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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d) of
The Securities Exchange Act of 1934
For the fiscal year ended December 31, 1999 Commission File Number 0-19278
OSTEOTECH, INC.
(Exact name of registrant as specified in its charter)
Delaware 13-13357370
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
51 James Way, Eatontown, New Jersey 07724
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (732) 542-2800
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock - $.01 Par Value
(Title of class)
Preferred Stock Purchase Rights
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value of the Common Stock, par value $.01 per share,
held by non-affiliates based upon the reported last sale price of the Common
Stock on March 20, 2000 was approximately $226,475,139.
As of March 20, 2000, there were 14,225,628 shares of Common Stock, par
value $.01 per share, outstanding.
The Index to Exhibits appears on page E-1.
Documents Incorporated by Reference
The registrant's definitive 1999 Proxy Statement which will be filed
pursuant to Regulation 14A is incorporated by reference into Part III of this
Annual Report on Form 10-K.
OSTEOTECH, INC.
1999 Form 10-K Annual Report
TABLE OF CONTENTS
Section Page
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PART I 1
Item 1. Business 1
Company Overview 1
Strategy 3
Business Summary 5
Allograft Bone Tissue Processing 7
Expansion of Allograft Bone Tissue Business in Europe 9
Other 10
Quality Assurance 11
Clients 12
Education and Marketing 13
Government Regulations 13
Research and Development 15
Competition 15
Environmental Matters 21
Patents and Proprietary Rights 21
Product Liability and Insurance 21
Employees 22
Item 2. Properties 22
Item 3. Legal Proceedings 23
Item 4. Submission of Matters to a Vote of Security Holders 27
PART II 28
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters 28
Item 6. Selected Financial Data 29
Item 7. Management's Discussion And Analysis Of Financial
Condition And Results Of Operations 30
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 40
Item 8. Financial Statements and Supplementary Data 40
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 40
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PART III 41
Item 10. Directors and Executive Officers of the Registrant 41
Item 11. Executive Compensation 41
Item 12. Security Ownership of Certain Beneficial Owners and Management 41
Item 13. Certain Relationships and Related Transactions 41
PART IV 42
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 42
The following trademarks and service marks appear in this Annual Report:
PolyActive(TM) and bio-d(TM) Threaded Cortical Bone Dowel are trademarks and
Osteotech(R), Grafton(R) Demineralized Bone Matrix (DBM), Versalok(R) Low Back
Fixation System (Versalok(R) System), and Allogard(R) Packaging are registered
trademarks of Osteotech, Inc.; D-MIN(sm) is a service mark of Osteotech, Inc.;
LUBBOC(R) AND LADDEC(R) are registered trademarks of OST Developpement SA and
OsteoPure(TM) is a trademark of OST Developpement SA; Segmental Spinal
Correction System(TM) (SSCS) is a trademark of Heinrich C. Ulrich, K.G.
iii
PART I
Item 1. Business
Information contained throughout this Annual Report contains
"forward-looking statements" which can be identified by the use of
forward-looking terminology such as "believes," "expects," "may," "will,"
"should," or "anticipates" or the negative thereof or variations thereon or
comparable terminology, or by discussions of strategy. No assurance can be given
that the future results covered by the forward-looking statements will be
achieved. Some of the matters set forth in the "Risk Factors" section of this
Annual Report and elsewhere in this Annual Report constitute cautionary
statements identifying factors with respect to such forward-looking statements,
including certain risks and uncertainties, that could cause results to vary
materially from the future results indicated in such forward-looking statements.
Other factors could also cause actual results to vary materially from the future
results indicated in such forward-looking statements.
Company Overview
Osteotech, Inc. ("Osteotech") provides services and products primarily
focused in the repair and healing of the musculoskeletal system. These products
and services are primarily marketed to the orthopaedic, neurological,
oral/maxillofacial, dental and general surgery markets in the United States and
Europe. Based on our knowledge of the allograft bone tissue industry, we believe
that we are the world's largest processor and developer of human bone and bone
connective tissue ("allograft bone tissue") products. The allograft bone tissue
we process is procured by independent tissue banks primarily through the
donation of tissue from deceased human donors and is used for transplantation.
We have two primary operating segments:
o the Grafton(R) Demineralized Bone Matrix (DBM) Segment (the
"Grafton(R) DBM Segment"); and
o the Base Allograft Bone Tissue Segment (the "Base Tissue Segment").
All of our other products and services which do not meet the criteria to be
separately identified as a segment are aggregated under the category of "other".
In the Grafton(R) DBM Segment we process and market Grafton(R) DBM which is
distributed by our clients. Grafton(R) DBM is processed using our validated,
advanced proprietary demineralization process. When applied to cortical bone,
this process yields allograft bone tissue which has osteoinductive (the process
by which bone is induced to grow) and osteoconductive (the matrix provided by
allograft bone tissue into which the host bone can grow) capabilities greater
than currently available forms of mineralized allograft bone tissue.
In the Base Tissue Segment we process primarily mineralized weight-bearing
allograft bone tissue which is generally marketed and distributed by our
clients. In December, 1998, we introduced the bio-d(TM) Threaded Cortical Bone
Dowel for posterior spinal fusion procedures and in August, 1999, we introduced
the bio-d(TM) Threaded Cortical Bone Dowel for anterior spinal fusion
procedures. Both of these products are processed in the Base Tissue Segment.
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These bone dowels are distributed by our clients, but unlike other tissue
processed in this segment, we market the bio-d(TM) Threaded Cortical Bone Dowel.
We have leveraged our expertise in musculoskeletal tissue technology to
develop innovative processes and proprietary products that are widely used by
orthopaedic, spinal, neurological and oral/maxillofacial surgeons for spinal
fusion procedures, to repair and replace bone loss caused by trauma or certain
disease states, to augment prosthetic implant procedures and to replace damaged
ligaments and tendons.
In addition to our Grafton(R) DBM Segment and Base Tissue Segment, we
provide ceramic and titanium plasma spray coating services and ceramic products
used as bone graft substitutes, to orthopaedic and dental implant manufacturers
through our operations based in Leiden, The Netherlands. We also market and
distribute metal spinal implant products, including Versalok(R) Low Back
Fixation System ("Versalok(R) System"), a lumbosacral spine fixation system with
an innovative polyaxial screw, and the Segmented Spinal Correction System(TM)
("SSCS"), a low profile, thoracolumbar pedicle screw and rod system featuring a
unique hinged screw that provides stabilization of the spine and allows for load
sharing between the spine and the implant system.
Through our acquisition of 90% of OST Developpement, SA ("OST") which was
completed in January, 1999, we also process, market and distribute both bovine
tissue products which are utilized as bone graft substitutes by surgeons,
primarily in Europe, Asia and the Middle East and human allograft bone tissue
grafts.
We estimate that the total bone graft market in the U.S. for 1999 was $533
million as compared to approximately $487 million in 1998. This market includes
allograft bone tissue procedures, synthetic graft substitutes and autograft bone
tissue procedures (transplant tissue harvested from the patient). We estimate
that the allograft bone tissue portion of the total bone graft market in the
U.S. grew 16% in 1999, to approximately $248 million. The allograft bone tissue
market is growing at a substantially faster rate than the general bone grafting
market, as allograft bone tissue is increasingly becoming an accepted surgical
alternative to autograft procedures. Autograft bone tissue often requires a
second surgical procedure to harvest bone from the patient's own body and,
therefore, exposes the patient to increased risk associated with blood loss,
infection and chronic pain. Increased use of allograft bone tissue is expected
to continue as physicians become increasingly educated about the benefits of
allograft bone tissue and concerns over disease transmission are diminished.
Moreover, allograft bone tissue is increasingly preferred for use in elderly
patients, who often lack sufficient harvestable bone.
Based upon our knowledge of the allograft bone tissue industry, we estimate
that we process about 40% of the allograft bone tissue donors in the U.S. We
believe that our strong market position is attributable to our proprietary
product line, our clients' national donor recovery programs, our large national
sales and marketing organization and the substantial investment we have made in
processing technology to ensure stringent standards and high quality control
which, combined with extensive donor screening and testing performed by our
clients, has virtually eliminated the risk of transmission of infectious agents.
2
Our clients pay us fees for our processing of the allograft bone tissue
that they procure. In the Grafton(R) DBM Segment, fees are paid on a per unit
basis for the Grafton(R) DBM products which we process. In the Base Tissue
Segment fees are paid on a per donor basis, except in the case of the bio-d(TM)
Threaded Cortical Bone Dowel, for which fees are paid on a per unit basis.
In the United States we process allograft bone tissue pursuant to contracts
with two large not-for-profit organizations, American Red Cross Tissue Services
("ARC") and Musculoskeletal Transplant Foundation ("MTF"). ARC and MTF are
responsible for donor procurement and the distribution of the allograft bone
tissue we process for them. Our contract with ARC expires in December, 2006 and
our contract with MTF expires in March, 2002. We also process allograft bone
tissue for several smaller tissue banks in Europe.
We market our proprietary allograft bone tissue products such as Grafton(R)
DBM and the bio-d(TM) Threaded Cortical Bone Dowel through independent agents
and direct field sales personnel. The non-proprietary products we process in our
Base Tissue Segment are marketed generally by our clients, primarily using
direct field personnel. Our products are gaining wide acceptance among surgeons
in a broad spectrum of orthopaedic procedures due to their flexibility, unique
handling characteristics and ability to enhance bone growth.
Revenues in our Grafton(R) DBM Segment increased 15 % to $45,136,000 in
1999 and revenues in our Base Tissue Segment increased 49 % to $25,751,000 in
1999. We expect that both our Grafton(R) DBM and Base Tissue Segments will
continue to be important contributors to the growth of our consolidated revenues
and profits in 2000, as processed allograft bone tissue forms continue to gain
increased acceptance.
Strategy
Overview
We intend to expand our business as follows:
o We intend to use our position as the leader in allograft bone tissue
processing and marketing to become a leading
orthopaedic/musculoskeletal company by bringing to market innovative
and cost-effective products.
o We will continue to educate the medical community and the general
public concerning the benefits of allograft bone tissue.
o We intend to use our strong research and development capabilities and
expertise in musculoskeletal science to:
* enhance the performance of our existing allograft bone tissue
forms;
3
* expand the safety claims of these tissue forms using proprietary
processes; and
* continue to introduce new tissue forms with enhanced performance
profiles.
o We intend to utilize our marketing and distribution network to enhance
the market share of both our allograft and non-allograft product
lines.
Grafton(R) DBM Segment
In the near term, we will continue to focus on marketing Grafton(R) DBM
through our direct marketing organization, our national agent network and
medical education programs. We will support these programs through prospective
clinical and outcome studies to further validate the performance, utility and
safety of Osteotech processed tissue. We will expand into new market segments,
such as the dental market, and into new geographic markets, including several
European countries. We also will continue to expand the Grafton(R) DBM product
line by adding additional forms.
We expect to continue expansion of sales of Grafton(R) DBM through:
o increasing our sales force to allow for expanded market coverage and
selling time with the surgeons;
o surgeon identified new procedures;
o surgeon oriented medical education programs;
o in-depth sales agent training programs;
o published clinical support;
o product line extensions;
o global expansion with an initial European focus; and
o the pursuit of opportunities created by the expected high growth in
spinal, trauma and total joint revisions.
Base Tissue Segment
We expect to achieve continued growth in the Base Tissue Segment through:
o introduction of additional allograft bone tissue grafts with
application in spinal and other surgical procedures;
o introduction of new packaging and a new validated viral inactivation
claim;
o global expansion of base allograft bone tissue grafts and tissue
processing business in selected countries, initially in Europe;
o development of proprietary tissue processing technology through
internal research;
4
o development of new allograft bone tissue products with enhanced
performance profiles; and
o retention of additional bone tissue processing clients and sources of
bone tissue.
Other
Biomaterials and Non-Allograft Bone Tissue Spinal Implant Products
Our strategy in our biomaterials and non-allograft bone tissue spinal
implant product business lines is to:
o continue focusing our European non-allograft bone tissue operations to
capture available opportunities for ceramic coating services and
ceramic products;
o capitalize on high-growth opportunities in the U.S. spinal products
market with innovative non-allograft bone tissue products; and
o enter into agreements with other health care product companies to
utilize our technology and expertise in the non-allograft bone tissue
area for the development and manufacture of proprietary product
components.
