstances. Actual results could
differ from these estimates.
Certain reclassifications have been made to the prior year financial statements
to conform to the current year's presentation.
We revised our presentation of cost of product revenues in 2006 to include
amortization of product technology-based intangible assets. Previously, this
amortization was included in intangible asset amortization in the condensed
consolidated statement of operations. We have revised prior period amounts to
conform to the current year's presentation. This revision increased cost of
product revenues by $380,000 and $1,138,000 for the three and nine-month periods
ended September 30, 2005, respectively.
Recently Adopted Accounting Standard
The Company adopted Statement of Financial Accounting Standards No. 123(R)
"Share-Based Payment" on January 1, 2006 using the modified prospective method
which requires companies (1) to record the unvested portion of previously issued
awards that remain outstanding at the initial date of adoption and (2) to record
compensation expense for any awards issued, modified or settled after the
effective date of the statement. As a result of the adoption of Statement
123(R), the Company began expensing stock options in the 2006 first quarter
using the fair value method prescribed by Statement 123(R). Stock-based
compensation cost is measured at the grant date based on the fair value of an
award and is recognized on a straight-line basis as an expense over the
requisite service period, which is the vesting period. Certain of these costs
are capitalized into inventory and will be recognized as an expense when the
related inventory is sold. The Company's income before income taxes and net
income for the nine months ended September 30, 2006 were $10.3 million and $3.3
million lower, respectively, than if it had continued to account for share-based
compensation under APB No. 25.
The Company recognizes stock-based compensation expense in the consolidated
statement of operations based on the awards that are expected to vest.
Accordingly, the Company's recognized stock-based compensation expense is net of
6
the impact of estimated forfeitures. Statement 123(R) requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates. The Company estimates
forfeitures based on historical experience.
Statement 123(R) supercedes the Company's previous accounting under Accounting
Principals Boards Opinion No. 25 "Accounting for Stock Issued to Employees" for
periods subsequent to December 31, 2005. In March 2005, the Securities and
Exchange Commission issued Staff Accounting Bulletin No. 107, which provides
interpretive guidance in applying the provisions of Statement 123(R). The
Company has applied the provisions of SAB 107 in its adoption of Statement
123(R). Had compensation cost for the Company's stock option plans been
determined based on the fair value of the award at the grant date consistent
with Statement 123, the Company's net income and basic and diluted net income
per share for the three and nine months ended September 30, 2005 would have been
as follows (in thousands, except per share amounts):
Three Months Ended Nine Months Ended
September 30, 2005 September 30, 2005
------------------ ------------------
Net income, as reported........................... $10,482 $26,580
Add back: Total stock-based employee compensation
expense determined under the intrinsic
value-based method for all awards, net of 30 53
related tax effects...................
Less: Total stock-based employee compensation
expense determined under the fair
value-based method for all awards, net of
related tax effects.................... (1,897) (5,383)
-------- -------
Pro forma .................................... $ 8,615 $21,250
======= =======
Net income per share:
Basic:
As reported .................................. $ 0.35 $ 0.88
Pro forma .................................... $ 0.29 $ 0.70
Diluted:
As reported .................................. $ 0.33 $ 0.82
Pro forma .................................... $ 0.28 $ 0.67
Statement 123(R) did not change the accounting for stock-based awards granted to
non-employees.
Recently Issued Accounting Standards and Other Matters
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS
No. 158, Employer's Accounting for Defined Benefit Pension and Other
Postretirement Plans--an amendment of FASB Statements No. 87, 88, 106 and 132(R)
.. SFAS No. 158 requires the Company to (a) recognize a plan's funded status in
its statement of financial position, (b) measure a plan's assets and its
obligations that determine its funded status as of the end of the employer's
fiscal year, and (c) recognize changes in the funded status of a defined
postretirement plan in the year in which the changes occur through other
comprehensive income. The requirement to recognize the funded status of a
benefit plan and the disclosure requirements are effective for the Company for
the fiscal year ending December 31, 2006. The Company believes the
implementation of this provision will not have a material impact on its
financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This
Statement defines fair value, establishes a framework for measuring fair value
in generally accepted accounting principles (GAAP), and expands disclosures
about fair value measurements. SFAS No. 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007. The
Company is currently assessing the impact this provision may have on its
financial position or results of operations.
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 the
quantification of misstatements based on their impact to both the balance sheet
and the income statement to determine materiality. The guidance provides for a
one-time cumulative effect adjustment to correct for misstatements for errors
that were not deemed material under a company's prior approach but are material
under the SAB 108 approach. SAB 108 is effective for the fiscal year ending
December 31, 2006. The Company believes the implementation of this
provision will not have a material impact on its financial position or results
of operations.
7
In July 2006, the FASB issued FASB Interpretation 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 tax recognition
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. FIN 48 also requires
additional disclosures of unrecognized tax benefits, including a reconciliation
of the beginning and ending balance. The provisions of FIN 48 are effective
January 1, 2007. The Company is currently assessing the impact that the adoption
of FIN 48 will have on its financial position or results of operations.
2. BUSINESS ACQUISITIONS
Newdeal Technologies SAS
In January 2005, the Company acquired all of the outstanding capital stock of
Newdeal Technologies SAS ("Newdeal Technologies") for $51.9 million in cash paid
at closing, a $0.7 million working capital adjustment paid in January 2006, and
$0.8 million of acquisition related expenses. Additionally, the Company agreed
to pay the sellers up to an additional 1.3 million Euros if the sellers were to
continue their employment with the Company through January 3, 2006. This
additional payment was accrued to selling, general and administrative expense on
a straight-line basis in 2005 over the one-year employment requirement period
and was paid in January 2006.
Radionics
On March 3, 2006, the Company acquired the assets of the Radionics Division of
Tyco Healthcare Group, L.P. for approximately $74.5 million in cash paid at
closing, subject to certain adjustments, and $3.2 million of acquisition-related
expenses in a transaction treated as a business combination. Radionics, based in
Burlington, Massachusetts, is a leader in the design, manufacture and sale of
advanced minimally invasive medical instruments in the fields of neurosurgery
and radiation therapy. Radionics' products include the CUSA EXcel(R) ultrasonic
surgical aspiration system, the CRW(R) stereotactic system, the XKnife(R)
stereotactic radiosurgery system, and the OmniSight(R) EXcel image-guided
surgery system.
The following summarizes the fair value of the assets acquired and liabilities
assumed:
Inventory .................................................. $ 8,201
Property, plant and equipment .............................. 1,365 Wtd. Avg. Life
--------------
Intangible assets:
Tradename ............................................. 18,100 Indefinite
Customer relationships ................................ 20,900 7 years
Technology ............................................ 10,000 10 years
Goodwill ................................................... 21,054
Other assets ............................................... 72
-------
Total assets acquired ................................. 79,692
-------
Accrued expenses and other current liabilities ............. 425
Deferred revenue ........................................... 1,605
-------
Total liabilities assumed ............................. 2,030
-------
Net assets acquired ........................................ $77,662
=======
8
Management determined the fair value of assets acquired with the assistance of a
third-party valuation firm. Certain adjustments were finalized in the second
quarter of 2006 relating to the Radionics valuation, which primarily resulted in
an increase to intangible assets and a reduction in goodwill of $4 million. The
adjustment was related to the finalization of certain assumptions in the
valuation of identifiable intangible assets. Additional direct costs of
approximately $450,000 were paid in the third quarter and have been added to
goodwill. The goodwill recorded in connection with this acquisition is based on
the benefits the Company expects to generate from the synergy between Radionics'
ultrasonic aspirator product line and the Company's ultrasonic aspirator product
lines. The goodwill acquired in the Radionics acquisition is expected to be
deductible for tax purposes.
Miltex
On May 12, 2006, the Company acquired all of the outstanding capital stock of
Miltex Holdings, Inc. ("Miltex") for $102.7 million in cash paid at closing,
subject to certain adjustments, and $0.6 million of transaction-related costs.
Miltex, based in York, Pennsylvania, is a leading provider of surgical and
dental hand instruments to alternate site facilities, which includes physician
and dental offices and ambulatory surgery care sectors. Miltex sells products
under the Miltex(R), Meisterhand(R), Vantage(R), Moyco(R), Union Broach(R), and
Thompson(R) trade names in over 65 countries, using a network of independent
distributors. Miltex operates a manufacturing and distribution facility in York,
Pennsylvania and also operates a leased facility in Tuttlingen, Germany, where
Miltex's staff coordinates design, production and delivery of instruments.
The following summarizes the preliminary allocation of the purchase price based
on the fair value of the assets acquired and liabilities assumed (in thousands):
Inventory .................................................. $ 16,775
Other current assets ....................................... 7,935
Property, plant and equipment .............................. 7,699
Intangible assets: Wtd. Avg. Life
--------------
Customer relationships ................................ 13,100 15 years
Tradename (Miltex)..................................... 13,500 Indefinite
Tradename (Moyco, Union Branch, Thompson).............. 300 4 years
Tradename (other product lines)........................ 600 15 years
Technology ............................................ 1,100 10 years
Supplier relationships................................. 29,300 30 years
Goodwill ................................................... 40,431
Other assets ............................................... 219
--------
Total assets acquired ................................. 130,959
--------
Accrued expenses and other current liabilities ............. 5,066
Deferred tax liabilities ................................... 22,588
--------
Total liabilities assumed ............................. 27,654
--------
Net assets acquired ........................................ $103,305
========
Management determined the preliminary fair value of assets acquired with the
assistance of a third-party valuation firm. Certain adjustments were made in the
third quarter of 2006 relating to the Miltex valuation. The most significant of
which resulted in the recognition of a $29.3 million supplier relationship
intangible asset, a decrease of $1.9 million in the customer relationship
intangible asset, a decrease in goodwill of $13.8 million and an increase in
deferred tax liabilities of $11.7 million. A portion of the goodwill acquired in
the Miltex acquisition is expected to be deductible for tax purposes. Certain
elements of the purchase price allocation are considered preliminary,
particularly as they relate to the final valuation of certain identifiable
intangible assets. Additional changes are not expected to be significant as the
allocations are finalized.
9
Canada Microsurgical, Ltd.
On July 5, 2006, the Company acquired all of the outstanding capital stock of
Canada Microsurgical, Ltd. ("CML") for $5.8 million in cash paid at closing,
subject to certain adjustments, and $0.1 million of transaction-related costs.
In addition, the Company may pay up to an additional 2.1 million Canadian
dollars over the next three years, depending on the performance of the business.
If and when such amounts are paid, then those payments will be added to
goodwill. CML, a long-standing distributor for the Company, has eight sales
representatives covering each province in Canada.
The following summarizes the preliminary allocation of the purchase price based
on the fair value of the assets acquired and liabilities assumed (in thousands):
Inventory .................................................. $1,576
Other current assets ....................................... 1,121
Intangible assets: Wtd. Avg. Life
--------------
Customer relationships ................................ 2,994 6 years
Tradename ............................................. 2,140 15 years
Non-compete............................................ 90 5 years
Goodwill ................................................... 610
Other assets ............................................... 21
------
Total assets acquired ................................. 8,552
------
Accrued expenses and other current liabilities ............. 686
Deferred tax liabilities ................................... 1,963
------
Total liabilities assumed ............................. 2,649
------
Net assets acquired ........................................ $5,903
======
Management determined the preliminary fair value of assets acquired. Certain
elements of the purchase price allocation are considered preliminary,
particularly as they relate to the final valuation of certain identifiable
intangible assets. Additional changes are not expected to be significant as the
allocations are finalized.
Kinetikos Medical, Inc.
On July 31, 2006, the Company acquired all of the outstanding capital stock of
Kinetikos Medical, Inc. ("KMI") for $39.5 million in cash paid at closing,
subject to certain adjustments, and $1.1 million of transaction-related costs.
In addition, the Company may pay up to an additional $20 million over the next
two years, depending on the performance of the business. If and when such
amounts are paid, then those payments will be added to goodwill. Subsequent to
closing, the Company implemented certain changes in the KMI business, including
eliminating approximately one-half of the positions located in the Carlsbad,
California facility. In addition, the Company plans to discontinue operating
under the name of KMI before the end of this year and to exit the Carlsbad
facility and move the remaining operations to its San Diego facility during
2007. A restructuring provision of $360,000 has been set up on the opening
balance sheet in connection with these plans as part of the purchase price
allocation.
KMI, based in Carlsbad, California, was a leading developer and manufacturer of
innovative orthopedic implants and surgical devices for small bone and joint
procedures involving the foot, ankle, hand, wrist and elbow. KMI marketed
products that addressed both the trauma and reconstructive segments of the
extremities market. KMI's reconstructive products are largely focused on
treating deformities and arthritis in small joints of the upper and lower
extremity, while its trauma products are focused on the treatment of fractures
of small bones most commonly found in the extremities. The Company has
integrated the KMI product line into its U.S. direct sales force while
maintaining seven former KMI independent sales agencies. The Company plans to
increase sales of KMI products internationally through its well-established
Newdeal infrastructure.
