PART
I. FINANCIAL INFORMATION
ITEM
1. FINANCIAL STATEMENTS
DJO
INCORPORATED
UNAUDITED
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except
share and par value data)
|
|
September 29,
2007
|
|
December 31,
2006
|
|
Assets
|
|
|
|
|
|
Current assets:
|
|
|
|
|
|
Cash and cash equivalents
|
|
$
|
11,956
|
|
$
|
7,006
|
|
Accounts receivable, net of provisions for
contractual allowances and doubtful accounts of $49,753 and $38,602 at
September 29, 2007 and December 31, 2006, respectively
|
|
96,348
|
|
90,236
|
|
Inventories, net
|
|
43,422
|
|
47,214
|
|
Deferred tax asset, net, current portion
|
|
10,813
|
|
10,797
|
|
Prepaid expenses and other current assets
|
|
10,730
|
|
14,521
|
|
Total current assets
|
|
173,269
|
|
169,774
|
|
Property, plant and equipment, net
|
|
30,226
|
|
32,699
|
|
Goodwill
|
|
281,176
|
|
277,495
|
|
Intangible assets, net
|
|
144,764
|
|
160,124
|
|
Debt issuance costs, net
|
|
4,899
|
|
5,634
|
|
Deferred tax asset, net
|
|
10,288
|
|
18,251
|
|
Other assets
|
|
5,135
|
|
4,357
|
|
Total assets
|
|
$
|
649,757
|
|
$
|
668,334
|
|
|
|
|
|
|
|
Liabilities and stockholders equity
|
|
|
|
|
|
Current liabilities:
|
|
|
|
|
|
Accounts payable
|
|
$
|
13,675
|
|
$
|
17,338
|
|
Accrued compensation
|
|
11,123
|
|
14,171
|
|
Accrued commissions
|
|
4,870
|
|
4,133
|
|
Accrued interest
|
|
3,116
|
|
3,984
|
|
Accrued taxes
|
|
4,148
|
|
3,738
|
|
Long-term debt, current portion
|
|
|
|
831
|
|
Other accrued liabilities, current portion
|
|
18,215
|
|
22,967
|
|
Total current liabilities
|
|
55,147
|
|
67,162
|
|
|
|
|
|
|
|
Long-term debt, less current portion
|
|
285,500
|
|
326,419
|
|
Other accrued liabilities, long-term
|
|
5,354
|
|
4,484
|
|
|
|
|
|
|
|
Commitments and contingencies
|
|
|
|
|
|
|
|
|
|
|
|
Stockholders equity:
|
|
|
|
|
|
Preferred stock, $0.01 par value; 1,000,000 shares
authorized, none issued and outstanding at September 29, 2007 and December
31, 2006
|
|
|
|
|
|
Common stock, $0.01 par value; 39,000,000 shares
authorized, 23,657,860 shares and 23,317,934 shares issued and outstanding at
September 29, 2007 and December 31, 2006, respectively
|
|
237
|
|
233
|
|
Additional paid-in-capital
|
|
179,863
|
|
163,711
|
|
Accumulated other comprehensive income
|
|
4,009
|
|
1,984
|
|
Retained earnings
|
|
119,647
|
|
104,341
|
|
Total stockholders equity
|
|
303,756
|
|
270,269
|
|
Total liabilities and stockholders equity
|
|
$
|
649,757
|
|
$
|
668,334
|
|
See accompanying Notes.
3
DJO
INCORPORATED
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per
share data)
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
|
September 29,
2007
|
|
September 30,
2006
|
|
September 29,
2007
|
|
September 30,
2006
|
|
|
|
|
|
|
|
|
|
|
|
Net revenues
|
|
$
|
119,784
|
|
$
|
113,205
|
|
$
|
354,869
|
|
$
|
302,293
|
|
Costs of goods sold
|
|
45,501
|
|
45,340
|
|
140,841
|
|
119,961
|
|
Gross profit
|
|
74,283
|
|
67,865
|
|
214,028
|
|
182,332
|
|
Operating expenses:
|
|
|
|
|
|
|
|
|
|
Sales and marketing
|
|
35,621
|
|
33,398
|
|
111,795
|
|
92,375
|
|
General and administrative
|
|
11,336
|
|
13,075
|
|
35,229
|
|
35,709
|
|
Research and development
|
|
2,018
|
|
2,580
|
|
6,185
|
|
6,745
|
|
Amortization of acquired intangibles
|
|
4,503
|
|
4,510
|
|
13,490
|
|
10,651
|
|
Merger costs
|
|
2,539
|
|
|
|
2,539
|
|
|
|
Total operating expenses
|
|
56,017
|
|
53,563
|
|
169,238
|
|
145,480
|
|
Income from operations
|
|
18,266
|
|
14,302
|
|
44,790
|
|
36,852
|
|
Interest expense, net of interest income
|
|
(5,321
|
)
|
(6,284
|
)
|
(16,932
|
)
|
(15,684
|
)
|
Other income, net
|
|
322
|
|
439
|
|
1,227
|
|
254
|
|
Income before income taxes
|
|
13,267
|
|
8,457
|
|
29,085
|
|
21,422
|
|
Provision for income taxes
|
|
(6,552
|
)
|
(4,098
|
)
|
(12,974
|
)
|
(9,790
|
)
|
Net income
|
|
$
|
6,715
|
|
$
|
4,359
|
|
$
|
16,111
|
|
$
|
11,632
|
|
|
|
|
|
|
|
|
|
|
|
Net income per share:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
0.28
|
|
$
|
0.19
|
|
$
|
0.68
|
|
$
|
0.51
|
|
Diluted
|
|
$
|
0.28
|
|
$
|
0.18
|
|
$
|
0.67
|
|
$
|
0.50
|
|
Weighted average shares outstanding used to
calculate per share information:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
23,641
|
|
22,968
|
|
23,536
|
|
22,620
|
|
Diluted
|
|
24,251
|
|
23,598
|
|
24,082
|
|
23,330
|
|
See accompanying Notes.
4
DJO
INCORPORATED
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
|
|
Nine Months Ended
|
|
|
|
September 29,
2007
|
|
September 30,
2006
|
|
|
|
|
|
|
|
Operating activities
|
|
|
|
|
|
Net income
|
|
$
|
16,111
|
|
$
|
11,632
|
|
Adjustments to reconcile net income to net cash
provided by operating activities:
|
|
|
|
|
|
Provision for contractual allowances and doubtful
accounts
|
|
41,997
|
|
30,146
|
|
Provision for excess and obsolete inventories
|
|
1,473
|
|
1,167
|
|
Depreciation and amortization
|
|
22,595
|
|
18,645
|
|
Amortization of debt issuance costs
|
|
735
|
|
618
|
|
Excess tax benefits from stock options exercised
|
|
(1,819
|
)
|
|
|
Stock-based compensation expense
|
|
8,058
|
|
6,836
|
|
Step-up to fair value of inventory charged to costs
of goods sold
|
|
|
|
1,498
|
|
Write-off of debt issuance costs
|
|
|
|
2,347
|
|
Other
|
|
|
|
47
|
|
Changes in operating assets and liabilities, net
|
|
(41,676
|
)
|
(35,927
|
)
|
Net cash provided by operating activities
|
|
47,474
|
|
37,009
|
|
|
|
|
|
|
|
Investing activities
|
|
|
|
|
|
Purchases of property, plant and equipment
|
|
(5,467
|
)
|
(12,485
|
)
|
Purchase of businesses, net of cash acquired
|
|
(5,977
|
)
|
(313,634
|
)
|
Proceeds from disposal of asset held for sale
|
|
3,365
|
|
|
|
Changes in other assets
|
|
(1,554
|
)
|
(958
|
)
|
Net cash used in investing activities
|
|
(9,633
|
)
|
(327,077
|
)
|
|
|
|
|
|
|
Financing activities
|
|
|
|
|
|
Proceeds from long-term debt
|
|
7,000
|
|
366,000
|
|
Repayment of long-term debt
|
|
(48,750
|
)
|
(79,250
|
)
|
Debt issuance costs
|
|
|
|
(6,328
|
)
|
Net proceeds from issuance of common stock
|
|
6,303
|
|
12,020
|
|
Excess tax benefits from stock options exercised
|
|
1,819
|
|
|
|
Net cash (used in) provided by financing activities
|
|
(33,628
|
)
|
292,442
|
|
Effect of exchange rate changes on cash and cash
equivalents
|
|
737
|
|
176
|
|
Net increase in cash and cash equivalents
|
|
4,950
|
|
2,550
|
|
Cash and cash equivalents at beginning of period
|
|
7,006
|
|
1,107
|
|
Cash and cash equivalents at end of period
|
|
$
|
11,956
|
|
$
|
3,657
|
|
See accompanying Notes.
5
DJO INCORPORATED
NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except
share and per share data)
1. General
Business and Organization
DJO Incorporated (the Company) is a global provider of
solutions for musculoskeletal and vascular health, specializing in
rehabilitation and regeneration products for the non-operative orthopedic,
spine and vascular markets.
Basis
of Presentation
The accompanying
unaudited condensed consolidated financial statements as of September 29, 2007
and for the three and nine months ended September 29, 2007 and September 30,
2006 have been prepared in accordance with accounting principles generally
accepted in the United States for interim financial information. Accordingly,
they do not include all of the information and disclosures required by
accounting principles generally accepted in the United States for complete
financial statements. These unaudited condensed consolidated financial
statements should be read in conjunction with the audited consolidated
financial statements of the Company and the notes thereto included in the
Companys Annual Report on Form 10-K for the year ended December 31, 2006. The
accompanying unaudited condensed consolidated financial statements as of
September 29, 2007 and for the three and nine months ended September 29, 2007
and September 30, 2006 have been prepared on the same basis as the audited
consolidated financial statements and include all adjustments (consisting of
normal recurring accruals and the adjustments described in Note 3) which, in
the opinion of management, are necessary for a fair presentation of the
financial position, operating results and cash flows for the interim date and
interim periods presented. Results for the interim periods are not necessarily
indicative of the results to be achieved for the entire year or future periods.
The
accompanying unaudited condensed consolidated financial statements present the
historical financial position and results of operations of the Company and
include the accounts of its operating subsidiary, DJO, LLC (DJO), DJOs wholly
owned Mexican subsidiary that manufactures a majority of DJOs products under
Mexicos maquiladora program and DJOs wholly owned subsidiaries in several
international countries. These unaudited condensed consolidated financial
statements also include the accounts of Aircast Incorporated and its wholly
owned domestic and international subsidiaries from and subsequent to April 7,
2006, the date on which the Company acquired Aircast Incorporated (see Note 3).
All intercompany accounts and transactions have been eliminated in
consolidation.
The
preparation of these unaudited condensed consolidated financial statements requires
that the Company make estimates and judgments that affect the reported amounts
of assets, liabilities, revenues and expenses and related disclosure of
contingent assets and liabilities. On an ongoing basis, the Company evaluates
its estimates, including those related to contractual allowances, doubtful
accounts, inventories, rebates, product returns, warranty obligations, income
taxes, goodwill and other intangible assets, and stock based compensation. The
Company bases its estimates on historical experience and on various other
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources. Actual
results may differ from these estimates.
The Companys
fiscal year ends on December 31. Each quarter consists of one five-week and two
four-week periods.
Cash
Equivalents
Cash equivalents are short-term, highly liquid
investments and consist of investments in money market funds and commercial
paper with maturities of three months or less at the time of purchase.
Financial Instruments
The Company utilizes derivative instruments,
specifically an interest rate swap agreement and forward contracts to purchase
foreign currencies, to manage its exposure to market risks such as changes in
interest rates and foreign currency exchange rates. In accordance with the
Financial Accounting Standards Board (FASB) Statement of Financial Accounting
Standards (SFAS) No. 133,
Accounting for
Derivative Instruments and Hedging Activities
, the Company records
derivative instruments as assets or liabilities in the consolidated balance
sheet, measured at fair value.
6
Per Share Information
Earnings per share
are computed in accordance with SFAS No. 128,
Earnings
Per Share
. Basic earnings per share are computed using the weighted
average number of common shares outstanding during each period. Diluted
earnings per share include the dilutive effect of weighted average common share
equivalents potentially issuable upon the exercise of stock options. For
purposes of computing diluted earnings per share, weighted average common share
equivalents (computed using the treasury stock method) do not include stock
options with an exercise price that exceeds the average fair market value of
the Companys common stock during the periods presented. The weighted average
shares outstanding used to calculate basic and diluted share information
consists of the following (in thousands):
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
|
September 29,
2007
|
|
September 30,
2006
|
|
September 29,
2007
|
|
September 30,
2006
|
|
Shares used in computations of basic net income per
share weighted average shares outstanding
|
|
23,641
|
|
22,968
|
|
23,536
|
|
22,620
|
|
Net effect of dilutive common share equivalents based
on treasury stock method
|
|
610
|
|
630
|
|
546
|
|
710
|
|
Shares used in computations of diluted net income
per share
|
|
24,251
|
|
23,598
|
|
24,082
|
|
23,330
|
|
Stock-Based
Compensation
The Company
records compensation expense associated with stock options and other
equity-based compensation in accordance with SFAS No. 123 (revised 2004),
Share-Based Payment
(SFAS No. 123(R)). The Company recognizes these compensation costs on a
straight-line basis over the requisite service period of the award, which is
generally four years. The Companys net income for each of the three month
periods ended September 29, 2007 and September 30, 2006, have been reduced by stock-based
compensation expense, net of taxes, of approximately $2.3 million. The Companys
net income for the nine months ended September 29, 2007 and September 30, 2006,
has been reduced by stock-based compensation expense, net of taxes, of
approximately $5.5 million and $5.3 million, respectively. See Note 7 for
additional information regarding stock-based compensation.
Recently Issued Accounting
Standards
In June 2006, the FASB issued FASB Interpretation
No. 48,
Accounting for Uncertainty in Income Taxes an
interpretation of SFAS No. 109, Accounting for Income Taxes
(FIN 48). FIN 48 prescribes a comprehensive model for how companies should
recognize, measure, present, and disclose in their financial statements
uncertain tax positions taken or expected to be taken on a tax return. Under
FIN 48, tax positions shall initially be recognized in the financial statements
when it is more likely than not the position will be sustained upon examination
by the tax authorities. Such tax positions shall initially and subsequently be
measured as the largest amount of tax benefit that is greater than 50% likely
of being realized upon ultimate settlement with the tax authority assuming full
knowledge of the position and all relevant facts. FIN 48 also revises disclosure
requirements to include an annual tabular rollforward of unrecognized tax
benefits. The provisions of this interpretation were required to be adopted for
fiscal periods beginning after December 15, 2006. The Company adopted FIN 48 on
January 1, 2007. See Note 5 for further details.
In September 2006, the FASB issued SFAS
No. 157,
Fair Value Measurements
, which
provides a single definition of fair value, a framework for measuring fair
value, and expanded disclosures concerning fair value. Previously, different
definitions of fair value were contained in various accounting pronouncements
creating inconsistencies in measurement and disclosures. SFAS No. 157
applies under those previously issued pronouncements that prescribe fair value
as the relevant measure of value, except for Statement No. 123(R) and
related interpretations and pronouncements that require or permit measurement
similar to fair value but are not intended to measure fair value. This
pronouncement is effective for fiscal years beginning after November 15, 2007.
The Company does not expect the adoption of SFAS No. 157 to have a material
impact on its consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159,
The Fair Value Option for Financial Assets and
Financial Liabilities - Including an Amendment of FASB Statement No. 115.
This standard permits an entity to choose to measure many financial instruments
and certain other items at fair value. Most of the provisions in SFAS No. 159
are elective; however, the amendment to SFAS No. 115,
Accounting for Certain Investments in Debt and Equity
Securities,
applies to all entities with available-for-sale and
trading securities. The fair value option established by SFAS No. 159 permits
all entities to choose to measure eligible items at fair value at specified
7
election dates. A
business entity will report unrealized gains and losses on items for which the
fair value option has been elected in earnings (or another performance indicator
if the business entity does not report earnings) at each subsequent reporting
date. The fair value option: (a)
may be applied instrument by instrument, with a few exceptions, such as
investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new
election date occurs); and (c)
is applied only to entire instruments and not to portions of instruments. SFAS
No. 159 is effective as of the beginning of an entitys first fiscal year that
begins after November 15, 2007. The Company does not expect the adoption
of SFAS No. 159 to have a material impact on its consolidated financial
statements.
Foreign
Currency Translation
The financial
statements of the Companys international subsidiaries, where the local
currency is the functional currency, are translated into U.S. dollars using
period-end exchange rates for assets and liabilities and average exchange rates
during the period for revenues and expenses. Cumulative translation gains and
losses are excluded from results of operations and recorded as a separate
component of consolidated stockholders equity. Gains and losses resulting from
foreign currency transactions (transactions denominated in a currency other
than the entitys local currency) are included in the consolidated statements
of income as either a component of costs of goods sold or other income or
expense, depending on the nature of the transaction. The Company incurred an
aggregate foreign currency transaction gain in the three and nine months ended
September 29, 2007 of approximately $0.3 million and $0.8 million, respectively.
The aggregate foreign currency transaction gain included in determining net
income for both the three and nine months ended September 30, 2006 was
approximately $0.4 million.
Proposed
Merger
On July 15, 2007,
the Company entered into an Agreement and Plan of Merger (the Merger Agreement)
with ReAble Therapeutics Finance LLC, a Delaware limited liability company (Parent),
and Reaction Acquisition Merger Sub, Inc., a Delaware corporation and a
wholly-owned subsidiary of Parent (Merger Sub). Parent is controlled by
affiliates of The Blackstone Group (Blackstone). The Merger Agreement and the
transactions contemplated thereby were unanimously approved by the Companys
Board of Directors (the Board) and a Transaction Committee of the Board
comprised entirely of independent directors and are subject to certain closing
conditions, including the approval of the Companys stockholders. Under the
terms of the Merger Agreement, Merger Sub will be merged with and into the
Company (the Merger), with the Company continuing as the surviving
corporation and becoming a wholly-owned subsidiary of Parent. As of the
effective time of the Merger, each issued and outstanding share of common stock
of the Company will generally be cancelled and converted into the right to
receive $50.25 in cash, without interest. The Merger Agreement also provides
that, at the effective time of the Merger, each outstanding option to purchase
common stock, vested and unvested, will be cancelled and the holders will be
entitled to receive a cash payment equal to the excess, if any, of the per
share merger price of the option multiplied by the number of shares subject to
the option, less applicable withholding taxes. Parent has provided the Company
an equity commitment from an affiliate of Blackstone and obtained debt
financing commitments, the proceeds of which will provide for the necessary
funds to consummate the transactions contemplated by the Merger Agreement. The
Merger Agreement provided for a 50-day go-shop provision during which the
Company was permitted to solicit competing takeover proposals. This go-shop
period ended on September 4, 2007 and the Company did not receive any takeover
proposals during the go-shop period. Commencing with the completion of the
go-shop period, the Company is subject to a no-shop provision, which
restricts its ability to solicit, discuss or negotiate competing proposals. The
no-shop restriction does not apply to any party that submits a written takeover
proposal after the go-shop period that the Board determines in good faith
constitutes or could reasonably be expected to lead to a Superior Proposal as
defined in the Merger Agreement, and that failure to enter into discussions or
negotiations with such party would reasonably be expected to result in a breach
of the Boards fiduciary duties.
The Merger
Agreement contains certain termination rights for both the Company, including
if the Company receives a takeover proposal that the Board determines in good
faith constitutes a Superior Proposal and that failure to terminate would
reasonably be expected to result in a breach of its fiduciary duties, and
otherwise complies with the terms of the Merger Agreement, and Parent under
specified circumstances. The Merger Agreement further provides that, upon
termination of the Merger Agreement under specified circumstances, the Company
will be required to pay a fee of $37.4 million to Parent. If the Companys
stockholders do not approve the Merger, the Company will be required to
reimburse up to $5.0 million of Parents expenses. If the Merger does not occur
because Parent is unable to obtain debt financing, Parent will be required to
pay a fee of $37.4 million to the Company. An affiliate of Blackstone has
delivered to the Company a limited guaranty of Parents obligation to pay
certain amounts under the Merger Agreement (including the $37.4 million fee),
up to a maximum amount equal to $100 million. Consummation of the Merger
remains subject to several conditions, including the adoption of the Merger
Agreement by the Companys stockholders, the absence of certain legal
impediments and other customary closing conditions. Subject to the completion
of these closing conditions, the proposed merger is expected to close in the
fourth quarter of 2007.
8
On August 31, 2007
and September 6, 2007, two purported shareholder class action lawsuits were
filed in California Superior Court, in the County of San Diego, on behalf of
the Companys public stockholders, challenging the Companys proposed merger
with Parent. The court ordered the two lawsuits consolidated for all purposes
on September 21, 2007. See Note 8 for further details.
Merger Costs
Merger costs of
$2.5 million included in the accompanying statements of income for the three
and nine months ended September 29, 2007 consist of certain costs related to
the proposed merger with ReAble Therapeutics Finance LLC discussed above.