Spinal Strategy
Our strategy consists of two primary components involving our Grafton(R)
DBM and Base Tissue Segments and our non-allograft bone tissue spinal implant
product line of business:
o continue the U.S. market penetration of the SSCS(TM) System, and the
Versalok(R) System; and
o market our bio-d(TM) Threaded Cortical Bone Dowel and our
non-allograft bone tissue spinal implant products together with our
Grafton(R) DBM through our extensive sales agency network.
Our intention is to educate surgeons to use Grafton(R) DBM, our bio-d(TM)
Threaded Cortical Bone Dowel and our metal spinal stabilization systems, either
alone or in conjunction with each other. Spinal implant products, both allograft
and non-allograft, which we add to our product mix in the future will be
included in this strategy.
Business Summary
Bone and related tissue transplants are often necessary to correct
deformities and repair and reconstruct defects caused by congenital
malformations, trauma, infections, cancer and other disease conditions. For
certain procedures, autograft bone tissue can be acquired from another part of
the patient's skeleton by an additional operative procedure. For a large number
of procedures
5
for which autograft bone tissue is not feasible or desirable, allograft bone
tissue previously obtained from cadavers or surgical patient donors can be
utilized. Allograft bone tissue is procured primarily from cadavers by a network
of organ procurement organizations and/or directly by tissue banks.
We process allograft bone tissue for our clients in both our Grafton(R) DBM
and Base Tissue Segments. Once processed, the allograft bone tissue is returned
to these clients for distribution to surgeons and medical institutions. The
surgeons and medical institutions pay the fees established and charged by our
clients. The surgeons and medical institutions in turn charge their patients for
the various aspects of transplant surgery performed by them, including standard
charges established by the surgeon or institution for each unit of processed
allograft bone tissue used. The cost to the patient for the processed allograft
bone tissue is generally reimbursable by medical insurance carriers as part of
the overall cost of the procedure.
In both our Grafton(R) DBM and Base Tissue Segments, our processing yields
a wide array of freeze-dried, frozen and demineralized allograft bone tissue
that is used by orthopaedic, neurological, plastic, dental, periodontal and
oral/maxillofacial surgeons for:
o spinal fusion procedures;
o repair and replacement of bone loss caused by trauma or certain
disease states;
o augmentation of prosthetic implant procedures; and
o replacement of damaged ligaments and tendons.
We believe our processing methods, our clients' tissue recovery techniques
and the multiple screening and testing procedures employed, virtually eliminate
the risk of transmission of infectious agents by allograft bone tissue we
process.
In our Grafton(R) DBM Segment, we have a validated viral inactivation
process for our demineralized bone tissue. Studies completed by an independent
testing laboratory specializing in viral inactivation studies demonstrated that
this proprietary demineralization process can virtually inactivate and eliminate
viruses such as HIV, hepatitis B, hepatitis C, cytomeglia and polio. To our
knowledge, we are the only processor of allograft tissue to have such a
validated process.
We expect to begin to implement additional proprietary processing
technologies that, once fully implemented, will enable us to expand our viral
inactivation claims to include the mineralized weight-bearing allograft bone
tissue processed in our Base Tissue Segment.
We believe that allograft bone tissue transplantation is one of the fastest
growing areas of transplant medicine. We estimate that in 1999 there were
approximately 520,000 grafting procedures in the U.S. for which allograft bone
tissue could have been utilized, representing an estimated available allograft
bone tissue market of approximately $533 million. We estimate that the allograft
bone tissue portion of the total bone graft market in the U.S. increased 16% in
1999
6
to $248 million. Industry data indicates that the musculoskeletal surgical
market is growing. We believe this will expand the potential market for
allograft bone tissue in both our Grafton(R) DBM and our Base Tissue Segments,
due to a number of factors, including:
o increasing frequency of surgical procedures that incorporate bone
grafting techniques;
o the desire by surgeons to avoid the additional procedure needed to
acquire autograft bone tissue, which often increases operating time
and risks such as excessive blood loss, infection and chronic pain;
o a reduction in the possibility of transmission of infectious agents
and toxicity because of improved allograft bone tissue processing
techniques and donor screening;
o increased awareness by, and training of, the medical community with
respect to the use of allograft bone tissue;
o an increasing number of musculoskeletal surgical procedures which
require more bone tissue than can be obtained through autograft
procedures;
o an increase in the number of patients who do not possess the quality
of bone tissue required for autograft procedures as a result of the
general aging of the population; and
o an increase in the availability of allograft bone tissue due to an
increase in bone tissue donations and improved recovery and processing
techniques.
Allograft bone tissue is employed in surgical procedures because of its
biologic and biomechanical properties. Bone from various locations in the body
can be processed to yield either dense cortical bone, porous cancellous bone or
units comprised of both cortical and cancellous bone. Cortical bone, the thick
outer portion of bone, provides biomechanical strength which allows the bone to
be weight-bearing, and therefore, is commonly used in surgery in the spine and
in the extremities and in other procedures requiring strong transplant material.
Cancellous bone, the spongy portion of bone tissue, is preferable for surgical
procedures, or aspects thereof, in which rapid penetration of new bone into the
pores of the transplant (a process known as osteoconduction) is desirable but
where weight-bearing strength is not paramount. Therefore, cancellous bone is
often used to fill smaller areas of bone loss and to augment more extensive
reconstructive procedures including knee and hip replacements. Most procedures
using allograft bone tissue, however, employ a combination of cortical and
cancellous bone in a variety of forms, shapes and sizes.
Allograft Bone Tissue Processing
Grafton(R) DBM Segment
In addition to the proprietary procedures which are particular to the
processing of Grafton(R) DBM, the technologies used in processing allograft bone
tissue in the Base Tissue
7
Segment are also used in processing Grafton(R) DBM. The methods used to process
Grafton(R) DBM have been validated as a viral inactivation process. This
proprietary process can virtually inactivate and eliminate viruses such as HIV,
hepatitis C, cytomeglia and polio. To our knowledge, we are the only processor
of allograft tissue that has such a validated process.
We have developed an advanced proprietary demineralization process for
cortical bone which yields Grafton(R) DBM -- a form of allograft bone tissue
which can be used to aid in the formation of new bone through the processes of
osteoconduction and osteoinduction. Osteoconduction is the process of providing
the matrix into which bone will grow and osteoinduction is the process by which
bone is induced to grow. Cortical bone is believed to be the principal reservoir
for various factors which are instrumental in osteoinduction. These biological
properties of cortical bone, however, are inhibited by the bone's structure and
various minerals, lipids and other substances comprising the bone. Our process
removes these inhibiting factors.
In our Grafton(R) DBM Segment we currently process four forms of Grafton(R)
DBM:
o Grafton(R) DBM Gel -- a gel-like substance with unique handling
characteristics which are useful in performing bone graft procedures
as part of spinal fusions, joint replacements and repairs of osseous
defects;
o Grafton(R) DBM Putty -- a moldable putty-like graft of entangled
fibers of demineralized bone, which is mixed easily with marrow and
other grafts, minimizes migration, can be molded easily and retains
its shape even in larger defects;
o Grafton(R) DBM Flex -- a flexible "pressed fiber" form of
demineralized bone processed by utilizing a pressed fiber technique,
providing surgeons a pliable form of bone graft. It is available in
square or strip forms, conforms to the body's natural anatomy and can
be easily cut for precise adaptation to host bone; and
o Grafton(R) DBM Crunch -- a ready to use mixture of demineralized bone
fibers and demineralized cortical cubes which packs and locks into
bone defects, providing structure and support to the graft site.
We expect that wider distribution and deeper market penetration of
Grafton(R) DBM utilizing our national network of independent agents in
combination with our direct marketing force, will drive the further growth in
the use of Grafton(R) DBM processed allograft bone tissue. Through December 31,
1999, Grafton(R) DBM forms had been utilized in over 300,000 procedures.
Base Tissue Segment
Unlike organs which require transplantation within hours of recovery,
allograft bone tissue generally goes through a processing phase in which it is
cleaned, cut into different sizes and forms for specific surgical procedures,
preserved, packaged and labeled. We process our clients'
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tissue utilizing technology we have developed which yields a wide array of
freeze-dried, frozen, demineralized bone and connective tissue products. Frozen
tissues include whole bones and major sections thereof, bone segments, tendons
and ligaments. Freeze-dried bone tissues include various wedges, strips, struts,
dowels, cancellous cortical chips, blocks, strips and ribs.
The suitability of an allograft bone tissue is partly dependent on the
methods and conditions used in the processing of the tissue. Processing includes
the removal of certain portions of the allograft bone tissue in a manner which
enables the tissue to maintain as much of the native biological characteristics
relating to the use of such tissue in bone grafting procedures as possible. To
provide suitable allografts, we have developed techniques that minimize the use
of chemicals and procedures that might render the allograft bone tissue less
suitable for use as a graft. We process allograft bone tissue in a
microbially-controlled environment, substantially cleaner than that of a typical
hospital operating room, created through the use of advanced air filtration,
water distillation and mineral control systems and other "clean room"
techniques. We believe that our use of such clean room techniques, a controlled
environment, in-line disinfection and other technologies preserve the properties
of the tissues that make them suitable as grafts and address the medical
community's and the general public's perceptions and concerns regarding the
possible transmission of infectious disease and toxicity. Once processed using
our current processing methods, freeze-dried bone tissues may be stored for up
to three years and frozen bone tissues may be stored for up to five years before
they must be used or discarded.
In December, 1998 we began a region-by-region roll-out of our new bio-d(TM)
Threaded Cortical Bone Dowel for spinal fusion. The bio-d(TM) Threaded Cortical
Bone Dowel has been tested and shown to withstand loads comparable to those
reported in the lumbar spine, and its inherent natural properties will permit
incorporation and remodeling. Additionally, the hollowed center of this bone
dowel can be packed with Grafton(R) DBM. Therefore, the dowel will provide
structural support and with Grafton(R) DBM added, will also aid in the fusion
process by inducing bone growth. During the year 2000, we expect to introduce
two and possibly three additional allograft bone tissue products for spinal
surgical procedures.
Expansion of Allograft Bone Tissue Business in Europe
In January, 1999, we completed the acquisition of 90% of OST , which is
located in Clermont-Ferrand, France. OST manufactures and markets bovine tissue
products for use as bone grafts in orthopaedic and dental surgery. These
products, marketed under the trade names of LUBBOC(R) and LADDEC(R), were
developed to address the shortage of safe and effective human allograft bone
grafts in France and other countries outside the United States. In the future,
as a complement to our human allograft tissue products, OST will continue to
market these products in certain markets.
We are expanding operations and staff at OST as we begin to use it as a
base for developing our human allograft tissue graft and tissue processing
business in Europe. OST has adapted its proprietary LUBBOC(R) and LADDEC(R)
processing technology to develop the OsteoPure(TM) process for the processing of
human femoral heads recovered during hip replacement
9
surgery. OST has concluded an agreement with OsteoBanque D'Auvergne and is in
the process of concluding similar agreements with other European tissue banks
for the provision of tissue for the OsteoPure(TM) Process. Additionally, we are
expanding the range of human allograft bone tissue grafts available to
orthopaedic and other surgeons in various countries in Europe by supplying
Grafton(R) DBM and other allograft bone tissue grafts processed in the US.
In conjunction with OsteoBanque D'Auvergne and other European tissue banks,
we plan to help establish a cadaveric tissue recovery network in medical centers
throughout France and other European countries in order to meet the growing
demands by European surgeons for safe human allograft bone tissue forms. France
will continue to be the prime base of operation in our efforts to expand the
distribution of our human allograft bone tissue grafts throughout Europe on a
country-by-country basis. Facilities and staff will be added to our current
operations, as required, to support this expansion.