10
The following summarizes the preliminary allocation of the purchase price based
on the fair value of the assets acquired and liabilities assumed (in thousands):
Inventory .................................................. $ 2,208
Other current assets ....................................... 2,451
Property, plant and equipment .............................. 1,646
Intangible assets: Wtd. Avg. Life
--------------
Customer relationships ................................ 6,100 3.5 years
Tradename (MBA, UNI2) ................................. 300 5 years
Developed technology patents........................... 2,000 15 years
In-process research and development.................... 5,600 Expensed immediately
Goodwill ................................................... 23,624
Other assets ............................................... 1,260
-------
Total assets acquired ................................. 45,189
-------
Accrued expenses and other liabilities ..................... 1,933
Deferred tax liabilities ................................... 2,684
-------
Total liabilities assumed ............................. 4,617
-------
Net assets acquired ........................................ $40,572
=======
Management determined the preliminary fair value of assets acquired with the
assistance of a third-party valuation firm. The Company recorded an in-process
research and development charge of $5.6 million in the third quarter of 2006 in
connection with this acquisition. Certain elements of the purchase price
allocation are considered preliminary, particularly as they relate to the final
valuation of certain identifiable intangible assets. Additional changes are not
expected to be significant as the allocations are finalized.
The results of operations of each of the acquired businesses have been included
in the condensed consolidated financial statements since their respective dates
of acquisition.
The following unaudited pro forma financial information summarizes the results
of operations for the three months and nine months ended September 30, 2006 and
2005 as if the acquisitions had been completed as of the beginning of 2005. The
pro forma results are based upon certain assumptions and estimates, and they
give effect to actual operating results prior to the acquisitions and
adjustments to reflect increased interest expense, depreciation expense,
intangible asset amortization, and income taxes at a rate consistent with the
Company's statutory rate in each year. No effect has been given to cost
reductions or operating synergies. As a result, these pro forma results do not
necessarily represent results that would have occurred if the acquisitions had
taken place on the basis assumed above, nor are they indicative of the results
of future combined operations.
Three Months Ended September 30, Nine Months Ended September
30,
(in thousands, except per share amounts) 2006 2005 2006 2005
---- ---- ---- ----
Total Revenue.................................. $117,768 $103,357 $337,692 $305,932
Net income ..................................... 7,777 12,286 22,568 23,754
Net income per share:
Basic ..................................... $0.27 $0.41 $0.77 $0.78
Diluted ................................... $0.26 $0.38 $0.75 $0.74
11
3. INVENTORIES
Inventories, net consisted of the following (in thousands):
September 30, 2006 December 31, 2005
Raw materials........................................ $15,138 $13,175
Work-in process...................................... 14,331 9,801
Finished goods....................................... 64,304 44,500
-------- --------
$93,773 $67,476
======= =======
The Company capitalizes inventory costs associated with certain products prior
to regulatory approval, based on management's judgment of probable future
commercialization. The Company could be required to expense previously
capitalized costs related to pre-approval inventory upon a change in such
judgment, due to, among other potential factors, a denial or delay of approval
by necessary regulatory bodies or a decision by management to discontinue the
related development program.
In June 2006, the Company recorded a $1.2 million charge to research and
development related to pre-approval inventory associated with a project to
develop an ultrasonic aspirator system. The Company discontinued this project in
June 2006 following management's review of the Company's existing technology and
the ultrasonic aspirator technology acquired in the Radionics acquisition.
Management determined that there was no future, alternative use for the
pre-approval inventory in any other development project.
4. GOODWILL AND OTHER INTANGIBLE ASSETS
Changes in the carrying amount of goodwill for the nine months ended September
30, 2006, were as follows:
Balance at December 31, 2005 ............................................................... $ 68,364
Radionics acquisition ...................................................................... 21,054
Newdeal working capital adjustment.......................................................... 694
Miltex acquisition (based on preliminary allocation) ....................................... 40,431
Canada Microsurgical Ltd. acquisition (based on preliminary allocation) .................... 610
Kinetikos Medical, Inc. acquisition (based on preliminary allocation) .................... . 23,624
Foreign currency translation ............................................................... 3,466
--------
Balance at September 30, 2006 .............................................................. $158,243
========
The components of the Company's identifiable intangible assets were as follows
(in thousands):
September 30, 2006 December 31, 2005
Weighted
Average Accumulated Accumulated
Life Cost Amortization Cost Amortization
Completed technology .............................. 12 years $ 32,816 $ (7,669) $ 18,921 $ (5,691)
Customer relationships ............................ 12 years 66,085 (8,705) 22,550 (4,823)
Trademarks/brand names ............................ Indefinite 31,600 -- -- --
Trademarks/brand names ............................ 34 years 34,726 (3,700) 31,175 (2,802)
Noncompetition agreements.......................... 5 years 7,109 (3,711) 6,943 (2,607)
Supplier relationships............................. 30 years 29,300 (375) -- --
All other ......................................... 15 years 1,620 (742) 2,233 (1,330)
-------- --------- -------- ---------
$203,256 $(24,902) $ 81,822 $(17,253)
Accumulated amortization .......................... (24,902) (17,253)
--------- ---------
$178,354 $ 64,569
======== ========
12
Annual amortization expense is expected to approximate $11.7 million in 2006,
$14.3 million in 2007, $14.0 million in 2008, $12.5 million in 2009, and $10.8
million in 2010. Identifiable intangible assets are initially recorded at fair
market value at the time of acquisition generally using an income or cost
approach.
5. RESTRUCTURING ACTIVITIES
In June 2005, management announced plans to restructure the Company's European
operations. The restructuring plan included closing the Company's Integra ME
production facility in Tuttlingen, Germany and reducing various positions in the
Company's production facility located in Biot, France, both of which were
substantially completed in December 2005. The Company transitioned the
manufacturing operations of Integra ME to its production facility in Andover,
UK. The Company also eliminated some duplicative sales and marketing positions,
primarily in Europe. The Company terminated 68 individuals under the European
restructuring plan.
During the nine months ended September 30, 2006, the Company terminated four
employees in connection with the transfer of certain manufacturing packaging
operations from its plant in Plainsboro, New Jersey to its plant in Anasco,
Puerto Rico. The Company may terminate approximately ten additional employees
over the next nine to twelve months in connection with this transfer; however no
final decision has been made.
In connection with these restructuring activities, the Company has recorded the
following charges during the three and nine months ended September 30, 2006 (in
thousands):
Research Selling
Cost of and General and
Sales Development Administrative Total
------- ----------- -------------- -----
Involuntary employee termination costs:
Three months ended September 30, 2006.......................... $ 63 -- -- $ 63
Nine months ended September 30, 2006........................... $ 418 $ 22 -- $ 440
Below is a reconciliation of the restructuring accrual activity recorded during
2006 (in thousands):
Employee Facility
Termination Exit
Costs Costs Total
Balance at December 31, 2005 ........................................................ $2,420 $ 124 $2,544
Additions............................................................................ 268 -- 268
Change in estimate................................................................... (18) -- (18)
Payments ............................................................................ (1,991) (115) (2,106)
Effects of Foreign Exchange ......................................................... 108 5 113
------ ----- ------
Balance at September 30, 2006 ....................................................... $ 787 $ 14 $ 801
====== ===== ======
The Company expects to pay all of the remaining costs by the end of 2007.
6. STOCK-BASED COMPENSATION
As of September 30, 2006, the Company had stock options, restricted stock
awards, performance stock awards, contract stock awards and restricted stock
unit awards outstanding under seven plans, the 1993 Incentive Stock Option and
Non-Qualified Stock Option Plan (the 1993 Plan), the 1996 Incentive Stock Option
and Non-Qualified Stock Option Plan (the 1996 Plan), the 1998 Stock Option Plan
(the 1998 Plan), the 1999 Stock Option Plan (the 1999 Plan), the 2000 Equity
Incentive Plan (the 2000 Plan), the 2001 Equity Incentive Plan (the 2001 Plan),
and the 2003 Equity Incentive Plan (the 2003 Plan, and collectively, the Plans).
No new awards may be granted under the 1993 Plan or the 1996 Plan.
Stock options issued under the Plans become exercisable over specified periods,
generally within four years from the date of grant for officers, employees and
consultants, and generally expire six years from the grant date. The transfer
and non-forfeiture provisions of restricted stock issued under the Plans lapse
over specified periods, generally at three years after the date of grant.
13
Prior to the adoption of Statement 123(R), the Company presented all tax
benefits resulting from the exercise of stock options as operating cash flows
(reflected in accrued taxes). Statement 123(R) requires the cash flows resulting
from excess tax benefits (tax deductions realized in excess of the compensation
costs recognized for the options exercised) from the date of adoption of
Statement 123(R) to be classified as financing cash flows. Therefore, as of
January 1, 2006, excess tax benefits for the nine months ended September 30,
2006, have been classified as financing cash flows.
At September 30, 2006, there were 6,697,371 shares authorized for issuance under
the Plans, with 1,537,024 shares available for grant under the Plans.
Employee stock-based compensation expense recognized under FAS 123(R) was as
follows (in thousands, except for per share data):
Three Months Ended Nine Months Ended
September 30, 2006 September 30, 2006
Research and development expense............................................ $ 168 $ 452
Selling, general and administrative......................................... 3,529 9,613
Amortization of amounts previously capitalized to inventory................. 112 217
------ -------
Total employee stock-based compensation expense............................. 3,809 10,282
Tax benefit related to employee stock-based compensation expense............ (1,212) (3,253)
------- --------
Net effect on net income.................................................... $2,597 $ 7,029
====== =======
Effect on earnings per share:
Basic.............................................................. $ .09 $ .24
Diluted............................................................ $ .09 $ .21
As of September 30, 2006, $111,000 of stock-based compensation costs remain
capitalized in inventory based on the underlying employees receiving the awards.
Stock Options
The following is a summary of stock option activity for the nine-month period
ended September 30, 2006 (shares in thousands):
Wtd. Avg.
Remaining Aggregate
Wtd. Avg. Contractual Intrinsic
Stock Options Ex. Price Term Years Value
Outstanding, December 31, 2005.................................. 4,001 $27.50
Granted ........................................................ 73 35.85
Exercised ...................................................... (436) 21.31
Cancelled ...................................................... (87) 33.30
----- -----
Outstanding, September 30, 2006................................. 3,551 $28.28 4.3 $32.7 million
======
Options exercisable at September 30, 2006....................... 2,146 $25.06 3.4 $26.6 million
The intrinsic value of options exercised during the nine-month periods ended
September 30, 2006 and 2005 was $7.7 million and $8.7 million, respectively. The
weighted-average per share fair value of stock options granted during the nine
months ended September 30, 2006 and 2005 was $15.35 and $14.49, respectively.
As of September 30, 2006, there was approximately $18.2 million of total
unrecognized compensation costs related to unvested stock options. These costs
are expected to be recognized over a weighted-average period of approximately
2.8 years.
The fair value of options granted prior to October 1, 2004 was calculated using
the Black-Scholes model, while the fair value of options granted on or after
October 1, 2004 was calculated using the binomial distribution model. Expected
volatilities are based on historical volatility of the Company's stock price
with forward-looking assumptions. The expected life of stock options is
estimated based on historical data on exercises of stock options, post-vesting
forfeitures and other factors to estimate the expected term of the stock options
granted. The risk-free interest rates are derived from the U.S. Treasury yield
14
curve in effect on the date of grant for instruments with a remaining term
similar to the expected life of the options. In addition, the Company applies an
expected forfeiture rate when amortizing stock-based compensation expenses. The
estimate of the forfeiture rate is based primarily upon historical experience of
employee turnover. As individual grant awards become fully vested, stock-based
compensation expense is adjusted to recognize actual forfeitures. The Company
used the following weighted-average assumptions to calculate the fair value for
stock options granted during the following periods:
Three Months Ended September 30, Nine Months Ended September 30,
2006 2005 2006 2005
---- ---- ---- ----
Dividend yield................................. 0% 0% 0% 0%
Expected volatility ............................ 43% 43% 43% 43%
Risk free interest ............................. 4.3% 3.4% 3.4% 3.4%
Expected life of option from grant date......... 5.4 years 5.4 years 5.4 years 5.4 years
The Company received proceeds of $9.2 million and $5.4 million from stock option
exercises for the nine months ended September 30, 2006 and 2005, respectively.