2. Financial
Statement Information
Inventories
consist of the following (in thousands):
|
|
September 29,
2007
|
|
December 31,
2006
|
|
|
|
|
|
|
|
Raw materials
|
|
$
|
16,183
|
|
$
|
17,920
|
|
Work-in-progress
|
|
1,435
|
|
753
|
|
Finished goods
|
|
28,432
|
|
30,615
|
|
|
|
46,050
|
|
49,288
|
|
Less reserves, primarily for excess and obsolete
inventories
|
|
(2,628
|
)
|
(2,074
|
)
|
Inventories, net
|
|
$
|
43,422
|
|
$
|
47,214
|
|
Prepaid expenses
and other current assets consist of the following (in thousands):
|
|
September 29,
2007
|
|
December 31,
2006
|
|
|
|
|
|
|
|
Held-for-sale assets
|
|
$
|
1,904
|
|
$
|
6,960
|
|
Prepaid expenses
|
|
5,374
|
|
4,050
|
|
Other current assets
|
|
3,452
|
|
3,511
|
|
Prepaid expenses and other current assets, net
|
|
$
|
10,730
|
|
$
|
14,521
|
|
Held-for-sale assets as of September 29, 2007
consisted of the Aircast Germany facility. Held-for-sale assets as of December
31, 2006 also included the Aircast manufacturing facility in New Jersey. These
held-for-sale facilities were vacated in connection with the Companys
integration of the Aircast business and are no longer in use. In August 2007,
the Company sold the former Aircast manufacturing building and land in New
Jersey for net proceeds of $3.4 million.
Other accrued liabilities, current portion, consists
of the following (in thousands):
|
|
September 29,
2007
|
|
December 31,
2006
|
|
|
|
|
|
|
|
Accrued contract fees
|
|
$
|
3,997
|
|
$
|
2,626
|
|
Accrued professional fees
|
|
1,607
|
|
1,326
|
|
Deferred rent, current portion
|
|
474
|
|
453
|
|
Other accrued liabilities, current portion
|
|
12,137
|
|
18,562
|
|
Other accrued liabilities, current portion
|
|
$
|
18,215
|
|
$
|
22,967
|
|
9
Other accrued
liabilities, long-term, consists of the following (in thousands):
|
|
September 29,
2007
|
|
December 31,
2006
|
|
|
|
|
|
|
|
Deferred rent, long-term
|
|
$
|
3,301
|
|
$
|
3,355
|
|
Fair value of interest rate swap
|
|
1,782
|
|
928
|
|
Accrued pension
|
|
271
|
|
201
|
|
Other accrued liabilities, long-term
|
|
$
|
5,354
|
|
$
|
4,484
|
|
Deferred rent relates primarily to the Companys headquarters in Vista,
California.
3. Acquisitions
and Investments
Aircast Acquisition
On April 7, 2006,
the Company completed the acquisition, under an agreement signed on February
27, 2006, of all the outstanding capital stock of Aircast Incorporated
(Aircast) for approximately $291.6 million in cash. The Company also incurred
approximately $4.9 million in transaction costs and other expenses in
connection with the acquisition and accrued approximately $10.5 million of
estimated costs in connection with the Companys plan to integrate the acquired
business, including severance expenses.
In April 2006, the Company began its integration of
the Aircast business. The integration plan consisted of: 1) integrating the Aircast sales force into
the Companys existing sales force, 2) closing the Aircast New Jersey
manufacturing facility and moving the manufacturing of the Aircast products to
the Companys Tijuana, Mexico manufacturing facility, with the exception of
Aircasts vascular systems products, which were moved to the Companys Vista,
California facility, 3) closing the Aircast New Jersey corporate headquarters
and integrating the administrative functions into the Companys Vista facility
and the Companys distribution facility in Indianapolis, Indiana, and 4)
closing various international Aircast locations and integrating their
operations into the Companys existing locations in those countries including
France, Germany and the United Kingdom. In conjunction with this integration
plan, the Company accrued approximately $10.8 million in severance costs for
approximately 300 Aircast employees. The Company completed the termination of
the affected Aircast employees in March 2007. Of this total estimated amount,
approximately $2.0 million of severance payments have not been paid out as of
September 29, 2007, and are not expected to be fully paid out until the first
quarter of 2008. This amount is included in accrued compensation in the
accompanying unaudited consolidated balance sheet at September 29, 2007.
Severance costs accrued as of September 29, 2007 for
Aircast employees as a result of the Companys integration of the acquired
business are as follows (in thousands):
|
|
Total Costs
Incurred
|
|
Cash
Payments
|
|
Accrued Liability At
September 29, 2007
|
|
Employee severance
|
|
$
|
10,752
|
|
$
|
(8,744
|
)
|
$
|
2,008
|
|
|
|
|
|
|
|
|
|
|
|
|
10
The
accompanying consolidated statements of income reflect the operating results of
the Aircast business since April 7, 2006. Assuming the acquisition of Aircast
had occurred on January 1, 2006, the pro forma unaudited results of operations
would have been as follows (in thousands):
|
|
Nine Months
Ended
September 30,
2006
|
|
Net revenues
|
|
$
|
327,215
|
|
Net income
|
|
$
|
9,626
|
|
Net income per share:
|
|
|
|
Basic
|
|
$
|
0.43
|
|
Diluted
|
|
$
|
0.41
|
|
Weighted average shares outstanding used to calculate
per share information:
|
|
|
|
Basic
|
|
22,620
|
|
Diluted
|
|
23,330
|
|
The
above pro forma unaudited results of operations do not include pro forma
adjustments relating to costs of integration or post-integration cost
reductions that might have been incurred or realized by the Company in excess
of actual amounts incurred or realized through September 30, 2006.
Purchase of Rights to Distributor Territories
From time to time
the Company purchases rights to certain distributor territories in the U.S. and
then sells the distribution rights to another party for similar amounts. These
distribution reorganizations are intended to achieve several objectives,
including improvement of sales results within the affected territories. The
Company generally receives promissory notes for the resale amounts, which are
recorded as notes receivable and included in other current and long-term assets
in the accompanying unaudited consolidated balance sheet. For the nine months
ended September 29, 2007, the Company purchased and resold territory rights for
amounts aggregating $1.4 million and did not record any material gains or
losses from the transfer of these distribution rights.
Full90 Note Investment
In March 2007, the Company entered into a Note
Purchase Agreement (Agreement) with Full90 Sports, Inc. (Full90) under
which the Company agreed to loan to Full90 a total of $1.5 million in exchange
for a Secured Convertible Promissory Note (Note). The Note bears interest at
the rate of 12% per annum, with accrued interest payable quarterly and all
principal payable on the third anniversary of the Note. The Note is secured by
all assets of Full90 and is convertible at the option of the Company into
2,573,781 shares of Series C Preferred Stock of Full90, representing approximately
14% of the equity of Full90. The Agreement provides that, prior to conversion
of the Note, the Company shall have the right of first refusal on any
acquisition of Full90 and on future debt or equity financings by Full90. Full90
is a manufacturer of orthopedic products, including a patented protective
soccer headgear, and has appointed the Company a world-wide distributor of the
protective soccer headgear. The Note is included in other long-term assets in
the accompanying unaudited consolidated balance sheet.
4. Comprehensive
Income
Comprehensive
income consists of the following components (in thousands):
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
|
September 29,
2007
|
|
September 30,
2006
|
|
September 29,
2007
|
|
September 30,
2006
|
|
|
|
|
|
|
|
|
|
|
|
Net income, as reported
|
|
$
|
6,715
|
|
$
|
4,359
|
|
$
|
16,111
|
|
$
|
11,632
|
|
Foreign currency translation adjustment
|
|
1,694
|
|
(53
|
)
|
2,879
|
|
1,521
|
|
Change in fair value of interest rate swap
|
|
(1,769
|
)
|
(2,208
|
)
|
(854
|
)
|
(1,197
|
)
|
Comprehensive income
|
|
$
|
6,640
|
|
$
|
2,098
|
|
$
|
18,136
|
|
$
|
11,956
|
|
11
5. Income Taxes
As
discussed in Note 1, the Company adopted the provisions of FIN 48 on January 1,
2007. No previously unrecognized tax benefits were recorded as of the date of
adoption. As a result of the implementation of FIN 48, the Company recognized a
$1.4 million increase in unrecognized tax benefits. A portion of the transition
adjustment related to historical exposures of the Company and was recorded as
permitted by FIN 48 as a reduction of retained earnings in the amount of
approximately $0.8 million. A portion of the transition adjustment related to
Aircast exposures created prior to the Companys acquisition of Aircast and was
therefore recorded as an increase of approximately $0.6 million in goodwill
related to the Aircast acquisition. The offset of the transition adjustment was
recorded as a reduction to deferred tax assets and additional taxes payable.
The
transition adjustment included approximately $0.2 million of interest and
approximately $0.1 million of penalties related to the unrecognized tax
benefits. Interest costs and penalties related to income taxes are classified
as part of the income tax provision in the Companys financial statements.
Of the
transition adjustment, a portion related to estimated possible transfer pricing
exposures. Such estimates will be evaluated each quarter based on changes to
transfer pricing and changes in foreign exchange rates. An estimate of the
range of reasonably possible future changes cannot be made. United States
federal and most state tax returns for all years after 2002 are subject to
future examination by tax authorities. Open tax years for foreign jurisdictions
vary.
The
Companys balance of unrecognized tax benefits as of September 29, 2007
remained unchanged at $1.4 million. There were no changes required to be made
to the balance as there were no new tax positions taken by the Company during
the current period, no settlements with taxing authorities and no lapses of
applicable statutes of limitations. Included in the balance of unrecognized tax
benefits is $0.8 million of tax benefits that, if recognized, would impact the
effective tax rate. Also included in the balance of unrecognized tax
benefits is $0.6 million of tax benefits that, if recognized, would result in
adjustments to other tax accounts, primarily deferred taxes and goodwill.
6. Segment and Related Information
The following are
the Companys reportable segments.
Domestic Rehabilitation
consists of the sale of the Companys
rehabilitation products (rigid knee braces, soft goods, cold therapy and
vascular systems products) in the United States through three sales channels,
DonJoy, ProCare/Aircast and OfficeCare.
Through the DonJoy
sales channel, the Company sells its rehabilitation products utilizing a few of
the Companys direct sales representatives and a network of approximately 392
independent commissioned sales representatives who are employed by
approximately 44 independent sales agents. These sales representatives are
primarily dedicated to the sale of the Companys products to orthopedic
surgeons, podiatrists, orthopedic and prosthetic centers, hospitals, surgery
centers, physical therapists, athletic trainers and other healthcare
professionals. Because certain of the DonJoy product lines require customer
education on the application and use of the product, these sales
representatives are technical specialists who receive extensive training both
from the Company and the agent and use their expertise to help fit the patient
with the product and assist the orthopedic professional in choosing the
appropriate product to meet the patients needs. After a product order is
received by a sales representative, the Company generally ships the product
directly to the orthopedic professional and pays a sales commission to the
agent. These commissions are reflected in sales and marketing expense in the
Companys consolidated financial statements. For certain custom rigid braces
and other products, the Company sells directly to the patient and bill a
third-party payor, if applicable, on behalf of the patient. The Company refers
to this portion of its DonJoy channel as its Insurance channel.
Through the ProCare/Aircast
sales channel, which is comprised of
approximately 100 direct and
independent representatives that manage over 380 dealers focused on primary and
acute facilities, the Company sells its rehabilitation products to national
third-party distributors, other regional medical supply dealers and medical
product buying groups, generally at a discount from list prices. The majority
of these products are soft goods which require little or no patient education.
The distributors and dealers generally resell these products to large hospital
chains, hospital buying groups, primary care networks and orthopedic physicians
for use by the patients.
12
Through the OfficeCare
sales channel,
the Company maintains an inventory of rehabilitation
products (mostly soft goods) on hand at orthopedic practices for immediate
distribution to the patient. For these products, the Company arranges billing
to the patient or third-party payor after the product is provided to the
patient. As of September 29, 2007, the OfficeCare program was located at over
1,200 physician offices throughout the United States. The Company has contracts
with over 750 third-party payors.
Regeneration
consists of the sale of the Companys bone
growth stimulation products in the United States. The Companys OL1000
product is sold through a combination of the DonJoy channel direct sales
representatives and approximately 155 additional sales representatives
dedicated to selling the OL1000 product, of which approximately 67 are employed
by the Company. The SpinaLogic product is also included in this segment and is
sold through a combination of several independent companies focused on selling
spine products, including DePuy Spine and International Rehabilitative Sciences
Inc. (which does business as RS Medical), and certain direct sales
representatives. These products are sold either directly to the patient or to
independent distributors. The Company arranges billing to the third-party
payors or patients, for products sold directly to the patient.
International
consists
of the sale of the Companys products in foreign countries through wholly owned
subsidiaries or independent distributors. The Company sells its products in
over 75 foreign countries, primarily in Europe, Canada, Japan and Australia.
Set forth below are net revenues, gross profit and
operating income for the Companys reporting segments for the three and nine
months ended September 29, 2007 and September 30, 2006 (in thousands). This
information excludes the impact of expenses not allocated to segments, which
are comprised primarily of general corporate expenses.
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
|
September 29,
|
|
September 30,
|
|
September 29,
|
|
September 30,
|
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
Net revenues:
|
|
|
|
|
|
|
|
|
|
Domestic rehabilitation
|
|
$
|
74,935
|
|
$
|
74,640
|
|
$
|
219,842
|
|
$
|
196,506
|
|
Regeneration
|
|
19,105
|
|
15,767
|
|
55,878
|
|
47,953
|
|
International
|
|
25,744
|
|
22,798
|
|
79,149
|
|
57,834
|
|
Consolidated net revenues
|
|
119,784
|
|
113,205
|
|
354,869
|
|
302,293
|
|
|
|
|
|
|
|
|
|
|
|
Gross profit:
|
|
|
|
|
|
|
|
|
|
Domestic rehabilitation
|
|
39,897
|
|
38,915
|
|
112,346
|
|
102,967
|
|
Regeneration
|
|
17,705
|
|
14,428
|
|
51,675
|
|
44,213
|
|
International
|
|
16,681
|
|
14,522
|
|
50,007
|
|
35,152
|
|
Consolidated gross profit
|
|
74,283
|
|
67,865
|
|
214,028
|
|
182,332
|
|
|
|
|
|
|
|
|
|
|
|
Income from operations:
|
|
|
|
|
|
|
|
|
|
Domestic rehabilitation
|
|
12,155
|
|
11,033
|
|
24,821
|
|
30,310
|
|
Regeneration
|
|
6,111
|
|
3,139
|
|
16,538
|
|
10,560
|
|
International
|
|
6,261
|
|
4,530
|
|
18,396
|
|
8,851
|
|
Income from operations of reportable segments
|
|
24,527
|
|
18,702
|
|
59,755
|
|
49,721
|
|
Expenses not allocated to segments
|
|
(6,261
|
)
|
(4,400
|
)
|
(14,965
|
)
|
(12,869
|
)
|
Consolidated income from operations
|
|
$
|
18,266
|
|
$
|
14,302
|
|
$
|
44,790
|
|
$
|
36,852
|
|
|
|
|
|
|
|
|
|
|
|
Number of operating days
|
|
63
|
|
63
|
|
191
|
|
191
|
|
The accounting
policies of the reportable segments are the same as the accounting policies of
the Company. The Company allocates resources and evaluates the performance of
segments based on income from operations and therefore has not disclosed
certain other items, such as interest, depreciation and amortization by
segment. The Company does not allocate assets to reportable segments because a
significant portion of assets are shared by the segments.
13
For the three and
nine months ended September 29, 2007 and September 30, 2006, the Company had no
individual customer or distributor that accounted for 10% or more of total
revenues.
Net revenues,
attributed to the geographic location of the customer, were as follows (in
thousands):
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
|
September 29,
2007
|
|
September 30,
2006
|
|
September 29,
2007
|
|
September 30,
2006
|
|
|
|
|
|
|
|
|
|
|
|
United States
|
|
$
|
94,040
|
|
$
|
90,407
|
|
$
|
275,720
|
|
$
|
244,459
|
|
Europe
|
|
19,713
|
|
17,732
|
|
61,641
|
|
45,784
|
|
Other countries
|
|
6,031
|
|
5,066
|
|
17,508
|
|
12,050
|
|
Total consolidated net revenues
|
|
$
|
119,784
|
|
$
|
113,205
|
|
$
|
354,869
|
|
$
|
302,293
|
|
Total assets by
region were as follows (in thousands):
|
|
September 29,
2007
|
|
December 31,
2006
|
|
United States
|
|
$
|
594,119
|
|
$
|
619,599
|
|
International
|
|
55,638
|
|
48,735
|
|
Total consolidated assets
|
|
$
|
649,757
|
|
$
|
668,334
|
|
7.
Stock-Based Compensation
The Company has three stock option plans which provide
for the issuance of options to employees, officers, directors and consultants: the 2001 Omnibus Plan, the 1999 Option Plan
and the 2001 Non-Employee Directors Stock Option Plan (Stock Option Plans). Eligible
employees can also purchase shares of the Companys common stock at 85% of its
fair market value on either the first day or the last day, whichever reflects
the lowest fair market price, of each six-month offering period under the
Companys Employee Stock Purchase Plan (ESPP). Stock options granted under the
Stock Option Plans have terms of up to ten years from the date of grant, and
generally vest over a four-year period. The expense recognized under SFAS No.
123(R) is recognized on a straight-line basis over the vesting period. As of
September 29, 2007, approximately 4.6 million shares were available for grant
under the Stock Option Plans and 1.4 million shares were available for issuance
under the ESPP.
The Companys worldwide effective tax rate increased
in connection with its adoption of SFAS No. 123(R) as of January 1, 2006. The
aggregate SFAS No. 123(R) compensation expense results in a reduced tax benefit
rate due to the required tax accounting for the mix of the Companys
outstanding and unvested incentive stock options and non-qualified stock
options.
The fair value of
each equity award is estimated on the date of grant using the Black-Scholes
valuation model for option pricing using the assumptions noted in the following
table. Expected volatility rates are based on the historical volatility (using
daily pricing) of the Companys stock. In accordance with SFAS No. 123(R), the
Company reduces the calculated Black-Scholes value by applying a forfeiture
rate, based upon historical pre-vesting option cancellations. The expected term
of options granted is estimated
14
based on a number of
factors, including the vesting term of the award, historical employee exercise
behavior for both options that have run their course and outstanding options,
the expected volatility of the Companys stock and an employees average length
of service. The risk-free interest rate is determined based upon a constant
U.S. Treasury security rate with a contractual life that approximates the
expected term of the option award.