We believe the advantages of locating our European operations in France are
significant. The French market is one of the larger and more sophisticated
European markets for bone grafts. Also, French laws and regulations governing
tissue banking are well defined and the most advanced of all the major European
countries. Although tissue banking operations in France are generally restricted
to non-profit public health organizations approved by the government, French
regulations also provide for governmental approval of for-profit organizations
as tissue banks if these organizations are able to provide haute technicite
(high technology) unavailable in the non-profit sector. We believe that our
tissue processing technology meets this requirement and that we will be able to
operate independently as an approved tissue bank in addition to providing
contract processing, marketing and management services to non-profit tissue
banks.
Other
Ceramic and Titanium Plasma Spray Coating Services and Products
We are providing ceramic hydroxyapatite ("HA") and titanium plasma spray
coating services to orthopaedic and dental implant companies in Europe. The
primary advantage of coating orthopaedic and dental prosthetic devices is that
it enables bone to grow onto the implanted device. This enhances the stability
of the device, which, in turn, lowers the amount of bone loss and reduces pain
caused by micro motion. We manufacture the HA powder which we use in our plasma
spray coating operations from raw materials which are readily available from
several sources. We also supply HA powder to various companies for use in their
in-house plasma spray coating operations. Additionally, we produce HA products
which are used to replace middle ear bones and for use as grafting material to
provide a matrix into which bone will grow as part of the process of the repair
of bone defects.
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Non-Allograft Bone Tissue Spinal Implants and Instruments
The human spine is subjected to various loading conditions including
tension, compression, torsion, bending and combinations of all four. When the
spine has been injured by tumors, fractures, degenerative conditions or
deformities, stabilizing instrumentation is required to maintain surgical
correction of the condition during the healing and fusion process. We offer
several metal spinal implant systems to achieve these results.
The Versalok(R) System, which is marketed by our national network of direct
and independent agency representatives -- in combination with our allograft and
other non-allograft spinal products-- is a lumbo-sacral spine fixation system
with an innovative polyaxial screw. The Versalok(R) System is designed in a
manner to allow the sharing of the forces to which the spine are subjected with
the system, which in turn is thought to provide improved results in spinal
fusion procedures.
We also market the SSCS(TM) System, a low profile, thoracolumbar pedicle
screw and rod system, featuring a proprietary hinged screw design that allows
for load sharing. We sell this product under an exclusive distribution agreement
with Heinrich C. Ulrich, K.G. ("Ulrich") of Ulm, Germany, the manufacturer of
the product. Ulrich also sells the product in Germany, the U.K., and South
Africa.
We expect to continue to expand our metal spinal implant product line so
that we are able to offer the surgeons implant systems capable of solving a
variety of spinal problems.
Quality Assurance
We have stringent quality assurance programs in place covering all of our
lines of business, including our Grafton(R) DBM and Base Tissue Segments, our
HA-titanium plasma spray coating services, and our non-allograft bone tissue
spinal implants and instruments. Our facilities in Clermont-Ferrand, France and
Leiden, The Netherlands have received International Standardization Organization
("ISO") certification for their quality systems.
In both the Grafton(R) DBM and Base Tissue Segments, our allograft bone
tissue quality assurance program commences with the recovery of allograft bone
tissue which is procured under strict aseptic conditions. The tissue is
recovered primarily in hospitals and, to a lesser extent, coroners' facilities
which have been prepared for recovery. Recovered allograft bone tissue is also
required to be sterilely wrapped and shipped in special containers. Upon receipt
of this tissue, a quarantine period is imposed to permit serologic and
microbiologic testing prior to release of allograft bone tissue for processing.
Upon satisfactory completion of all testing, the allograft bone tissue is
processed in a microbially-controlled environment. Under constant monitoring,
the allograft bone tissue is cleaned, soaked in antibiotics and then cut and
shaped in accordance with client specifications. Before being released to our
clients, all processed bone tissue is inspected and again tested for
microbiological contaminants by our quality assurance team.
11
We believe that the serologic screening of donors, the extensive screening
of donor profiles and medical histories performed by our clients and our
processing technologies virtually eliminate the likelihood of the presence of
infectious agents, including HIV and hepatitis viruses, in Osteotech processed
allograft bone tissue. Studies completed by an independent testing laboratory
specializing in viral inactivation studies demonstrated that our proprietary
demineralization process used in our Grafton(R) DBM Segment can virtually
inactivate and eliminate viruses such as HIV, hepatitis B, hepatitis C,
cytomeglia and polio.
In addition to the proprietary demineralization process used in our
Grafton(R) DBM segment, we expect to begin to implement additional processing
technologies that once fully implemented will enable us to expand our viral
inactivation claims to include virtually all of the allograft bone tissue we
process in our Base Tissue Segment. These proprietary, tissue-specific
technologies are expected to further enhance graft safety while maintaining the
tissue's biologic and physical properties.
To our knowledge, none of the approximately 2 million transplanted grafts
we have processed in our Grafton(R) DBM and Base Tissue Segments have resulted
in a confirmed transmission of infectious diseases. This record is due to the
rigorous donor screening and tissue recovery techniques used by our clients,
extensive donor testing, as well as our demanding quality assurance and
processing protocols.
Clients
We are the exclusive processor of allograft bone tissue for two large
United States clients. In the Base Tissue Segment, with the exception of the
bio-d(TM) Threaded Cortical Bone Dowel for which we are paid on a per unit
basis, we are paid fees on a per donor basis for processing, finishing and
packaging our clients' mineralized, weight-bearing allograft bone tissue. In the
Grafton(R) DBM Segment our clients pay us fees on a per unit basis. During 1999
MTF and ARC accounted for approximately 56% and 38%, respectively, of our
consolidated revenues. We receive revenues in both our Grafton(R) DBM and Base
Tissue Segments from each of these clients. We have processing agreements with
MTF and ARC which run through March 31, 2002 and December 31, 2006,
respectively.
We rely on our clients to obtain the donor allograft bone tissue which we
process and to distribute the processed allograft bone tissue to hospitals and
physicians for transplantation. We perform marketing services which generate
demand for our products. See "Education and Marketing."
In the fourth quarter of 1999, we commenced using the OsteoPure(TM) System
for processing allograft bone tissue grafts for French tissue bank clients. We
expect to increase our clients for OsteoPure(TM) Processed Tissue in 2000. In
the fourth quarter, we also concluded a contract with BioImplant Services of The
Netherlands for expanded distribution of Grafton(R) DBM in Europe.
12
Our plasma spray coating customers and non-allograft bone tissue spinal
implant product customers generally purchase our services and products pursuant
to purchase orders or non-exclusive supply agreements which are cancelable at
any time by either party.
Education and Marketing
We believe the markets for processed allograft bone tissue will continue to
be orthopaedic, neurological, plastic and oral/maxillofacial surgical
specialties. Our future growth in these areas will depend upon a wider
acceptance by these specialties of the use of allograft bone tissue as an
alternative to autograft bone tissue and other available materials and
treatments.
As of December 31, 1999, we employed 21 persons engaged directly in efforts
to educate surgeons as to the benefits and applications of processed allograft
bone tissue and five employees engaged in training our independent sales agents.
We complement our direct sales organization with a national network of
independent sales agents who market Grafton(R) DBM, our bio-d(TM) Threaded
Cortical Bone Dowel and our non-allograft bone tissue spinal implant products.
These agents also educate the medical community about processed allograft bone
tissue. At December 31, 1999, we had appointed 58 agencies which employ over 260
sales representatives.
Currently, a small group of marketing and sales employees located in
Clermont-Ferrand, France markets and sells our LUBBOC(R) and LADDEC(R) bovine
bone grafts to orthopaedic surgeons and dentists. This staff is being retrained
to market our OsteoPure(TM) human femoral head and cancellous bone grafts,
Grafton(R) DBM and other human allograft tissue products in connection with a
network of agents and distributors we have retained.
A small in-house marketing staff located at our Leiden facility markets its
plasma spray coating services. These marketing activities consist primarily of
attendance at trade shows, placement of advertisements in trade journals and
direct mailings to orthopaedic and dental implant companies. We market our HA
powders and ceramic products directly and through independent contract
representatives in Europe.
Government Regulations
Both of our Grafton(R) DBM and Base Tissue Segments involve the processing
of human tissue intended for transplantation and are subject to the same
regulations in the U.S.
The procurement and transplantation of allograft bone tissue is subject to
federal law pursuant to the National Organ Transplant Act ("NOTA"), a criminal
statute which prohibits the purchase and sale of human organs, including bone
and related tissue, for "valuable consideration." NOTA permits the payment of
reasonable expenses associated with the removal, transportation, processing,
preservation, quality control, implantation and storage of human bone tissue. We
provide services in all of these areas, with the exception of removal and
implantation.
The FDA currently regulates human tissue-based products such as the
allograft bone tissue that we process, including Grafton(R) DBM, under certain
provisions (Section 361) of the Public
13
Health Services Act. Such products are not regulated as drugs, medical devices
or blood products, but as "human tissue for transplantation." FDA regulations do
not require a premarket clearance for such products, though these products are
subject to regulations concerning tissue donor screening and testing, processing
and record keeping, and other controls. Tissue-based and cellular products that
are not classified as human tissue intended for transplantation will be
regulated under different regulations as either drugs, devices or biologics.
In August 1995, the FDA designated Grafton(R) DBM as within the scope of
human tissue intended for transplantation. Human tissue such as demineralized
bone matrix has been considered, and still is considered, exempt from FDA
premarketing clearance requirements imposed upon medical products such as drugs,
devices and biologics. Grafton(R) DBM is a demineralized bone matrix that is
mixed with glycerol, a basically inactive substance, to provide desirable
physical handling characteristics to the demineralized bone matrix.
The FDA has proposed a more comprehensive regulatory framework that will,
if adopted, build upon and supersede the existing regulations for human
tissue-based products. Implementation of this proposed regulatory approach would
lead to new regulations for the allograft bone tissue we process. One set of new
regulations has been proposed by publication in the Federal Register and
additional proposed regulations are expected to be published in the Federal
Register in the future.
The bio-d(TM) Threaded Cortical Bone Dowel and other bone tissue
bioimplants are currently regulated as human tissue for transplantation. The FDA
had proposed that these allograft bone tissues be regulated as medical devices,
but, to date, has not taken any action to regulate these as medical devices. If
these implants are regulated by the FDA as a medical device in the future, we
may be required to halt or to limit the marketing of these products until we
conduct clinical trials to support an application to receive marketing clearance
from the FDA.
Allograft bone tissue and processing operations are regulated in most major
countries, though with different regulations and standards in each country. We
believe that we and our subsidiaries do comply, and will be able to in the
future, comply with the national regulations of the various countries in which
we currently operate or plan to operate.
The non-allograft metal spinal implant products that we distribute in the
U.S., are regulated as medical devices under the Federal Food, Drug and Cosmetic
Act. Both the Versalok(R) System and the SSCS are being marketed in the United
States pursuant to 510K marketing approvals issued by the FDA.
ISO certification for production facilities were made mandatory in 1998 for
companies that market or distribute products within the European Union. Our
facility located in Clermont-Ferrand, France has received ISO 9001 certification
for the quality systems used in the manufacture of bovine tissue products. The
LUBBOC(R) and LADDEC(R) Bovine Grafts produced and marketed by OST are regulated
as medical devices in Europe and most other international markets in which these
products are marketed.
14
Our European HA plasma spray coating services meet existing regulatory
requirements in the specific countries where they are marketed. Our facility in
Leiden, The Netherlands has received ISO 9001 certification for its quality
systems used in the development and manufacture of ceramic products and ceramic
and titanium spray coatings. The certification was awarded by Tuv Product
Service, GmbH of Munich, Germany, a leading Notified Body in medical devices.
Notified Bodies are independent organizations authorized by the European Union
member countries to administer the ISO certification process. Upon
certification, a company may then affix a CE Mark to its device products, thus
allowing for the sale of the products throughout the European Union.
Ceramic products produced by us in The Netherlands are currently
distributed only in Europe. These products meet existing regulatory requirements
in the specific countries where they are produced and marketed. We do not
currently intend to market these products in the U.S.; however, if it does
decide to do so, these products would require premarket clearance by FDA as
medical devices.
HA powder produced and sold in bulk by us in the U.S. and Europe is
considered to be a component product and, as such, is not currently subject to
regulation by the FDA and similar agencies in Europe.