Awards of Restricted Stock, Performance Stock and Contract Stock
The following is a summary of awards of restricted stock, performance stock and
contract stock for the nine-month period ended September 30, 2006 (shares in
thousands):
Performance Stock and
Restricted Stock Awards Contract Stock Awards
Wtd. Avg. Fair Wtd. Avg. Fair
Shares Value Per Share Shares Value Per Share
Unvested, December 31, 2005.................... 19 $ 35.08 -- --
Grants ......................................... 168 38.43 218 $ 35.41
Vested ......................................... --- -- -- --
Cancellations................................... (6) 37.68 -- --
--- ---
Unvested, September 30, 2006.................... 181 $ 38.11 218 $ 35.41
=== ===
Performance stock awards have performance features associated with them.
Performance stock, restricted stock and contract stock awards generally have
requisite service periods of three years. The fair value of these awards is
being expensed on a straight-line basis over the vesting period. As of September
30, 2006, there was approximately $11.2 million of total unrecognized
compensation costs related to unvested awards. These costs are expected to be
recognized over a weighted-average period of approximately 2.8 years. The
Company granted 13,496 restricted stock awards with a weighted average fair
value of $34.08 during the nine months ended September 30, 2005.
The Company has no formal policy related to the repurchase of shares for the
purpose of satisfying stock-based compensation obligations. Independent of these
programs, the Company does have a practice of repurchasing shares, from time to
time, in the open market.
The Company also maintains an Employee Stock Purchase Plan (the ESPP), which
provides eligible employees of the Company with the opportunity to acquire
shares of common stock at periodic intervals by means of accumulated payroll
deductions. The ESPP was amended in 2005 to eliminate the look-back option and
to reduce the discount available to participants to five percent. Accordingly,
the ESPP is a non-compensatory plan under Statement 123(R).
15
7. RETIREMENT BENEFIT PLANS
The Company maintains defined benefit pension plans that cover employees in its
manufacturing plants located in Andover, United Kingdom and its former
manufacturing plant in Tuttlingen, Germany. Net periodic benefit costs for the
Company's defined benefit pension plans included the following amounts (in
thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
---- ---- ---- ----
Service cost .............................................. $ 53 $ 61 $ 157 $ 185
Interest cost ............................................. 142 103 424 313
Expected return on plan assets ............................ (124) (85) (370) (260)
Recognized net actuarial loss.............................. 54 34 162 106
----- ----- ----- -----
Net periodic benefit cost ................................. $ 125 $ 113 $ 373 $ 344
===== ===== ===== =====
The Company made $126,000 and $167,000 of contributions to its defined benefit
pension plans for the nine months ended September 30, 2006 and 2005
respectively.
8. COMPREHENSIVE INCOME
Comprehensive income was as follows (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
---- ---- ---- ----
Net income .............................................. $2,594 $10,482 $19,276 $26,580
Foreign currency translation adjustment ................. 1,312 (232) 7,310 (9,978)
Unrealized holding gains (losses) on
available-for-sale securities, net of tax........... 522 -- 784 (163)
Reclassification adjustment for losses included in net
income, net of tax.................................. (237) -- 17 18
Minimum pension liability adjustment, net of tax......... (55) -- (149) --
------ ------- ------- -------
Comprehensive income .................................... $4,136 $10,250 $27,238 $16,457
====== ======= ======= =======
16
9. NET INCOME PER SHARE
Basic and diluted net income per share was as follows (in thousands, except per
share amounts):
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
---- ---- ---- ----
Basic net income per share:
Net income......................................... $ 2,594 $10,482 $19,276 $26,580
Weighted average common shares outstanding ........ 29,193 30,039 29,457 30,334
Basic net income per share ........................ $ 0.09 $ 0.35 $ 0.65 $ 0.88
Diluted net income per share:
Net income ........................................
$ 2,594 $10,482 $19,276 $26,580
Add back: Interest expense and other income/(expense)
related to convertible notes payable, net
of tax .................................. -- 800 -- 1,832
------- ------- ------- -------
Net income applicable to common stock.............. $ 2,594 $11,282 $19,276 $28,412
======= ======= ======= =======
Weighted average common shares outstanding - Basic 29,193 30,039 29,457 30,334
Effect of dilutive securities:
Stock options and restricted stock............ 674 744 705 879
Shares issuable upon conversion of notes payable
-- 3,514 -- 3,514
------- ------- ------- ------
Weighted average common shares for diluted earnings
per share.......................................... 29,867 34,297 30,162 34,727
====== ====== ====== ======
Diluted net income per share....................... $ 0.09 $ 0.33 $ 0.64 $ 0.82
Options outstanding at September 30, 2006 and 2005 to acquire approximately 1.8
million shares and 921,000 shares of common stock, respectively, were excluded
from the computation of diluted net income per share for the three months ended
September 30, 2006 and 2005, respectively, because their effects would be
anti-dilutive. Options outstanding at September 30, 2006 and 2005 to acquire
approximately 1.9 million shares and 624,000 shares of common stock,
respectively, were excluded from the computation of diluted net income per share
for the nine months ended September 30, 2006 and 2005, respectively, because
their effects would be anti-dilutive. The Company excluded from the computation
of diluted earnings per share for the three months and nine months ended
September 30, 2006 approximately 3.5 million shares issuable upon conversion of
its convertible notes payable because their effects would be anti-dilutive.
17
10. SEGMENT AND GEOGRAPHIC INFORMATION
The Company's management reviews financial results and manages the business on
an aggregate basis. Therefore, financial results are reported in a single
operating segment, the development, manufacture and marketing of medical devices
for use in neurosurgery, reconstructive surgery and general surgery.
In 2006, the Company revised the manner in which it presents its revenues. The
Company now presents its revenues in two categories: Neurosurgical / Orthopedic
Implants and Medical / Surgical Equipment. This change better aligns our product
categories by functional product characteristic and intended use. The Company's
revenues were as follows (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
---- ---- ---- ----
Revenue:
Neurosurgical and Orthopedic Implants ........ $ 43,136 $ 33,516 $118,778 $ 99,219
Medical Surgical Equipment.................... 73,511 35,818 175,125 105,732
------ ------ ------- -------
Total Revenue ..................................... $116,647 $ 69,334 $293,903 $204,951
======== ======== ======== ========
Certain of the Company's products, including the DuraGen(R) and NeuraGen(TM)
product families and the INTEGRA(R) Dermal Regeneration Template and
wound-dressing products, contain material derived from bovine tissue. Products
that contain materials derived from animal sources, including food as well as
pharmaceuticals and medical devices, are increasingly subject to scrutiny from
the press and regulatory authorities. These products constituted 23% and 32% of
total revenues in each of the three-month periods ended September 30, 2006 and
2005, respectively, and 26% and 31% of total revenues in each of the nine-month
periods ending September 30, 2006 and 2005, respectively. Accordingly,
widespread public controversy concerning collagen products, new regulation, or a
ban of the Company's products containing material derived from bovine tissue
could have a material adverse effect on the Company's current business or its
ability to expand its business.
Total revenues by major geographic area are summarized below (in thousands):
United Asia Other
States Europe Pacific Foreign Total
Three months ended September 30, 2006....................... $ 88,740 $ 21,165 $ 2,815 $ 3,927 $116,647
Three months ended September 30, 2005....................... 53,504 10,443 2,662 2,725 69,334
Nine months ended September 30, 2006........................ $220,393 $ 56,884 $ 8,809 $ 7,817 $293,903
Nine months ended September 30, 2005........................ 152,623 36,187 8,443 7,698 204,951
11. COMMITMENTS AND CONTINGENCIES
In consideration for certain technology, manufacturing, distribution and selling
rights and licenses granted to the Company, the Company has agreed to pay
royalties on the sales of products that relate to those granted rights and
licenses. Royalty payments under these agreements by the Company were not
significant for any of the periods presented.
Various lawsuits, claims and proceedings are pending or have been settled by the
Company. The most significant of those are described below.
In May 2006, Codman & Shurtleff, Inc. ("Codman"), a division of Johnson &
Johnson, commenced an action in the United States District Court for the
District of New Jersey for declaratory judgment against Integra LifeSciences
Corporation with respect to United States Patent No. 5,997,895 (the "'895
Patent") held by Integra. Integra's patent covers dural repair technology
related to Integra's Duragen(R) family of duraplasty products.
The action seeks declaratory relief that Codman's DURAFORM(TM) product does not
infringe Integra's patent and that Integra's patent is invalid and
unenforceable. Codman does not seek either damages from Integra or injunctive
18
relief to prevent Integra from selling the Duragen(R) Dural Graft Matrix.
Integra has filed a counterclaim against Codman, alleging that Codman's
DURAFORM(TM) product infringes the '895 Patent, seeking injunctive relief
preventing the sale and use of DURAFORM(TM), and seeking damages, including
treble damages, for past infringement.
In July 1996, the Company sued Merck KGaA, a German corporation, seeking damages
for patent infringement. The patents in question are part of a group of patents
granted to The Burnham Institute and licensed by Integra that are based on the
interaction between a family of cell surface proteins called integrins and the
arginine-glycine-aspartic acid ("RGD") peptide sequence found in many
extracellular matrix proteins.
The case has been tried, appealed and returned to the trial court. Most
recently, in September 2004, the trial court ordered Merck KgaA to pay Integra
$6.4 million in damages. Merck KGaA filed a petition for a writ of certiorari
with the United States Supreme Court seeking review of the Circuit Court's
decision, and the Supreme Court granted the writ in January 2005.
On June 13, 2005, the Supreme Court vacated the June 2003 judgment of the
Circuit Court. The Supreme Court held that the Circuit Court applied an
erroneous interpretation of 35 U.S.C. ss.271(e)(1) when it rejected the
challenge of Merck KGaA to the jury's finding that Merck KGaA failed to show
that its activities were exempt from claims of patent infringement under that
statute. On remand, the Circuit Court was to have reviewed the evidence under a
reasonableness test that does not provide categorical exclusions of certain
types of activities. The hearing before the Circuit Court occurred in June 2006,
and a ruling is expected by the end of this year. Further enforcement of the
trial court's order has been stayed. We have not recorded any gain in connection
with this matter, pending final resolution and completion of the appeals
process.
In addition to these matters, the Company is subject to various claims, lawsuits
and proceedings in the ordinary course of its business, including claims by
former employees, distributors and competitors and with respect to our products.
In the opinion of management, such claims are either adequately covered by
insurance or otherwise indemnified, or are not expected, individually or in the
aggregate, to result in a material adverse effect on the Company's financial
condition. However, it is possible that the Company's results of operations,
financial position and cash flows in a particular period could be materially
affected by these contingencies.
12. CONTINGENT CONVERTIBLE NOTES
On September 27, 2006, the Company exchanged of $115.2 million (out of a total
of $120.0 million) of its 2 1/2% Contingent Convertible Subordinated Notes due
2008 (the "old notes")for the equivalent amount of 2 1/2% Contingent Convertible
Subordinated Notes due 2008 (the "new notes"). The terms of the new notes are
substantially similar to those of the old notes, except that the new notes have
a net share settlement feature and include "takeover protection," whereby the
Company will pay a premium to holders who convert their notes upon the
occurrence of designated events, including a change in control. The net share
settlement feature requires that, upon conversion of the new notes, the Company
will pay holders in cash for up to the principal amount of the converted new
notes, with any amounts in excess of this cash amount settled, at the election
of the Company, in cash or shares of our common stock. Holders who exchanged
their old notes in the exchange offer received an exchange fee of $2.50 per
$1,000 principal amount of their old notes.
In addition, since the closing price of the Company's stock on the issuance date
of the new notes was higher than the market price trigger of the new notes, the
holders have the option to convert their notes into cash, and if applicable,
shares of our common stock at any time. As a result, $115.2 million of
contingent convertible notes have been classified as current liabilities on the
balance sheet. The Company recorded a $1.2 million write-off of the unamortized
debt issuance costs and $0.3 million of fees associated with the old notes that
were exchanged.
13. SUBSEQUENT EVENT
In October 2006, the Company exchanged an additional $4.3 million of old notes
in exchange for an equal amount of new notes under the same terms of the
exchange offer which expired on September 27, 2006.
19
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our condensed consolidated
financial statements and the related notes thereto appearing elsewhere in this
report and our consolidated financial statements for the year ended December 31,
2005 included in our Annual Report on Form 10-K.
We have made statements in this report which constitute forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934. These forward-looking
statements are subject to a number of risks, uncertainties and assumptions about
the Company. Our actual results may differ materially from those anticipated in
these forward-looking statements as a result of many factors, including but not
limited to those set forth above under the heading "Risk Factors" in our Annual
Report on Form 10-K for the year ended December 31, 2005 and in subsequent
Quarterly Reports on Form 10-Q.
You can identify these forward-looking statements by forward-looking words such
as "believe," "may," "could," "will," "estimate," "continue," "anticipate,"
"intend," "seek," "plan," "expect," "should," "would" and similar expressions in
this report.
GENERAL
Integra is a market-leading, innovative medical device company focused on
helping the medical professional enhance the standard of care for patients.