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
|
September 29,
2007
|
|
September 30,
2006
|
|
September 29,
2007
|
|
September 30,
2006
|
|
Stock Option Plans:
|
|
|
|
|
|
|
|
|
|
Expected volatility
|
|
43.2
|
%
|
49.5
|
%
|
45.4
|
%
|
49.5
|
%
|
Risk-free interest rate
|
|
4.1
|
%
|
4.7
|
%
|
4.7
|
%
|
4.7
|
%
|
Forfeitures
|
|
8.0
|
%
|
7.5
|
%
|
8.0
|
%
|
7.5
|
%
|
Dividend yield
|
|
|
|
|
|
|
|
|
|
Expected term (in years)
|
|
4.1
|
|
3.7
|
|
4.0
|
|
3.7
|
|
Employee Stock Purchase Plan:
|
|
|
|
|
|
|
|
|
|
Expected volatility
|
|
38.4
|
%
|
31.0
|
%
|
38.4
|
%
|
38.0
|
%
|
Risk-free interest rate
|
|
4.6
|
%
|
5.2
|
%
|
4.6
|
%
|
4.9
|
%
|
Dividend yield
|
|
|
|
|
|
|
|
|
|
Expected term (in years)
|
|
0.5
|
|
0.5
|
|
0.5
|
|
0.5
|
|
The following table summarizes option activity under
all plans from December 31, 2006 through September 29, 2007:
|
|
Number of Shares
|
|
Price per Share
|
|
Weighted
Average
Exercise Price
per Share
|
|
Weighted
Average
Remaining Life
in Years
|
|
Outstanding at December 31, 2006
|
|
2,649,790
|
|
$ 3.52 - $44.09
|
|
|
$
|
25.99
|
|
6.9
|
|
Granted
|
|
59,300
|
|
41.72 - 41.99
|
|
|
41.94
|
|
N/A
|
|
Exercised
|
|
(195,308
|
)
|
3.96 - 26.65
|
|
|
15.39
|
|
N/A
|
|
Cancelled/Expired/Forfeited
|
|
(104,575
|
)
|
3.76 - 41.99
|
|
|
32.24
|
|
N/A
|
|
Outstanding at March 31, 2007
|
|
2,409,207
|
|
3.52 - 44.09
|
|
|
26.97
|
|
7.8
|
|
Granted
|
|
539,500
|
|
39.07 - 39.99
|
|
|
39.85
|
|
N/A
|
|
Exercised
|
|
(86,999
|
)
|
4.05 - 39.40
|
|
|
18.19
|
|
N/A
|
|
Cancelled/Expired/Forfeited
|
|
(23,800
|
)
|
3.52 - 39.40
|
|
|
32.63
|
|
N/A
|
|
Outstanding at June 30, 2007
|
|
2,837,908
|
|
3.52 - 44.09
|
|
|
29.64
|
|
8.0
|
|
Granted
|
|
|
|
N/A
|
|
|
N/A
|
|
N/A
|
|
Exercised
|
|
(29,925
|
)
|
4.05 - 39.40
|
|
|
24.73
|
|
N/A
|
|
Cancelled/Expired/Forfeited
|
|
(1,500
|
)
|
39.40
|
|
|
39.40
|
|
N/A
|
|
Outstanding at September 29, 2007
|
|
2,806,483
|
|
3.52 - 44.09
|
|
|
29.69
|
|
7.8
|
|
Exercisable at September 29, 2007
|
|
1,067,814
|
|
3.52 - 41.72
|
|
|
22.33
|
|
6.7
|
|
Remaining reserved for grant at September 29, 2007
|
|
4,646,162
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The aggregate
intrinsic value of options outstanding at September 29, 2007 was approximately
$54.5 million and the aggregate intrinsic value of options exercisable at
September 29, 2007 was approximately $28.6 million. The total intrinsic value
of options exercised during the three and nine months ended September 29, 2007
was approximately $0.7 million and $7.3 million, respectively. The
weighted-average fair value per share for options that were not vested at
December 31, 2006, not vested at March 31, 2007, vested during the three months
ended March 31, 2007 and cancelled/expired/forfeited during the three months
ended March 31, 2007, were $30.33, $31.69, $14.79 and $32.24, respectively. The
weighted-average fair value per share for options that were not vested at
December 31, 2006, not vested at June 30, 2007, vested during the three months
ended June 30, 2007 and cancelled/expired/forfeited during the three months
ended June 30, 2007, were $30.33, $33.56, $36.37 and $32.63, respectively. The
weighted-average fair value per share for options that were not vested at
December 31, 2006, not vested at September 29, 2007, vested during the three
months ended September 29, 2007 and cancelled/expired/forfeited during the
three months ended September 29, 2007, were $30.33, $34.21, $20.62 and $39.40,
respectively. At September 29, 2007, there was approximately $20.1 million of
15
compensation expense that
had not yet been recognized related to non-vested stock-based awards. That
expense is expected to be recognized over a weighted-average period of 1.4
years, subject to the impact of the merger agreement discussed below. During
the three months ended September 29, 2007, cash received from options exercised
was $0.7 million.
The merger
agreement discussed in Note 1 above provides that, except as otherwise agreed
in writing by the holder and Parent (as defined in Note 1), each outstanding
option to purchase common stock under the Stock Option Plans, vested or
unvested, will be cancelled and only entitle the holder to receive a cash
payment equal to the excess, if any, of the per share merger consideration over
the per share exercise price of the applicable stock option, multiplied by the
number of shares subject to the stock option, less any applicable taxes
required to be withheld. In accordance with the merger agreement, immediately
prior to the merger closing date there will be an early termination of the
offering period, under the ESPP, that began on July 1, 2007 and participants
payroll deductions will be applied to purchase shares in accordance with the
terms of the ESPP. These shares will be treated in the same manner as the
Companys other outstanding common stock in the merger. The ESPP will terminate
immediately prior to the closing of the merger.
8. Contingencies
From time to time,
the Company is involved in legal and administrative disputes and proceedings
arising in the ordinary course of business. With respect to these matters,
management believes that it has adequate insurance coverage or has made
adequate accruals for related costs, and it may also have effective legal
defenses. The Company is not aware of any pending proceedings or lawsuits that
could have a material adverse effect on its business, financial condition and
results of operations. As part of its business as a government supplier, both
for Medicare and Medicaid beneficiaries and under contracts with veterans and
other military agencies, the Company is subject to periodic audits of its
billing and pricing practices and of its general compliance to contract terms
and regulatory requirements, and the Company is exposed to claims of recovery
and related fines and penalties if these audits reveal noncompliance. One of
the Companys supply contracts with a government agency has expired, and the
Company has requested the government to permit the products sold under the
expired contract to be moved to a comparable contract held by Aircast and to be
sold under that contract. The agency will review compliance by the Company of
its pricing obligations during the past five-year term of the expiring contract.
Although the Company believes that it has been in material compliance with
those obligations, no assurance can be given that the agency will agree with
the Companys analysis or that it will not seek repayment based on pricing
discrepancies.
Pending
Stockholder Litigation
On August 31, 2007 and September 6, 2007, two
purported shareholder class action lawsuits were filed in California Superior
Court, in the County of San Diego, on behalf of the Companys public
stockholders, challenging the Companys proposed merger with Parent. The court
ordered the two lawsuits consolidated for all purposes on September 21, 2007. The
court further ordered that plaintiffs shall file a consolidated amended
complaint as soon as practicable, and that the defendants need not respond to
either of the two original complaints.
The two original complaints named the Company, ReAble
Therapeutics, Inc., an affiliate of Parent, and the current members of the
Companys board of directors as defendants. One of the original complaints also
named Blackstone as a defendant. The two substantially similar original
complaints alleged, among other things, that the individual defendants breached
their fiduciary duties of care, good faith and loyalty by approving the
proposed merger with an allegedly inadequate price, without adequately
informing themselves of the Companys highest transactional value, and without
adequately marketing the company to other potential buyers. The original
complaints also alleged that the individual defendants and the Company failed
to make full and adequate disclosures in the preliminary proxy statement
regarding the proposed merger. The original complaints pray for, among other
things, class certification, declaratory relief, an injunction of the proposed
merger or a rescission order, corrective disclosures to the proxy statement,
damages, interest, attorneys fees, expert fees and other costs; and such other
relief as the court may find just and proper.
Discovery is ongoing and the parties have stipulated
to a November 2, 2007 hearing on plaintiffs preliminary injunction motion, and
a related briefing schedule. The Company believes that the lawsuit is without
merit and intends to vigorously oppose it.
9. Subsequent Event
In October 2007,
in anticipation of the repayment of all amounts outstanding under the Companys
credit agreement in connection with the completion of its pending merger with
ReAble Therapeutics Finance LLC, the Company paid $2.1 million to terminate its
interest rate swap agreement.
16
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND
RESULTS OF
OPERATIONS
The following
discussion should be read in conjunction with our historical consolidated
financial statements and the related notes thereto and the other financial data
included in this Form 10-Q and in our Annual Report on Form 10-K for the year
ended December 31, 2006.
Forward-Looking Statements
This quarterly
report on Form 10-Q contains, in addition to historical information, statements
by us with respect to our expectations regarding financial results and other
aspects of our business that involve risks and uncertainties and may constitute
forward-looking statements within the meaning of Section 27A of the Securities
Act and Section 21E of the Exchange Act. These statements reflect our current
views and are based on certain assumptions. Actual results could differ
materially from those currently anticipated as a result of a number of factors,
including, the risks discussed under Item 1A Risk Factors in this Form 10-Q.
If the expectations or assumptions underlying our forward-looking statements
prove inaccurate or if risks or uncertainties arise, actual results could differ
materially from those predicted in any forward-looking statement.
Overview
We are a global
provider of solutions for musculoskeletal and vascular health, specializing in
rehabilitation and regeneration products for the non-operative orthopedic, spine
and vascular markets. Our broad range of over 750 rehabilitation products,
including rigid knee braces, soft goods, and cold therapy products, are used in
the prevention of injury, in the treatment of chronic conditions and for
recovery after surgery or injury. Our regeneration products consist of bone
growth stimulation devices that are used to treat nonunion fractures and as an
adjunct therapy after spinal fusion surgery. Our vascular systems products help
prevent deep vein thrombosis and pulmonary embolism that can occur after
orthopedic and other surgeries. We sell our products in the United States and
in more than 75 other countries through networks of agents, distributors and
our direct sales force that market our products to orthopedic and spine surgeons,
podiatrists, orthopedic and prosthetic centers, third-party distributors,
hospitals, surgery centers, physical therapists, athletic trainers and other
healthcare professionals. Our rigid knee braces, soft goods, cold therapy,
regeneration and vascular systems products represented 21%, 51%, 8%, 16% and
4%, respectively, of our consolidated net revenues for the first nine months of
2007.
Segments
The following are our reportable segments.
Domestic Rehabilitation
consists of the sale of our rehabilitation
products (rigid knee braces, soft goods, cold therapy and vascular systems
products) in the United States through three sales channels, DonJoy,
ProCare/Aircast and OfficeCare.
Through the DonJoy
sales channel, we sell our rehabilitation products utilizing a few of our
direct sales representatives and a network of approximately 392 independent
commissioned sales representatives who are employed by approximately 44
independent sales agents. These sales representatives are primarily dedicated
to the sale of our products to orthopedic surgeons, podiatrists, orthopedic and
prosthetic centers, hospitals, surgery centers, physical therapists, athletic
trainers and other healthcare professionals. Because certain of the DonJoy
product lines require customer education on the application and use of the
product, these sales representatives are technical specialists who receive
extensive training both from us and the agent and use their expertise to help
fit the patient with the product and assist the orthopedic professional in
choosing the appropriate product to meet the patients needs. After a product
order is received by a sales representative, we generally ship the product
directly to the orthopedic professional and pay a sales commission to the
agent. These commissions are reflected in sales and marketing expense in our
consolidated financial statements. For certain custom rigid braces and other
products, we sell directly to the patient and bill a third-party payor, if
applicable, on behalf of the patient. We refer to this portion of our DonJoy
channel as our Insurance channel.
Through the ProCare/Aircast
sales channel, which is comprised of
approximately 100 direct and
independent representatives that manage over 380 dealers focused on primary and
acute facilities, we sell our rehabilitation products to national third-party
distributors, other regional medical supply dealers and medical product buying
groups, generally at a discount from list prices. The majority of these
products are soft goods which require little or no patient education.
17
The distributors and dealers generally resell these
products to large hospital chains, hospital buying groups, primary care
networks and orthopedic physicians for use by the patients.
Through the OfficeCare
sales channel,
we maintain an inventory of rehabilitation products
(mostly soft goods) on hand at orthopedic practices for immediate distribution
to the patient. For these products, we arrange billing to the patient or
third-party payor after the product is provided to the patient. As of September
29, 2007, the OfficeCare program was located at over 1,200 physician offices
throughout the United States. We have contracts with over 750 third-party
payors.
Regeneration
consists of the sale of our bone growth
stimulation products in the United States. Our OL1000 product is sold
through a combination of the DonJoy channel direct sales representatives and
approximately 155 additional sales representatives dedicated to selling the
OL1000 product, of which approximately 67 are employed by us. The SpinaLogic
product is also included in this segment and is sold through a combination of
several independent companies focused on selling spine products, including
DePuy Spine and International Rehabilitative Sciences Inc. (does business as
RS Medical), and certain of our direct sales representatives. These products
are sold either directly to the patient or to independent distributors. We
arrange billing to the third-party payors or patients, for products sold
directly to the patient.
International
consists
of the sale of our products in foreign countries through wholly owned
subsidiaries or independent distributors. We sell our products in over 75
foreign countries, primarily in Europe, Canada, Japan and Australia.
Our Strategy
Our strategy is to increase revenues and profitability
and enhance cash flow by strengthening our market leadership position. Our key
initiatives to implement this strategy include:
Increase our Lead in the Domestic Rehabilitation
Market Segment.
We believe
we are the market leader in the Domestic Rehabilitation markets in which we
compete. We believe we will be able to continue to grow our Domestic
Rehabilitation business segment and increase our market share further by
focusing on maintaining a continuous flow of new product introductions and
continuing to enhance the productivity of our sales force and optimize our
distribution strategy. Our key Domestic Rehabilitation growth strategies
include the following:
Introduce New Products and Product
Enhancements.
We have a history of developing and introducing
innovative products into the marketplace, and are committed to continuing that
tradition by introducing new products across our product platform. In the
twelve months ended September 29, 2007, we launched 15 new products. We believe
that product innovation through effective and focused research and development
will provide a sustainable competitive advantage. We believe we are currently a
technology leader in several product categories and we intend to continue to
develop next generation technologies.
Increase Sales Force Productivity.
We have integrated the Aircast sales force into our existing sales
organization and focused its various elements on specific targeted customers. Our
sales representatives generally have a targeted customer base and a broad
product offering for those customers. For example, the DonJoy sales force
focuses on orthopedic and podiatry offices, orthotists, and athletic trainers,
while the Aircast and ProCare sales force concentrates primarily on hospitals
and third party distributors. With our focused sales organization and a sales
compensation plan in place to incentivize all the sales representatives to sell
the full range of products we offer, we believe that we can encourage
cross-selling and increase the productivity of the entire sales force.
Expand Our OfficeCare and Insurance
Channels.
Through
OfficeCare, we maintain an inventory of product (mostly soft goods) on hand at
orthopedic practices for immediate distribution to the patient. For these
products, we bill the patient or third-party payor after the product is
provided to the patient. Through our Insurance channel, we also provide our
custom knee braces and certain other products directly to patients and bill the
patient or the patients third-party payor. Our
OfficeCare and Insurance channels currently cover over 1,200 physician offices
encompassing over 4,800 physicians. We believe that our OfficeCare and Insurance
channels serve a growing need among orthopedic practices to improve inventory
management and patient
18
service. Expanding our OfficeCare and Insurance
channels also permits us to increase our weighted-average selling prices, as
the units sold through these channels are billed to insurance companies and
other third-party payors at higher prices than units sold through most of our
other sales channels. Accordingly, our OfficeCare and Insurance initiatives
represent opportunities for sales growth based on increases in both unit volume
and average selling prices. We intend to expand our OfficeCare and Insurance
channels into more large orthopedic offices, thereby increasing the number of
potential customers to whom we sell our products. In the three months ended
September 29, 2007, we added approximately 33 new offices to our OfficeCare and
Insurance channels, net of account terminations.
Maximize Existing and Secure Additional
National Accounts.
We plan to capitalize on the growing practice in
healthcare in which hospitals and other large healthcare providers seek to
consolidate their purchasing activities to national buying groups. Contracts
with these national accounts represent a significant opportunity for sales
growth. We believe that our broad range of products is well suited to the goals
of these buying groups and intend to aggressively pursue these contracts. In
the twelve months ended September 29, 2007, we signed or renewed five
significant national contracts; including a new three-year sole source contract
with Consorta, Inc. for all of our bracing and soft goods products, a new
private label contract with Amerinet, Inc. for our pain management and cold
therapy products, a renewal of our sole source contract with Broadlane, Inc.
for all of our soft goods, bracing and cold therapy products, a renewal of our
multi-source agreement with Premier Purchasing Partners, L.P. for all of our
bracing, soft goods, cold therapy and BGS products, and a renewal of our sole
source bracing agreement with Healthtrust Purchasing Group, L.P. In addition,
we successfully added Aircast products to each of these national contracts.
Grow Our Regeneration Business.
We have increased the number of regeneration
sales specialists dedicated to selling our OL1000 BGS product, and we have
aligned these specialists with our DonJoy sales force. We believe these
specialists will be able to use the established relationships of our DonJoy
sales representatives to enhance sales of the OL1000 product. Our distribution
arrangement with DePuy Spine became non-exclusive beginning in March 2006,
permitting us to sell our SpinaLogic BGS product through our own sales
representatives or other independent sales representatives in all territories
where we choose to do so. We have added additional selling resources in those
geographical parts of the country where sales were not meeting our
expectations. We believe our patented Combined Magnetic field technology has
features that make our BGS products significantly easier for patients to use
than our competitors products. We believe that our new selling strategies for
our Regeneration segment and our technology advantages will permit us to
maintain or improve our growth in this business.
Expand
International Sales
. Since 2002, we have successfully established direct
distribution capabilities in several major international markets. We believe
that sales to foreign markets continue to represent a significant growth
opportunity, and we intend to continue
to develop direct distribution capabilities in selected additional foreign
markets. We also believe we can increase our international revenues by
expanding the number of our products we sell in international markets. Historically,
we sold only a limited range of our products in our international markets. Beginning
in 2005, we began to focus on selling an expanded range of soft goods, our cold
therapy products and our BGS products in our International segment. In 2006, we completed the Axmed acquisition,
which increased our international revenues in France. The Aircast acquisition,
in April 2006, also substantially increased our international revenues,
especially in Germany, France, the United Kingdom and Canada. Effective in
April 2007, we began to directly distribute our products in two new markets,
Italy and the Benelux countries. For the nine months ended September 29, 2007,
international sales increased to 22.3% of our revenues.
Pursue
Selective Acquisitions
. We believe that acquisitions represent an
attractive and efficient means to broaden our product lines, expand our
geographic reach and increase our revenues and profitability. We intend to
pursue acquisition opportunities that enhance sales growth, are accretive to
earnings, increase customer penetration and/or provide geographic diversity.
Since the beginning of 2005, we have completed four acquisitions, all of which
we believe met these criteria: our acquisition of substantially all of
the assets of Superior Medical Equipment, LLC (SME acquisition) and our
acquisition of substantially all of the assets of the orthopedics soft goods
business of Encore Medical, L.P. (OSG acquisition), both of which were
completed in 2005, as well as the Axmed acquisition in January 2006 and the
Aircast acquisition in April 2006.
19
Recent Developments
On July 15, 2007, we entered into an Agreement and
Plan of Merger (the Merger Agreement) with ReAble Therapeutics Finance LLC, a
Delaware limited liability company (Parent), and Reaction Acquisition Merger
Sub, Inc., a Delaware corporation and a wholly-owned subsidiary of Parent (Merger
Sub). Parent is controlled by affiliates of The Blackstone Group (Blackstone).
The Merger Agreement and the transactions contemplated thereby were unanimously
approved by our board of directors and a transaction committee of the board of
directors comprised entirely of independent directors. Under the terms of the
Merger Agreement, Merger Sub will be merged with and into us (the Merger),
and we will continue as the surviving corporation and a wholly-owned subsidiary
of Parent. As of the effective time of the Merger, each issued and outstanding
share of our common stock will generally be cancelled and converted into the
right to receive $50.25 in cash, without interest. In addition, as of the
effective date of the Merger, each outstanding vested and unvested stock option
will be cancelled and the holder will receive a cash payment equal to the
excess of the per share merger consideration over the per share exercise price
multiplied by the number of shares subject to the option, less applicable
withholding taxes.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition
and results of operations is based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements
requires us to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. On an on-going basis, we evaluate our
estimates including those related to contractual allowances, doubtful accounts,
inventories, rebates, product returns, warranty obligations, income taxes,
intangible assets and stock-based compensation. We base our estimates on
historical experience and on various other assumptions that we believe to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.
We believe the following critical accounting policies
affect our more significant judgments and estimates used in the preparation of
our consolidated financial statements and this discussion and analysis of our
financial condition and results of operations:
Provision for Contractual Allowances and Doubtful
Accounts.
We maintain provisions for estimated contractual
allowances for reimbursement amounts from our third-party payor customers based
on negotiated contracts and historical experience for non-contracted payors. We
also maintain provisions for doubtful accounts for estimated losses resulting
from the failure of our customers to make required payments. We have contracts
with certain third-party payors for our third-party reimbursement billings, which
call for specified reductions in reimbursement of billed amounts based upon
contractual reimbursement rates. For both 2006 and the first nine months of
2007, we reserved for and reduced gross revenues from third-party payors,
excluding those related to our Regeneration business, by approximately 36%, for
estimated aggregate allowances related to these contractual arrangements with
these payors. For our Regeneration business, we record revenues net of actual
contractual allowances and discounts from our gross prices, which are
determined on a specific identification basis and amount to approximately 42%
of our gross prices for bone growth stimulation products.
Our reserve for doubtful accounts is based upon
estimated losses from customers who are billed directly and the portion of
third-party reimbursement billings that ultimately become the financial
responsibility of the end user patients. Direct-billed customers represent
approximately 75% of our net revenues for the three months ended September 29, 2007
and approximately 61% of our net accounts receivable at September 29, 2007.
Since the beginning of 2006, we have experienced write-offs of less than 1% of
related net revenues. Our third-party reimbursement customers, including
insurance companies, managed care companies, certain governmental payors, such
as Medicare, and patients for certain co-pay amounts, include all of our
OfficeCare customers and certain other customers of our Domestic Rehabilitation
business segment and the majority of our Regeneration customers. Our
third-party payor customers represented approximately 25% of our net revenues
for the three months ended September 29, 2007 and 39% of our net accounts
receivable at September 29, 2007. For 2006 and the first nine months of 2007,
we estimated bad debt expense to be approximately 10% and 17%, respectively, of
gross revenues from third-party reimbursement customers, excluding those
related to our Regeneration business, and 7% and 9%, respectively, of gross
revenues from third-party reimbursement customers of our Regeneration business.