Research and Development
During 1999, 1998 and 1997, we spent approximately $5,506,000, $4,610,000
and $3,728,000, respectively, on research and development activities. The
majority of these expenditures were made in our Grafton(R) DBM and Base Tissue
Segments. We are engaged in continuing research and development efforts in the
allograft bone tissue processing field which include our continuing efforts to
improve upon and maintain the safety and performance of the processed allograft
bone tissue, increase the amount of transplantable allograft bone tissue derived
from each donor, reduce processing costs through efficiency advances and develop
new forms of allograft bone tissue.
Competition
Market Overview
The bone grafting market is an extension of the general orthopaedic surgery
market, as bone grafts are used adjunctively in a broad range of reconstructive
orthopaedic surgical procedures such as the repair of fractures and skeletal
defects, spinal and joint arthrodeses, and revision arthroplasties. These
procedures are performed by virtually all orthopaedic subspecialties and by
neurosurgeons, some plastic surgeons and certain other surgical specialties.
Dental and other oral maxillofacial procedures are not considered to be a
primary portion of the bone graft market, but are instead considered to
constitute a secondary market. Three basic categories of products or
alternatives currently compete in the bone graft market:
o autograft bone tissue;
15
o allograft bone tissue; and
o synthetic bone void fillers.
A potential fourth product category, growth factor products, is still in
the investigational stage.
We estimate that total domestic allograft bone tissue sales increased 16%
in 1999 to $248 million, comprising approximately 46% of the U.S. bone graft
market.
U.S. Bone Graft Market
1999
Specialty Graft Procedures(1) Allograft Market Size(1)
- --------- ---------------- ---------------------
Spinal Fusions 243,000
General Orthopaedics 195,000
Craniomaxillofacial 82,000
-------
Total 520,000
Average Selling Price(2) $ 1,025
Market Size (000) $533,000 $248,000 (46.5%)
- ----------
(1) Source: Datamonitor, "US Bone Substitutes"
(2) Source: Osteotech estimate
The number of bone graft procedures is forecast to increase during the next
five years due to an expected increase in the number of reconstructive
orthopaedic surgical procedures utilizing bone grafts, particularly in spinal
procedures using pedicle screw implants and spinal cages.
Factors producing the continued growth in the number of reconstructive
orthopaedic surgical procedures that incorporate a bone graft include the
following:
o the aging of the U.S. population;
o improving success rates for surgical procedures that involve a bone
graft procedure;
o development of less invasive reconstructive orthopaedic surgical
procedures that will be used in a wider patient population; and
o the increasing number of revision, spinal fusion and joint
arthroplasty procedures resulting from a more active and longer living
U.S. population.
While the general bone graft market has experienced low-single-digit growth
in recent years, we estimate that allograft bone tissue sales have increased at
an average annual rate of approximately 16% since 1994. This displacement trend
is expected to continue as physicians gain confidence in, and experience with,
allograft bone tissue. Some of the factors contributing to the increased use of
allograft bone tissue include:
16
o the desire by surgeons to avoid the additional procedure needed to
acquire autograft bone tissue, which often increases costs due to
additional operating time, medical supplies and extended hospital
stay, and patient risks due to excessive blood loss, infection,
chronic pain and morbidity;
o increased awareness by, and training of, the medical community with
respect to the use and safety of processed allograft bone tissue;
o an increase in the number of patients who do not possess the quality
of bone tissue required for autograft procedures as a result of the
general aging of the population; and
o an increase in the availability of allograft bone tissue due to an
increase in bone tissue donations and to improved recovery and
processing techniques.
Competitive Overview
In both our Grafton(R) DBM and Base Tissue Segments we compete in the bone
graft market with autograft bone tissue, synthetic bone void fillers and
allograft bone tissue processed by others. Autograft bone tissue has
traditionally been the primary choice for surgeons and we believe it still
maintains an approximate 50% share of the U.S. bone graft market. Due to factors
such as the increased cost and potential complications associated with an
additional procedure needed to acquire autograft bone tissue, more surgeons are
beginning to choose allograft bone tissue over autograft bone tissue for their
bone grafting needs.
Grafton(R) DBM Segment
We have been successful in persuading many surgeons to switch to Osteotech
processed allograft bone tissue through the introduction of our proprietary
tissue processing technology. We have expanded the applications of allograft
bone tissue through Grafton(R) DBM, a proprietary form of allograft bone tissue.
The demineralization process used in Grafton(R) DBM removes most of the
minerals, thus exposing the proteins that promote bone growth (osteoinduction)
and creating a lattice work for new bone (osteoconduction). Grafton(R) DBM has a
validated viral inactivation process for HIV, hepatitis B and C, cytomeglia and
polio. Grafton(R) DBM is produced in four forms - gel, flex, putty, and crunch,
packaged in sterile, single patient delivery systems. We introduced Grafton(R)
DBM Crunch, a mixture of demineralized bone fibers and demineralized cortical
cubes, into the market in December, 1999. With the varying textural and handling
characteristics of its four forms, Grafton(R) DBM can be used in virtually all
non-weight-bearing bone graft procedures and has been used in over 300,000
procedures through December 31, 1999.
Given its osteoinductive and osteoconductive properties, Grafton(R)DBM has
a distinct advantage over synthetic bone void fillers, all of which are
exclusively osteoconductive.
17
Grafton(R) DBM vs. Competitive Synthetic Products
Mechanism(s) of Published Available
Bone Healing Applications Safety Data Forms
------------ ------------ ----------- -----
Grafton(R) Osteoinduction & All Yes Gel
DBM Osteoconduction non-weight-bearing Flex
bone graft procedures Putty
Crunch
ProOsteon Osteoconduction Acute metaphysical Yes Blocks
(Interpore) fracture defects Granules
less than or equal
to 30 cc with
internal fixation
Collagraft Osteoconduction Long bone defects Yes Paste Strips
(Zimmer) & fractures less
than or equal to
30ml with fixation
Osteo Set Osteoconduction Non weight-bearing Yes Pellets
(Wright Medical) defects in long
bones and spine
Grafton(R) DBM's advantages over synthetic grafting materials in the market
for non-weight-bearing applications include:
o superior handling and performance qualities, including providing a
matrix for bone to grow into and inducing bone to grow; and
o the suitability of Grafton(R) DBM for all non-weight-bearing bone
graft procedures versus the limited applications of competitive
products.
GRAFTON(R) DBM VERSUS COMPETITIVE ALLOGRAFT PRODUCTS
Validated
Viral
Product/ Mechanisms(s) of Inactivation Available Size of Sales
Company Bone Healing Process Ingredients/Forms Force(1)
------- ------------ ------------ ----------------- -----
Grafton(R)DBM Osteoinduction & Yes DBM/Glycerol 260
(Osteotech) Osteoconduction o Gel
o Flex
o Putty
o Crunch
Dyna Graft Osteoconduction(3) No DBM/Collagen 225
(Gen Sci/ o Matrix
DePuy)(2) DBM/Pluronic F-127
o Gel
o Putty
Osteofil Osteoconduction No DBM/Porcein Gel 230
(Reg. Tech/ & Partially o Paste
Sofamor Danek) Osteoinductive
(1) Source: Based upon Osteotech's Survey of Competition
(2) As a result of a patent law suit settlement with Osteotech, DePuy will
cease to market DynaGraft no later than February, 2001.
(3) GenSci claims that its DynaGraft products are osteoinductive; however
studies conducted by an independent laboratory concluded that the DynaGraft
products are not osteoinductive.
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Although it already occupies a leading position in the U.S. market for
non-weight-bearing grafting materials, in recent years, our Grafton(R) DBM
products have faced increasing competitive pressures as more companies have
developed, or have announced they are developing, products with characteristics
similar to Grafton(R) DBM. We expect that this competition will continue to
increase in the future. Many of these competitors have research and development,
marketing and other resources that are significantly greater than ours. They
also offer a full line of metal implants and other products used in spinal
surgeries. This could give them a competitive advantage over us since they can
offer surgeons a more complete line of products than we currently can.
Notwithstanding the increasing competition, Grafton(R) DBM has significant
opportunities for growth. Currently, Grafton(R) DBM sales are almost exclusively
domestic. We estimate that Grafton(R) DBM was used in only 16% of the total bone
graft procedures performed in the U.S. during 1999. We estimate the potential
non-domestic bone graft market to be at least as large as that of the U.S.
market. The European market, in particular, provides us with an opportunity in
an area where we already have a sales presence.
Grafton(R) DBM U.S. Procedure Penetration
1999
--------------------------------------
Grafton(R) DBM
--------------------------------------
Potential(1) Actual(2) Percent
Specialty --------- ------ Penetration
- --------- -----------
Spinal Fusions 243,000 48,104 19.8%
General Orthopaedics 195,000 25,998 13.3%
Craniomaxillofacial 82,000 7,089 8.6%
------- ------ -----
Total 520,000 81,192 15.6%
(1) Source: Osteotech Estimates Based on Orthopaedic News Network, Medical
Data International and MarketLine Data
(2) Source: Osteotech Estimate
Base Tissue Segment
Allograft bone tissue is still the only alternative to autograft bone
tissue for bone grafting procedures which require weight-bearing tissue. Our
primary competition in this segment is surgeons who use autograft bone tissue
instead of allograft bone tissue. We plan to continue to differentiate our Base
Tissue Segment operations from those of other allograft bone tissue processors
by expanding our viral inactivation claim to include our mineralized
weight-bearing bone tissue. We will also introduce our Allogard(R) Packaging
plastic tray for most of the allograft bone tissue processed in our Base Tissue
Segment. This packaging will be easier for operating room nurses to work with.
In addition, this will allow us to differentiate our "Osteotech processed bone"
from most competitive allograft processed bone which is usually packaged in
glass bottles.
19
In order to maintain our leading position in the allograft bone tissue
processing market and to encourage more surgeons to switch from autograft bone
tissue to Osteotech processed allograft bone tissue, we plan to:
o leverage our knowledge of allograft bone tissue processing to expand
our proprietary tissue safety claims to our weight-bearing mineralized
allograft bone tissue;
o expand our external scientific presence through publication and
presentation of clinical research and outcome studies;
o expand our market differentiation through tissue performance
improvements, including line extensions of existing base allograft
bone tissue products and new product introductions; and
o increase education of surgeons regarding the use of allograft bone
tissue through expanded grand rounds, seminars and workshops.
The various national markets in Europe for bone grafts are currently
dominated by the use of autograft and synthetic bone graft substitutes.
Autograft remains the bone graft of choice due to surgeons' attitudes and
concerns about bone graft safety and performance. There is also a significant
number of surgeons who have not yet become aware of the safety and performance
advantages of processed allografts and who continue to use unprocessed
allografts. Our OsteoPure(TM) Process, Grafton(R) DBM and base allograft bone
tissue are designed to address these needs. However, other firms have developed
or are developing allograft bone tissue grafts and allograft bone tissue-based
products to also address these needs. Tissue Bank of France, a unit of Groupe
Lepine of France and Tutogen, Inc. of Germany offer allograft bone tissue grafts
which directly compete with the OsteoPure(TM) Base Allograft Bone tissue grafts
in certain European countries. Also, several US tissue bank organizations have
formed strategic alliances with orthopaedic device firms to market allograft
bone tissue grafts and are expected to enter certain European markets in 2000
and 2001.
Other
Our ceramic and titanium plasma spray coating and HA product operations
face competition in Europe from divisions and subsidiaries of several large
corporations engaged in providing such services and products to others and from
several smaller independent companies. In addition, we also face competition
from medical implant companies which have in-house plasma spray coating
operations. We compete primarily on the quality of our coatings and price. We
believe that the spraying technology we use, which is computer controlled and
utilizes robotics, enables us to provide high quality coatings at competitive
prices. It should be noted, however, that the ceramic and titanium coating
industry is highly competitive.
20
Environmental Matters
Our allograft bone tissue processing generates waste which is classified as
medical hazardous waste by the United States Environmental Protection Agency and
the New Jersey Department of Environmental Protection. We segregate this waste
and dispose of it through a licensed hazardous waste transporter in compliance
with applicable regulations. The production of HA powder at our facility in The
Netherlands generates small amounts of hazardous waste, which we segregate and
dispose of through a licensed hazardous waste transporter. Although we believe
we are in compliance with applicable environmental regulations, if we fail to
fully comply with any such regulations could result in the imposition of
penalties, fines and/or sanctions which could have a material adverse effect on
our business.