Integra provides customers with clinically relevant, innovative and
cost-effective products that improve the quality of life for patients. We focus
on cranial and spinal procedures, peripheral nerve repair, small bone and joint
injuries, and the repair and reconstruction of soft tissue.
Our distribution channels include two direct sales organizations (Integra
NeuroSciences and Integra Reconstructive Surgery), two networks of
manufacturer's representatives managed by a direct sales organization (JARIT
Surgical Instruments and Miltex) and strategic alliances with market leaders
such as Johnson & Johnson, Medtronic, Inc., Wyeth and Zimmer Holdings, Inc. We
have direct sales forces in the United States, Canada, Germany, the United
Kingdom, the Benelux (Belgium, Netherlands, Luxembourg) region and France.
Elsewhere throughout the world, our products are distributed through a number of
independent distributors. We invest substantial resources and management effort
to develop our sales organizations, and we believe that we compete very
effectively in this aspect of our business.
In 2006, we revised the manner in which we present our revenues. This change
better aligns our product categories by functional product characteristic and
intended use. We now present revenues in two categories: Neurosurgical and
Orthopedic Implants and Medical Surgical Equipment. Our Neurosurgical and
Orthopedic Implants product group includes dural grafts that are indicated for
the repair of the dura matter, dermal regeneration and engineered wound
dressings, implants used in small bone and joint fixation, repair of peripheral
nerves, and hydrocephalus management, and implants used in bone regeneration and
in guided tissue regeneration in periodontal surgery. Our Medical Surgical
Equipment product group includes ultrasonic surgery systems for tissue ablation,
cranial stabilization and brain retraction systems, instrumentation used in
general, neurosurgical, spinal and plastic and reconstructive surgery and dental
procedures, systems for the measurement of various brain parameters, and devices
used to gain access to the cranial cavity and to drain excess cerebrospinal
fluid from the ventricles of the brain.
We manage these product groups and distribution channels on a centralized basis.
Accordingly, we report our financial results under a single operating segment -
the development, manufacturing and distribution of medical devices.
We manufacture many of our products in various plants located in the United
States, Puerto Rico, France, the United Kingdom and Germany. We also manufacture
some of our ultrasonic surgical instruments and source most of our hand-held
surgical instruments through specialized third-party vendors.
We believe that we have a particular advantage in the development, manufacture
and sale of specialty tissue repair products derived from bovine collagen. We
develop and manufacture these products primarily in our facilities in
Plainsboro, New Jersey and Puerto Rico. Products that contain materials derived
20
from animal sources, including food as well as pharmaceuticals and medical
devices, are increasingly subject to scrutiny from the press and regulatory
authorities. These products comprised 26% and 31% of total revenues in each of
the nine-month periods ended September 30, 2006 and 2005, respectively.
Accordingly, widespread public controversy concerning collagen products, new
regulation, or a ban of the Company's products containing material derived from
bovine tissue, could have a material adverse effect on the Company's current
business or its ability to expand its business.
Our objective is to continue to build a customer-focused and profitable medical
device company by developing or acquiring innovative medical devices and other
products to sell through our sales channels. Our strategy therefore entails
substantial growth in product revenues through internal means - through
launching new and innovative products and selling existing products more
intensively - and by acquiring existing businesses or already successful product
lines.
We aim to achieve this growth in revenues while maintaining strong financial
results. While we pay attention to any meaningful trend in our financial
results, we pay particular attention to measurements that are indicative of
long-term profitable growth. These measurements include revenue growth, derived
through acquisitions and products developed internally, gross margins on total
revenues, operating margins, which we aim to continually expand on as we
leverage our existing infrastructure, and earnings per fully diluted share of
common stock.
ACQUISITIONS
Our strategy for growing our business includes the acquisition of complementary
product lines and companies. Our recent acquisitions of businesses, assets and
product lines may make our financial results for the nine months ended September
30, 2006 not directly comparable to those of the corresponding prior-year
period. See Note 2 to the unaudited condensed consolidated financial statements
for a further discussion. Since the beginning of 2005, we have acquired the
following businesses:
In January 2005, we acquired all of the outstanding capital stock of Newdeal
Technologies SAS ("Newdeal Technologies") for $51.9 million in cash paid at
closing, a $0.7 million working capital adjustment paid in January 2006, and
$0.8 million of acquisition related expenses. Additionally, we agreed to pay the
sellers up to an additional 1.3 million Euros if the sellers were to continue
their employment with us through January 3, 2006. This additional payment was
accrued to selling, general and administrative expense on a straight-line basis
in 2005 over the one-year employment requirement period and was paid in January
2006.
Newdeal is a leading developer and marketer of specialty implants and
instruments specifically designed for foot and ankle surgery. Newdeal's products
include a wide range of products for the forefoot, the mid-foot and the hind
foot, including the Bold(R) Screw, Hallu-Fix(R) plate system and the HINTEGRA(R)
total ankle prosthesis. Newdeal's target physicians include orthopedic surgeons
specializing in injuries of the foot, ankle and extremities, as well as
podiatric surgeons.
On March 3, 2006, Integra acquired certain assets of the Radionics Division of
Tyco Healthcare Group, L.P. for approximately $74.5 million in cash paid at
closing, subject to certain adjustments, and $3.2 million of acquisition related
expenses in a transaction treated as a business combination. Radionics, based in
Burlington, Massachusetts, is a leader in the design, manufacture and sale of
advanced minimally invasive medical instruments in the fields of neurosurgery
and radiation therapy. Radionics' products include the CUSA EXcel(R) ultrasonic
surgical aspiration system, the CRW(R) stereotactic system, the XKnife(R)
stereotactic radiosurgery system, and the OmniSight(R) EXcel image guided
surgery system.
Tyco Healthcare sold Radionics products in over 75 countries, using a network of
independent distributors in the United States and both independent distributors
and Tyco Healthcare affiliates internationally. We are using distributors in
many of the markets in which Tyco Healthcare sold directly to customers. As a
result, we expect that revenue and pre-tax income attributable to the acquired
product lines will be less than the 2005 levels recognized by Tyco. In addition,
because the CUSA Excel ultrasonic aspiration system competes with our existing
line of ultrasonic surgery systems, our sales force may, in some situations,
sell the CUSA system in lieu of our existing ultrasonic aspirator products.
21
On May 12, 2006, we acquired all of the outstanding capital stock of Miltex
Holdings, Inc. ("Miltex") for $102.7 million in cash paid at closing, subject to
certain adjustments, and $0.6 million of transaction related costs. Miltex,
based in York, Pennsylvania, is a leading provider of surgical and dental hand
instruments to alternate site facilities, which includes physician and dental
offices and ambulatory surgery care sectors. Miltex sells products under the
Miltex(R), Meisterhand(R), Vantage(R), Moyco(R), Union Broach(R), and
Thompson(R) trade names in over 65 countries, using a network of independent
distributors. Miltex operates a manufacturing and distribution facility in York,
Pennsylvania and also operates a leased facility in Tuttlingen, Germany, where
Miltex's staff coordinates design, production and delivery of instruments.
On July 5, 2006, we acquired a direct sales force in Canada through the
acquisition of our longstanding distributor, Canada Microsurgical Ltd. Canada
Microsurgical has eight sales representatives covering each province in Canada.
We paid $5.8 million (6.4 million Canadian dollars) for Canada Microsurgical at
closing and $0.1 million of transaction related costs. In addition, we may pay
up to an additional 2.1 million Canadian dollars over the next three years,
depending on the performance of the business.
On July 31, 2006 we acquired the shares of Kinetikos Medical, Inc. ("KMI") for
$39.5 million in cash, subject to certain adjustments, including future payments
based on the performance of the KMI business after the acquisition. KMI, based
in Carlsbad, California, was a leading developer and manufacturer of innovative
orthopedic implants and surgical devices for small bone and joint procedures
involving the foot, ankle, hand, wrist and elbow. KMI marketed products that
addressed both the trauma and reconstructive segments of the extremities market.
KMI's reconstructive products are largely focused on treating deformities and
arthritis in small joints of the upper and lower extremity, while its trauma
products are focused on the treatment of fractures of small bones most commonly
found in the extremities. The Company has integrated the KMI product line into
its U.S. direct sales force while maintaining seven former KMI independent sales
agencies. The Company plans to increase sales of KMI products internationally
through our well-established Newdeal infrastructure.
IMPACT OF RESTRUCTURING ACTIVITIES
In June 2005, we announced plans to restructure our European operations. The
restructuring plan included closing our Integra ME production facility in
Tuttlingen, Germany and reducing various positions in our production facility
located in Biot, France, both of which were substantially completed in December
2005. We transitioned the manufacturing operations of Integra ME to our
production facility in Andover, UK. We also eliminated some duplicative sales
and marketing positions, primarily in Europe. The Company terminated 68
individuals under the European restructuring plan.
In 2005, we also completed the transfer of the Spinal Specialties assembly
operations from our San Antonio, Texas plant to our San Diego, California plant
and we continue to transfer certain assembly, processing and packaging
operations to our San Diego and Puerto Rico facilities. During the nine months
ended September 30, 2006, the Company terminated four employees in connection
with the transfer of certain manufacturing packaging operations from its plant
in Plainsboro, New Jersey to its plant in Anasco, Puerto Rico. The Company may
terminate approximately ten additional employees over the next nine to twelve
months in connection with this transfer; however no final decision has been
made.
In connection with these restructuring activities, we recorded employee
termination costs of $63,000 and $440,000, respectively, during the three and
nine months ended September 30, 2006.
While we expect to achieve a positive impact from the restructuring and
integration activities, such results remain uncertain. We have reinvested most
of the savings from these restructuring and integration activities into further
expanding our European sales, marketing and distribution organization, and
integrating the Radionics and KMI businesses into our existing sales and
distribution network.
22
RESULTS OF OPERATIONS
Net income for the three months ended September 30, 2006 was $2.6 million, or
$0.09 per diluted share, as compared to net income of $10.5 million, or $0.33
per diluted share, for the three months ended September 30, 2005.
Net income for the nine months ended September 30, 2006 was $19.3 million, or
$0.64 per diluted share, as compared to a net income of $26.6 million, or $0.82
per diluted share, for the nine months ended September 30, 2005.
These amounts include the following charges (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
---- ---- ---- ----
Acquisition-related charges:
Inventory fair market value purchase accounting adjustments ..... $ 1,399 $ -- $ 4,012 $ 466
Acquired in-process research and development.. .................. 5,600 500 5,600 500
Charges associated with convertible debt exchange offer............. 1,792 -- 1,879 --
Charges associated with termination of interest rate swap........... 1,425 -- 1,425 --
Employee termination and related costs.............................. 63 666 440 2,740
Facility consolidation, acquisition integration, manufacturing
transfer, enterprise business system integration and
related costs.................................................. 582 492 1,299 1,314
Impairment of inventory and fixed assets related to discontinued
development project and product lines.......................... -- -- 1,578 478
------- ------ ------- ------
Total............................................................... $10,861 $1,658 $16,233 $5,498
======= ====== ======= ======
Of these amounts, $5.4 million and $1.8 million were charged to cost of product
revenues in the nine-month periods ended September 30, 2006 and 2005,
respectively, and $7.2 million and $1.0 million was charged to research and
development in the nine months ended September 30, 2006. The remaining amounts
were primarily charged to selling, general and administrative expenses.
We believe that, given our ongoing, active strategy of seeking new acquisitions
and integrating recent acquisitions, our current focus on rationalizing our
existing manufacturing and distribution infrastructure, our recent review of
various product lines in relation to our current business strategy, and a
renewed focus on enterprise business systems integrations, charges similar to
those discussed above could recur with similar materiality in the future. We
believe that the delineation of these costs provides useful information to
measure the comparative performance of our business operations.
Net income for the three and nine months ended September 30, 2006 also includes
approximately $2.6 million and $7.0 million, respectively, net of tax, of
stock-based compensation expense recorded in connection with the adoption of
Statement of Financial Accounting Standards No 123(R) "Shared Based Payment".
23
Revenues and Gross Margin on Product Revenues
Our revenues and gross margin on product revenues were as follows (in
thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
---- ---- ---- ----
Neurosurgical and Orthopedic Implants ............................... $43,136 $33,516 $118,778 $99,219
Medical Surgical Equipment........................................... 73,511 35,818 175,125 105,732
------- -------- -------- --------
Total revenue ....................................................... $116,647 $69,334 $293,903 $204,951
Cost of product revenues ............................................ 47,559 26,394 116,869 78,423
-------- ------- -------- --------
Gross margin on total revenues ...................................... 69,088 42,940 177,034 126,528
Gross margin as a percentage of total revenues ...................... 59% 62% 60% 62%
THREE MONTHS ENDED SEPTEMBER 30, 2006 AS COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 2005
Revenues and Gross Margin
For the quarter ended September 30, 2006, total revenues increased 68% over the
prior-year period to $116.6 million. Domestic revenues increased $35.7 million
to $89.1 million, or 76% of total revenues, as compared to 77% of revenues in
the three months ended September 30, 2005.