This estimated bad debt expense for 2007 includes $4.6 million recorded in the
second quarter of 2007 related to additional provisions for certain aged
accounts receivable. We have experienced rapid growth in revenues from our
third-party reimbursement customers. Together with our third-party billing and
collections service provider, we also made changes to improve the
cost-effectiveness of our billing and collections process in early 2006.
The rapid growth of these businesses, combined with the
20
transitional impact of
the changes in our process, placed a strain on the effectiveness of our billing
and collections process in 2006. We recognized this strain and placed
additional resources in this area beginning in late 2006. We have seen
improving trends in cash collections on current accounts receivable from
third-party reimbursement customers. However, in spite of the additional
resources allocated, collections of certain aged receivables had not progressed
as well as expected through June 2007. Accordingly, we increased our estimates
of related bad debt expense for these aged accounts receivable. If the
financial condition of our customers were to deteriorate resulting in an
impairment of their ability to make payments or if third-party payors were to
deny claims for late filings, incomplete information or other reasons,
additional provisions may be required.
We rely heavily on a third-party billing service
provider to bill and collect from certain of our third-party reimbursement
customers and to provide information about the accounts receivable of these
customers, including the data utilized to determine reserves for contractual
allowances and doubtful accounts. Based on information currently available to
us, we believe we have provided adequate reserves for our third-party payor
accounts receivable. If claims are denied, or amounts are otherwise not paid,
in excess of our estimates, the recoverability of our net accounts receivable
could be reduced by a material amount. In addition, if our third-party
insurance billing service provider does not perform to our expectations we may
be required to increase our reserve estimates.
Reserve for Excess and Obsolete Inventories
.
We provide reserves for estimated excess or obsolete inventories equal to the
difference between the cost of inventories on hand plus future purchase
commitments and the estimated market value based upon assumptions about future
demand. If future demand is less favorable than currently projected by
management, additional inventory write-downs may be required. In addition,
reserves for inventories on hand in our OfficeCare locations are provided based
on historical shrinkage rates of approximately 16%. If actual shrinkage rates
differ from our estimated shrinkage rates, revisions to the reserve may be
required. We also provide reserves for newer product inventories, as
appropriate, based on any minimum purchase commitments and our level of sales
of the new products.
Rebates.
We offer certain of our
distributors rebates based on sales volume, sales growth and to reimburse the
distributor for certain discounts. We record estimated reductions to revenues
for customer rebate programs based upon historical experience and estimated
revenue levels.
Returns and Warranties.
We
provide for the estimated cost of returns and product warranties at the time
revenue is recognized based on historical trends. While we engage in extensive
product quality programs and processes, including actively monitoring and
evaluating the quality of our suppliers, our actual returns and warranty costs
could differ from our estimates. If actual product returns, failure rates,
material usage or service costs differ from our estimates, revisions to the
estimated return and/or warranty liabilities may be required.
Valuation Allowance for Deferred Tax Asset.
As
of September 29, 2007, we had approximately $21.1 million of net deferred tax
assets on our balance sheet related primarily to tax deductible goodwill
arising at the date of our reorganization in 2001 and not recognized for book
purposes, goodwill acquired in connection with our Regeneration acquisition and
net tax loss carryforwards. Realization of our net deferred tax assets is
dependent on our ability to generate future taxable income prior to the
expiration of our net operating loss carryforwards. Our management believes
that it is more likely than not that the deferred tax assets will be realized
based on forecasted future taxable income. However, there can be no assurance
that we will meet our expectations of future taxable income. Management will
evaluate the realizability of the deferred tax assets on a quarterly basis to
assess any need for valuation allowances.
Income
Taxes.
In
June 2006, the FASB issued FASB Interpretation No. 48,
Accounting for Uncertainty in Income Taxes an interpretation of SFAS
No. 109, Accounting for Income Taxes
, (FIN 48). FIN 48
prescribes a comprehensive model for how companies should recognize, measure,
present, and disclose in their financial statements uncertain tax positions
taken or expected to be taken on a tax return. Under FIN 48, tax positions
shall initially be recognized in the financial statements when it is more
likely than not the position will be sustained upon examination by the tax
authorities. Such tax positions shall initially and subsequently be measured as
the largest amount of tax benefit that is greater than 50% likely of being
realized upon ultimate settlement with the tax authority assuming full
knowledge of the position and all relevant facts. FIN 48 also revises
disclosure requirements to include an annual tabular rollforward of
unrecognized tax benefits. The provisions of this interpretation were required
to be adopted for fiscal periods beginning after December 15, 2006. We adopted
FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, we
recognized $1.4 million in additional unrecognized tax benefits. A portion of
the transition adjustment related to our historical exposures and was recorded
as permitted by FIN 48 as a reduction of retained earnings in the amount of
approximately $0.8 million. A portion of the transition adjustment related to
Aircast exposures created prior to our acquisition of Aircast and was therefore
recorded
21
as an increase of
approximately $0.6 million in goodwill related to the Aircast acquisition. The
offset of the transition adjustment was recorded as a reduction to deferred tax
assets and additional taxes payable.
The
transition adjustment included approximately $0.2 million of interest and
approximately $0.1 million of penalties related to the unrecognized tax
benefits. Interest costs and penalties related to income taxes are classified
as a part of income tax provision in our financial statements.
Of the
transition adjustment, a portion related to estimated possible transfer pricing
exposures. Such estimates will be evaluated each quarter based on changes to
transfer pricing and changes in foreign exchange rates. An estimate of the
range of reasonably possible future changes cannot be made. United States
federal and most state tax returns for all years after 2002 are subject to
future examination by tax authorities. Open tax years for foreign jurisdictions
vary.
Our
balance of unrecognized tax benefits as of September 29, 2007 remained
unchanged at $1.4 million. There were no changes required to be made to the
balance as there were no new tax positions taken by us during the current
period, no settlements with taxing authorities and no lapses of applicable
statutes of limitations. Included in the balance of unrecognized tax benefits
is $0.8 million of tax benefits that, if recognized, would affect the effective
tax rate. Also included in the balance of unrecognized tax benefits is
$0.6 million of tax benefits that, if recognized, would result in adjustments
to other tax accounts, primarily deferred taxes and goodwill.
Goodwill and Other Intangibles.
In accordance with Statement of Financial Accounting Standards No. 142, or SFAS
No. 142,
Goodwill and Other Intangible
Assets
, we do not amortize goodwill. In lieu of amortization, we are
required to perform an annual review for impairment. Goodwill is considered to
be impaired if we determine that the carrying value of the segment or reporting
unit exceeds its fair value. At October 1, 2006, our goodwill acquired through
December 31, 2005 was evaluated for impairment and we determined that no
impairment existed at that date. With the exception of goodwill related to our
Regeneration acquisition of $39 million, we believe that the goodwill acquired
through December 31, 2005 benefits the entire enterprise and since our
reporting units share the majority of our assets, we compared the total
carrying value of our consolidated net assets (including goodwill) to our fair
value. With respect to goodwill related to our Regeneration acquisition, we
compared the carrying value of the goodwill related to the Regeneration segment
to the fair value of the Regeneration segment. We acquired additional goodwill
in 2006 in connection with our Axmed and Aircast acquisitions. These additional
goodwill amounts will be evaluated for impairment beginning in 2007.
At December 31, 2006, other intangibles were evaluated
for impairment as required by SFAS No. 144,
Accounting
for Impairment or Disposal of Long-Lived Assets
. The determination
of the fair value of certain acquired assets and liabilities is subjective in
nature and often involves the use of significant estimates and assumptions. Determining
the fair values and useful lives of intangible assets requires the exercise of
judgment. While there are a number of different generally accepted valuation
methods to estimate the value of intangible assets acquired, we primarily used
the undiscounted cash flows expected to result from the use of the assets. This
method requires significant management judgment to forecast the future
operating results used in the analysis. In addition, other significant
estimates are required such as residual growth rates and discount factors. The
estimates we have used are consistent with the plans and estimates that we use
to manage our business and are based on available historical information and
industry averages.
Stock-Based
Compensation.
As of January 1, 2006, we began recording
compensation expense associated with stock options and other equity-based
compensation in accordance with SFAS No. 123
(revised 2004),
Share-Based Payment
(SFAS No. 123(R)), using the modified prospective transition method. Under the
modified prospective transition method, stock-based compensation expense for
2006 includes: 1) compensation expense for all stock-based awards granted on or
after January 1, 2006 as determined based on the grant date fair value
estimated in accordance with the provisions of SFAS No. 123(R) and 2) stock-based
compensation awards granted prior to, but not yet vested as of January 1, 2006,
based on the grant date fair value estimated in accordance with the original
provisions of SFAS No. 123. We recognize these compensation costs on a
straight-line basis over the requisite service period of the award, which is
generally four years. As a result of the adoption of SFAS No. 123(R), our net
income for the three months ended September 29, 2007 and September 30, 2006,
both have been reduced by stock-based compensation expense, net of taxes, of
approximately $2.3 million, respectively, and our net income for the nine
months ended September 29, 2007 and September 30, 2006, has been reduced by
stock-based compensation expense, net of taxes, of approximately $5.5 million
and $5.3 million, respectively.
The fair value of
each equity award is estimated on the date of grant using the Black-Scholes
valuation model for option pricing using managements assumptions. Expected
volatility rates are based on the historical volatility (using daily pricing)
of our stock. In accordance with SFAS No. 123(R), we reduce the calculated
Black-Scholes value by applying a forfeiture rate, based upon
22
historical pre-vesting option cancellations. The
expected term of options granted is estimated based on a number of factors,
including the vesting term of the award, historical employee exercise behavior
for both options that have run their course and outstanding options, the
expected volatility of our stock and an employees average length of service. The
risk-free interest rate is determined based upon a constant U.S. Treasury
security rate with a contractual life that approximates the expected term of
the option award.
Results of Operations
We operate our
business on a manufacturing calendar, with our fiscal year always ending on
December 31. Each quarter is 13 weeks, consisting of one five-week and two
four-week periods. Our first and fourth quarters may have more or less
operating days from year to year based on the days of the week on which
holidays and December 31 fall. The quarters ended September 29, 2007 and
September 30, 2006 each included 63 days. The nine months ended September 29,
2007 and September 30, 2006 each included 191 days.
Three Months Ended September 29, 2007 Compared To Three
Months Ended September 30, 2006
Net
Revenues.
Set
forth below are net revenues for our reporting segments (in thousands):
|
|
Three Months Ended
|
|
|
|
|
|
|
|
September 29,
2007
|
|
% of Net
Revenues
|
|
September 30,
2006
|
|
% of Net
Revenues
|
|
Increase
|
|
% Increase
|
|
Domestic Rehabilitation
|
|
$
|
74,935
|
|
62.6
|
|
$
|
74,640
|
|
65.9
|
|
$
|
295
|
|
0.4
|
|
Regeneration
|
|
19,105
|
|
15.9
|
|
15,767
|
|
13.9
|
|
3,338
|
|
21.2
|
|
International
|
|
25,744
|
|
21.5
|
|
22,798
|
|
20.2
|
|
2,946
|
|
12.9
|
|
Consolidated net revenues
|
|
$
|
119,784
|
|
100.0
|
|
$
|
113,205
|
|
100.0
|
|
$
|
6,579
|
|
5.8
|
|
Net revenues of
our Domestic Rehabilitation segment stayed relatively consistent for the third
quarter of 2007 compared to the third quarter of 2006 due primarily to the
Domestic Rehabilitation net revenues for the third quarter of 2006 including the
benefit of approximately $1.6 million related to a change in shipping terms for
certain Aircast products from FOB destination to FOB shipping point and the
shipment of certain products that were on backorder at the end of the second
quarter of 2006 due to issues related to the integration of Aircast (our
International segment included approximately $0.3 million in the third quarter
of 2006 related to clearing these backorders). We had normal market growth in
existing product lines and sales of new products in our Domestic Rehabilitation
segment. We also increased the number of units billed to third-party payors,
which are sold at higher average selling prices than units sold through our
other channels. A substantial portion of the increased units billed to
third-party payors resulted from the addition of approximately 220 net new
OfficeCare locations since October 1, 2006. Net OfficeCare revenues for the
third quarter of 2007 were $0.6 million higher than net OfficeCare revenues for
the third quarter of 2006. Net revenues in our Regeneration segment increased
due to market growth and our expanding distribution strategy in the United
States that includes both direct and independent representatives. International
net revenues increased in the third quarter of 2007 compared to the third
quarter of 2006 due to increased sales volume from market growth, an expanding
range of products sold internationally and the benefit of $1.2 million related
to favorable changes in foreign exchange rates. Excluding the impact of changes
in exchange rates, local currency international revenues increased 7.9% in the
third quarter of 2007 compared to the third quarter of 2006. Net revenues in
our Domestic Rehabilitation segment decreased as a percentage of total net
revenues due to proportionately higher growth rates in our Regeneration and
International segment revenues.
Gross Profit.
Set forth below is gross profit information for our
reporting segments (in thousands):
|
|
Three Months Ended
|
|
|
|
|
|
|
|
September 29,
2007
|
|
% of Net
Revenues
|
|
September 30,
2006
|
|
% of Net
Revenues
|
|
Increase
|
|
% Increase
|
|
Domestic Rehabilitation
|
|
$
|
39,897
|
|
53.2
|
|
$
|
38,915
|
|
52.1
|
|
$
|
982
|
|
2.5
|
|
Regeneration
|
|
17,705
|
|
92.7
|
|
14,428
|
|
91.5
|
|
3,277
|
|
22.7
|
|
International
|
|
16,681
|
|
64.8
|
|
14,522
|
|
63.7
|
|
2,159
|
|
14.9
|
|
Consolidated gross profit
|
|
$
|
74,283
|
|
62.0
|
|
$
|
67,865
|
|
59.9
|
|
$
|
6,418
|
|
9.5
|
|
23
The increase in
gross profit for the third quarter of 2007 compared to the third quarter of
2006 in total and as a percentage of net revenues is due to incremental gross
profit from an increase in revenues and the absence in the third quarter of
2007 of $1.7 million of certain charges and expenses related to the Aircast and
Axmed acquisitions and $0.8 million of expenses related to our headquarters
move which were included in the third quarter of 2006. The increase in the
International segment gross profit as a percentage of net revenues is related
to favorable changes in product mix and foreign currency exchange rates.
Operating
Expenses.
Set forth below is operating expense information
(in thousands):
|
|
Three Months Ended
|
|
|
|
|
|
|
|
September 29,
2007
|
|
% of Net
Revenues
|
|
September 30,
2006
|
|
% of Net
Revenues
|
|
Increase
(Decrease)
|
|
% Increase
(Decrease)
|
|
Sales and marketing
|
|
$
|
35,621
|
|
29.7
|
|
$
|
33,398
|
|
29.5
|
|
$
|
2,223
|
|
6.7
|
|
General and administrative
|
|
11,336
|
|
9.5
|
|
13,075
|
|
11.5
|
|
(1,739
|
)
|
(13.3
|
)
|
Research and development
|
|
2,018
|
|
1.7
|
|
2,580
|
|
2.3
|
|
(562
|
)
|
(21.8
|
)
|
Amortization of acquired intangibles
|
|
4,503
|
|
3.8
|
|
4,510
|
|
4.0
|
|
(7
|
)
|
(0.2
|
)
|
Merger costs
|
|
2,539
|
|
2.1
|
|
|
|
0.0
|
|
2,539
|
|
100.0
|
|
Consolidated operating expenses
|
|
$
|
56,017
|
|
46.8
|
|
$
|
53,563
|
|
47.3
|
|
$
|
2,454
|
|
4.6
|
|
Sales and Marketing Expenses.
Sales
and marketing expenses for the third quarter of 2007 increased compared to the
third quarter of 2006 due to volume related increases in commissions, sales
incentive bonuses and delivery charges due to the increase in revenues. These
increases in selling and marketing expenses were partially offset by the
absence in the third quarter of 2007 of integration costs of $0.4 million
associated with the Aircast and Axmed acquisitions, and headquarter move costs
of approximately $0.3 million, which were included in the third quarter of
2006.
General and Administrative Expenses.
The
decrease in general and administrative expenses for the third quarter of 2007
compared to the third quarter of 2006 is primarily due to the elimination of
certain duplicate general and administrative expenses in connection with the
integration of the acquired Aircast business and the absence in the third
quarter of 2007 of integration costs of $0.3 million associated with the
Aircast and Axmed acquisitions, and headquarter move costs of approximately
$0.2 million, which were included in the third quarter of 2006.
Research and Development Expenses.
The
decrease in research and development expenses for the third quarter of 2007
compared to the third quarter of 2006 is primarily due to the absence in the
third quarter of 2007 of headquarter move costs of approximately $0.2 million
which were included in the third quarter of 2006.
Amortization of Acquired Intangibles.
Amortization
of acquired intangibles includes amortization expense related to intangible
assets acquired in connection with the Regeneration acquisition, which are
being amortized over lives ranging from four months to ten years, intangible
assets acquired in connection with the Axmed acquisition, which are being
amortized over lives ranging from one to nine years, and intangible assets
acquired in connection with the Aircast acquisition which are being amortized
over lives ranging from seven to 20 years.
Merger Costs.
Merger costs of $2.5 million
incurred in the third quarter of 2007 consist of certain costs related to the
proposed merger with ReAble Therapeutics Finance LLC.
24
Income from Operations.
Set forth below is income from operations
information for our reporting segments (in thousands):
|
|
Three Months Ended
|
|
|
|
|
|
|
|
September 29,
2007
|
|
% of Net
Revenues
|
|
September 30,
2006
|
|
% of Net
Revenues
|
|
Increase
(Decrease)
|
|
% Increase
(Decrease)
|
|
Domestic Rehabilitation
|
|
$
|
12,155
|
|
16.2
|
|
$
|
11,033
|
|
14.8
|
|
$
|
1,122
|
|
10.2
|
|
Regeneration
|
|
6,111
|
|
32.0
|
|
3,139
|
|
19.9
|
|
2,972
|
|
94.7
|
|
International
|
|
6,261
|
|
24.3
|
|
4,530
|
|
19.9
|
|
1,731
|
|
38.2
|
|
Income from operations of reportable segments
|
|
24,527
|
|
20.5
|
|
18,702
|
|
16.5
|
|
5,825
|
|
31.1
|
|
Expenses not allocated to segments
|
|
(6,261
|
)
|
(5.3
|
)
|
(4,400
|
)
|
(3.9
|
)
|
(1,861
|
)
|
(42.3
|
)
|
Consolidated income from operations
|
|
$
|
18,266
|
|
15.2
|
|
$
|
14,302
|
|
12.6
|
|
$
|
3,964
|
|
27.7
|
|
The
increase in income from operations for our Domestic Rehabilitation segment is
due to increased net revenues and gross profit and the absence in 2007 of
certain integration costs and costs associated with our headquarters move,
which we incurred in 2006 as discussed above. The increase in income from
operations for our Regeneration and International segments is due primarily to
increased net revenues and gross profit and reduced spending in general and
administrative and research and development as discussed above.
Interest
Expense, Net of Interest Income.
Interest
expense, net of interest income, was $5.3 million in the third quarter of 2007
compared to $6.3 million in the third quarter of 2006. Interest expense, net of
interest income decreased in the third quarter of 2007 compared to the third
quarter of 2006 due to the fact that we have reduced our debt balance by $48.8
million since October 1, 2006.
Other
Income, Net.
Other
income for the third quarter of 2007 increased compared to the third quarter of
2006 primarily due to higher net foreign exchange transaction gains.
Provision
for Income Taxes.
Our
estimated worldwide effective tax rate was 49.4% for the third quarter of 2007
compared to 48.5% for the third quarter of 2006. Our worldwide effective tax
rate increased in connection with our adoption of SFAS No. 123(R) as of January
1, 2006. The stock-based compensation expense recorded in accordance with SFAS
No. 123(R) results in a related tax benefit rate of only 23.2% and 13.4% for
the third quarters of 2007 and 2006, respectively, due to the mix of our
outstanding and unvested incentive stock options and non-qualified stock
options.
Net
Income
.
Net
income was $6.7 million for the third quarter of 2007 compared to net income of
$4.4 million for the third quarter of 2006 as a result of the changes discussed
above.
Nine Months Ended September 29, 2007 Compared To Nine Months
Ended September 30, 2006
Net
Revenues.