Patents and Proprietary Rights
We consider our processing technology and procedures proprietary and rely
primarily on trade secrets to protect our technology and innovations.
Significant research and development activities have been conducted on our
behalf by consultants employed by third parties or in conjunction with
unaffiliated medical institutions. Accordingly, disputes could arise in the
future concerning the proprietary rights to information applied to our projects
which have been independently developed by the consultants or researchers at the
medical institutions.
At February 29, 2000, we held (i) 39 United States patents and eight
foreign patents relating to our aseptic processing technology and our transplant
support products, including 11 United States Grafton(R) DBM patents and three
foreign Grafton(R) DBM patents, (ii) six United States and six foreign patents
relating to our biomaterials technology, (iii) 14 United States and seven
foreign patent applications relating to aspects of our processing technology and
our osteogenic and other products under development, (iv) one United States
patent related to instrumentation and (v) 12 United States patent applications
and 10 foreign patent applications relating to our biomaterials technology. We
believe that our Grafton(R) DBM patents are significant in maintaining our
competitive position. These patents expire on various dates ranging from 2009 to
2019. Our other patents expire at various dates ranging from 2007 to 2019.
There can be no assurance that any pending patent applications will result
in issued patents or that any currently issued patents, or patents which may be
issued, will provide us with sufficient protection in the case of an
infringement of our technology or that others will not independently develop
technology comparable or superior to ours. We are currently involved in three
patent-related lawsuits. See Item 3. "Legal Proceedings."
Product Liability and Insurance
The testing and use of allograft bone tissue and the implantation of
medical devices coated with our HA powder, medical devices developed with our
biomaterials technology and medical devices manufactured by others and
distributed by us entail inherent risks of medical complications for patients,
and therefore may result in product liability claims against us. Further,
21
our agreements with our bone tissue processing clients provide them with
indemnification by us for liabilities arising out of defects in allograft bone
tissue caused as a result of processing performed by us.
As a distributor of implants and instruments for spinal surgery, including
bone screws, manufactured by Ulrich, we have been named as a defendant in
lawsuits in which plaintiffs claim that they have suffered damages from the
implantation of allegedly defective spinal fixation devices. Pursuant to its
distribution agreement with us, Ulrich has agreed to indemnify us for all costs
and damages we incur in connection with our distribution of products
manufactured by Ulrich, except such costs and damages which are caused by our
gross negligence or willful misconduct or unauthorized claims made by us in
marketing the products. Ulrich maintains its own product liability insurance
coverage. To date, Ulrich has made indemnity payments to us for a portion of the
costs incurred by us in defending the lawsuits involving the Ulrich products we
have distributed. We cannot assure you that we will in fact be indemnified by
Ulrich for all such costs. See Item 3. "Legal Proceedings" and Note 11 of "Notes
to Consolidated Financial Statements."
We presently maintain product liability insurance in the amount of $102
million per occurrence and per year in the aggregate. We cannot assure you that
we will be able to maintain such insurance in the future or that such insurance
will be sufficient to cover the amount of claims asserted against us on all
types of liabilities.
Employees
At December 31, 1999, we had 349 employees, of whom 214 were engaged in
allograft bone tissue processing, ceramic plasma spray coating and the
manufacture of products; 32 were engaged in research and development; 52 were
engaged in education and marketing; and 51 were engaged in regulatory, finance
and administration. Our employees are not covered by any collective bargaining
agreement. We consider relations with our employees to be good.
Item 2. Properties
Our principal executive offices are located in approximately 38,000 square
feet in Eatontown, New Jersey, which is occupied pursuant to a lease which
expires in December, 2004 and provides for a base annual rental of approximately
$264,000. This facility is occupied by our corporate, financial, administration,
marketing, research and development, regulatory and clinical affairs staff.
Our processing facility is located in approximately 45,000 square feet of
space in Shrewsbury, New Jersey, which is occupied pursuant to a lease which
expires in October 2008 and provides for a base annual rental of approximately
$367,000 through October 2003 and $410,000 for the remaining term of the lease.
The lease is renewable at our option for an additional five year term. Both the
Grafton(R) DBM and Base Tissue Segments utilize this facility.
Our European subsidiary which is engaged in the biomaterial business line
occupies a 21,000 square foot facility in Leiden, The Netherlands. The lease for
this facility expires in May, 2008 and the
22
annual rent is dfl 626,000 (approximately $287,000 at the December 31, 1999
exchange rate). We are subleasing 5,300 square feet of this facility to an
unrelated third party at an annual rent of dfl 212,000 (approximately $97,000 at
the December 31, 1999 exchange rate). The sublease agreement expires in March,
2004.
Our subsidiary in France, OST Developpement SA, which is engaged in the
production, processing and distribution of bovine bone graft substitute products
and of human allograft tissue products, occupies an 11,000 square foot facility
in Clermont-Ferrand, France. The lease for this facility expires in June, 2002
and has an annual rent of FRF 556,000 (approximately $85,000 at the December 31,
1999 exchange rate). We have the option to acquire the building and related land
for the fair market value of the property at the time of purchase as determined
by an independent appraisal.
In 1997, we purchased approximately 13 acres of land surrounding our
Eatontown, New Jersey facility. We plan to utilize this land for future
expansion to meet our anticipated facilities requirements. In connection with
the first stage of this expansion, we have engaged a developer to build an
additional 65,000 square foot processing facility to our specifications. We
expect to occupy this facility in the second half of 2000. We are financing the
construction of this facility with a $4.5 million loan from our bank which will
be secured by a mortgage on the real property, building and fixtures, a $17
million equipment line of credit from our bank which will be secured by the
equipment purchased with the proceeds from this loan facility and through our
current cash reserves.
Item 3. Legal Proceedings
GenSci Regeneration Laboratories, Inc. v. Osteotech, Inc.; Osteotech, Inc. v.
GenSci Regeneration Sciences, Inc., 10111-MRP (Eex) (C.D. Cal.)
In January, 1998, we filed a patent infringement action against GenSci
Regeneration Laboratories, Inc. ("GenSci Labs") and GenSci Regeneration
Sciences, Inc. ("GenSci Sciences") alleging that the GenSci parties violated
claims of one of the patents involving our Grafton(R) Demineralized Bone Matrix
(DBM) process. Approximately two weeks after our filing, GenSci Labs filed a
suit against us alleging that our Grafton(R) DBM Flex product infringes two
patents assigned to GenSci Labs and that we engaged in tortious interference
with a business expectancy, negligent interference with a prospective economic
advantage and inducing breach of contract. The GenSci parties have also sought a
declaratory judgment of the invalidity of our patents U.S. Patent Nos. 5,284,655
and 5,290,558 covering Grafton(R) DBM. In February, 1998, GenSci Labs amended
its complaint alleging essentially the same causes of action but adding a third
patent to the allegation of patent infringement. In August, 1998, the actions
were consolidated into one case before the United States District Court for the
Central District of California.
In September, 1998, GenSci Labs served an amended complaint, which
asserted, in addition to the previously asserted claims, claims of false
advertising under Federal law. In September, 1998, we served our answer to this
amended complaint, asserted counterclaims against GenSci Labs and served a
third-party complaint against GenSci Sciences, and DePuy
23
AcroMed, Inc.("DePuy"). Our counterclaims and third party complaint accused the
GenSci parties of infringing a second patent of ours, in addition to the patent
referred to above, and accused the DePuy and GenSci parties of acting jointly
and severally in infringing on the claims of both patents.
In May, 1999, GenSci Labs amended its complaint to allege that in addition
to our Grafton(R) DBM Flex product, our Grafton(R) DBM Gel and Putty products
infringe GenSci Lab's patents at issue. GenSci Labs also amended its complaint
to modify its false advertising claim, alleging that in addition to Osteotech,
individuals acting on our behalf engaged in false advertising. We filed and
served our answer and counterclaims to the amended complaint in May, 1999. In
this action, GenSci Labs is seeking injunctive relief and monetary damages in an
amount not yet specified.
In November, 1999, we settled all claims which we had filed against DePuy.
As part of the settlement, DePuy has agreed to stop selling the GenSci products
accused of infringing our patents, no later than February 4, 2001 and to pay us
$3,000,000. A payment of $2,000,000 was received in the fourth quarter of 1999
and payments of $250,000 each will be made at the end of each quarter in 2000
unless DePuy discontinues selling the GenSci products during the year, at which
time DePuy would not be obligated for payments beyond the quarter in which it
stopped selling the GenSci products.
Discovery on all of the claims asserted in this litigation is ongoing. We
believe that the claims made against us by the GenSci parties are without merit
and will continue to vigorously defend any claims against us, prosecute the
claims we have asserted in this action, and vigorously and affirmatively protect
our products and intellectual property to the fullest extent possible under the
law.
GenSci has announced publicly that it intends to withdraw its claims that
our Grafton(R) DBM Products infringe the patents asserted by GenSci in this
litigation
GenSci Orthobiologics, Inc. v. Osteotech, Inc., Civil Action No. 02313-LGB (C.D.
Cal.)
On March 6, 2000, GenSci Orthobiologics, Inc. ("GenSci") filed a complaint
in the United States District Court for the Central District of California
against us, alleging unlawful monopolization and attempts to monopolize the
market for demineralized bone matrix and for entering agreements in restraint of
trade, in violation of sections 1 and 2 of the Sherman Antitrust Act and Section
3 of the Clayton Act; and for unlawful and unfair business practices in
violation of section 17200 of the California Unfair Competition Law. GenSci has
alleged that we have monopoly power in the market for demineralized bone matrix
products in the United States, and have engaged in anticompetitive conduct by
improperly asserting our patents through patent infringement actions, seeking to
have the Food and Drug Administration remove certain of GenSci's products from
the market, restricting competitors' access to raw materials, interfering with
GenSci's arrangements to manufacture demineralized bone matrix implants,
interfering with GenSci's marketing and distribution arrangements, and
disparaging GenSci's products. GenSci seeks compensatory, incidental,
consequential, and punitive damages in an unspecified amount,
24
and injunctive relief to stop us from restricting the tissue banks for which we
process tissue from (a) supplying processed demineralized bone matrix to our
competitors and (b) distributing the demineralized bone matrix implant products
of our competitors. Many of these allegations were previously asserted by GenSci
in its ongoing patent litigation with us in the Central District of California
federal court.
We believe the claims made against us in this lawsuit are without merit and
we intend to vigorously defend against these claims.
University of Florida Tissue Bank, Inc. v. Osteotech, Inc., Case No. 1:99cv33
MMP (N.D. Fla.)
In February, 1999, a complaint was filed against us in the United States
District Court for the Northern District of Florida. This action, which has been
brought by plaintiffs, University of Florida Tissue Bank, Inc., Regeneration
Technologies, Inc., Sofamor Danek Group, Inc., and Sofamor Danek L.P. alleges
that our bio-d(TM) Threaded Cortical Bone Dowel and Endodowel infringe on the
claims of U.S. Patent No. 5,814,084, entitled "Diaphysical Cortical Dowel." In
April, 1999, plaintiffs filed an amended complaint adding a claim for patent
infringement against us with respect to US Patent No. 5,814,084, entitled "Bone
Grafting Units", which is owned by plaintiff University of Florida Tissue Bank,
Inc. The plaintiffs in this action have sought injunctive relief and monetary
damages in an amount not yet specified. In May, 1999, we filed our answer and
counterclaim seeking declaratory judgment that the patents in question in this
action are invalid and otherwise not infringed by us. In May, 1999, plaintiffs
filed their reply to our counterclaims.
Discovery on all of the claims asserted in this litigation is ongoing. We
believe that the claims made against us in this action are without merit and we
will continue to vigorously defend against such claims.
Medtronic Sofamor Danek, Inc., Sofamor Danek L.P. and Sofamor Holdings, Inc. v.
Osteotech, Inc., Case No. 99-2656 (W.D. Tenn.)