In the Neurosurgical and Orthopedic Implants category, sales of our
reconstructive surgery implant products continued to grow strongly. Rapid growth
in nerve and dermal repair products and sales of products for the hand, foot and
ankle accounted for much of the increase in implant product revenues.
INTEGRA(TM) dermal repair product revenues increased 32% over the third quarter
of 2005, nerve repair product revenues increased by 44%, and our hand, foot and
ankle products more than doubled. Revenues from bone graft and collagen dental
products increased by 57% over the third quarter of 2005. KMI products
contributed $1.9 million of sales to the quarter.
In the Medical Surgical Equipment category, increased sales of our JARIT(R)
surgical instrument lines and sales of the recently acquired Radionics and
Miltex products provided the year-over-year growth in equipment product revenues
for the third quarter. Radionics, Miltex and non-Integra distributed products
sold through our former Canadian distributor (all acquired in 2006) contributed
$33.8 million of sales to the quarter.
We have generated our product revenue growth through acquisitions, new product
launches and increased direct sales and marketing efforts both domestically and
in Europe. We expect that our expanded domestic sales force, the recent
conversion of JARIT domestic sales from a distributor billing model to a direct
billing model, the continued implementation of our direct sales strategy in
Europe and sales of internally developed and acquired products will drive our
future revenue growth. We also intend to continue to acquire businesses that
complement our existing businesses and products. Many of our recent acquisitions
involve businesses or product lines that overlap in some way with our existing
products. Our sales and marketing departments are integrating these
acquisitions, and there has been, and we expect there will continue to be, some
cannibalization of sales of our existing products that will affect our internal
growth. Overall, we target our revenues to continue to grow internally and
through acquisitions in the range of 20% to 30% per year.
In 2006, we revised our presentation of cost of product revenues to include
amortization of product technology-based intangible assets. Previously, this
amortization was included in intangible asset amortization in the condensed
consolidated statement of operations. We have revised prior period amounts to
conform to the current year's presentation. This revision increased cost of
product revenues by $673,000 and $379,000 for the three-month period ended
September 30, 2006 and 2005, respectively.
24
Gross margin on total revenues in the third quarter of 2006 was 59.2%. Strong
sales growth in many higher gross margin products was offset by sales of the
relatively lower-margin Radionics and Miltex products. We recognized $1.4
million in inventory fair value purchase accounting adjustments from
acquisitions as the products were sold, a $1.3 million change in estimate
related to consignment inventory and $582,000 in restructuring and manufacturing
transfer and systems integration costs. These charges reduced our gross margin
in the third quarter of 2006 by approximately 2 percentage points.
We expect that sales of our higher gross margin products will continue to
increase as a proportion of total product revenues, but be offset slightly by
relatively lower gross margin generated from sales of Radionics and Miltex
products. Also, we now invoice hospital customers directly for sales of JARIT
instruments rather than distributors. This has resulted in increased product
revenues as a result of higher selling prices, a higher gross margin, and also
increased selling expenses from commissions paid to distributors.
Other Operating Expenses
The following is a summary of other operating expenses as a percent of total
revenues:
Three Months Ended
September 30,
2006 2005
---- ----
Research and development .................... 9% 4%
Selling, general and administrative ......... 37% 33%
Intangible asset amortization ............... 2% 2%
Total other operating expenses .............. 49% 39%
Total other operating expenses, which consist of research and development
expense, selling, general and administrative expense and amortization expense,
increased $30.4 million, or 113%, to $57.3 million in the third quarter of 2006,
compared to $26.8 million in the third quarter of 2005. The increase is
partially related to a $5.6 million in-process research and development charge
related to the acquisition of KMI, a $3.7 million stock-based compensation
expense associated with the adoption of Statement 123(R) (the majority of which
is included in selling, general and administrative expense) and higher
commission expenses associated with the JARIT direct bill initiative. Expenses
also increased because of the continued expansion of our direct sales and
marketing organizations in our direct selling platforms and increased corporate
staff to support the recent growth in our business and to integrate acquired
businesses. The recently acquired Radionics, Miltex, KMI and our former Canadian
distributor businesses contributed approximately $8.9 million in other operating
expenses in the third quarter 2006.
Research and development expenses in the third quarter of 2006 increased by $7.9
million compared to the prior-year period. Included in research and development
costs were a $5.6 million in-process research and development charge related to
the KMI acquisition, a $0.5 million charge related to an upfront payment
pursuant to a new product development alliance and $168,000 of stock-based
compensation expenses associated with the adoption of Statement 123(R). In
connection with our acquisition of Radionics and KMI, research and development
expenses increased by $1.1 million in the third quarter ended September 30,
2006. There was also an overall increase of $1.5 million associated with product
development initiatives compared to the prior-year period. Our research and
development efforts in 2006 are expected to be focused on clinical activities
directed towards expanding the indications for use of our absorbable implant
technology products, including a multi-center clinical trial suitable to support
an application to the FDA for approval of the DuraGen Plus(TM) Adhesion Barrier
Matrix product, and development of a next-generation ultrasonic aspirator
system.
Selling, general and administrative expenses increased $20.8 million, or 92%, as
compared to the prior-year period to $43.4 million. The increase in selling,
general and administrative expenses includes $3.5 million of stock-based
compensation expense associated with the adoption of Statement 123(R) and higher
commission expenses associated with the JARIT direct bill initiative. Selling,
general and administrative costs also increased in the third quarter of 2006 in
connection with the recently acquired Radionics, Miltex and KMI businesses. We
also continued to expand our direct sales and marketing organizations in our
direct selling platforms and increased corporate staff to support the recent
growth in our business and to integrate acquired businesses. Additionally, we
have incurred higher operating costs in connection with our recent investments
in our infrastructure, including the continued implementation of an enterprise
business system and the relocation and expansion of our domestic and
international distribution capabilities through third-party service providers.
We expect that we will continue to incur costs related to these activities
during the remainder of 2006 and 2007 as we complete these ongoing activities.
25
Amortization expense increased in the third quarter of 2006 as a result of
amortization of intangible assets from acquisitions completed in 2006.
Non-Operating Income and Expenses
Interest expense primarily relates to the $120 million of 2 1/2% contingent
convertible subordinated notes that we have outstanding and a related interest
rate swap agreement, which was terminated on September 27, 2006 and interest on
the used and unused portion of the $200 million senior secured credit facility
that we established in December 2005. The increase in interest expense in the
third quarter of 2006 is primarily related to the write-off of unamortized debt
issuance costs related to the old notes and interest associated with the credit
facility that was established in December 2005. In the third quarter of 2006, we
made net additional borrowings of $23 million under our credit facility.
On September 27, 2006, the Company exchanged $115.2 million (out of a total of
$120.0 million) of its old contingent convertible notes for the equivalent
amount of new notes. See Note 12 to the unaudited condensed consolidated
financial statements for a further discussion. In connection with the exchange
of our convertible notes, the Company recorded a $1.2 million write-off of the
unamortized debt issuance costs and $0.3 million of fees associated with the old
contingent convertible notes that were exchanged. Our reported interest expense
for the three-month period ended September 30, 2005 included $204,000 of
non-cash amortization of debt issuance costs.
We will pay additional interest on our convertible notes under certain
conditions. The fair value of this contingent interest obligation is marked to
its fair value at each balance sheet date, with changes in the fair value
recorded to interest expense. In the third quarter of 2006, the change in the
estimated fair value of the contingent interest obligation increased interest
expense by $104,000. In the third quarter of 2005, the fair value increased by
$300,000.
On September 27, 2006, we terminated an interest rate swap agreement with a $50
million notional amount to hedge the risk of changes in fair value attributable
to interest rate risk with respect to a portion of our fixed rate convertible
notes. The interest rate swap agreement qualified as a fair value hedge under
SFAS No. 133, as amended "Accounting for Derivative Instruments and Hedging
Activities". The net amount to be paid or received under the interest rate swap
agreement was recorded as a component of interest expense. Interest expense
associated with the interest rate swap for the three months ended September 30,
2006 and 2005 was $345,000 and $100,000, respectively.
The Company paid the counterparty approximately $2.2 million in connection with
the termination of the swap, consisting of a $0.6 million payment of accrued
interest and a $1.6 million payment representing the fair market value of the
interest rate swap on the termination date. The termination payment was already
accrued by the Company. During the three months ended September 30, 2005, the
net fair value of the interest rate swap increased $500,000 to $2.0 million, and
the carrying value of our convertible notes decreased by $512,000. The net
difference between changes in the fair value of the interest rate swap and the
contingent convertible notes represents the ineffective portion of the hedging
relationship, and this amount is recorded in other income/(expense), net.
Our income tax expense was $3.5 million and $5.2 million for the three-month
periods ended September 30, 2006 and 2005, respectively. The overall effective
tax rate for the three months ended September 30, 2006 and 2005 was 57.2% and
33.2 %, respectively. The third quarter of 2006 included a $5.6 million
in-process research and development charge related to the KMI acquisition which
is not deductible for tax purposes. The effective tax rate for the third quarter
of 2006 would have been 29.7% without this charge. The decrease in the effective
income tax rate in 2006 was primarily due to a continued favorable impact of
various planning and reorganization initiatives, a change in the geographic mix
of earnings and losses and our realization of additional deductions related to
qualified production activities income provided for under the American Jobs
Creation Act of 2004.
26
In 2006, we have used all of our remaining unrestricted and current year
allowable acquired net operating loss carryforwards to offset 2006 taxable
income. At September 30, 2006, several of our subsidiaries had unused net
operating loss carryforwards arising from periods prior to our ownership which
expire through 2010. The Internal Revenue Code limits the timing and manner in
which we may use any acquired net operating losses.
Our effective tax rate may vary from period to period depending on, among other
factors, the geographic and business mix of taxable earnings and losses. We
consider these factors and others, including our history of generating taxable
earnings, in assessing our ability to realized deferred tax assets.
NINE MONTHS ENDED SEPTEMBER 30, 2006 AS COMPARED TO THE NINE MONTHS ENDED
SEPTEMBER 30, 2005
Revenues and Gross Margin
For the nine months ended September 30, 2006, total revenues increased 43% over
the prior-year period to $293.9 million. Domestic revenues increased $67.8
million to $220.4 million, or 75% of total revenues, as compared to 74% of
revenues in the nine months ended September 30, 2005.
In the Neurosurgical and Orthopedic Implants category, sales of our
Reconstructive Surgery implant products continued to grow strongly. Rapid growth
in the NeuraGen(TM) Nerve Guide, the INTEGRA(TM) dermal repair products and
sales of products for the hand, foot and ankle accounted for much of the
increase in implant product revenues. INTEGRA(TM) dermal repair product revenues
increased approximately 33% over the nine months of 2005, nerve repair product
revenues increased by 40%, and our Newdeal(TM) foot and ankle products increased
approximately 37%.
Sales of Reconstructive Surgery products continued their fast growth, while our
Neurosurgery products, including the DuraGen(R) family of duraplasty products
continued to grow modestly. Increased revenues of the Absorbable Collagen Sponge
that we supply for use in Medtronic's INFUSE(TM) bone graft product and of the
dental products we supply to Zimmer also contributed to the growth in implant
revenues.
In the Medical Surgical Equipment category, increased sales of our JARIT(R)
surgical instrument lines and sales of the recently acquired Radionics and
Miltex products provided the year-over-year growth in equipment product revenues
for the nine months. Sales of Radionics and Miltex products contributed $59.5
million in the nine months ended September 2006.
In 2006, we revised our presentation of cost of product revenues to include
amortization of product technology-based intangible assets. Previously, this
amortization was included in intangible asset amortization in the condensed
consolidated statement of operations. We have revised prior period amounts to
conform to the current year's presentation. This revision increased cost of
product revenues by $1.8 million and $1.1 million for the nine-month periods
ended September 30, 2006 and 2005, respectively.
Gross margin on total revenues in the nine months of 2006 was 60.2%. Although we
had strong sales growth in many higher gross margin products, we recognized $4.0
million in inventory fair value purchase accounting adjustments from
acquisitions as the products were sold and $1.3 million in restructuring and
manufacturing transfer and systems integration costs. These charges reduced our
gross margin by approximately 2%. We recognized the impact of $466,000 of
inventory fair value purchase accounting adjustments in the nine months of 2005.
Additionally, in the second quarter of 2006 we recorded a $1.2 million
impairment charge to cost of product revenues against a range of electrosurgical
generators and accessories sold exclusively in Europe following a review of
on-hand inventory quantities of those products in relation to expected demand
for that product line.