Set
forth below are net revenues for our reporting segments (in thousands):
Net revenues:
|
|
Nine Months Ended
|
|
|
|
|
|
|
|
|
|
September 29,
2007
|
|
% of Net
Revenues
|
|
September 30,
2006
|
|
% of Net
Revenues
|
|
Increase
|
|
%
Increase
|
|
Domestic Rehabilitation
|
|
$
|
219,842
|
|
62.0
|
|
$
|
196,506
|
|
65.0
|
|
$
|
23,336
|
|
11.9
|
|
Regeneration
|
|
55,878
|
|
15.7
|
|
47,953
|
|
15.9
|
|
7,925
|
|
16.5
|
|
International
|
|
79,149
|
|
22.3
|
|
57,834
|
|
19.1
|
|
21,315
|
|
36.9
|
|
Consolidated net revenues
|
|
$
|
354,869
|
|
100.0
|
|
$
|
302,293
|
|
100.0
|
|
$
|
52,576
|
|
17.4
|
|
Net revenue
increases of approximately $15.3 million and $9.6 million related to our
Domestic Rehabilitation and International segments, respectively, are due to the
fact that our acquisition of Aircast closed April 7, 2006. Accordingly, our
revenue results for the nine months ended September 30, 2006 did not include a
full nine months of Aircast revenue. The additional increase in net revenues of
our Domestic Rehabilitation segment is partly due to normal market growth in
existing product lines and sales of new products. We also increased the number
of units billed to third-party payors, which are sold at higher average selling
prices than units sold through our other channels. A substantial portion of the
increased units billed to third-party payors resulted from the addition of
approximately 220 net new OfficeCare locations since October 1, 2006. Net
OfficeCare revenues for the first nine months
25
of 2007 were $4.5 million higher than net OfficeCare
revenues for the first nine months of 2006. Net revenues in our Regeneration
segment increased due to market growth and our expanding distribution strategy
in the United States that includes both direct and independent representatives.
International net revenues increased in the first nine months of 2007 compared
to the first nine months of 2006, due to our acquisition of Aircast, increased
sales volume due to market growth, an expanding range of products sold
internationally and the benefit of $2.8 million related to favorable changes in
foreign exchange rates. Excluding the impact of changes in exchange rates,
local currency international revenues increased 32.1% in the first nine months
of 2007 compared to the first nine months of 2006. Net revenues in our Domestic
Rehabilitation and Regeneration segments decreased as a percentage of total net
revenues due to a proportionately higher increase in our International segment revenues
related to the acquisition of Aircast in April 2006.
Gross Profit.
Set forth below is gross profit information for our
reporting segments (in thousands):
|
|
Nine Months Ended
|
|
|
|
|
|
|
|
September 29,
2007
|
|
% of Net
Revenues
|
|
September 30,
2006
|
|
% of Net
Revenues
|
|
Increase
|
|
%
Increase
|
|
Domestic Rehabilitation
|
|
$
|
112,346
|
|
51.1
|
|
$
|
102,967
|
|
52.4
|
|
$
|
9,379
|
|
9.1
|
|
Regeneration
|
|
51,675
|
|
92.5
|
|
44,213
|
|
92.2
|
|
7,462
|
|
16.9
|
|
International
|
|
50,007
|
|
63.2
|
|
35,152
|
|
60.8
|
|
14,855
|
|
42.3
|
|
Consolidated gross profit
|
|
$
|
214,028
|
|
60.3
|
|
$
|
182,332
|
|
60.3
|
|
$
|
31,696
|
|
17.4
|
|
Consolidated gross
profit increased for first nine months of 2007 compared to the first nine
months of 2006 due to incremental gross profit from an increase in revenues,
including the contribution from our Aircast acquisition, and the absence in the
first nine months of 2007 of costs related to a write-up of acquired Axmed and
Aircast inventories to fair value of $1.5 million, other integration costs of
$3.3 million associated with the Aircast and Axmed acquisitions and $0.8
million of headquarter move costs which were included in the first nine months
of 2006, offset by a $0.8 million charge to write-down raw material inventories
in the first nine months of 2007 based on the results of a physical count of
such inventories. Gross profit decreased as a percentage of net revenues in the
Domestic Rehabilitation segment due to the impact of the raw material
adjustment noted above, of which $0.6 million related to the Domestic
Rehabilitation segment, a change in product mix to include more lower gross
profit soft goods due to our recent acquisitions and increased costs of freight
and distribution, manufacturing overhead and certain material costs. The
increase in the International segment gross profit as a percentage of net
revenues is primarily related to favorable changes in product mix and foreign
currency exchange rates and the absence in the first nine months of 2007 of
costs related to the write-up of acquired Axmed and Aircast inventories to fair
value, which were included in the first nine months of 2006.
Operating
Expenses.
Set forth below is operating expense information
(in thousands):
|
|
Nine Months Ended
|
|
|
|
|
|
|
|
September 29,
2007
|
|
% of Net
Revenues
|
|
September 30,
2006
|
|
% of Net
Revenues
|
|
Increase
|
|
%
Increase
|
|
Sales and marketing
|
|
$
|
111,795
|
|
31.5
|
|
$
|
92,375
|
|
30.6
|
|
$
|
19,420
|
|
21.0
|
|
General and administrative
|
|
35,229
|
|
9.9
|
|
35,709
|
|
11.8
|
|
(480
|
)
|
(1.3
|
)
|
Research and development
|
|
6,185
|
|
1.8
|
|
6,745
|
|
2.2
|
|
(560
|
)
|
(8.3
|
)
|
Amortization of acquired intangibles
|
|
13,490
|
|
3.8
|
|
10,651
|
|
3.5
|
|
2,839
|
|
26.7
|
|
Merger costs
|
|
2,539
|
|
0.7
|
|
|
|
0.0
|
|
2,539
|
|
100.0
|
|
Consolidated operating expenses
|
|
$
|
169,238
|
|
47.7
|
|
$
|
145,480
|
|
48.1
|
|
$
|
23,758
|
|
16.3
|
|
Sales and Marketing Expenses.
Sales
and marketing expenses for the first nine months of 2007 include $4.6 million
related to an increase in estimates of bad debt provisions required for certain
aged accounts receivable recorded in the second quarter of 2007. Sales and
marketing expenses for the first nine months of 2007 also included volume
related increases in commissions, sales incentive bonuses and delivery charges
due to the increase in revenues, including the contribution from our Aircast acquisition.
These increases were partially offset by the absence in the first nine months
of 2007 of integration costs of $0.9 million associated to the Aircast and
Axmed acquisitions and $0.3 million of headquarter move costs which were
included in the first nine months of 2006.
General and Administrative Expenses.
The decrease in general and administrative expenses in the first nine months of
2007 is primarily due to the absence in the first nine months of 2007 of
integration costs of $0.7 million associated to the Aircast and Axmed
acquisitions and $0.2 million of headquarter move costs which were included in
the first nine months of 2006.
26
Research and Development Expenses.
The
decrease in research and development expenses for the first nine months of 2007
compared to the first nine months of 2006 is primarily due to the absence in
first nine months of 2007 of headquarter move costs of approximately $0.2
million which were included in the first nine months of 2006.
Amortization of Acquired Intangibles.
Amortization
of acquired intangibles includes amortization expense related to intangible
assets acquired in connection with the Regeneration acquisition, which are
being amortized over lives ranging from four months to ten years, intangible
assets acquired in connection with the Axmed acquisition, which are being
amortized over lives ranging from one to nine years, and intangible assets
acquired in connection with the Aircast acquisition which are being amortized
over lives ranging from seven to 20 years. The increase in amortization of
acquired intangibles is due to amortization expense related to the April 2006
acquisition of Aircast.
Merger Costs.
Merger costs of $2.5
million incurred in the third quarter of 2007 consist of certain costs related to
the proposed merger with ReAble Therapeutics Finance LLC.
Income from Operations.
Set forth below is income
from operations information for our reporting segments (in thousands):
|
|
Nine Months Ended
|
|
|
|
|
|
|
|
September 29,
2007
|
|
% of Net
Revenues
|
|
September 30,
2006
|
|
% of Net
Revenues
|
|
Increase
(Decrease)
|
|
% Increase
(Decrease)
|
|
Domestic Rehabilitation
|
|
$
|
24,821
|
|
11.3
|
|
$
|
30,310
|
|
15.4
|
|
$
|
(5,489
|
)
|
(18.1
|
)
|
Regeneration
|
|
16,538
|
|
29.6
|
|
10,560
|
|
22.0
|
|
5,978
|
|
56.6
|
|
International
|
|
18,396
|
|
23.2
|
|
8,851
|
|
15.3
|
|
9,545
|
|
107.8
|
|
Income from operations of reportable segments
|
|
59,755
|
|
16.8
|
|
49,721
|
|
16.5
|
|
10,034
|
|
20.2
|
|
Expenses not allocated to segments
|
|
(14,965
|
)
|
(4.2
|
)
|
(12,869
|
)
|
(4.3
|
)
|
(2,096
|
)
|
16.3
|
|
Consolidated income from operations
|
|
$
|
44,790
|
|
12.6
|
|
$
|
36,852
|
|
12.2
|
|
$
|
7,938
|
|
21.5
|
|
The
decrease in income from operations for our Domestic Rehabilitation segment is
due to increased net revenues and gross profit being more than offset by
increased sales and marketing expenses as discussed above. The increase in
income from operations for our Regeneration and International segments is due
primarily to increased net revenues and gross profit.
Interest
Expense, Net of Interest Income.
Interest
expense, net of interest income, was $16.9 million in the first nine months of
2007 compared to $15.7 million in the fist nine months of 2006. Interest
expense, net of interest income, increased in the first nine months of 2007
compared to the first nine months of 2006 primarily due to an increase in our outstanding
long-term debt balances in April 2006 to finance the Aircast acquisition.
Other
Income, Net.
Other
income for the first nine months of 2007 primarily reflects net foreign
exchange transaction gains. Other income for the first nine months of 2006
reflects net foreign exchange transaction gains, offset by a write-off of costs
related to potential acquisition that was abandoned in the first quarter of
2006.
Provision
for Income Taxes.
Our
estimated worldwide effective tax rate was 44.6% for the first nine months of
2007 compared to 45.7% for the first nine months of 2006. Our worldwide
effective tax rate increased in connection with our adoption of SFAS No. 123(R)
as of January 1, 2006. The stock-based compensation expense recorded in
accordance with SFAS No. 123(R) results in a related tax benefit rate of only
31.4% and 22.0% for the first nine months of 2007 and 2006, respectively, due
to the mix of our outstanding and unvested incentive stock options and
non-qualified stock options.
Net
Income
.
Net
income was $16.1 million for the first nine months of 2007 compared to net
income of $11.6 million for the first nine months of 2006 as a result of the
changes discussed above.
Liquidity and Capital Resources
Our principal liquidity requirements are to service
our debt and meet our working capital and capital expenditure needs. Total
indebtedness at September 29, 2007 was $285.5 million. Total cash and cash
equivalents were $11.9 million at September 29, 2007.
27
Net cash provided by operating activities was $47.5
million and $37.0 million for the nine months ended September 29, 2007 and
September 30, 2006, respectively. The net cash provided by operations in the
first nine months of 2007 primarily reflected positive operating results offset
by an increase in net accounts receivable of $6.1 million and $2.5 million of
merger costs consisting of transaction costs to close the proposed merger with
ReAble Therapeutics Finance LLC. As required by SFAS No. 123(R), our cash flow
provided by operating activities for the nine months ended September 29, 2007
is shown net of $1.8 million of excess tax benefits from stock options
exercised, the amount deemed to be realized for tax purposes. These excess tax
benefits are included in cash flows provided by financing activities for the
nine months ended September 29, 2007. The net cash provided by operations in
the first nine months of 2006 primarily reflected positive operating results
offset by an increase in net accounts receivable and net inventories and
payments made in connection with the integration of our recently acquired
businesses.
Cash flows used in investing activities were $9.6
million and $327.1 million for the nine months ended September 29, 2007
and September 30, 2006, respectively. Cash used in investing activities for the
first nine months of 2007 included $1.2 million used for a final payment
related to our January 2006 acquisition of Axmed, $4.8 million used for
additional costs related to the acquisition of Aircast, $1.5 million used for
the Full90 convertible note investment discussed in Note 3 to the unaudited
condensed consolidated financial statements included in Part I, Item 1, $5.5
million used for capital expenditures offset by $3.4 million in proceeds from
the disposal of the Aircast
manufacturing facility which we vacated in connection with the integration of
the Aircast business. Cash used in investing activities for the first nine
months of 2006 included $16.3 million used for the acquisition of Axmed, $297.3
million used for the acquisition of Aircast, and $12.5 million used for capital
expenditures. Capital expenditures for the nine months ended September 30, 2006
included $7.7 million related to tenant improvements and equipment for our
corporate headquarters and the expansion of our Indianapolis distribution
center.
Cash flows (used in) provided by financing activities
were ($33.6) million and $292.4 million for the nine months ended September 29, 2007 and September 30, 2006,
respectively. In the first nine months of 2007, the cash used in financing
activities included $41.8 million used to pay down long-term debt, offset by
$5.3 million of net proceeds received from the exercise of stock options, $1.0
million received from the issuance of stock under our Employee Stock Purchase
Plan and $1.8 million of excess tax benefits from stock options exercised. In
the first nine months of 2006, the cash provided by financing activities
included $286.8 million of net proceeds from long-term debt, $11.1 million of
net proceeds received from the exercise of stock options and $0.9 million from
the issuance of stock under our Employee Stock Purchase Plan.
Contractual Obligations and Commercial Commitments
In April 2006, we entered into a credit agreement with
a syndicate of lenders and with Wachovia Bank, National Association, as
administrative agent, to finance the Aircast acquisition and repay amounts
outstanding under our previous credit agreement. The credit agreement provided
for total borrowings of $400 million, consisting of a term loan of $350
million, which was fully drawn at closing and up to $50 million available under
a revolving credit facility. As of September 29, 2007, the balance outstanding
under the term loan was $285.5 million and $49.2 million was available under
the revolving credit facility, net of $0.8 million of outstanding letters of
credit. Under the credit agreement, up to $25 million of outstanding borrowings
may be denominated in British Pounds or Euros.
Borrowings under the term loan and on the revolving
credit facility bear interest at variable rates (either a LIBOR rate or the
lenders base rate, as elected by us) plus a margin. The interest rate for the
term loan is LIBOR plus a margin of 1.50%, or the lenders base rate plus a
margin of 0.50%. The applicable margin on the revolving credit facility varies
based on our leverage ratio. The interest rate for the revolving credit
facility is LIBOR plus an applicable margin of 1.25% to 2.00%, or the lenders
base rate plus an applicable margin of 0.25% to 1.00%. At our current leverage
ratio, the applicable interest rate on the revolving credit facility is either
LIBOR plus 1.5% or the lenders base rate plus 0.5%.
Interest
Rate Swap Agreement.
In connection with our credit agreement,
in April 2006 we entered into an interest rate swap agreement with Wachovia
Bank for a notional amount of $250 million of the term loan. The interest rate
swap agreement converts the variable LIBOR rate to a fixed LIBOR rate of 5.29%
for a term of five years. Accordingly, with respect to a beginning notional
amount of $250 million of the term loan, our interest rate is fixed at 6.79%
(5.29% plus applicable margin of 1.50%) for the term of the swap. The notional
amount of $250 million is scheduled to amortize to zero over the term of the
swap in proportion to expected future cash flows. As of September 29, 2007, the
outstanding notional amount of the interest rate swap was $250 million. Effective
July 11, 2007, the notional amount of the swap was reduced to $187.5 million. Our
interest rate swap qualifies as a cash flow hedge under SFAS No. 133,
Accounting for Derivative Instruments and Hedging
Activities
. In accordance with SFAS No. 133, the fair market value
of the swap at September 29, 2007 was recorded as a long-term liability, with
the change in such fair value accounted for
28
in accumulated other comprehensive income (loss)
included in the stockholders equity in the accompanying consolidated balance
sheet. The weighted average interest rate applicable to our total borrowings as
of September 29, 2007 was 6.87%. In October 2007, in anticipation of the
repayment of all amounts outstanding under our credit agreement in connection
with the completion of our pending merger with ReAble Therapeutics Finance LLC,
we paid $2.1 million to terminate our interest rate swap agreement.
Repayment.
We were
initially required to make quarterly principal payments of $0.9 million on the
term loan, beginning in June 2006. The balance of the term loan, if any, is due
in full on April 7, 2013. In the nine months ended September 29, 2007 we made
$41.8 million of prepayments on the term loan. Under the credit agreement,
prepayments are applied to reduce outstanding principal balance in direct order
of maturity to payments scheduled over the twelve months following the
prepayment and thereafter to remaining scheduled principal payments on a
prorated basis. Accordingly, no principal payments will be required until
September 2009 and such payments have been reduced to $0.7 million per quarter.
Any borrowings under the revolving credit facility are due in full on April 7,
2012. We are also required to make annual mandatory prepayments on the term
loan in an amount equal to 50% of our excess cash flow if our ratio of total
debt to consolidated EBITDA exceeds 2.50 to 1.00. Excess cash flow represents
our net income adjusted for extraordinary gains or losses, depreciation,
amortization and other non-cash charges, changes in working capital, changes in
deferred revenues, payments for capital expenditures and permitted acquisitions
and repayment of certain indebtedness. In addition, the term loan is subject to
mandatory prepayments in an amount equal to (a) 100% of the net cash proceeds
of certain debt issuances by us; (b) 50% of the net cash proceeds of
certain equity issuances by us if our ratio of total debt to consolidated
EBITDA exceeds 2.50 to 1.00; (c) 100% of the net cash proceeds of certain
insurance, condemnation awards or other compensation in respect to any casualty
event; and (d) 100% of the net cash proceeds of certain asset sales or
other dispositions of property by us, in each case subject to certain
exceptions. We were not required to make any mandatory prepayments for 2006 or
the first nine months of 2007.
Security; Guarantees
. Our
obligations under our credit agreement are irrevocably guaranteed, jointly and
severally, by us, and all of our current and future U.S. subsidiaries. In
addition, the credit agreement and the guarantees thereunder are secured by
substantially all of our U.S. assets, including real and personal property,
inventory, accounts receivable, intellectual property and other intangibles.
Covenants.
Our credit agreement imposes certain restrictions on us, including restrictions
on the ability to incur indebtedness, incur or guarantee obligations, prepay
other indebtedness or amend other debt instruments, pay dividends or make other
distributions (except for certain tax distributions), redeem or repurchase
equity, make investments, loans or advances, make acquisitions, engage in
mergers or consolidations, change the business conducted by us and our
subsidiaries, make capital expenditures, grant liens, sell assets and engage in
certain other activities. Our credit agreement requires us to maintain: a ratio
of total debt to consolidated EBITDA of no more than 3.50 to 1.00 and gradually
decreasing to 2.50 to 1.00 for the first quarter of 2010 and thereafter; and a
ratio of consolidated EBITDA to fixed charges of at least 1.50 to 1.00. Material
violations of these covenants and restrictions, or the payment terms described
above, can result in an event of default and acceleration of the entire
indebtedness. We were in compliance with all covenants as of September 29,
2007.
Debt issuance costs.
In
2006, we capitalized debt issuance costs of approximately $6.4 million in
association with our credit agreement, which will be amortized over the term of
the agreement. Remaining debt issuance costs of $4.9 million, net of
accumulated amortization, were included in the accompanying balance sheet at
September 29, 2007.
As part of our strategy, we may pursue additional
acquisitions, investments and strategic alliances. We may require new sources
of financing to consummate any such transactions, including additional debt or
equity financing. We cannot assure you that such additional sources of
financing will be available on acceptable terms, if at all. In addition, we may
not be able to consummate any such transactions due to the operating and
financial restrictions and covenants in our credit agreement.
Our ability to pay principal and interest on our
indebtedness, fund working capital requirements and make anticipated capital
expenditures will depend on our future performance, which is subject to general
economic, financial and other factors, some of which are beyond our control. We
believe that based on current levels of operations and anticipated growth, cash
flow from operations, together with other available sources of funds including
the availability of borrowings under our revolving credit facility, will be
adequate for at least the next twelve months to make required payments of
principal and interest on our indebtedness, to fund anticipated capital
expenditures and for working capital requirements. There can be no assurance,
however, that our business will generate sufficient cash flow from operations
or that future borrowings will be available under the revolving credit facility
in an amount sufficient to enable us to service our indebtedness or to fund our
other liquidity needs. In such event, we may need to raise additional funds
through public or private equity or debt financings. We cannot assure you that
any such funds will be available to us on favorable terms or at all.
29
We do not currently have and have never had any
relationships with unconsolidated entities or financial partnerships, such as
entities often referred to as structured finance or special purpose entities,
which would have been established for the purpose of facilitating off-balance
sheet arrangements or other contractually narrow or limited purposes. In
addition, we do not engage in trading activities involving non-exchange traded
contracts. As such, we are not materially exposed to any financing, liquidity,
market or credit risk that could arise if we had engaged in these
relationships.
As of September 29, 2007, we had available liquidity
of approximately $11.9 million in cash and cash equivalents and $49.2 million
available under our revolving credit facility, net of $0.8 million of
outstanding letters of credit. For the remainder of 2007, we have or expect to
spend total cash of approximately $13.0 million for the following requirements:
up to approximately $4.9 million for
estimated interest payments on our credit facility;
approximately $2.1 million to
terminate our interest rate swap agreement;
approximately $2.0 million scheduled
payments for noncancellable operating leases; and
up to approximately $4.0 million for
capital expenditures.