In July, 1999, Medtronic Sofamor Danek Inc., Sofamor Danek L.P. and Sofamor
Danek Holdings, Inc. ("Danek") sued us in the United States District Court for
the Western District of Tennessee alleging that instruments, instrument sets and
cortical bone dowel products, including but not limited to the bio-d(TM)
Threaded Cortical Bone Dowel and Endodowel, manufactured, sold and/or otherwise
distributed by us infringe on certain claims of U.S. Patent Nos. 5,741,253,
entitled "Method for Inserting Spinal Implants", and 5,484,437, entitled
"Apparatus and Method of Inserting Spinal Implants", which are owned by Danek.
The plaintiffs in this action have sought injunctive relief and monetary damages
in an amount not yet specified. In September, 1999, we filed our answer and
counterclaim seeking a declaratory judgement that the patents in question in
this action are invalid and otherwise not infringed by us. Plaintiffs filed
their reply to the counterclaims in October, 1999.
25
Discovery on all of the claims asserted in this litigation is ongoing. We
believe that the claims made against us in this action are without merit and we
will continue to vigorously defend against such claims.
"O" Company, Inc. v. Osteotech, Inc., Case No. Civ. 98-981 BB/LFG (D.N.M.)
In July, 1998, a complaint was filed against us in the Second Judicial
District Court, Bernallilo County, New Mexico, which alleges negligence, strict
liability, breach of warranty, negligent misrepresentation, fraud, and violation
of the New Mexico Unfair Trade Practices Act arising from allegedly defective
dental implant coating and coating services provided to plaintiffs by a
subsidiary of ours, Cam Implants BV. Plaintiffs have demanded unspecified
monetary damages. In August, 1998, we removed this action to the United States
District Court for the District of New Mexico and filed and served our answer,
denying any and all liability in this action, and moved to dismiss five of the
seven claims alleged against us. In March, 1999, the court dismissed with
prejudice the plaintiff's negligence and strict liability claims. Remaining are
claims for breach of warranty, negligent misrepresentation, fraud, and violation
of the New Mexico Unfair Trade Practices Act. As to those claims, we have moved
for summary judgement on the basis that all of the remaining claims are barred
by their applicable statutes of limitations. At plaintiffs' request, the court
permitted limited discovery on the matters related to the statute of limitations
issue, which is ongoing.
We believe that the claims made against us in this action are without merit
and we will continue to vigorously defend against such claims.
Orthopaedic Bone Screw Products Liability Litigation
We remain a defendant in one previously reported state court products
liability action involving orthopaedic bone screws: Ponder v. Synthes, Case No.
960602729 (Ct. of Common Pleas, Philadelphia County, Pa.). With respect to us
and numerous other defendants, the case remains stayed.
We believe that the claims made against us in this action are without merit
and we will continue to vigorously defend against such claims.
Medtronic Sofamor Danek, Inc. v. Arthur Alfaro, Case No. 99-0867-1 (Chancery Ct.
of Tenn., Memphis)
In September, 1999, Medtronic Sofamor Danek, Inc. ("Medtronic"), sued
Arthur A. Alfaro, a former Division President of Medtronic and currently our
President and Chief Operating Officer, in the Chancery Court of Tennessee for
the Thirtieth Judicial District at Memphis, seeking to enjoin Mr. Alfaro from
using or disclosing to any third party, including us, alleged confidential
information or trade secrets of Medtronic and from working for us for a period
of twelve months. In September, 1999, the Court issued a temporary restraining
order prohibiting Mr. Alfaro from issuing or divulging any confidential
information or trade secrets of Medtronic to any third party. In October, 1999,
Mr. Alfaro filed and served his answer, denying any and all
26
liability. In November, 1999, Mr. Alfaro and Medtronic reached a settlement of
this action, and the action has been dismissed. Mr. Alfaro continues to be our
President and Chief Operating Officer. Pursuant to an employment agreement
between Mr. Alfaro and us, we paid Mr. Alfaro's legal fees and costs in
connection with this action.
Item 4. Submissions of Matters to a Vote of Security Holders
None.
27
PART II
Item 5. Market for the Registrant's Common Equity
and Related Stockholder Matters
Our Common Stock has been traded on the Nasdaq Stock Market(R) under the
trading symbol "OSTE" since our initial public offering in July 1991.
The following table sets forth the high and low sale prices for the Common
Stock for each of the fiscal quarters during the years ended December 31, 1999
and 1998 based on transaction data as reported by the Nasdaq Stock Market(R).
Year Ended December 31, 1999 High Low
- --------------------------------------------------------------------------
First Quarter $39.08 $25.42
Second Quarter $41.13 $24.75
Third Quarter $30.25 $12.20
Fourth Quarter $22.25 $11.75
Year Ended December 31, 1998 High Low
- --------------------------------------------------------------------------
First Quarter $19.58 $14.67
Second Quarter $17.33 $ 8.75
Third Quarter $19.83 $11.67
Fourth Quarter $31.33 $11.00
On February 11, 1999, our Board of Directors authorized a three-for-two
stock split in the form of a 50% stock dividend that was distributed on March
19, 1999 to stockholders of record on March 5, 1999. The high and low sales
prices have been restated to give retroactive recognition to the stock split for
all periods prior to the effective date of the stock split.
As of March 17, 2000 there were 292 holders of record of Osteotech Common
Stock. We believe that there are approximately 6,300 beneficial owners of our
Common Stock.
We have never paid a cash dividend and do not anticipate the payment of
cash dividends in the foreseeable future as earnings are expected to be retained
to finance our growth. Declaration of dividends in the future will remain within
the discretion of our Board of Directors, which will review our dividend policy
from time to time.
28
Item 6. Selected Financial Data
Set forth below is the selected financial data for the five fiscal
years ended December 31, 1999. The following data should be read in conjunction
with our consolidated financial statements and related notes thereto contained
elsewhere herein and "Management's Discussion and Analysis of Financial
Condition and Results of Operations." All per share data have been adjusted for
the three-for-two stock split in the form of a 50% stock dividend in March,
1999.
- ---------------------------------------------------------------------------------------------------------------------
Selected Financial Data
(dollars in thousands except per
share data)
For the Year ended December 31, 1999 1998 1997 1996 1995
- ---------------------------------------------------------------------------------------------------------------------
Consolidated Results of Operations
- ---------------------------------------------------------------------------------------------------------------------
Net revenues $75,610 $59,201 $44,931 $34,895 $27,934
- ---------------------------------------------------------------------------------------------------------------------
Gross profit 51,701 41,562 29,096 20,075 15,375
- ---------------------------------------------------------------------------------------------------------------------
Operating expenses (a) 33,849 25,281 20,109 18,326 15,137
- ---------------------------------------------------------------------------------------------------------------------
Income from litigation settlement 2,000 0 0 0 0
- ---------------------------------------------------------------------------------------------------------------------
Operating Income 19,582 16,281 8,987 1,749 238
- ---------------------------------------------------------------------------------------------------------------------
Other income, net (b) 1,032 1,132 585 271 4,582
- ---------------------------------------------------------------------------------------------------------------------
Income before income taxes 20,884 17,413 9,572 2,020 4,820
- ---------------------------------------------------------------------------------------------------------------------
Net income (loss) 12,351 10,304 5,686 (324) 4,582
- ---------------------------------------------------------------------------------------------------------------------
Net income (loss) per share (c)
- ---------------------------------------------------------------------------------------------------------------------
Basic .88 .78 .46 (.03) .39
- ---------------------------------------------------------------------------------------------------------------------
Diluted .84 .73 .43 (.03) .38
- ---------------------------------------------------------------------------------------------------------------------
Dividends per share 0 0 0 0 0
- ---------------------------------------------------------------------------------------------------------------------
Year End Financial Position
- ---------------------------------------------------------------------------------------------------------------------
Working capital $37,082 $26,373 $19,922 $12,273 $12,135
- ---------------------------------------------------------------------------------------------------------------------
Total assets 89,807 57,114 43,052 31,483 30,170
- ---------------------------------------------------------------------------------------------------------------------
Long-term obligations 6,359 0 203 840 1,598
- ---------------------------------------------------------------------------------------------------------------------
Stockholders' equity 69,406 45,930 34,292 22,717 22,594
- ---------------------------------------------------------------------------------------------------------------------
(a) Operating expenses include: (i) a charge to earnings in 1996 of $1,350,000
related to the restructuring of our operations located in Leiden, The
Netherlands and (ii) a charge to earnings in 1995 of $980,000 resulting
from the termination of a distribution agreement.
(b) Other income in 1995 includes principal payments aggregating $4,147,000
received from a major client on a fully-reserved note.
(c) All per share data have been adjusted for the three-for-two stock split in
the form of a 50% stock dividend in March 1999.
29
Item 7. Management's Discussion And Analysis Of Financial
Condition And Results Of Operations
For the Three Years Ended December 31, 1999, 1998 and 1997
Results of Operations
All per share data have been adjusted for the three-for-two stock split in
the form of a 50% stock dividend effected in March, 1999.
Net Income (Loss)
Consolidated net income increased to $12,351,000 or $.84 diluted income per
share in 1999 compared to net income of $10,304,000 or $.73 diluted income per
share in 1998 and $5,686,000 or $.43 diluted income per share in 1997.
Consolidated income before income taxes increased to $20,884,000 in 1999
compared to $17,413,000 in 1998 and $9,572,000 in 1997. Income before income
taxes in 1999 includes $2,000,000 related to a patent litigation settlement with
DePuy. (See Part I, Item 3. "Legal Proceedings" and Note 11 of "Notes to
Consolidated Financial Statements").
The following is a discussion of factors affecting results of operations
for the years ended December 31, 1999, 1998 and 1997.
Net Revenues
Consolidated net revenues increased 28% in 1999 to $75,610,000 from
$59,201,000 in 1998. The increase was principally due to higher revenues in both
the Grafton(R) DBM and Base Tissue Segments. Domestic revenues, which consist
principally of revenues from the Grafton(R) DBM and Base Tissue Segments,
increased 26% to $71,517,000 from $56,876,000 in 1998. Foreign revenues
increased 76% to $4,093,000 from $2,325,000 in 1998. The increase in foreign
revenues resulted primarily from revenues of OST which were not in our revenues
in 1998. In January, 1999, we completed the acquisition of 90% of OST, which
primarily processes, markets and distributes bovine bone tissue products for
orthopaedic and dental use.
In 1998, consolidated net revenues increased 32% to $59,201,000 from
$44,931,000 in 1997. The increase was principally due to higher revenues in both
the Grafton(R) DBM and Base Tissue Segments. Domestic revenues increased 36% to
$56,876,000 from $41,887,000 in 1997 and foreign revenues decreased 24% to
$2,325,000 from $3,044,000 in 1997. The decline in foreign revenues in 1998
resulted primarily from decreased unit volume for our ceramic products.
Grafton(R) DBM Segment revenues increased 15% in 1999 to $45,136,000 from
$39,128,000 in 1998. 1998 revenues in this segment were 47% higher than 1997
segment revenues of $26,653,000. These increases resulted from increased demand
for Grafton(R) DBM.
30
Our Grafton(R) DBM products have faced increasing competition as more companies
have developed products with characteristics similar to Grafton(R) DBM. We
expect that this competition will continue in the future. Base Tissue Segment
revenues increased 49% in 1999 to $25,751,000 from $17,323,000 in 1998. 1998
revenues in this segment were 20% higher than 1997 Segment revenues of
$14,426,000. These increases occurred as a result of increased unit volume of
allograft bone tissue processed for our clients.
During 1999, 1998 and 1997, two of our clients in the Grafton(R) DBM and
Base Tissue Segments accounted for 56% and 38%, 56% and 39% and 57% and 34%,
respectively, of consolidated net revenues. We have exclusive processing
agreements with each of these clients which expire in April, 2002 and December,
2006, respectively.
Gross Profit
Gross profit as a percentage of revenues was 68% in 1999, 70% in 1998 and
65% in 1997. The decline in gross profit as a percentage of revenues in 1999
results from; (i) the absorption of costs associated with additional allograft
tissue processing capacity which was added to meet the anticipated growth in our
allograft tissue business, and (ii) a decline in the percentage of consolidated
revenues coming from the Grafton(R) DBM Segment, which has a higher gross profit
than other services and products. The increase in gross profit in 1998 as
compared with 1997 resulted primarily from an increase in the percentage of
consolidated revenues represented by our Grafton(R) DBM Segment.