27
Other Operating Expenses
The following is a summary of other operating expenses as a percent of total
revenues:
Nine Months Ended
September 30,
2006 2005
---- ----
Research and development ...................... 7% 5%
Selling, general and administrative ........... 38% 35%
Intangible asset amortization.................. 2% 2%
Total other operating expenses................. 47% 42%
Total other operating expenses, which consist of research and development
expense, selling, general and administrative expense and amortization expense,
increased $53.1 million, or 62%, to $138.4 million in the nine months of 2006,
compared to $85.3 million in the nine months of 2005. The increase includes
$10.1 million of stock-based compensation expense associated with the adoption
of Statement 123(R) (the majority of which is included in selling, general and
administrative expense). Businesses we acquired in 2006 contributed
approximately $15.0 million of other operating expenses for the nine-month
period ended September 30, 2006.
Research and development expenses increased $11.3 million in the nine months of
2006 and included a $5.6 million in-process research and charge associated with
the KMI acquisition, $452,000 of stock-based compensation expenses associated
with the adoption of Statement 123(R), $2.3 million of research and development
activities from the recently acquired Radionics and KMI businesses, a $1.6
million charge related to the discontinued ultrasonic aspirator development
project and a $0.5 million charge related to an upfront payment pursuant to a
new product development alliance.
Selling, general and administrative expenses increased $39.2 million, or 54%, as
compared to the prior-year period to $111.8 million. This increase is primarily
related to a $9.6 million stock-based compensation expense associated with the
adoption of Statement 123(R), higher commission costs associated with the Jarit
distributor network, and operating costs associated with the recently acquired
Radionics and Miltex businesses. Additionally, we have incurred higher operating
costs in connection with our recent investments in our infrastructure, including
the continued implementation of an enterprise business system, the relocation
and expansion of our domestic and international distribution capabilities
through third-party service providers, the continued expansion of our direct
sales and marketing organizations in our direct selling platforms and increased
corporate staff to support the recent growth in our business and to integrate
acquired businesses also contributed to the increase. We expect that we will
continue to incur costs related to these activities during the remainder of 2006
and 2007 as we complete these ongoing activities.
Amortization expense increased by approximately $2.7 million in the nine months
of 2006 as a result of amortization of intangible assets from the acquisitions
completed in 2006.
Non-Operating Income and Expenses
The increase in interest expense in the nine months of 2006 is primarily related
to an increase in the variable rate that we paid on our $50 million interest
rate swap, which was terminated on September 27, 2006, the write-off of
unamortized debt issuance costs related to the old contingent convertible notes
and interest on the used and unused portion of the $200 million senior credit
facility that was established in December 2005. In the nine months ended
September 30, 2006, we made net borrowings of $87 million under our credit
facility.
On September 27, 2006, the Company exchanged $115.2 million (out of a total of
$120.0 million) of its old contingent convertible notes for the equivalent
amount of new notes. See Note 12 to the unaudited condensed consolidated
financial statements for a further discussion. In connection with the exchange
of our convertible notes, the Company recorded a $1.2 million write-off of the
unamortized debt issuance costs and $0.3 million of fees associated with the old
contingent convertible notes that were exchanged. Our reported interest expense
for the nine-month periods ended September 30, 2006 and 2005 included $599,000
and $611,000, respectively, of non-cash amortization of debt issuance costs.
28
We will pay additional interest on our convertible notes under certain
conditions. The fair value of this contingent interest obligation is marked to
its fair value at each balance sheet date, with changes in the fair value
recorded to interest expense. Changes in the estimated fair value of the
contingent interest obligation increased interest expense by $271,000 and
$78,000 for the nine months ended September 30, 2006 and 2005, respectively.
On September 27, 2006, we terminated an interest rate swap agreement with a $50
million notional amount to hedge the risk of changes in fair value attributable
to interest rate risk with respect to a portion of our fixed rate convertible
notes. The net amount to be paid or received under the interest rate swap
agreement was recorded as a component of interest expense. Interest expense
associated with the interest rate swap for the nine months ended September 30,
2006 was $827,000. Interest expense for the nine months ended September 30, 2005
included an insignificant benefit associated with the interest rate swap.
The Company paid the counterparty approximately $2.2 million in connection with
the termination of the swap, consisting of a $0.6 million payment of accrued
interest and a $1.6 million payment representing the fair market value of the
interest rate swap on the termination date. The termination payment was already
accrued by the Company. During the nine months ended September 30, 2005, the net
fair value of the interest rate swap increased $0.6 million to $2.0 million, and
this amount was included in other liabilities. The net difference between
changes in the fair value of the interest rate swap and the contingent
convertible notes represents the ineffective portion of the hedging
relationship, and this amount is recorded in other income (expense), net.
Our income tax expense was $11.4 million and $13.7 million for the nine-month
periods ended September 30, 2006 and 2005, respectively. The overall effective
tax rate for the nine months ended September 30, 2006 and 2005 was 37.1% and
34.0%, respectively. The third quarter of 2006 included a $5.6 million
in-process research and development charge which is not deductible for tax
purposes. The effective tax rate for the nine months of 2006 would have been
31.4% without this charge. The decrease in the effective income tax rate in 2006
was primarily due to a continued favorable impact of various planning and
reorganization initiatives, a change in the geographic mix of earnings and
losses and our realization of additional deductions related to qualified
production activities income provided for under the American Jobs Creation Act
of 2004.
INTERNATIONAL PRODUCT REVENUES AND OPERATIONS
Product revenues by major geographic area are summarized below (in thousands):
United Asia Other
States Europe Pacific Foreign Total
------ ------ ------- ------- -----
Three months ended September 30, 2006.............. $ 88,740 $ 21,165 $ 2,815 $ 3,927 $116,647
Three months ended September 30, 2005.............. 53,504 10,443 2,662 2,725 69,334
Nine months ended September 30, 2006............... 220,393 56,884 8,809 7,817 293,903
Nine months ended September 30, 2005............... 152,623 36,187 8,443 7,698 204,951
For the three months ended September 30, 2006, revenues from customers outside
the United States totaled $27.9 million, or 24% of total revenues, of which
approximately 82% were to European customers. Revenues from customers outside
the United States included $22.3 million of revenues generated in foreign
currencies.
In the three months ending September 30, 2005, revenues from customers outside
the United States totaled $15.8 million, or 23% of total revenues, of which
approximately 66% were from European customers. Revenues from customers outside
the United States included $12.0 million of revenues generated in foreign
currencies.
29
For the nine months ended September 30, 2006, revenues from customers outside
the United States totaled $73.5 million, or 25% of total revenues, of which
approximately 77% were to European customers. Revenues from customers outside
the United States included $52.9 million of revenues generated in foreign
currencies.
In the nine months ending September 30, 2005, revenues from customers outside
the United States totaled $52.3 million, or 26% of total revenues, of which
approximately 69% were from European customers. Revenues from customers outside
the United States included $41.0 million of revenues generated in foreign
currencies.
Because we have operations based in Europe and we generate revenues and incur
operating expenses in Euros and British pounds, we experience currency exchange
risk with respect to those foreign currency denominated revenues or expenses. We
currently do not hedge our exposure to foreign currency risk. We will continue
to assess the potential effects that changes in foreign currency exchange rates
could have on our business. If we believe this potential impact presents a
significant risk to our business, we may enter into derivative financial
instruments to mitigate this risk.
Additionally, we generate significant revenues outside the United States, a
portion of which are U.S. dollar-denominated transactions conducted with
customers who generate revenue in currencies other than the U.S. dollar. As a
result, currency fluctuations between the U.S. dollar and the currencies in
which those customers do business may have an impact on the demand for our
products in foreign countries.
Local economic conditions, regulatory or political considerations, the
effectiveness of our sales representatives and distributors, local competition
and changes in local medical practice all may combine to affect our sales into
markets outside the United States.
Relationships with customers and effective terms of sale frequently vary by
country, often with longer-term receivables than are typical in the United
States.
LIQUIDITY AND CAPITAL RESOURCES
Cash and Marketable Securities
At September 30, 2006, we had cash and cash equivalents totaling approximately
$24.3 million. In the third quarter of 2006, we liquidated the remaining $16.7
million of our current and non-current investments.
Cash Flows
Cash provided by operations has recently been and is expected to continue to be
our primary means of funding existing operations and capital expenditures. We
have generated positive operating cash flows on an annual basis, including $56.8
million for the year ended December 31, 2005 and $50.8 million for the nine
months ended September 30, 2006. Operating cash flows for the nine months ended
September 30, 2005 were $41.9 million. Overall, operating cash flows in the nine
months ended of 2006 were negatively affected by subsequent investments in
working capital made in connection with the Radionics acquisition.
Our principal uses of funds during the nine-month period ended September 30,
2006 were $227.1 million for acquisition consideration, $31.8 million paid for
the purchase of 857,650 shares of our common stock and $7.2 million in capital
expenditures. We received $96.8 million in cash from sales and maturities of
available for sale securities, net of purchases. In addition to the $50.4
million in operating cash flows for the nine months ended September 30, 2006, we
received $9.2 million from the issuance of common stock through the exercise of
stock options during the period and $87.0 million from borrowings under our
credit facility.
Working Capital
At September 30, 2006 we have a negative working capital of $36.3 million
compared to a positive working capital on December 31, 2005 of $234.7 million.
The decrease in working capital is primarily related to the use of $227.1
million for acquisition consideration in the first nine months of 2006. Also
30
contributing to this decrease is the reclassification of $115.2 million of
contingent convertible notes to current liabilities. Such classification is made
since the closing price of the Company's stock on the issuance date of the new
notes was higher than the market price trigger of the new notes, the holders
have the option to convert their notes into cash, and if applicable, shares of
our common stock at any time.
Convertible Debt and Related Hedging Activities
On September 27, 2006, we concluded an offer to exchange up to $120 million
principal amount of new notes with a "net share settlement" mechanism for our
currently outstanding contingent convertible subordinated notes. As of that
date, an aggregate principal amount of $115,205,000 of old notes was tendered.
See Note 12 to the unaudited condensed consolidated financial statements for a
further discussion. Also on September 27, 2006, we terminated our interest rate
swap agreement with a $50 million notional amount to hedge the risk of changes
in fair value attributable to interest rate risk with respect to a portion of
the notes. See "Results of Operations - Non-Operating Income and Expenses" for a
further discussion.
We pay interest on both our old and new contingent convertible subordinated
notes at an annual rate of 2 1/2% each September 15 and March 15. We will also
pay contingent interest on the notes if, at thirty days prior to maturity, our
common stock price is equal to or greater than $37.56. The contingent interest
will be payable at maturity for each of the last three years the notes remain
outstanding in an amount equal to the greater of (1) 0.50% of the face amount of
the notes and (2) the amount of regular cash dividends paid during each such
year on the number of shares of common stock into which each note is
convertible. Holders of the old notes may convert the notes into shares of our
common stock under certain circumstances, including when the market price of our
common stock on the previous trading day is equal to or greater than $37.56 per
share, based on an initial conversion price of $34.15 per share. Holders of the
new notes may convert their notes into cash, and if applicable, shares of our
common stock under certain circumstances, including when the market price of our
common stock on the previous trading day is equal to or greater than $37.56 per
share. Between September 27 and September 30, 2006, our stock price exceeded
$37.56 and no convertible notes have been converted to cash or common stock.
The notes are general, unsecured obligations of the Company and are subordinate
to any senior indebtedness. We cannot redeem the notes prior to their maturity,
and the notes' holders may compel us to repurchase the notes upon a change of
control. There are no financial covenants associated with the convertible notes.
Share Repurchase Plan
In February 2006, our Board of Directors authorized us to repurchase shares of
our common stock for an aggregate purchase price not to exceed $50 million
through December 31, 2006 and terminated our prior repurchase program. Shares
may be purchased either in the open market or in privately negotiated
transactions.
The Company purchased 456,750 and 400,900 shares of our common stock for a total
purchase price of approximately $16.7 million and $15.1 million during the three
months ended September 30, 2006 and June 30, 2006, respectively under this
repurchase program. No purchases were made under this program during the first
quarter of 2006.
In October 2006, our Board of Directors terminated the repurchase program
approved in February 2006 and adopted a new program that authorizes us to
repurchase shares of our common stock for an aggregate purchase price not to
exceed $75 million through December 31, 2007. Shares may be repurchased either
in the open market or in privately negotiated transactions.
Dividend Policy
We have not paid any cash dividends on our common stock since our formation. Our
credit facility limits the amount of dividends that we may pay. Any future
determinations to pay cash dividends on our common stock will be at the
discretion of our Board of Directors and will depend upon our financial
condition, results of operations, cash flows and other factors deemed relevant
by the Board of Directors.
31
Requirements and Capital Resources
In December 2005, we established a $200 million, five-year, senior secured
revolving credit facility. The credit facility currently allows for revolving
credit borrowings in a principal amount of up to $200 million, which can be
increased to $250 million should additional financing be required in the future.