In addition, we expect to make other general corporate
payments in 2007.
Seasonality
We generally record our highest net revenues per day
in the fourth quarter due to a greater number of orthopedic surgeries and
injuries resulting from increased sports activity, particularly football and
skiing. In addition, during the fourth quarter, a patient has a greater
likelihood of having satisfied his or her annual insurance deductible than in
the first three quarters of the year, and thus there is an increase in the
number of elective orthopedic surgeries. We follow a manufacturing calendar
that has a varied number of operating days in each quarter. Although on a per
day basis revenues may be higher in a certain quarter, total net revenues may
be higher or lower based upon the number of operating days in such quarter.
Conversely, we generally have lower net revenues per day during our second
quarter as a result of decreased sports activity, with the end of both football
and skiing seasons. For 2007 and 2006, our number of operating days per quarter
is as follows:
|
|
2007
|
|
2006
|
|
First quarter
|
|
64
|
|
64
|
|
Second quarter
|
|
64
|
|
64
|
|
Third quarter
|
|
63
|
|
63
|
|
Fourth quarter
|
|
62
|
|
61
|
|
Total
operating days
|
|
253
|
|
252
|
|
ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to certain market risks as part of our
ongoing business operations. Our primary exposures include changes in interest
rates and foreign exchange rates.
We are exposed to interest rate risk in connection
with the term loan and borrowings under our revolving credit facility, which
bear interest at floating rates based on the London Inter-Bank Offered Rate
(LIBOR) or the prime rate plus an applicable borrowing margin. For variable
rate debt, interest rate changes generally do not affect the fair market value
of the underlying debt, but do impact future earnings and cash flows, assuming
other factors are held constant.
Following a scheduled reduction in the notional amount
of our interest rate swap agreement in October 2007, we have $98.0 million of
variable rate debt represented by borrowings under our credit facility which
are not covered by the interest rate swap agreement. Based on the balance of
the variable rate debt outstanding under the credit facility as of September
29, 2007, an immediate change of one percentage point in the applicable
interest rate would have caused an increase or decrease in interest expense of
approximately $1.0 million on an annual basis. At September 29, 2007, up to
$49.2 million of variable rate borrowings were available under our
$50.0 million revolving credit facility. We may use derivative financial
instruments, where appropriate, to manage our
30
interest rate risks.
However, as a matter of policy, we do not enter into derivative or other
financial investments for trading or speculative purposes. In April 2006, in
connection with our credit agreement, we entered into an interest rate swap
agreement for a notional amount of $250 million of the term loan. The interest
rate swap agreement converts the variable LIBOR rate to a fixed LIBOR rate of
5.29% for a term of five years. Accordingly, with respect to a beginning
notional amount of $250 million, our interest rate is fixed at 6.79% (5.29%
plus applicable margin of 1.50%) for the term of the swap. The notional amount
of $250 million is scheduled to amortize to zero over the term of the swap in
proportion to expected cash flows. As of September 29, 2007, the outstanding
notional amount of the interest rate swap was $187.5 million. Effective July
11, 2007, the notional amount of the swap was reduced to $187.5 million. For
the quarter and nine months ended September 29, 2007, the change in fair value
of the swap was accounted for as an increase in accumulated other comprehensive
income (loss) included in stockholders equity in the accompanying consolidated
balance sheet. In October 2007, in anticipation of the repayment of all amounts
outstanding under our credit agreement in connection with the completion of our
pending merger with ReAble Therapeutics Finance LLC, we paid $2.1 million to
terminate our interest rate swap agreement.
Through our wholly owned international subsidiaries,
we sell products in several foreign currencies, primarily Euros, Pounds
Sterling and Canadian Dollars. The U.S. dollar equivalent of our international
sales denominated in foreign currencies in the first quarters of 2007 and 2006
were favorably impacted by foreign currency exchange rate fluctuations with the
weakening of the U.S. dollar against the foreign currencies of our subsidiaries.
The U.S. dollar equivalent of the related costs denominated in these foreign
currencies was unfavorably impacted during the same period. In addition, the
costs associated with our Mexico-based manufacturing operations are incurred in
Mexican pesos. As we continue to distribute and manufacture our products in
selected foreign countries, we expect that future sales and costs associated
with our activities in these markets will continue to be denominated in the
applicable foreign currencies, which could cause currency fluctuations to
materially impact our operating results. Occasionally we seek to reduce the
potential impact of currency fluctuations on our net income through hedging
transactions. As of September 29, 2007, we had outstanding hedges in the form
of forward contracts to purchase Mexican pesos aggregating a U.S. dollar
equivalent of $15.8 million. As of September 29, 2007, we had an unrealized
foreign currency gain of $0.2 million related to these contracts.
ITEM
4. CONTROLS AND PROCEDURES
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 Commissions rules and forms, and that such information is accumulated
and communicated to our management, including our Chief Executive Officer and
Chief Financial Officer, as appropriate, to allow timely decisions regarding
required disclosure. In designing and evaluating the disclosure controls and
procedures, management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives, and management is required to apply
its judgment in evaluating the cost-benefit relationship of possible controls
and procedures.
Under the supervision and with the participation of
our management, including our Chief Executive Officer and our Chief Financial
Officer, we carried out an evaluation of the effectiveness of the design and
operation of our disclosure controls and procedures (as such term is defined in
SEC Rules 13a 15(e) and 15d 15(e)) as of the end of the quarter covered by
this report. Based on the foregoing, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures were
effective at the reasonable assurance level.
Changes
in Internal Control over Financial Reporting
There has been no
change to our internal control over financial reporting during our most recent
fiscal quarter that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.
31
PART
II. OTHER INFORMATION
ITEM
1. LEGAL PROCEEDINGS
From time to time,
we are involved in legal and administrative disputes and proceedings arising in
the ordinary course of business, most of which are not material to the conduct
of our business. With respect to these ordinary course matters, management
believes that it has adequate insurance coverage or has made adequate accruals
for related costs, and it may also have effective legal defenses.
Pending
Stockholder Litigation
On August 31, 2007 and September 6, 2007, two
purported shareholder class action lawsuits were filed in California Superior
Court, in the County of San Diego, on behalf of our public stockholders,
challenging our proposed merger with Parent. The court ordered the two lawsuits
consolidated for all purposes on September 21, 2007. The court further ordered
that plaintiffs file a consolidated amended complaint as soon as practicable,
and that the defendants need not respond to either of the two original
complaints.
The two original complaints named us, ReAble
Therapeutics, Inc., an affiliate of Parent, and the current members of our
board of directors as defendants. One of the original complaints also named
Blackstone as a defendant. The two substantially similar original complaints
alleged, among other things, that the individual defendants breached their
fiduciary duties of care, good faith and loyalty by approving the proposed
merger with an allegedly inadequate price, without adequately informing
themselves of the Companys highest transactional value, and without adequately
marketing the company to other potential buyers. The original complaints also
alleged that the individual defendants and the Company failed to make full and
adequate disclosures in the preliminary proxy statement regarding the proposed
merger. The original complaints pray for, among other things, class certification,
declaratory relief, an injunction of the proposed merger or a rescission order,
corrective disclosures to the proxy statement, damages, interest, attorneys
fees, expert fees and other costs; and such other relief as the court may find
just and proper.
Discovery is ongoing and the parties have stipulated
to a November 2, 2007 hearing on plaintiffs preliminary injunction motion, and
a related briefing schedule. We believe that the lawsuit is without merit and
intend to vigorously oppose it.
32
ITEM 1A. RISK FACTORS
Our
ability to achieve our operating and financial goals is subject to a number of
risks, including risks relating to our business operations, our debt level and
government regulations. If any of the following risks actually occur, our
business, operating results, prospects or financial condition could be
materially and adversely affected. The risk factors described below reflect any
material changes from the risk factors previously disclosed in our Annual
Report on Form 10-K for the year ended December 31, 2006. The risks described
below are not the only ones that we face. Additional risks not presently known
to us or that we currently deem immaterial may also affect our business operations.
Risks
Related to the Proposed Merger
Failure
to complete the proposed merger could negatively affect the Company.
On July 15, 2007, we entered into the Merger Agreement
with Parent and Merger Sub. There is no assurance that the Merger Agreement and
the proposed merger will be approved by our stockholders, and there is no
assurance that the other conditions to the completion of the proposed merger
will be satisfied. In connection with the proposed merger, we will be subject
to several risks, including the following:
the
occurrence of any effect, event, development or change that could give rise to
the termination of the Merger Agreement;
the
outcome of the legal proceedings instituted against us following announcement
of entering into the Merger Agreement;
the
inability to complete the merger due to the failure to obtain stockholder
approval or the failure to satisfy other conditions to completion of the
merger;
the
failure of Parent or Merger Sub to obtain the necessary financing arrangements
set forth in commitment letters received in connection with the proposed
merger;
the payment of a significant break-up fee or
expense reimbursement if the merger is not completed under certain
circumstances;
risks
that the proposed transaction disrupts current plans and operations and the
potential difficulties in employee retention;
risks
that the proposed transaction causes our distribution network, customers or
vendors to terminate or reduce their relationship with us;
the
amount of the costs, fees, expenses and charges related to the merger and the
actual terms of certain financings that will need to be obtained for the
merger; and
the
impact of the substantial indebtedness that will need to be incurred to finance
the consummation of the merger.
Any of these events could have a material negative
impact on our results of operations and financial condition and could adversely
affect the price of our common stock.
Risks Related to Our Business
We intend
to pursue, but may not be able to identify, finance or successfully complete,
other strategic acquisitions.
Our
growth strategy will continue to include the pursuit of acquisitions, both
domestically and, in particular, internationally. We may not be able to
identify acceptable opportunities or complete acquisitions of targets
identified in a timely manner or on acceptable terms. Acquisitions involve a
number of risks, including the following:
our managements
attention will be diverted from our existing business while evaluating acquisitions
and thereafter while integrating the operations and personnel of the new
business into our business;
we may experience
adverse short-term effects on our operating results;
33
we may be unable to
successfully and rapidly integrate the new businesses, personnel and products
with our
existing business,
including financial reporting, management and information technology systems;
we may experience
higher than anticipated costs of integration and unforeseen operating
difficulties and expenditures;
an acquisition may
be in a market or geographical area in which we have little experience;
we may have
difficulty in retaining key employees, including employees who may have been
instrumental to the success or growth of the acquired business; and
we may use a
substantial amount of our cash and other financial resources to consummate an
acquisition.
In addition, we may require
additional debt or equity financing for future acquisitions, and such financing
may not be available or on favorable terms, if available at all. We may not be
able to successfully integrate or operate profitably any new business we
acquire, and we cannot assure you that any such acquisition will meet our
expectations. Finally, in the event we decide to discontinue pursuit of a
potential acquisition, we will be required to immediately expense all costs
incurred in pursuit of the possible acquisition that could have an adverse
effect on our results of operations in the period in which the expense is
recognized
Weaknesses
in our internal control over financial reporting could result in material
misstatements in our financial statements.
Our management is responsible for establishing and
maintaining adequate internal control over financial reporting. Our internal
controls are processes designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements
in accordance with U.S. generally accepted accounting principles. A material
weakness is a control deficiency, or combination of control deficiencies, that
results in a more than remote likelihood that a material misstatement of annual
or interim financial statements will not be prevented or detected.
Management determined that a material weakness in our
internal control over financial reporting existed as of December 31, 2006 with
regard to inventory that was in transit from the Aircast facilities in New
Jersey to our facilities in Indianapolis and Tijuana, Mexico as a part of the
integration of the Aircast business into our business operations. We did not
perform adequate detailed procedures with respect to such inventory and failed
to adequately reconcile the related intercompany transactions. See Item 9A
Controls and Procedures in our Annual Report on Form 10-K for the year ended
December 31, 2006 for a more complete description of this material weakness.
We have remediated this material weakness with a
detailed analysis and reconciliation of the in-transit inventory and related
intercompany accounts. We cannot assure you that additional control
deficiencies or material weaknesses will not be identified by our management or
independent registered public accounting firm in the future, including in
connection with the integration of our Aircast acquisition, Axmed acquisition
or other acquisitions we may consummate in the future. In addition, even after
having taken these remediation steps, our internal controls may not prevent all
potential errors or fraud. Any control system, no matter how well designed and
implemented, can only provide reasonable and not absolute assurance that the
objectives of the control system will be achieved. Failure to achieve adequate
internal control over financial reporting could adversely affect our business
operations and financial position.
If we do not effectively manage
our growth, our existing infrastructure may become strained, and we may be
unable to increase sales of our products or generate revenue growth.
The
growth that we have experienced, and in the future may experience, including
due to acquisitions may provide challenges to our organization, requiring us to
expand our personnel, manufacturing and distribution operations. Future growth
may strain our infrastructure, operations, product development and other
managerial and operating resources. If our business resources become strained,
we may be unable to increase sales of our products or generate revenue growth.
34
We have outsourced certain administrative
functions relating to our OfficeCare and Insurance channels to a third-party
contractor and this arrangement may not prove successful.
Our
OfficeCare sales channel maintains an inventory of products (mostly soft goods)
on hand at orthopedic practices for immediate distribution to patients. In our
Insurance channel, we provide products, principally custom-made rigid knee
braces, directly to patients. In both situations, we bill patients or their
third-party payors after the product is provided to the patient. We outsource
the revenue cycle of these channels, from billing to collections, to an
independent third-party contractor. Our outsource contractor has undergone
significant changes in their business operations in the last two years,
including locating some administrative functions overseas, in order to improve
performance from order entry to collections. We are also working closely with
them to upgrade the software system used in these revenue cycle processes. The
inability of this provider to upgrade its processes and demonstrate improved
billing and collection results could have an adverse effect on our operations
and financial results in the OfficeCare and Insurance channels.
We rely on intellectual
property to develop and manufacture our products and our business could be
adversely affected if and when we lose our intellectual property rights.
We hold or license U.S. and foreign patents relating
to a number of our components and products and have patent applications pending
with respect to other components and products. We also expect to apply for
additional patents as we deem appropriate. We believe that many of our patents
are, and will continue to be, extremely important to our success.
However, we cannot assure you that:
our
existing or future patents, if any, will afford us adequate protection;
our
patent applications will result in issued patents; or
our
patents will not be circumvented or invalidated.
Our
success also depends on non-patented proprietary know-how, trade secrets,
processes and other proprietary information. We employ various methods to
protect our proprietary information, including confidentiality agreements and
proprietary information agreements with vendors, employees, consultants and others
who have access to our proprietary information. However, these methods may not
provide us with adequate protection. Our proprietary information may become
known to, or be independently developed by, competitors, or our proprietary
rights in intellectual property may be challenged, any of which could have an
adverse effect on our business.
If we are not able to
develop, license or acquire and market new products or product enhancements we
may not remain competitive.
Our
future success and the ability to grow our revenues and earnings require the
continued development, licensing or acquisition of new products and the
enhancement of our existing products. We may not be able to:
continue
to develop or license successful new products and enhance existing products;
obtain
required regulatory clearances and approvals for such products;
market
such products in a commercially viable manner; or
gain
market acceptance for such products.
We may
be unable to remain competitive if we fail to develop, license or acquire and
market new products and product enhancements. In addition, if any of our new or
enhanced products contain undetected errors or design defects, especially when
first introduced, our ability to market these products could be substantially
delayed, resulting in lost revenues, potential damage to our reputation and/or
delays in obtaining acceptance of the product by orthopedic and spine surgeons
and other healthcare professionals.
35
We rely heavily on our
relationships with orthopedic professionals who prescribe and dispense our
products and our failure to maintain these relationships could adversely affect
our business.
The
sales of our products depend significantly on the prescription or
recommendation of such products by orthopedic and spine surgeons and other
healthcare professionals. We have developed and maintain close relationships
with a number of widely recognized orthopedic surgeons and specialists who
support and recommend our products. Failure of our products to retain the
support of these surgeons and specialists, or the failure of our products to
secure and retain similar support from leading surgeons and specialists, could
have an adverse effect on our business.
The majority of our sales force
consists of independent agents and distributors who maintain close
relationships with our hospital and physician customers.
Our
success also depends largely upon arrangements with independent agents and
distributors and their relationships with our hospital and physician customers
in the marketplace. These agents and distributors are not our employees, and
our ability to influence their actions and performance is limited. Our
inability to effectively manage these agents and distributors or our failure
generally to maintain relationships with these independent agents and
distributors could have an adverse effect on our business.
We operate in a very
competitive business environment.
The
non-operative orthopedic and spine markets are highly competitive and
fragmented. Our competitors include several large, diversified general
orthopedic products companies and numerous smaller niche companies. Some of our
competitors are part of corporate groups that have significantly greater
financial, marketing and other resources than we have. Accordingly, we may be
at a competitive disadvantage with respect to these competitors.
In the
rehabilitation market, our primary competitors in the rigid knee bracing
product line include Orthofix International, N.V., Bledsoe Brace Systems, Ossur
hf. and Townsend Industries Inc. Our competitors in the soft goods products
market include Biomet, Inc., DeRoyal Industries, Ossur hf. and Zimmer Holdings,
Inc. Our primary competitors in the pain management products market include I-Flow
Corp., Orthofix and Stryker Corporation.
In the
regeneration market, our primary competitors selling bone growth stimulation
products approved by the FDA for the treatment of nonunion fractures are
Orthofix, Biomet, Inc. and Smith & Nephew. Biomet and Orthofix also sell
bone growth stimulation products for use by spinal fusion patients. We estimate
that Biomet has dominant shares of the U.S. markets for bone growth stimulation
products used both to treat nonunion fractures and as adjunct therapy after
spinal fusion surgery.
Our quarterly operating
results are subject to substantial fluctuations and you should not rely on them
as an indication of our future results.
Our
quarterly operating results may vary significantly due to a combination of
factors, many of which are beyond our control. These factors include:
the
number of business days in each quarter;
demand
for our products, which historically has been higher in the fourth quarter when
scholastic sports and ski injuries are more frequent;
our
ability to meet the demand for our products;
the
direct distribution of our products in foreign countries, which have more
seasonality than the U.S.;
the
number, timing and significance of new products and product introductions and
enhancements by us and our competitors, including delays in obtaining
government review and clearance of medical devices;
our
ability to develop, introduce and market new and enhanced versions of our
products on a timely basis;
36
the
impact of any acquisitions that occur in a quarter;
fluctuations
in gross profit due to changes in product mix;
the
impact of any changes in generally accepted accounting principles;
changes
in pricing policies by us and our competitors and reimbursement rates by
third-party payors, including government healthcare agencies and private
insurers;
the
loss of any of our distributors;
changes
in the treatment practices of orthopedic and spine surgeons and their allied
healthcare professionals; and
the
timing of significant orders and shipments.
Accordingly,
our quarterly sales and operating results may vary significantly in the future
and period-to-period comparisons of our results of operations may not be meaningful
and should not be relied upon as indications of future performance. We cannot
assure you that our sales will increase or be sustained in future periods or
that we will be profitable in any future period.
Our business plan relies
on certain assumptions for the market for our products, which, if incorrect,
may adversely affect our profitability.
We
believe that various demographics and industry specific
trends will help drive growth in the rehabilitation and regeneration markets,
including:
a growing elderly population with broad
medical coverage, increased disposable income and longer life expectancy;
a growing emphasis on physical fitness,
leisure sports and conditioning, which has led to increased injuries,
especially among women; and
the
increasing awareness and use of non-invasive devices for prevention, treatment
and rehabilitation purposes.
These demographics and trends are beyond our control.
The projected demand for our products could materially differ from actual
demand if our assumptions regarding these factors prove to be incorrect or do
not materialize or if alternative treatments to those offered by our products
gain widespread acceptance.
Our business, operating
results and financial condition could be adversely affected if we become
involved in litigation regarding our patents or other intellectual property
rights.
The
orthopedic products industry has experienced extensive litigation regarding
patents and other intellectual property rights. We or our products may become
subject to patent infringement claims or litigation or interference proceedings
declared by the U.S. Patent and Trademark Office, or USPTO, or the foreign
equivalents thereto to determine the priority of inventions. The defense and
prosecution of intellectual property suits, USPTO interference proceedings or
the foreign equivalents thereto and related legal and administrative
proceedings are both costly and time consuming. An adverse determination in
litigation or interference proceedings to which we may become a party could:
subject
us to significant liabilities to third-parties;
require
disputed rights to be licensed from a third-party for royalties that may be
substantial; or
require
us to cease using such technology.
37
Any
one of these outcomes could have an adverse effect on us. Furthermore, we may
not be able to obtain necessary licenses on satisfactory terms, if at all.
Accordingly, adverse determinations in a judicial or administrative proceeding
or our failure to obtain necessary licenses could prevent us from manufacturing
and selling our products, which would have a material adverse effect on our
business, operating results and financial condition. Moreover, even if we are
successful in such litigation, the expense of defending such claims could be
material.