In the fourth quarter of 1998, we commenced construction of a new allograft
tissue processing facility in Eatontown, New Jersey which is expected to be in
use during the second half of 2000. We expect that the incremental expenses
associated with the added capacity will only be partially offset by increased
volume in 2000, and therefore consolidated gross profit as a percentage of
revenues in 2000 is expected to decrease from the level achieved in 1999.
Marketing, General and Administrative Expenses
Marketing, general and administrative expenses increased 37% in 1999 to
$28,343,000 from $20,671,000 in 1998. 1998 marketing, general and administrative
expenses were 26% higher than 1997 marketing, general and administrative
expenses of $16,381,000. The increase in 1999 was primarily attributable to: (i)
incremental agent commissions resulting from increased volume in the Grafton(R)
DBM Segment, (ii) expanded marketing and promotional activities associated with
the launch of two new products, the bio-d(TM) Threaded Cortical Bone Dowel which
is included in the Base Tissue Segment and the SSCS(TM) system, (iii) increased
legal fees associated with patent infringement lawsuits (See Part I, Item 3.
Legal Proceedings" and Note 11 of "Notes to Consolidated Financial Statements")
and (iv) the inclusion of OST's operating expenses. We are committed to
aggressively asserting and defending our technology and related intellectual
property. As a result we are currently a party in three patent lawsuits.
Prosecuting and defending these lawsuits is expensive and has had, and will
likely have, a negative impact on
31
our operating results. However, we believe it is necessary to defend our
technology and related intellectual property which we invest significant amounts
of money to develop.
The increase in 1998 was primarily attributable to the Grafton(R) DBM
Segment and resulted from expanded marketing and promotional activities and
increased agent commissions associated with increased volume.
Research and Development Expenses
Consolidated research and development expenses increased 19% in 1999 to
$5,506,000 from $4,610,000 in 1998. Research and development expenses in 1998
were 24% higher than 1997 research and development expenses of $3,728,000. These
increases were primarily attributable to increased spending in the Base Tissue
Segment associated with the continued development of a viral inactivation
process for mineralized weight-bearing allograft tissue, development of new
allograft tissue products and ongoing support for existing products and
services.
Income From Litigation Settlement
In November, 1999, we settled all claims which we had filed against DePuy
in the patent infringement lawsuit against GenSci Labs and GenSci Sciences (See
Part I, Item 3. "Legal Proceedings" and Note 11 of "Notes to Consolidated
Financial Statements"). As part of the settlement, DePuy has agreed to stop
selling the GenSci products accused of infringing our patents no later than
February 4, 2001 and to pay us $3,000,000. We received a payment of $2,000,000
in the fourth quarter of 1999, of which $1,750,000 was recognized in income in
the third quarter of 1999 and $250,000 was recognized in income in the fourth
quarter of 1999. DePuy will make payments of $250,000 in each quarter of 2000.
These payments will be recognized in income as earned unless DePuy discontinues
selling the GenSci products during the year, at which time DePuy would not be
obligated for payments beyond the quarter in which it stopped selling the GenSci
products.
Operating Income
Consolidated operating income increased 22% in 1999 to $19,852,000 from
$16,281,000 in 1998. 1998 consolidated operating income was 81% higher than 1997
operating income of $8,987,000. The increase in both years results primarily
from improved operating income in the Grafton(R) DBM Segment resulting from
increased revenues and, in 1999, the litigation settlement with DePuy discussed
above. Grafton(R) DBM Segment operating income increased 27% in 1999 to
$17,063,000 from $13,404,000 in 1998. In 1998 Grafton(R) DBM Segment operating
income was 93% higher than 1997 operating income of $6,962,000. Base Tissue
Segment operating income increased 54% in 1999 to $6,434,000 from $4,170,000 in
1998 primarily as a result of higher revenues. Base Tissue Segment operating
income in 1997 was $2,686,000. Other segment operating income declined 182% in
1999 to a loss of $3,645,000 and declined 96% in 1998 to a loss of $1,293,000
from a loss of $661,000 in 1997. The decline in 1999 resulted principally from
32
increased marketing and promotional expenses associated with the launch of
SSCS(TM), while the decline in 1998 resulted from a decrease in revenues for our
ceramic products.
Other Income (Expense)
Other income decreased $100,000 in 1999 principally due to lower interest
income resulting from a decline in interest rates. In 1998, other income
increased $547,000 due to higher invested cash and lower outstanding debt
balances.
Income Tax Provision
Our effective income tax rate in 1999, 1998 and 1997 was 41%, respectively.
The effective income tax rate exceeded the federal statutory income tax rate
principally due to the impact of state income taxes.
Liquidity and Capital Resources
At December 31, 1999, we had cash and short-term investments of $20,716,000
compared to $18,041,000 at December 31, 1998. We invest our excess cash in U.S.
Government-backed securities and investment grade commercial paper of major U.S.
corporations. Working capital increased $10,709,000 to $37,082,000 at December
31, 1999 compared to $26,373,000 at December 31, 1998. The increase resulted
primarily from increases in accounts receivable, deferred processing costs,
inventories and prepaid expenses.
Net cash provided by operating activities decreased to $7,917,000 in 1999
from $8,338,000 in 1998. The decrease resulted primarily from increases in
accounts receivable, deferred processing costs, inventories and prepaid
expenses, partly offset by improved earnings in 1999. The increases in accounts
receivable and deferred processing costs result from the growth in our
Grafton(R) DBM and Base Tissue Segments. The increase in inventories is
associated with our acquisition of the Versalok(R) Low Back Fixation System (See
Note 4 of "Notes to Consolidated Financial Statements"). The increase in prepaid
expenses in 1999 resulted primarily from an increase in prepaid income taxes
(See Note 10 of "Notes to Consolidated Financial Statements").
Cash used in investing activities increased to $22,173,000 in 1999 from
$7,800,000 in 1998. The increase results from: (i) an increase in capital
expenditures to $18,743,000 from $5,521,000 resulting from our continued
investment in facilities and equipment needed for current and future business
requirements, (ii) our purchase of an additional 85% interest in OST, and (iii)
our acquisition of the Versalok(R) System. In the fourth quarter of 1998, we
commenced construction of a new allograft tissue processing facility in
Eatontown, New Jersey (See Item 2. "Properties" and Note 6 of "Notes to
Consolidated Financial Statements"). The estimated aggregate cost for the
construction of the facility, including furniture, fixtures and equipment, is
approximately $32,000,000, $21,500,000 of which will be funded through the
building mortgage loan and equipment line of credit included in the credit
facility concluded with our bank in June 1999 (See Note 9 of "Notes to
Consolidated Financial Statements"). The remaining balance will
33
be funded through available cash reserves or anticipated cash flow from
operations. Through December 31,1999, we have incurred $10,272,000 of capital
expenditures, including capitalized interest of $51,000, related to the new
allograft tissue processing facility, of which $6,359,000 was funded through
bank financing.
Net cash provided by financing activities increased to $15,930,000 from
$616,000 in 1998. The increase results from cash proceeds received and related
income tax benefits associated with stock option exercises and borrowings under
the bank lines of credit. The net cash provided by financing activities in 1998
is net of $4,958,000 used to repurchase and retire 367,500 shares of our common
stock in 1998.
In June, 1999, we replaced our then existing domestic lines of credit with
a credit facility that includes a $5,000,000 revolving line of credit, a
$4,500,000 building mortgage loan and a $17,000,000 equipment line of credit. At
December 31, 1999, $4,500,000 was outstanding under the revolving line of credit
and $1,859,000 was outstanding under the equipment line of credit. We also have
a line of credit with a Dutch bank, which provides for borrowings of up to dfl
5,000,000, or approximately $2,285,000 at the December 31, 1999 exchange rate.
Analysis of our cash position and anticipated cash flow indicated that it most
likely would not be necessary to utilize a significant portion of this line of
credit in 1999 and, therefore, we agreed with the bank to limit our borrowings,
if any, to no more than dfl 3,000,000, or approximately $1,371,000 at the
December 31, 1999 exchange rate. At December 31, 1999, there were no borrowings
outstanding under this credit line. Additionally, we have a line of credit with
a French bank which provides for borrowings of up to FRF 1,750,000, or
approximately $269,000 at the December 31, 1999 exchange rate. At December 31,
1999, there were no borrowings outstanding under this credit line. (See Note 9
of "Notes to Consolidated Financial Statements").
At December 31, 1999, certain of our foreign-based subsidiaries have net
operating loss carryforwards aggregating $3,192,000 at the December 31, 1999
exchange rate ($364,000 with no expiration date; $2,962,000 expiring 2004
through 2007). (See Note 10 of "Notes to Consolidated Financial Statements").
We believe that our cash and cash equivalents, short-term investments and
available lines of credit, together with anticipated future cash flow from
operations, will be sufficient to meet our near-term requirements. From time to
time, we may seek additional funds through equity or debt financing. However,
there can be no assurance that such additional funds will be available to us or,
if available, that such funds will be available to us on favorable terms.
Impact of Inflation and Foreign Currency Exchange Fluctuations
The results of operations for the periods discussed have not been
materially affected by inflation or foreign currency fluctuations.
34
Litigation
We are involved in various legal proceedings involving product liability
and patent infringement claims. For a complete discussion of these matters see,
Part I, Item 3. "Legal Proceedings" and Note 11 of "Notes to Consolidated
Financial Statements." It is possible that our results of operations or
liquidity and capital resources could be adversely affected by the ultimate
outcome of the pending litigation or as a result of the costs of contesting such
lawsuits.
Year 2000
We recognized the need to ensure that Year 2000 issues would not adversely
impact our operations and we, therefore, prior to 2000 took actions designed to
minimize the risk of Year 2000 issues. We identified our potential Year 2000
risk in three categories: internal business software and hardware; internal
non-financial systems; and noncompliance by suppliers and customers. To date, we
have not experienced any Year 2000 issues with our internal business software
and hardware systems, non-financial systems, and our suppliers and customers.
Based on our experience to date we do not foresee significant risks associated
with Year 2000 issues at this time.
Risk Factors
We are dependent upon two primary clients who provide the bulk of our
revenues.
We are the exclusive processor of allograft bone tissue for large national
and international not-for-profit organizations. During 1999, MTF and ARC
accounted for approximately 56% and 38%, respectively, of our revenues. We
entered into a 10-year exclusive processing agreement with ARC in December, 1996
and a five-year exclusive processing agreement with MTF in April, 1997. The loss
of either MTF or ARC as a client or a substantial reduction in the amount of
allograft bone tissue which we process for either entity would have a material
adverse effect on our business, financial condition and results of operations.
Our dependence upon a limited supply of human donors may curtail business
expansion.
Our allograft bone tissue processing business depends upon the availability
of bone and related connective tissue from human donors recovered by our
clients. We rely on the efforts of not-for-profit donor procurement agencies,
including our current clients, to educate the public and foster an increased
willingness to donate bone tissue. These organizations may not be able to find a
sufficient number of persons to donate sufficient amounts of tissue to meet
present or future demand for either allograft bone tissue or any allograft bone
tissue-based osteogenic materials we are developing. Our ability to secure
enough donors to meet our demands could have a material adverse effect on our
business, financial condition and results of operations.
35
We face strong competitive threats from firms with greater financial
resources and lower costs.
The allograft bone tissue we process competes in the bone graft market with
autograft bone tissue, synthetic bone void fillers and allograft bone tissue
processed by others, primarily tissue banks. Autograft bone tissue has
traditionally been the primary choice for surgeons and we believe autograft bone
tissue still maintains approximately a 50% share of the United States bone graft
market. Certain of our competitors have greater financial resources than we do.
For numerous circumstances and procedures for which autograft bone tissue
transplantation is either not feasible or not desirable, there are a number of
competing alternatives available, including allograft bone tissue processed by
others.