We plan to utilize the credit facility for working capital, capital
expenditures, share repurchases, acquisitions and other general corporate
purposes. We have borrowed against this credit facility in 2006 for acquisition
related purposes. As of September 30, 2006, we had $87 million of outstanding
borrowings under our credit facility, and the weighted average interest rate for
this borrowing was 6.58% per annum.
The indebtedness under the credit facility is guaranteed by all but one of our
domestic subsidiaries. The Company's obligations under the credit facility and
the guarantees of the guarantors are secured by a first-priority security
interest in all present and future capital stock of (or other ownership or
profit interest in) each guarantor and substantially all of the Company's and
the guarantors' other assets, other than real estate, intellectual property and
capital stock of foreign subsidiaries.
Borrowings under the credit facility bear interest, at our option, at a rate
equal to (i) the Eurodollar Rate in effect from time to time plus an applicable
rate (ranging from 0.75% to 1.5%) or (ii) the higher of (x) the weighted average
overnight Federal funds rate, as published by the Federal Reserve Bank of New
York, plus 0.5%, and (y) the prime commercial lending rate of Bank of America,
N.A. plus an applicable rate (ranging from 0% to 0.5%). The applicable rates are
based on a financial ratio at the time of the applicable borrowing.
We will also pay an annual commitment fee (ranging from 0.15% to 0.25%) on the
daily amount by which the commitments under the credit facility exceed the
outstanding loans and letters of credit under the credit facility.
The credit facility requires us to maintain various financial covenants,
including leverage ratios, a minimum fixed charge coverage ratio and a minimum
liquidity ratio. The credit facility also contains customary affirmative and
negative covenants, including those that limit the Company's and its
subsidiaries' ability to incur additional debt, incur liens, make investments,
enter into mergers and acquisitions, liquidate or dissolve, sell or dispose of
assets, repurchase stock and pay dividends, engage in transactions with
affiliates, engage in certain lines of business and enter into sale and
leaseback transactions. As of September 30, 2006, we were in compliance with all
of our debt covenants.
Contractual Obligations and Commitments
Under certain agreements, we are required to make payments based on sales levels
of certain products or if specific development milestones are achieved.
OTHER MATTERS
Critical Accounting Estimates
The critical accounting estimates included in our Annual Report on Form 10-K for
the fiscal year ended December 31, 2005 have not materially changed other than
as set forth below.
Recently Adopted Accounting Standard
We adopted Statement of Financial Accounting Standards No. 123(R) "Share-Based
Payment" on January 1, 2006 using the modified prospective method which requires
companies (1) to record the unvested portion of previously issued awards that
remain outstanding at the initial date of adoption and (2) to record
compensation expense for any awards issued, modified or settled after the
effective date of the statement. As a result of the adoption of Statement
123(R), we began expensing stock options in the first quarter of 2006 using the
fair value method prescribed by Statement 123(R). Stock-based compensation cost
is measured at the grant date based on the fair value of an award and is
recognized on a straight-line basis as an expense over the requisite service
32
period, which is the vesting period. Certain of these costs are capitalized into
inventory and will be recognized as an expense when the related inventory is
sold. Our income before income taxes and net income for the nine months ended
September 30, 2006 were $10.3 million and $7.0 million lower, respectively, than
if we had continued to account for share-based compensation under APB No. 25.
We recognize stock-based compensation expense in the consolidated statement of
operations based on the awards that are expected to vest. Accordingly, we have
adjusted stock-based compensation expense to reflect estimated forfeitures.
Statement 123(R) requires forfeitures to be estimated at the time of grant and
revised, if necessary, in subsequent periods if actual forfeitures differ from
those estimates. We estimate forfeitures based on historical experience.
Statement 123(R) supercedes our previous accounting under Accounting Principals
Boards Opinion No. 25 "Accounting for Stock Issued to Employees" for periods
subsequent to December 31, 2005. In March 2005, the Securities and Exchange
Commission issued Staff Accounting Bulletin No. 107, which provides interpretive
guidance in applying the provisions of Statement 123(R). We have applied the
provisions of SAB 107 in our adoption of Statement 123(R).
Our condensed consolidated statement of operations for the nine months ended
September 30, 2006, includes compensation expense related to (i) stock-based
awards granted prior to, but not fully vested as of, January 1, 2006, based on
grant date fair values estimated in accordance with the pro forma provisions of
Statement of Financial Accounting Standards Statement No 123 "Accounting for
Stock-Based Compensation", and (ii) stock-based awards granted in 2006, based on
grant-date fair values estimated in accordance with Statement 123(R).
We calculate the fair value of our restricted stock awards and restricted stock
unit awards based on the closing market price of our common stock on the date of
the grant. We calculated the fair value of options granted prior to October 1,
2004 using the Black-Scholes model, while we calculate the fair value of options
granted on or after October 1, 2004 using the binomial distribution model. These
models include assumptions regarding the expected term of our option awards,
expected future volatility in the market price of our common stock, future
risk-free interest rates, and future dividends, if any, on our common stock. We
believe that the binomial distribution model is better than the Black-Scholes
model because the binomial distribution model is a more flexible model that
considers the impact of non-transferability, vesting and forfeiture provisions
in the valuation of employee stock options.
The assumptions used in calculating the fair value of stock-based compensation
awards involve inherent uncertainties and the application of management
judgment. If factors were to change, and we used different assumptions,
depending on the level of our future stock-based awards, our stock-based
compensation expense in the future could be materially different from that
reported for the nine months ended September 30, 2006 or pro forma amounts
reported for periods prior to January 1, 2006. In addition, if our actual
forfeiture rate varies significantly from our current estimate, the amount of
stock-based compensation expense recognized in future periods will be affected.
Recently Issued Accounting Standards
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS
No. 158, Employer's Accounting for Defined Benefit Pension and Other
Postretirement Plans--an amendment of FASB Statements No. 87, 88, 106 and 132(R)
.. SFAS No. 158 requires the Company to (a) recognize a plan's funded status in
its statement of financial position, (b) measure a plan's assets and its
obligations that determine its funded status as of the end of the employer's
fiscal year, and (c) recognize changes in the funded status of a defined
postretirement plan in the year in which the changes occur through other
comprehensive income. The requirement to recognize the funded status of a
benefit plan and the disclosure requirements are effective for the Company for
the fiscal year ending December 31, 2006. The Company does not believe the
implementation of this provision will have a material impact on its financial
position or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This
Statement defines fair value, establishes a framework for measuring fair value
in generally accepted accounting principles (GAAP), and expands disclosures
about fair value measurements. SFAS No. 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007. The
Company is currently assessing the impact this provision may have on its
financial position or results of operations.
33
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 the
quantification of misstatements based on their impact to both the balance sheet
and the income statement to determine materiality. The guidance provides for a
one-time cumulative effect adjustment to correct for misstatements for errors
that were not deemed material under a company's prior approach but are material
under the SAB 108 approach. SAB 108 is effective for the fiscal year ending
December 31, 2006. The Company does not believe the implementation of this
provision will have a material impact on its financial position or results of
operations.
In July 2006, the FASB issued FASB Interpretation 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 tax recognition
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. FIN 48 also requires
additional disclosures of unrecognized tax benefits, including a reconciliation
of the beginning and ending balance. The provisions of FIN 48 are effective
January 1, 2007. The Company is currently assessing the impact that the adoption
of FIN 48 will have on its financial position or results of operations.
34
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to various market risks, including changes in foreign currency
exchange rates and interest rates that could adversely impact our results of
operations and financial condition. To manage the volatility relating to these
typical business exposures, we may enter into various derivative transactions
when appropriate. We do not hold or issue derivative instruments for trading or
other speculative purposes.
Foreign Currency Exchange Rate Risk
A discussion of foreign currency exchange risks is provided under the caption
"International Product Revenues and Operations" under "Management's Discussion
and Analysis of Financial Condition and Results of Operations."
Interest Rate Risk - Marketable Securities
We are exposed to the risk of interest rate fluctuations on the fair value and
interest income earned on our cash and cash equivalents and investments in
available-for-sale marketable debt securities. A hypothetical 100 basis point
movement in interest rates applicable to our cash and cash equivalents and
investments in marketable debt securities outstanding at September 30, 2006
would increase or decrease interest income by approximately $243,000 on an
annual basis. We are not subject to material foreign currency exchange risk with
respect to these investments.
Interest Rate Risk - Senior Secured Credit Facility
We are exposed to the risk of interest rate fluctuations on the interest paid
under the terms of our senior secured credit facility. A hypothetical 100 basis
point movement in interest rates applicable to this credit facility would
increase or decrease interest expense by approximately $870,000 on an annual
basis.
35
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in our Exchange Act reports is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms and that such information
is accumulated and communicated to our management, including our principal
executive officer and principal financial officer, as appropriate, to allow for
timely decisions regarding required disclosure. Disclosure controls and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives, and management
is required to apply its judgment in evaluating the cost-benefit relationship of
possible controls and procedures. Management has designed our disclosure
controls and procedures to provide reasonable assurance of achieving the desired
control objectives.
As required by Rule 13a-15(b) under the Exchange Act, we have carried out an
evaluation, under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, of
the effectiveness of the design and operation of our disclosure controls and
procedures as of the end of the period covered by this report. Based on the
foregoing, our principal executive officer and principal financial officer
concluded that our disclosure controls and procedures were effective at the
reasonable assurance level.
Changes in Internal Control over Financial Reporting
No changes in our internal control over financial reporting (as defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter
ended September 30, 2006, that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.
On March 3, 2006 and May 12, 2006 the Company completed the purchases of
Radionics and Miltex, respectively, and is in the process of integrating the
operations and related controls of both businesses within the Company. On July
5, 2006 and July 31, 2006 the Company completed the purchases of Canada
Microsurgical Ltd. And Kinetikos Medical, Inc., respectively, and is in the
process of integrating the operations and related controls of these businesses
within the Company. See Note 2, "Business Acquisitions", to the unaudited
interim condensed consolidated financial statements included in this Quarterly
Report on Form 10-Q for a discussion of the acquisitions and related financial
data.
Internal control over financial reporting cannot provide absolute assurance of
achieving financial reporting objectives because of its inherent limitations.
Internal control over financial reporting is a process that involves human
diligence and compliance and is subject to lapses in judgment and breakdowns
resulting from human failures. Internal control over financial reporting also
can be circumvented by collusion or improper management override. Because of
such limitations, there is a risk that material misstatements may not be
prevented or detected on a timely basis by internal control over financial
reporting. However, these inherent limitations are known features of the
financial reporting process. Therefore, it is possible to design into the
process safeguards to reduce, though not eliminate, this risk.
36
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEDINGS
Various lawsuits, claims and proceedings are pending or have been settled by the
Company. The most significant of those are described below.
In May 2006, Codman & Shurtleff, Inc., a division of Johnson & Johnson,
commenced an action in the United States District Court for the District of New
Jersey for declaratory judgment against Integra LifeSciences Corporation with
respect to United States Patent No. 5,997,895 (the "'895 Patent") held by
Integra. Integra's patent covers dural repair technology related to Integra's
Duragen(R) family of duraplasty products.
The action seeks declaratory relief that Codman's DURAFORM(TM) product does not
infringe Integra's patent and that Integra's patent is invalid and
unenforceable. Codman does not seek either damages from Integra or injunctive
relief to prevent Integra from selling the Duragen(R) Dural Graft Matrix.
Integra has filed a counterclaim against Codman, alleging that Codman's
DURAFORM(TM) product infringes the '895 Patent, seeking injunctive relief
preventing the sale and use of DURAFORM(TM), and seeking damages, including
treble damages, for past infringement.
In July 1996, the Company sued Merck KGaA, a German corporation, seeking damages
for patent infringement. The patents in question are part of a group of patents
granted to The Burnham Institute and licensed by Integra that are based on the
interaction between a family of cell surface proteins called integrins and the
arginine-glycine-aspartic acid ("RGD") peptide sequence found in many
extracellular matrix proteins.
The case has been tried, appealed and returned to the trial court. Most
recently, in September 2004, the trial court ordered Merck KgaA to pay Integra
$6.4 million in damages. Merck KGaA filed a petition for a writ of certiorari
with the United States Supreme Court seeking review of the Circuit Court's
decision, and the Supreme Court granted the writ in January 2005.
On June 13, 2005, the Supreme Court vacated the June 2003 judgment of the
Circuit Court. The Supreme Court held that the Circuit Court applied an
erroneous interpretation of 35 U.S.C. ss.271(e)(1) when it rejected the
challenge of Merck KGaA to the jury's finding that Merck KGaA failed to show
that its activities were exempt from claims of patent infringement under that
statute. On remand, the Circuit Court was to have reviewed the evidence under a
reasonableness test that does not provide categorical exclusions of certain
types of activities. The hearing before the Circuit Court occurred in June 2006,
and a ruling is expected this year. Further enforcement of the trial court's
order has been stayed. We have not recorded any gain in connection with this
matter, pending final resolution and completion of the appeals process.