In
addition, we have from time to time needed to, and may in the future need to,
litigate to enforce our patents, to protect our trade secrets or know-how or to
determine the enforceability, scope and validity of the proprietary rights of
others. Such enforcement of our intellectual property rights could involve
counterclaims against us. Any future litigation or interference proceedings
will result in substantial expense to us and significant diversion of effort by
our technical and management personnel.
We have limited suppliers
for some of our components and products which makes us susceptible to supply
shortages and could disrupt our operations.
Some
of our important suppliers are in China and other parts of Asia and provide us
predominately finished soft goods products. In fiscal year 2006, we obtained
approximately 15% of our total purchased materials from suppliers in China and
other parts of Asia. Political and economic instability and changes in
government regulations in these areas could affect our ability to continue to
receive materials from our suppliers there. The loss of our suppliers in China
and other parts of Asia, any other interruption or delay in the supply of our
required materials or our inability to obtain these materials at acceptable
prices and within a reasonable amount of time could impair our ability to meet
scheduled product deliveries to our customers and could hurt our reputation and
cause customers to cancel orders.
In
addition, we purchase the microprocessor used in the OL1000
â
and SpinaLogic devices from a single manufacturer. Although there are feasible
alternate microprocessors that might be used immediately, all are produced by a
single supplier. In addition, there are single suppliers for other components
used in the OL1000 and SpinaLogic devices and only two suppliers for the
magnetic field sensor employed in them. Establishment of additional or
replacement suppliers for these components cannot be accomplished quickly.
Our international sales
and profitability may be adversely affected by foreign currency exchange
fluctuations and other risks.
We
sell products in foreign currency through our foreign subsidiaries. The U.S.
dollar equivalent of international sales denominated in foreign currencies in
fiscal years 2006, 2005 and 2004 were favorably impacted by foreign currency
exchange rate fluctuations with the weakening of the U.S. dollar against the
foreign currencies of our subsidiaries. The U.S. dollar equivalent of the
related costs denominated in these foreign currencies was unfavorably impacted
during the same periods. In addition, the costs associated with our
Mexico-based manufacturing operations are incurred in Mexican pesos. As we
continue to distribute and manufacture our products in selected foreign
countries, we expect that future sales and costs associated with our activities
in these markets will continue to be denominated in the applicable foreign
currencies, which could cause currency fluctuations to materially impact our
operating results.
We are
also subject to other risks inherent in international operations such as
political and economic conditions, foreign regulatory requirements, exposure to
different legal requirements and standards, exposure to different approaches to
treating injuries, potential difficulties in protecting intellectual property,
import and export restrictions, increased costs of transportation or shipping,
currency fluctuations, difficulties in staffing and managing international
operations, labor disputes, difficulties in collecting accounts receivable and
longer collection periods and potentially adverse tax consequences. For
example, in Germany, our largest foreign market, orthopedic professionals began
re-using our bracing devices on multiple patients during 2004, which has
adversely impacted our sales of these devices in this market since 2004. As we
continue to expand our international business, our success will be dependent,
in part, on our ability to anticipate and effectively manage these and other
risks. If we are unable to do so, these and other factors may have an adverse
effect on our international operations.
38
The direct distribution
of our products in selected foreign countries involves financial and
operational risks.
Since 2002, we have been
implementing a strategy to selectively replace our third-party international
distributors with wholly owned distributorships, and in 2006 we increased the
portion of our revenues derived from international customers to over 20% as a
result of the Axmed and Aircast acquisitions and growth generally in
international markets. We have subsidiaries in several foreign countries and
plan to continue to expand our international business. Our foreign activities
require experienced management in each subsidiary who are familiar with the
market dynamics in the particular country and overall operational, financial,
administrative and sales management to oversee the international business. We
added significant capability in this regard during 2006, but are still in the
process of adding certain of the management resources we need. We also are in
the process of identifying and securing additional financial and operational
controls for the international business. We cannot assure you that we will be
able to successfully complete our international management team on a timely
basis or secure and maintain adequate organizational controls in our foreign
operations or that our international strategy will result in increased revenues
or profitability.
Our
concentration of manufacturing operations in Mexico increases our business and
competitive risks.
Other
than a relatively small manufacturing operation in Tunisia acquired in the
recent Axmed acquisition and other than the manufacturing of our BGS products,
our custom rigid knee braces and certain of our vascular products that is
conducted in Vista, California, all of our manufacturing activities are carried
out in our facility in Tijuana, Mexico. These operations are subject to risks
of political and economic instability inherent in activities conducted in
foreign countries. In addition, as a result of this concentration of
manufacturing activities, our sales in foreign markets may be at a competitive
disadvantage to products manufactured locally due to freight costs, custom and
import duties and favorable tax rates for local businesses. In order to reduce
the risk involved in the concentration of most of our manufacturing activities
in one foreign jurisdiction and to compete successfully with foreign
manufacturers, we may be required to open or expand manufacturing operations
abroad, which would be costly to implement and may not effectively reduce the
risk of doing business in foreign countries. We may not be able to successfully
operate additional offshore manufacturing operations.
Product liability claims
may harm our business if our insurance proves inadequate or the number of
claims increases significantly.
We
face an inherent business risk of exposure to product liability claims in the
event that the use of our technology or products is alleged to have resulted in
adverse effects. We have, from time to time, been subject to product liability
claims. In addition, we have operated a Knee Guarantee program since 2001 in
relation to our Defiance knee brace. The Knee Guarantee program will, in
specified instances, cover a patients insurance deductible up to $1,000, or
give uninsured patients $1,000, towards surgery should an ACL re-injury occur
while wearing the brace. In 2003, the Technology You Can Trust program was
introduced in connection with our BGS products. If a patient has a nonunion
fracture that fails to heal while using a BGS product, the Technology You Can
Trust program will, if the patient meets the specified requirements of the
program, refund the costs for treatment using the BGS product. Claims under the
Technology You Can Trust program were not material and the program was
terminated.
We
maintain product liability insurance with coverage of an annual aggregate
maximum of $20 million. The policy is provided on a claims made basis and
is subject to annual renewal. There can be no assurance that liability claims
will not exceed the coverage limit of such policy or that such insurance will
continue to be available on commercially reasonable terms or at all. If we do
not or cannot maintain sufficient liability insurance, our ability to market
our products may be significantly impaired.
We may be adversely affected if we
lose the services of any member of our senior management team.
We are dependent on the continued services of our
senior management team, who have made significant contributions to our growth
and success. Leslie H. Cross, our President and Chief Executive Officer, for
example, has worked for us for nearly 17 years and helped lead our 1999
recapitalization and transition from ownership by Smith & Nephew to a
stand-alone company. The loss of any one or more members of our senior
management team could have a material adverse effect on us.
39
Any claims relating to
our improper handling, storage or disposal of wastes could be time consuming
and costly.
Our facilities and operations are subject to
federal, state and local environmental and occupational health and safety
requirements of the United States and foreign countries, including those
relating to discharges of substances to the air, water, and land, the handling,
storage and disposal of wastes and the cleanup of properties affected by
pollutants. In the future, federal, state, local or foreign governments could
enact new or more stringent laws or issue new or more stringent regulations
concerning environmental and worker health and safety matters that could affect
our operations. We became the owner of a New Jersey factory as a result of the
Aircast acquisition and that factory is the site of an environmental clean-up
project that is currently being performed by a prior owner. We sold that
factory in August 2007. Also, contamination may be found to exist at our other
current, former or future facilities, including the facility in Tempe, Arizona
that we occupied following the Regeneration acquisition, or off-site locations
where we have sent wastes. We could be held liable for such contamination,
which could have a material adverse effect on our business or financial
condition. In addition, changes in environmental and worker health and safety
requirements or liabilities from newly discovered contamination could have a material
effect on our business or financial condition.
If a natural or man-made
disaster strikes our manufacturing facilities, we will be unable to manufacture
our products for a substantial amount of time and our sales will decline.
Nearly
all of our rehabilitation products are manufactured in our new facility in
Tijuana, Mexico, with a number of products for the European market manufactured
in our recently-acquired Tunisian facility. The products that are still
manufactured in Vista, California consist of our custom rigid bracing products,
which remain in the U.S. to facilitate quick turn-around on custom orders and
the Regeneration product line. These facilities and the manufacturing equipment
we use to produce our products would be difficult to repair or replace. Our
facilities may be affected by natural or man-made disasters. If one of our
facilities were affected by a disaster, we would be forced to rely on
third-party manufacturers or shift production to another manufacturing facility.
In such an event, we would face significant delays in manufacturing which would
prevent us from being able to sell our products. In addition, our insurance may
not be sufficient to cover all of our potential losses and may not continue to
be available to us on acceptable terms, or at all.
Because we have various
mechanisms in place to discourage takeover attempts, a change in control of our
company that a stockholder may consider favorable could be prevented.
Provisions
of our certificate of incorporation and bylaws may discourage, delay or prevent
a change in control of our company that a stockholder may consider favorable.
These provisions could also discourage proxy contests and make it more
difficult for stockholders to elect directors and take other corporate actions.
These provisions include:
authorizing
the issuance of blank check preferred stock by our board of directors to
increase the number of outstanding shares and thwart a takeover attempt;
a
classified board of directors with staggered, three-year terms, which may
lengthen the time required to gain control of the board of directors;
prohibiting
cumulative voting in the election of directors, which would otherwise allow
less than a majority of stockholders to elect director candidates;
requiring
supermajority voting to effect particular amendments to our certificate of
incorporation and bylaws;
limitations
on who may call special meetings of stockholders;
prohibiting
stockholder action by written consent, thereby requiring all actions to be
taken at a meeting of the stockholders; and
establishing
advance notice requirements for the nomination of candidates for election to
the board of directors or for proposing matters that can be acted upon by
stockholders at stockholder meetings.
40
In addition, Section 203 of the Delaware General
Corporation Law prohibits a publicly held Delaware corporation from engaging in
a business combination with an interested stockholder, generally defined as a
person that together with its affiliates owns or within the last three years
has owned 15% of the corporations voting stock, for a period of three years
after the date of the transaction in which the person became an interested
stockholder, unless the business combination is approved in a prescribed manner.
Accordingly, Section 203 may discourage, delay or prevent a change in
control of our company.
As a result, these provisions could limit the price
that investors are willing to pay in the future for shares of our common stock.
Risks Related to Government
Regulation
Our failure to comply with regulatory
requirements or receive regulatory clearance or approval for our products or
operations in the United States or abroad would adversely affect our revenues
and potential for future growth.
Our products are medical
devices that are subject to extensive regulation in the United States by the
Food and Drug Administration, or FDA, and by respective authorities in foreign
countries where we do business. The FDA regulates virtually all aspects of a
medical devices design and testing, manufacture, safety, labeling, storage,
recordkeeping, reporting, clearance and approval, promotion and distribution. The
FDA also regulates the export of medical devices to foreign countries. Failure
to comply with the regulatory requirements of the FDA and other applicable U.S.
regulatory requirements may subject a company to administrative or judicially
imposed sanctions ranging from warning letters to criminal penalties or product
withdrawal. Unless an exemption applies, a medical device must receive either
clearance or premarket approval from the FDA before it can be marketed in the
United States. The FDAs 510(k) clearance process for Class II devices usually
takes from three to twelve months, but may take significantly longer. The
premarket approval process for Class III devices generally takes from one to
three years from the time the application is filed with the FDA, but also can
be significantly longer. Premarket approval typically requires extensive
clinical data and can be significantly longer, more expensive and more
uncertain than the 510(k) clearance process. Despite the time, effort and
expense expended, there can be no assurance that a particular device will be
approved or cleared by the FDA through either the 510(k) clearance process or
the premarket approval process.
Medical devices may only be marketed for the
indications for which they are approved or cleared. We may be required to
obtain additional new premarket approvals, premarket approval supplements or
510(k) clearances to market additional products or for new indications for or
modifications to our existing products. We cannot be certain that we would
obtain additional premarket approvals or 510(k) clearances in a timely manner
or at all. We have modified various aspects of our devices in the past and we
determined that new approvals, supplements or clearances were not required. The
FDA may not agree with our decisions not to seek approvals, supplements or
clearances for particular device modifications. If the FDA requires us to
obtain premarket approvals, supplement approvals or 510(k) clearances for any
modification to a previously cleared or approved device, we may be required to
cease manufacturing and marketing the modified device or to recall such modified
device until we obtain FDA clearance or approval and we may be subject to
significant regulatory fines or penalties. In addition, there can be no
assurance that the FDA will clear or approve such submissions in a timely
manner, if at all.
Our failure to obtain FDA clearance or approvals of new
products, new indications or product modifications that we develop in the
future, any limitations imposed by the FDA on such products development or
use, or the costs of obtaining FDA clearance or approvals could have a material
adverse effect on our business.
In many of the foreign countries in which we market our
products, we are subject to extensive regulations essentially the same as those
of the FDA, including those in Germany, our largest foreign market. The
regulation of our products in Europe falls primarily within the European
Economic Area, which consists of the twenty-seven member states of the European
Union, as well as Iceland, Liechtenstein and Norway. The Council of the
European Union (formerly the Council of the European Communities) and the
Council of the European Parliament have adopted three directives in order to
harmonize national provisions regulating the design, manufacture, clinical
trials, labeling and adverse event reporting for medical devices to ensure that
medical devices marketed are safe and effective for their intended uses. The
member states of the European Economic Area have implemented the directives
into their respective national law. Medical devices that comply with the
conformity requirements of the national provisions and the directives will be
entitled to bear a CE marking. Unless an exemption applies, only medical
devices which bear a CE marking may be marketed within the European Economic
Area. Switzerland also allows the marketing of medical devices that bear a CE
marking. Due to the movement towards harmonization of standards in the European
Union and the expansion of the European Union, we expect a changing regulatory
environment in Europe characterized by a shift from a country-by-country
regulatory system to a European Union-wide single regulatory system. Failure to
receive, or delays in the receipt of, relevant foreign qualifications, such as
the CE marking, could have a material adverse effect on our international operations.
41
Legislative or regulatory
initiatives and reforms could adversely impact our business.
In both the United States and
certain international markets, there have been a number of legislative and
regulatory initiatives and changes, such as the Medicare Prescription Drug,
Improvement, and Modernization Act of 2003 and the Food and Drug Administration
Amendments Act of 2007, which could and have altered the healthcare system in
ways that could impact our ability to sell our medical devices profitably. Recent,
widely-publicized events concerning the safety certain drug, food and medical
device products have raised concerns among members of Congress, medical
professionals, and the public regarding the FDAs handling of these events and
its perceived lack of oversight over regulated products. The increased
attention to safety and oversight issues could result in, among other things,
new and more burdensome legal and regulatory requirements or a more cautious
approach by the FDA to device clearances and approvals and post-market
compliance, which could prevent, delay clearance or approval of our new
products or product modifications, or require us to expend additional resources
on post-market studies and controls.
In addition, changes in the
regulatory status of our medical devices could adversely affect our operations
and financial results. The FDA has the authority to reclassify devices, either
on its on initiative or in response to a petition filed by a third party. For
instance, a third party filed a petition with the FDA in February 2005 seeking
to reclassify non-invasive BGS devices from Class III to Class II, but withdrew
the petition after the FDA proposed to deny it. We cannot be sure that changes
in the classification of our devices or other regulatory changes will not be
proposed or implemented that adversely impact our business.
Our products are subject to recalls even after
receiving FDA clearance or approval, or after receiving CE-markings, which
would harm our reputation and business.
We are subject to medical device reporting, or MDR,
regulations that require us to report to the FDA or governmental authorities in
other countries if our products cause or contribute to a death or serious injury
or malfunction in a way that would be reasonably likely to contribute to death
or serious injury if the malfunction were to recur. The FDA and similar
governmental authorities in other countries have the authority to require the
recall of our products in the event of material deficiencies or defects in
design or manufacturing, and we have been subject to product recalls in the
past. A government mandated, or voluntary, recall by us could occur as a result
of component failures, manufacturing errors or design defects, including
defects in labeling. Any recall would divert managerial and financial resources
and could harm our reputation with customers. There can be no assurance that
there will not be product recalls in the future or that such recalls would not
have a material adverse effect on our business.
If we fail to comply with the FDAs Quality
System Regulation, our manufacturing could be delayed, and our product sales
and profitability could suffer.
Our manufacturing processes are required to comply with the FDAs
Quality System Regulation, which covers the procedures concerning (and
documentation of) the design, testing, production processes, controls, quality
assurance, labeling, packaging, storage and shipping of our devices. We also
are subject to state requirements and licenses applicable to manufacturers of
medical devices. In addition, we must engage in extensive recordkeeping and
reporting and must make available our manufacturing facilities and records for
periodic unscheduled inspections by governmental agencies, including the FDA,
state authorities and comparable agencies in other countries. Moreover, failure
to pass a Quality System Regulation inspection or to comply with these and
other applicable regulatory requirements could result in disruption of our
operations and manufacturing delays. Failure to take adequate corrective action
could result in, among other things, significant fines, suspension of
approvals, seizures or recalls of products, operating restrictions and criminal
prosecutions. We cannot assure you that the FDA or other governmental
authorities would agree with our interpretation of applicable regulatory
requirements or that we have in all instances fully complied with all
applicable requirements. Any failure to comply with applicable requirements
could adversely affect our product sales and profitability.
If the FDA
or another regulatory agency determines that we have promoted off-label use of
our products, we may be subject to various penalties, including civil or
criminal penalties, and the off-label use of our products may result in
injuries that lead to product liability suits, which could be costly to our
business.
The FDA and other regulatory agencies actively enforce regulations
prohibiting the promotion of a medical device for a use that has not been
cleared or approved by FDA. Use of a device outside its cleared or approved
indications is known as off-label use. Physicians may use our products
for off-label uses, as the FDA does not restrict or regulate a physicians
choice of treatment within the practice of medicine. However, if the FDA
or another regulatory agency determines that our promotional materials or
training constitutes promotion of an off-label use, it could request that we
modify our training or promotional materials or subject us to regulatory
enforcement actions, including the issuance of a warning letter, injunction,
seizure, civil fine and criminal penalties.
42
Although our policy is to
refrain from statements that could be considered off-label promotion of our
products, the FDA or another regulatory agency could disagree and conclude that
we have engaged in off-label promotion. In addition, the off-label use of
our products may increase the risk of injury to patients, and, in turn, the
risk of product liability claims. Product liability claims are expensive
to defend and could divert our managements attention and result in substantial
damage awards against us.
Audits or denials of our claims by government
agencies as well as failure to comply with governmental purchasing programs
pricing practices and/or contract requirements could reduce our revenues or
profits.
As part of our business
structure, we submit claims directly to and receive payments directly from the
Medicare and Medicaid programs, as well as other governmental payors, such as
military and veterans healthcare programs. Therefore, we are subject to
extensive government regulation, including requirements for maintaining certain
documentation to support our claims. Medicare contractors, Medicaid agencies
and government contracting agencies periodically conduct pre- and post-payment
review and other audits of claims, and are under increasing pressure to
scrutinize more closely healthcare claims and supporting documentation
generally. We periodically receive requests for documentation during
governmental audits of individual claims either on a pre-payment or
post-payment basis. As a result of such audits, we may be subject to requests for
refunds. We cannot assure you that such reviews and/or other audits of our
claims will not result in material delays in payment, material recoupments or
denials and fines or penalties, any of which could reduce our revenues or
profits.
Additionally, we participate in
the Federal governments supply schedule program for medical equipment, whereby
we contract with the government to supply certain of our products.
Participation in this program requires us to follow certain pricing practices
and other contract requirements. Failure to comply with such pricing practices
and/or other contract requirements could result in delays in payment, fines or
penalties, which could reduce our revenues or profits.
Changes in United States coverage and
reimbursement policies for our products by third-party payors or reductions in
reimbursement rates for our products could adversely affect our business and
results of operations.
Our products are sold to healthcare providers and
physicians who may receive reimbursement for the cost of our products from
private third-party payors and, to a lesser extent, from Medicare, Medicaid and
other governmental programs. In certain circumstances, such as for our
Regeneration products and the products sold through our OfficeCare program, we
submit claims to third-party payors for reimbursement. Our ability to sell our
products successfully will depend in part on the purchasing and practice
patterns of healthcare providers and physicians, who are influenced by cost
containment measures taken by third-party payors. Limitations or reductions in
third-party coverage and reimbursement of our products can have a material
adverse effect on our sales and profitability.
The United States Congress and state legislatures from
time-to-time consider reforms in the healthcare industry that may modify
reimbursement methodologies and practices, including controls on spending by
the Medicare and Medicaid programs. It is not clear at this time what
proposals, if any, will be adopted or, if adopted, what effect these proposals
would have on our business. Many private health insurance plans model their
coverage and reimbursement policies after Medicare policies. Therefore,
congressional or regulatory measures that reduce Medicare reimbursement rates
could cause private health insurance plans to reduce their reimbursement rates
for our products, which could have an adverse effect on our ability to sell our
products or cause our orthopedic professional customers to prescribe less
expensive products introduced by us and our competitors.
With the passage of the Medicare Prescription Drug,
Improvement, and Modernization Act of 2003, or Modernization Act, a number of
changes have been mandated that affect Medicare payment methodology and
conditions for coverage for our orthotic devices and durable medical equipment,
including our bone growth stimulators. These changes include a freeze in
reimbursement levels for certain medical devices from 2004 through 2008,
competitive bidding requirements, new clinical conditions for payment and
quality standards. The changes affect our products generally, although specific
products may be affected by some but not all of the Modernization Acts
provisions. CMS has proposed, for instance, that our Class III bone growth
stimulator devices be subject to the freeze in reimbursement levels for 2007
and 2008. If finalized, Class III devices such as our bone growth stimulator
product would not receive an increase in reimbursement levels under Medicare. Class
III bone growth stimulator devices, however, are not subject to competitive
bidding. The Modernization Act, however, does subject off-the-shelf orthotic
devices to competitive bidding. The Modernization Act requires competitive
bidding to be implemented in phases, with the initial phase now scheduled to
begin on July 1, 2008. The bidding process for this initial phase of
competitive bidding closed on September 25, 2007. Under competitive bidding,
Medicare will change its approach to reimbursing certain items and services of
durable medical equipment, orthotics, prosthetics and supplies covered by
Medicare from the current fee schedule amount to an amount established through
a bidding process between the government and suppliers. Competitive bidding may
reduce the number of suppliers providing certain items and
43
services to Medicare beneficiaries and the amounts paid
for such items and services. Also, Medicare payments in regions not subject to
competitive bidding may be reduced using payment information from regions
subject to competitive bidding. Any payment reductions or the inclusion of
certain of our orthotic devices in competitive bidding, in addition to the
other changes to Medicare reimbursement and standards contained in the Modernization
Act, could have a material adverse effect on our results of operations.
The Centers for Medicare and Medicaid Services, or CMS,
released its final regulations regarding the implementation of competitive
bidding on April 2, 2007. The final regulations indicate, among other things,
how CMS will determine which products and which metropolitan statistical areas
of the United States will be subject to competitive bidding. The final
regulations also describe how CMS plans to award contracts and how it will
evaluate bids and set payment rates. In conjunction with issuing its final
regulations, CMS announced the ten areas of the United States in which the
initial phase of competitive bidding will be implemented, as well as the
product categories subject to the initial phase. CMS did not select
off-the-shelf orthotics as a product category for the initial phase, although
these products could be made subject to competitive bidding during future
rounds of the program. The regulation also includes a new definition of off-the-shelf
orthotics, so that the category will include only orthotics that require
minimal self-adjustment for appropriate use and do not require expertise in
trimming, bending, molding, assembling, or customizing to fit the individual. CMS further defines minimal self-adjustment
to mean adjustments that the beneficiary, caretaker for the beneficiary, or
supplier of the device can perform without the assistance of a certified
orthotist, or an individual who has specialized training. CMS also deferred for future rulemaking any
policy on applying the competitive bidding payment rate to areas not selected
for competitive bidding. Despite the issuance of final regulations on
competitive bidding, significant uncertainty remains as to how the competitive
bidding program will be implemented and whether any of our products will be
made subject to competitive bidding during future rounds of the program. At
this time, therefore, we do not have sufficient details to assess the impact
that competitive bidding would have on our business.
In addition, CMS finalized its interim final regulation
implementing inherent reasonableness authority. The final regulation went
into effect on February 13, 2006 and essentially kept in place policies
first announced in 2002 in the earlier interim final regulation. The regulation
allows the agency and its contractors to make adjustments to payment amounts
for certain items and services covered by Medicare when the existing payment
amount is determined to be grossly excessive or grossly deficient. The
regulation lists factors that may be used to determine whether an existing
reimbursement rate is grossly excessive or grossly deficient and to determine
what is a realistic and equitable payment amount. Also, under the regulation, a
payment amount will not be considered grossly excessive or grossly deficient if
an overall payment adjustment of less than fifteen percent would be necessary
to produce a realistic and equitable payment amount. The Modernization Act
clarified that the use of inherent reasonableness authority is precluded for
devices provided under competitive bidding. When using the inherent
reasonableness authority, CMS may reduce reimbursement levels for certain items
and services, which could have a material adverse effect on our results of
operations.
44
We cannot assure you that third-party coverage or
reimbursement for our products will continue to be available or at what rate
such products will be reimbursed. Failure by users of our products to obtain
sufficient coverage and reimbursement from third-party payors for our products
or adverse changes in governmental and private payors policies toward coverage
and reimbursement for our products could have a material adverse effect on our
results of operations.
Changes in international
regulations regarding coverage and reimbursement for our products could
adversely affect our business and results of operations.
Similar to our domestic business, our success in international
markets also depends upon coverage and reimbursement of our products through
government-sponsored healthcare payment systems and third-party payors, the
portion of cost subject to reimbursement, and the cost allocation between the
patient and government-sponsored healthcare payment systems and third-party
payors. Coverage and reimbursement practices vary significantly by country,
with certain countries requiring products to undergo a lengthy regulatory
review in order to be eligible for third-party coverage and reimbursement. In
addition, healthcare cost containment efforts similar to those that we face in
the United States are prevalent in many of the foreign countries in which our
products are sold, and these efforts are expected to continue in the future,
possibly resulting in the adoption of more stringent standards. Any
developments in our foreign markets that eliminate or reduce reimbursement
rates for our products could have an adverse effect on our ability to sell our
products or cause our orthopedic professional customers to use less expensive
products in these markets.
Medicare laws mandating new supplier quality
standards and conditions for coverage could adversely impact our business.
Medicare regulations require entities or individuals
submitting claims and receiving payment to obtain a supplier number, which in
turn is predicated on compliance with a number of supplier standards. Under the
Modernization Act, any entity or individual that bills Medicare for durable
medical equipment, such as bone growth stimulators and orthotics and that has a
supplier number will also be subject to new quality standards as a condition of
receiving payment from the Medicare program. On August 14, 2006, CMS finalized
its supplier quality standards, and in November 2006, CMS published a list of
recognized independent accreditation organizations that may accredit suppliers
as meeting the quality standards. We were required to become accredited to
continue to bill Medicare as a supplier. We have completed the process of
becoming accredited.
The final quality standards include business-related
standards, such as financial and human resources management standards, which
are applicable to all durable medical equipment, orthotics and prosthetics
suppliers. The final quality standards also contain certain product-specific
standards, including several standards related to customized orthotics
products, which focus on product specialization and service standards for such
items. The Modernization Act also authorizes CMS to establish clinical
conditions for payment for durable medical equipment, including establishing
types or classes of covered items that require a prescription and a
face-to-face examination of the individual by a physician or practitioner. CMS
has proposed to expand the face-to-face visit requirement for clinical
conditions of coverage to prosthetics, orthotics and supplies (POS), because
the agency believes that items of POS require the same level of medical
intervention and skill as durable medical equipment. These new supplier quality
standards and proposed clinical conditions for payment could affect our ability
to bill Medicare, could limit or reduce the number of individuals who can fit,
sell or provide our products and could restrict coverage for our products.
Healthcare reform, managed care and buying
groups have put downward pressure on the prices of our products.
The development of managed care programs in which the
providers contract to provide comprehensive healthcare to a patient population
at a fixed cost per person (referred to as capitation) has put pressure on, and
is expected to continue to cause, healthcare providers to lower costs. One
result has been, and is expected to continue to be, a shift toward lower-priced
products, and any such shift in our product mix to lower margin, off-the-shelf
products could have an adverse impact on our operating results. For example, in
our rigid knee-bracing segment, we and many of our competitors are offering
lower-priced, off-the-shelf products in response to managed care customers.
A further result of managed care and the related
pressure on costs has been the advent of buying groups in the United States. Such
buying groups enter into preferred supplier arrangements with one or more
manufacturers of orthopedic or other medical products in return for price
discounts. The extent to which such buying groups are able to obtain compliance
by their members with such preferred supplier agreements varies considerably
depending on the particular buying groups. In response to the organization of
45
new buying groups, we have entered into national
contracts with selected groups and believe that the high levels of product
sales to such groups and the opportunity for increased market share have the
potential to offset the financial impact of discounting. We believe that our
ability to maintain our existing arrangements will be important to our future
success and the growth of our revenues. In addition, we may not be able to
obtain new preferred supplier commitments for major buying groups, in which
case we could lose significant potential sales, to the extent these groups are
able to command a high level of compliance by their members. On the other hand,
if we receive preferred supplier commitments from particular groups which do
not deliver high levels of compliance, we may not be able to offset the
negative impact of lower per unit prices or lower margins with any increases in
unit sales or in market share.
In international markets, we have experienced downward
pressure on product pricing and other effects of healthcare reform similar to
that which we have experienced in the United States. We expect healthcare
reform and managed care to continue to develop in our primary international
markets, which we expect will result in further downward pressure in product
pricing. The timing and effects on us of healthcare reform and the development
of managed care in international markets cannot currently be predicted.
Proposed laws that would limit the types of
orthopedic professionals who can fit, sell or seek reimbursement for our
products could, if adopted, adversely affect our business.
In response to pressure from certain groups (mostly
orthopedic practitioners), the United States Congress and state legislatures
have periodically considered proposals that limit the types of orthopedic
professionals who can fit or sell our orthotic device products or who can seek
reimbursement for them. Several states have adopted legislation which imposes
certification or licensing requirements on the measuring, fitting and adjusting
of certain orthotic devices. Although some of these state laws exempt
manufacturers representatives, other states laws subject the activities of
such representatives to certification or licensing requirements. Additional
states may be considering similar legislation. Such laws could limit our
potential customers in those jurisdictions in which such legislation or
regulations are enacted. We may not be successful in opposing the adoption of
such legislation or regulations and, therefore, such laws could have a material
adverse effect on our business.
In addition, efforts have been made to establish
similar requirements at the federal level for the Medicare program. For
example, in 2000, Congress passed the Medicare, Medicaid, and SCHIP Benefits
Improvement and Protection Act of 2000 (BIPA). BIPA contained a provision
requiring, as a condition for payment by the Medicare program, that certain
certification or licensing requirements be met for individuals and suppliers
furnishing certain, but not all, custom-fabricated orthotic devices. Although
CMS has not implemented this requirement, we cannot predict the effect of
implementation of BIPA or implementation of other such laws will have on our
business.
We could be subject to governmental
investigations under various healthcare fraud and abuse laws with respect to
our business arrangements with prescribing physicians and other health care
professionals.
We
are directly, or indirectly through our clients, subject to various federal and
state laws pertaining to health care fraud and abuse. These laws, which
directly or indirectly affect our ability to operate our business include, but
are not limited to, the following:
the federal Anti-Kickback Statute, which
prohibits persons from knowingly and willfully soliciting, offering, receiving
or providing remuneration, directly or indirectly, in cash or in kind, to
induce either the referral of an individual, or furnishing or arranging for a
good or service, for which payment may be made under federal healthcare
programs, such as Medicare and Medicaid, Veterans Administration health
programs, and TRICARE;
the federal False Claims Act, which imposes
civil and criminal liability on individuals and entities who submit, or cause
to be submitted, false or fraudulent claims for payment to the government;
the federal Health Insurance Portability and
Accountability Act of 1996, or HIPAA, which prohibits executing a scheme to
defraud any healthcare benefit program;
the federal False Statements Statute, which
prohibits knowingly and willfully falsifying, concealing or covering up a
material fact or making any materially false statement in connection with the
delivery of or payment for healthcare benefits, items or services;
46
the federal physician self-referral prohibition,
commonly known as the Stark Law, which, in the absence of a statutory or
regulatory exception, prohibits the referral of Medicare patients by a
physician to an entity for the provision of certain designated healthcare
services, if the physician or a member of the physicians immediate family has
a direct or indirect financial relationship, including an ownership interest
in, or a compensation arrangement with, the entity and also prohibits that
entity from submitting a bill to a federal payor for services rendered pursuant
to a prohibited referral; and
state law equivalents to the Anti-Kickback Law
and the Stark Law, some of which may apply even more broadly than their federal
counterparts because they are not limited to government reimbursed items and
include items or services reimbursed by any payor.
The federal government has significantly increased investigations of
medical device manufacturers with regard to alleged kickbacks and other forms
of remuneration to physicians who use and prescribe their products. Such
investigations often arise based on allegations of violations of the Federal Anti-Kickback
Statute. Recently, the United States Attorneys Office has entered into
Deferred Prosecution Agreements (DPA) with four of five large companies in the
orthopedics industry providing for settlement of alleged criminal violations of
Federal Anti-Kickback Statute. The DPAs require significant remediation and
cooperation with federal authorities and continued compliance with the relevant
federal statutes, including, the appointment of an independent monitor selected
by the government to evaluate and monitor each companys compliance with the
DPA, the strengthening of the internal corporate compliance function, specific
limitations on and approval procedures for all consulting agreements with
healthcare professionals and the entry into five year Corporate Integrity
Agreements.
We have numerous business arrangements with physicians and other
potential referral sources, including but not limited to arrangements whereby
physicians serve as consultants to DJO or serve as speakers for training,
educational and marketing programs provided by DJO. Many of these arrangements
involve payment for services or coverage of, or reimbursement for, common
business expenses (such as meals, travel and accommodations) associated with
the arrangement. Governmental authorities could attempt to take the position
that one or more of these arrangements, or the payments or other remuneration
provided thereunder, violates the Anti-Kickback Statute, the Stark Law or
similar state laws. In addition, if any of our past or present arrangements
were found to violate such laws, federal authorities or whistleblowers could
take the position that our submission of claims for payment to a federal health
care program for items or services realized as a result of such violations also
violate the federal False Claims Act.
If our past or present operations are found to be in violation of any of
the laws described above or the other similar governmental regulations to which
we or our customers are subject, we may be subject to the applicable penalty
associated with the violation, including civil and criminal penalties, damages,
fines, exclusion from the Medicare and Medicaid programs and the curtailment or
restructuring of our operations. Similarly, if the physicians or other
providers or entities with whom we do business are found to be non-compliant
with applicable laws, they may be subject to sanctions, which could also have a
negative impact on us. Any penalties, damages, fines, curtailment or
restructuring of our operations could adversely affect our ability to operate
our business and our financial results. The risk of our being found in
violation of these laws is increased by the fact that many of them have not
been fully interpreted by the regulatory authorities or the courts, and their provisions
are open to a variety of interpretations, and additional legal or regulatory
change. Any action against us for violation of these laws, even if we
successfully defend against it, could cause us to incur significant legal
expenses, divert our managements attention from the operation of our business
and damage our reputation.
47
Risks Related to our Debt
We substantially increased our indebtedness in connection with the
Aircast acquisition.
In order to finance the purchase
price of the Aircast acquisition and to cover related acquisition costs as well
as repay our existing bank debt, we entered into a new credit facility on April
7, 2006, consisting of a term loan of $350 million which was fully drawn at
closing and up to $50 million available under a revolving credit facility. Following
the transaction, we are a much more highly leveraged company, and our
flexibility in conducting business operations and continuing to invest in
growth opportunities could be reduced as a result of this increased
indebtedness. Our increased indebtedness could limit our ability to obtain
future additional financing we may need to fund future working capital, capital
expenditures, product development or acquisitions. As of September 29, 2007,
the balance outstanding under the term loan was $285.5 million and $49.2
million was available under the revolving credit facility, net of outstanding
letters of credit.
Our debt agreements contain operating and
financial restrictions, which restrict our business and financing activities.
The operating and financial restrictions and covenants
in our credit agreement and any future financing agreements may adversely
affect our ability to finance future operations, meet our capital needs or
engage in our business activities. Currently, our existing credit agreement
restricts our ability to:
incur additional
indebtedness;
issue redeemable
equity interests and preferred equity interests;
pay dividends or make
distributions, repurchase equity interests or make other restricted payments;
redeem subordinated
indebtedness;
create liens;
enter into certain
transactions with affiliates;
make investments;
sell assets; or
enter into mergers or
consolidations.
With respect to mergers or acquisitions, our credit
agreement limits our ability to finance acquisitions through additional
borrowings. In addition, our credit agreement prohibits us from acquiring
assets or the equity of another company unless:
we are not in default under the credit
agreement;
after giving pro forma effect to the
transaction, we remain in compliance with the financial covenants contained in
the credit agreement;
if the acquisition price is greater than $15
million, the company we are acquiring has positive EBITDA;
the acquisition price is less than $75 million
individually and less than $200 million in the aggregate with all other
permitted acquisitions consummated during the term of the credit agreement; and
if the acquisition involves assets outside the
United States, the acquisition price is less than $40 million in the aggregate
with all other permitted acquisitions consummated outside the United States
during the term of the agreement.
48
Restrictions contained in our credit agreement could:
limit our ability to
plan for or react to market conditions or meet capital needs or otherwise
restrict our activities or business plans; and
adversely affect our
ability to finance our operations, acquisitions, investments or strategic
alliances or other capital needs or to engage in other business activities that
would be in our interest.
A breach of any of these covenants, ratios, tests or
other restrictions could result in an event of default under the credit
agreement. Upon the occurrence of an event of default under the credit
agreement, the lenders could elect to declare all amounts outstanding under the
credit agreement, together with accrued interest, to be immediately due and payable.
If we were unable to repay those amounts, the lenders could proceed against the
collateral granted to them to secure such indebtedness. If the lenders under
the credit agreement accelerate the payment of the indebtedness, there can be
no assurance that our assets would be sufficient to repay in full such
indebtedness and our other indebtedness.
We may not be able to generate
sufficient cash to service our indebtedness, which could require us to reduce
our expenditures, sell assets, restructure our indebtedness or seek additional
equity capital.
We may not have sufficient cash to service our
indebtedness. Our ability to satisfy our obligations will depend upon, among
other things:
our future financial
and operating performance, which will be affected by prevailing economic
conditions and financial, business, regulatory and other factors, many of which
are beyond our control; and
the future
availability of borrowings under our revolving credit facility or any successor
facility, the availability of which depends or may depend on, among other
things, our complying with covenants in the credit agreement.
If we cannot service our indebtedness, we will be forced to take actions
such as reducing or delaying acquisitions, investments, strategic alliances
and/or capital expenditures, selling assets, restructuring or refinancing our
indebtedness, or seeking additional equity capital or bankruptcy protection. We
cannot assure you that any of these remedies can be effected on satisfactory
terms, if at all. In addition, the terms of existing or future debt agreements
may restrict us from adopting any of these alternatives.
49
ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE
OF PROCEEDS
None.
ITEM 3.
DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS
None.
ITEM 5.
OTHER INFORMATION
None.
50
ITEM 6.
EXHIBITS
(a) Exhibits
2.1
|
|
Agreement
and Plan of Merger among ReAble Therapeutics Finance LLC, Reaction
Acquisition Merger Sub, Inc. and DJO Incorporated, dated July 15, 2007
(Incorporated by reference to the Registrants Report on Form 8-K filed on
July 16, 2007)
|
|
|
|
3.1
|
|
Amended
and Restated Certificate of Incorporation of the Registrant (Incorporated by
reference to Exhibit 4.1 to the Registration Statement of the Registrant on
Form S-8 (Reg. No. 333-73966))
|
|
|
|
3.2
|
|
Certificate
of Amendment of Amended and Restated Certificate of Incorporation of the Registrant
(Incorporated by reference to the Registration Statement of the Registrant on
Form S-3 (Reg. No. 333-111465))
|
|
|
|
3.3
|
|
Amended
and Restated By-laws of the Registrant (Incorporated by reference to Exhibit
4.2 to the Registration Statement of the Registrant on Form S-8 (Reg. No.
333-73966))
|
|
|
|
3.4
|
|
Certificate of Ownership and Merger of DJO Merger Sub, Inc. with and
into dj Orthopedics, Inc. dated May 26, 2006 (Incorporated by reference to
the Registrants Report on Form 8-K filed on July 1, 2006)
|
|
|
|
10.1
|
|
Form
of Change in Control Severance Agreement entered into with Chief Executive
Officer (Incorporated by reference to the Registrants Report on Form 8-K
filed on September 25, 2007)
|
|
|
|
10.2
|
|
Form
of Change in Control Severance Agreement entered into with other Named
Executive Officers (Incorporated by reference to the Registrants Report on
Form 8-K filed on September 25, 2007)
|
|
|
|
31.1+
|
|
Certification
of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of
the Securities Exchange Act, as amended
|
|
|
|
31.2+
|
|
Certification
of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of
the Securities Exchange Act, as amended
|
|
|
|
32.0+*
|
|
Certification
of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|
+
|
|
Filed
herewith
|
|
|
|
*
|
|
This
certification is being furnished solely to accompany this quarterly report
pursuant to 18 U.S.C. § 1350, and is not being filed for purposes of Section
18 of the Securities Exchange Act of 1934, as amended, and is not to be
incorporated by reference into any filing of DJO Incorporated, whether made
before or after the date hereof, regardless of any general incorporation
language in such filing.
|
51