In addition to these matters, we are subject to various claims, lawsuits and
proceedings in the ordinary course of its business, including claims by former
employees, distributors and competitors and with respect to our products. In the
opinion of management, such claims are either adequately covered by insurance or
otherwise indemnified, or are not expected, individually or in the aggregate, to
result in a material adverse effect on our financial condition. However, it is
possible that our results of operations, financial position and cash flows in a
particular period could be materially affected by these contingencies.
37
ITEM 1A. RISK FACTORS
The Risk Factors included in the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 2005 (as modified by the subsequent Quarterly
Report on Form 10-Q) have not materially changed other than the modifications to
the risks factors as set forth below.
Certain Of Our Products Contain Materials Derived From Animal Sources And May
Become Subject To Additional Regulation.
Certain of our products, including our dermal regeneration products, our
duraplasty products and our nerve repair products, contain material derived from
bovine tissue. Products that contain materials derived from animal sources,
including food as well as pharmaceuticals and medical devices, are increasingly
subject to scrutiny in the press and by regulatory authorities. Regulatory
authorities are concerned about the potential for the transmission of disease
from animals to humans via those materials. This public scrutiny has been
particularly acute in Japan and Western Europe with respect to products derived
from animal sources, because of concern that materials infected with the agent
that causes bovine spongiform encephalopathy, otherwise known as BSE or mad cow
disease, may, if ingested or implanted, cause a variant of the human
Creutzfeldt-Jakob Disease, an ultimately fatal disease with no known cure.
Recent cases of BSE in cattle discovered in Canada and the United States have
increased awareness of the issue in North America.
We take great care to provide that our products are safe and free of agents that
can cause disease. In particular, the collagen used in the products that Integra
manufactures is derived only from the deep flexor tendon of cattle less than 24
months old from New Zealand, a country that has never had a case of BSE, or the
United States. The collagen used in a product that we sell, but do not
manufacture, is derived from bovine pericardium. We are also qualifying sources
of collagen from other countries that are considered BSE-free. The World Health
Organization classifies different types of cattle tissue for relative risk of
BSE transmission. Deep flexor tendon and bovine pericardium are in the lowest
risk categories for BSE transmission (the same category as milk, for example),
and are therefore considered to have a negligible risk of containing the agent
that causes BSE (an improperly folded protein known as a prion). Nevertheless,
products that contain materials derived from animals, including our products,
may become subject to additional regulation, or even be banned in certain
countries, because of concern over the potential for prion transmission.
Significant new regulation, or a ban of our products, could have a material
adverse effect on our current business or our ability to expand our business.
In addition, we have been notified that Japan has issued new regulations
regarding medical devices that contain tissue of animal origin. Among other
regulations, Japan requires that the tendon used in the manufacture of medical
devices sold in Japan originate in a country that has never had a case of BSE.
Currently, we purchase our tendon from the United States and New Zealand. We
received approval in Japan for the use of New Zealand sourced tendon in the
manufacturing of our products sold in Japan. If we cannot continue to use or
qualify a source of tendon from New Zealand or another country that has never
had a case of BSE, we will not be permitted to sell our collagen hemostatic
agents and products for oral surgery in Japan. We do not currently sell our
dural or skin repair products in Japan.
Lack Of Market Acceptance For Our Products Or Market Preference For Technologies
That Compete With Our Products Could Reduce Our Revenues And Profitability.
We cannot be certain that our current products or any other products that we may
develop or market will achieve or maintain market acceptance. Certain of the
medical indications that can be treated by our devices can also be treated by
other medical devices or by medical practices that do not include a device. The
medical community widely accepts many alternative treatments, and certain of
these other treatments have a long history of use. For example, the use of
autograft tissue is a well-established means for repairing the dermis, and it
competes for acceptance in the market with the INTEGRA(R) Dermal Regeneration
Template. In addition, we face similar competition for acceptance of our Newdeal
and Kinetikos Medical products, which previously were distributed by third
parties.
We cannot be certain that our devices and procedures will be able to replace
those established treatments or that either physicians or the medical community
in general will accept and utilize our devices or any other medical products
that we may develop.
38
In addition, our future success depends, in part, on our ability to develop
additional products. Even if we determine that a product candidate has medical
benefits, the cost of commercializing that product candidate may be too high to
justify development. Competitors may develop products that are more effective,
achieve more favorable reimbursement status from third-party payors, cost less
or are ready for commercial introduction before our products. If we are unable
to develop additional commercially viable products, our future prospects could
be adversely affected.
Market acceptance of our products depends on many factors, including our ability
to convince prospective collaborators and customers that our technology is an
attractive alternative to other technologies, to manufacture products in
sufficient quantities and at acceptable costs, and to supply and service
sufficient quantities of our products directly or through our distribution
alliances. In addition, unfavorable reimbursement methodologies or
determinations of third-party payors could harm acceptance or continued use of
our products. The industry is subject to rapid and continuous change arising
from, among other things, consolidation and technological improvements. One or
more of these factors may vary unpredictably, which could have a material
adverse effect on our competitive position. We may not be able to adjust our
contemplated plan of development to meet changing market demands.
We Are Exposed To A Variety Of Risks Relating To Our International Sales And
Operations, Including Fluctuations In Exchange Rates, Local Economic Conditions
And Delays In Collection Of Accounts Receivable.
We generate significant revenues outside the United States in Euros, British
pounds and in U.S. dollar-denominated transactions conducted with customers who
generate revenue in currencies other than the U.S. dollar. For those foreign
customers who purchase our products in U.S. dollars, currency fluctuations
between the U.S. dollar and the currencies in which those customers do business
may have an impact on the demand for our products in foreign countries where the
U.S. dollar has increased in value compared to the local currency.
Because we have operations based in Europe and we generate revenues and incur
operating expenses in Euros and British pounds, we experience currency exchange
risk with respect to those foreign currency-denominated revenues and expenses.
We also experience currency exchange risk with respect to the yen.
Currently, we do not use derivative financial instruments to manage operating
foreign currency risk. As the volume of our business transacted in foreign
currencies increases, we expect to continue to assess the potential effects that
changes in foreign currency exchange rates could have on our business. If we
believe that this potential impact presents a significant risk to our business,
we may enter into derivative financial instruments to mitigate this risk.
In general, we cannot predict the consolidated effects of exchange rate
fluctuations upon our future operating results because of the number of
currencies involved, the variability of currency exposure and the potential
volatility of currency exchange rates.
Our international operations subject us to customs and import-export laws. These
laws restrict, and in some cases prohibit, United States companies from directly
or indirectly selling goods, technology or services to people or entities in
certain countries. These laws also prohibit transactions with certain designated
persons.
Our sales to foreign markets also may be affected by local economic conditions,
legal, regulatory or political considerations, the effectiveness of our sales
representatives and distributors, local competition and changes in local medical
practice. Relationships with customers and effective terms of sale frequently
vary by country, often with longer-term receivables than are typical in the
United States.
Our Current Strategy Involves Growth Through Acquisitions, Which Requires Us To
Incur Substantial Costs And Potential Liabilities For Which We May Never Realize
The Anticipated Benefits.
In addition to internal growth, our current strategy involves growth through
acquisitions. Since 1999, we have acquired 24 businesses or product lines at a
total cost of approximately $335 million.
39
We may be unable to continue to implement our growth strategy, and our strategy
ultimately may be unsuccessful. A significant portion of our growth in revenues
has resulted from, and is expected to continue to result from, the acquisition
of businesses complementary to our own. We engage in evaluations of potential
acquisitions and are in various stages of discussion regarding possible
acquisitions, certain of which, if consummated, could be significant to us. Any
new acquisition can result in material transaction expenses, increased interest
and amortization expense, increased depreciation expense and increased operating
expense, any of which could have a material adverse effect on our operating
results. Certain businesses that we acquire may not have adequate financial,
regulatory or quality controls at the time we acquire them. As we grow by
acquisition, we must integrate and manage the new businesses to bring them into
our systems for financial, regulatory and quality control, realize economies of
scale, and control costs. In addition, acquisitions involve other risks,
including diversion of management resources otherwise available for ongoing
development of our business and risks associated with entering new markets with
which our marketing and sales force has limited experience or where experienced
distribution alliances are not available. Our future profitability will depend
in part upon our ability to develop further our resources to adapt to these new
products or business areas and to identify and enter into satisfactory
distribution networks. We may not be able to identify suitable acquisition
candidates in the future, obtain acceptable financing or consummate any future
acquisitions. If we cannot integrate acquired operations, manage the cost of
providing our products or price our products appropriately, our profitability
could suffer. In addition, as a result of our acquisitions of other healthcare
businesses, we may be subject to the risk of unanticipated business
uncertainties, regulatory matters or legal liabilities relating to those
acquired businesses for which the sellers of the acquired businesses may not
indemnify us.
40
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
In February 2006, our Board of Directors authorized us to repurchase shares of
our common stock for an aggregate purchase price not to exceed $50 million
through December 31, 2006. Shares may be purchased either in the open market or
in privately negotiated transactions.
The following table summarizes our repurchases of our common stock during the
quarter ended September 30, 2006 under this program:
Approximate
Dollar Value
Total Number of
of Shares Shares that
Purchased as May
Part of Yet be
Total Number Average Publicly Purchased
of Shares Price Paid Announced Under the
Period Purchased per Share Program Program
------ --------- --------- ------- -------
July 1, 2006 - July 31, 2006 55,300 $ 37.93 55,300 $32,715,891
August 1, 2006 - August 31, 2006 401,450 36.26 401,450 18,161,013
September 1, 2006 - September 30, 2006 -- -- -- 18,161,013
------- -------
Total 456,750 $ 36.46 456,750 $18,161,013
======= =======
In October 2006, our Board of Directors terminated the repurchase program
approved in February 2006 and adopted a new program that authorizes us to
repurchase shares of our common stock for an aggregate purchase price not to
exceed $75 million through December 31, 2007. Shares may be repurchased either
in the open market or in privately negotiated transactions.
41
ITEM 6. EXHIBITS
4.1 Indenture, dated as of September 29, 2006, between Integra
LifeSciences Holdings Corporation and Wells Fargo Bank, N.A.
(Incorporated by reference to Exhibit 4.1 to the Company's Current
Report on Form 8-K filed on October 5, 2006)
4.2 Form of 2 1/2% Contingent Convertible Subordinated Note due 2008
(Incorporated by reference to Exhibit 4.2 to the Company's Current
Report on Form 8-K filed on October 5, 2006)
10.1 Integra LifeSciences Holdings Corporation Management Incentive
Compensation Plan.
10.2 Fourth Amendment to Sublease, dated as of August 15, 2006, by and
between Sorrento Montana, L.P. and Integra LifeSciences Corporation
(Incorporated by reference to Exhibit 10.1 to the Company's Current
Report on Form 8-K filed on August 17, 2006).
10.3 Lease Contract, dated April 1, 2005, between the Puerto Rico Industrial
Development Company and Integra CI, Inc. (executed on September 15,
2006)
31.1 Certification of Principal Executive Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
31.2 Certification of Principal Financial Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
32.1 Certification of Principal Executive Officer Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
32.2 Certification of Principal Financial Officer Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
42
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
INTEGRA LIFESCIENCES HOLDINGS CORPORATION
Date: November 9, 2006 /s/ Stuart M. Essig
-------------------
Stuart M. Essig
President and Chief Executive Officer
Date: November 9, 2006 /s/ Maureen B. Bellantoni
-------------------
Maureen B. Bellantoni
Executive Vice President and Chief
Financial Officer
43
Exhibits
4.1 Indenture, dated as of September 29, 2006, between Integra
LifeSciences Holdings Corporation and Wells Fargo Bank, N.A.
(Incorporated by reference to Exhibit 4.1 to the Company's Current
Report on Form 8-K filed on October 5, 2006)
4.2 Form of 2 1/2% Contingent Convertible Subordinated Note due 2008
(Incorporated by reference to Exhibit 4.2 to the
Company's Current Report on Form 8-K filed on October 5, 2006)
10.1 Integra LifeSciences Holdings Corporation Management Incentive
Compensation Plan.
10.2 Fourth Amendment to Sublease, dated as of August 15, 2006, by and
between Sorrento Montana, L.P. and Integra LifeSciences Corporation
(Incorporated by reference to Exhibit 10.1 to the Company's Current
Report on Form 8-K filed on August 17, 2006).
10.3 Lease Contract, dated April 1, 2005, between the Puerto Rico Industrial
Development Company and Integra CI, Inc. executed on September 15,
2006)
31.1 Certification of Principal Executive Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
31.2 Certification of Principal Financial Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
32.1 Certification of Principal Executive Officer Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
32.2 Certification of Principal Financial Officer Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
44