In recent years, our Grafton(R) DBM products have faced increasing
competitive pressures as more companies have developed, or have announced they
are developing, products with characteristics similar to Grafton(R) DBM. We
expect that this competition will continue in the future. Many of these
competitors offer a full line of metal implants and other products used in
spinal surgeries. This could give them a competitive advantage over us since
they can offer surgeons a more complete line of products than we currently can.
We believe that a majority of the cadaveric bone banks operating in the
United States are engaged in processing allograft bone tissue for
transplantation. Substantially all of these bone tissue banks are not-for-profit
organizations, and, as such, they may be able to supply processing services at a
lower cost than we can. We compete with such entities on the basis of our
advanced processing technology and the quality and quantity of the bone tissue
our processing yields. Since we introduced our allograft bone tissue processing
technology in 1987, certain competing processors have claimed to have developed
technology similar to that which we use. Although we believe, based upon our
knowledge of the industry, that we process bone tissue from more donors than any
other processor in the world, we can not assure you that we will continue to
compete successfully in the area of allograft bone tissue processing.
We are currently involved in patent litigation which could have a
significant adverse impact on our business. We may become involved in additional
patent litigation in the future.
We are currently involved in three litigations involving our patents and
patents held by certain of our competitors. Prosecuting and defending these
lawsuits is very expensive and these expenses have had, and are likely to have,
an adverse affect on our results of operations. We are committed to aggressively
asserting and defending our technology and related intellectual property which
we have spent a significant amount of money to develop. In addition, the
industry in which we compete is known for having a great deal of litigation
involving patents. These factors could cause us to become involved in additional
patent litigations in the future. The expense of prosecuting or defending these
future lawsuits could also have a material adverse effect on our business,
financial condition and results of operations.
If we were to lose those litigations in which another party is asserting
that our products infringe its patents, we would likely be prohibited from
marketing those products and could also
36
be liable for significant damages. Either or both of these results may have a
material adverse effect on our business, financial condition and results of
operations. If we lose those litigations in which we are claiming that another
party's products are infringing our patents and thus, are unable to enforce our
patents, it may have a material adverse effect on our business, financial
condition and results of operations.
During the course of the patent litigations in which we are involved,
interim information about the status of each of these litigations may be
released. Although these interim releases may differ from the final
determinations in these litigations, such information may have a material
adverse effect on the market price of our common stock.
Our revenues will depend upon reimbursement from public and private
insurers and national health systems.
The continued ability of our clients to pay our processing charges depends
upon our clients' ability to distribute processed allograft bone tissue and
collect fees from their clients, which are typically medical institutions. The
ability of medical institutions to pay fees to our clients depends in part on
the extent to which reimbursement for the costs of such materials and related
treatments will continue to be available from government health administration
authorities, private health coverage insurers and other organizations. We may
have difficulty gaining market acceptance for our products and services if
government and third-party payors do not provide adequate coverage and
reimbursement.
The medical community could choose not to use our allograft bone tissue
products.
We believe the market for allograft bone tissue will continue to be based
upon the use of such products by physicians specializing in the orthopaedic,
neurological, plastic and oral/maxillofacial surgical areas. Our future growth
depends in part upon such physicians' wider use of allograft bone tissue as an
alternative to autograft bone tissue and other available materials and
treatments. We have tried to educate physicians through our marketing
activities. Although our education and marketing efforts to date have enabled us
to expand our business, our future efforts in this regard may fail to generate
additional demand.
Governmental regulation of organ transplantation could restrict the use of
our products.
In the United States the procurement and transplantation of allograft bone
tissue are subject to federal regulation pursuant to NOTA, a criminal statute
which prohibits the purchase and sale of human organs, including bone and
related tissue, for "valuable consideration." NOTA permits the payment of
reasonable expenses associated with the removal, transportation, processing,
preservation, quality control, implantation and storage of human bone tissue. We
provide services in all of these areas, with the exception of removal and
implantation. We and other allograft bone tissue processors are engaged in
ongoing efforts designed to educate the medical community as to the benefits of
processed allograft bone tissue and we will continue to expand our educational
activities. Although we believe that NOTA permits reimbursement of these costs
as costs associated with the processing, transportation and implantation of our
allograft
37
bone tissue products, our inability to be reimbursed for our education efforts
in the future could adversely affect our business and prospects. No federal
agency or court has determined whether NOTA is, or will be, applicable to every
allograft bone tissue-based material which our processing technologies may
generate. Assuming that NOTA applies to our processing of allograft bone tissue,
we believe that we comply with NOTA, but there can be no assurance that more
restrictive interpretations of, or amendments to, NOTA will not be adopted in
the future which would call into question one or more aspects of our method of
operations.
In various countries outside the United States, national laws and
regulations restrict or control the availability and or use of tissues. There
can be no assurance that more restrictive laws, regulations or interpretations
will not be adopted in the future which would call into question one or more
aspects of our method of operations in those countries.
Loss of key persons could limit our success.
Our success depends upon the continued contributions of our executive
officers and scientific and technical personnel. The competition for qualified
personnel is intense, and the loss of services of our key personnel,
particularly members of senior management, could adversely affect our business.
If we are unable to enforce our patents or if it is determined that we
infringe patents held by others it could damage our business.
We consider our allograft bone tissue processing technology and procedures
proprietary and rely primarily on trade secrets and patents to protect our
technology and innovations. Consultants employed by third parties and persons
working in conjunction with medical institutions unaffiliated with us have
conducted significant research and development for our products. Accordingly,
disputes may arise concerning the proprietary rights to information applied to
our projects which have been independently developed by such consultants or
medical institutions. In addition, you should recognize that although we have
attempted to protect our technology with patents, our existing patents may prove
invalid or unenforceable as to products or services marketed by our competitors.
Our pending patent applications may not result in issued patents. Moreover, our
existing or future products and technologies could be found to infringe the
patents of others. We are currently involved in three lawsuits in which we are
accused of infringing patents held by others. See Part I, Item 3 "Legal
Proceedings."
Our products face competitive threats from alternate technologies.
The primary advantage of synthetic bone substitutes as compared to
allograft bone tissue is that they do not depend on the availability of human
donors. In addition, members of the medical community and the general public may
perceive synthetic materials as safer than allograft-based bone tissue. The
allograft bone tissue we process may be incapable of competing successfully with
synthetic bone substitutes and recombinant bone growth factors which are
developed and commercialized by others, which could have a material adverse
effect on our business, financial condition and results of operations.
38
Our spray coating, HA products and bovine tissue products operations face
intense competition.
Our plasma spray coatings, HA products and bovine tissue products
operations face intense competition in Europe from divisions and subsidiaries of
several large corporations engaged in providing such services and products to
others and from several smaller independent companies. In addition, we also face
competition from medical implant companies which have in-house plasma spray
coating operations. We compete primarily on the quality of our coatings, bovine
tissue products and our prices. We believe that the spraying technology we use,
which is computer-controlled and utilizes robotics, enables us to provide high
quality coatings at competitive prices. You should note, however, that the
industries in which we compete in Europe are highly competitive, certain of our
competitors have greater resources than we do, and we may be unable to compete
successfully.
We may incur losses from product liability lawsuits.
The testing and use of human allograft bone tissue, bovine tissue products
and the implantation of medical devices coated with our HA powder or titanium
and medical devices manufactured by others and which we distribute, entail
inherent risks of medical complications for patients and therefore may result in
product liability claims against us. Further, our agreements with our allograft
bone tissue processing clients provide for indemnification by us for liabilities
arising out of defects in allograft bone tissue they distribute which is caused
by our processing.
As a distributor of implants and instruments for spinal surgery, including
bone screws, manufactured by Ulrich, we are currently named as a defendant in
one lawsuit in which patients claim that they have suffered damages from the
implantation of allegedly defective spinal fixation devices. This lawsuit is
currently stayed as to us and several other defendants.
The ultimate outcome of the pending litigation or further litigation or the
costs of contesting these suits could materially adversely affect our results of
operations or liquidity and capital resources. We are unable to estimate the
potential liability, if any, that may result from the pending bone screw
litigation and, accordingly, have made no provision for any possible future
liability in the consolidated financial statements. See Part I, Item 3 "Legal
Proceedings."
We presently maintain product liability insurance in the amount of $102
million per occurrence and per year in the aggregate. We may be unable to
maintain such insurance in the future and such insurance may not be sufficient
to cover all claims made against us or all types of liabilities which may be
asserted against us.
We face potential lawsuits or governmental enforcement activities based on
hazardous waste we generate in our operations.
Our bone tissue processing generates waste which is classified as medical
hazardous waste by the United States Environmental Protection Agency and the New
Jersey Department of
39
Environmental Protection. We segregate such waste and dispose of it through a
licensed hazardous waste transporter in compliance with applicable regulations.
The production of HA powder at our facility in The Netherlands generates small
amounts of hazardous waste, which we segregate and dispose of through a licensed
hazardous waste transporter.
Although we believe we are in compliance with applicable environmental
regulations, our failure to fully comply with any such regulations could result
in the imposition of penalties, fines and/or sanctions or, in some cases,
private lawsuits, which could have a material adverse effect on our business,
financial condition and results of operations.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Not applicable.
Item 8. Financial Statements and Supplementary Data
The response to this item is submitted as a separate section of this Annual
Report commencing on page F-1.
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure
Not applicable.
40
PART III
Item 10. Directors and Executive Officers of the Registrant
The section of our 2000 Proxy Statement entitled "Election of Directors" is
incorporated herein by reference.
Item 11. Executive Compensation
The section of our 2000 Proxy Statement entitled "Executive Compensation"
is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The section of our 2000 Proxy Statement entitled "Security Ownership of
Certain Beneficial Owners and Management" is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
The section of our 2000 Proxy Statement entitled "Certain Relationships and
Related Transactions" is incorporated herein by reference.
41
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a)(1) and (2). The response to this portion of Item 14 is submitted as a
separate section of this report commencing on page F-1.
(a)(3) and (c). Exhibits (numbered in accordance with Item 601 of
Regulation S-K).
42
Exhibit Page
Number Description Number
- ------ ----------- ------
3.1 Restated Certificate of Incorporation of Osteotech *
3.2 Amended and Restated Bylaws of Osteotech #
3.3 Form of Stock Certificate **
3.4 Certificate of Amendment of Restated Certificate of Incorporation of ^^^^
Osteotech, Inc.
4.1 Stock and Warrants Purchase Agreement, as amended **
4.2 Amended Security Holders Agreement **
4.3 Rights Agreement dated as of February 1, 1996 between Osteotech, Inc. #
and Registrar and Transfer Co.
10.1 1991 Stock Option Plan, as amended ^ *****
10.2 1991 Independent Directors Stock Option Plan, as ammended ^ *****
10.3 Various Written Option Agreements between Osteotech and certain ***
employees, officers, directors and consultants or advisors of
Osteotech ^
10.4 Senior Management Loan Program ^ ****
10.5 Lease for Osteotech's Leiden, The Netherlands facility dated May 28, 1993 +
10.6 Processing Agreement between Osteotech and Stichting Eurotransplant **
Nederland, dated September 26, 1988
10.7 Loan and Security Agreement between Osteotech and United Jersey +
Bank/Central, N.A. dated May 27, 1993
10.8 First Amendment to Loan and Security Agreement between Osteotech and +++
United Jersey Bank/Central, N.A. dated July 14, 1994
10.9 Lease for Osteotech's Eatontown facility dated October 20, 1994. ******
10.10 Form of Confidentiality Agreement and Non-Competition Agreement with ******
Executive Officers
10.11 Second Amendment to Loan and Security Agreement between Osteotech and ++++
United Jersey Bank/Central N.A. dated June 30, 1995
10.12 Amendment to the lease for Osteotech's Leiden, The Netherlands facility ++++
dated June 27, 1995
10.13 Agreement dated December 10, 1996 between American Red Cross Tissue ********
Services and Osteotech
10.14 Lease for Osteotech's Shrewsbury, New Jersey processing facility ********
10.15 Agreement dated April 1, 1997 between Musculoskeletal Transplant ++++++
Foundations and Osteotech
10.16 Credit Agreement between Osteotech b.v. and ING Bank N.V. dated March +++++
14, 1996
43
Exhibit Page
Number Description Number
- ------ ----------- ------
10.17 Third Amendment to Loan and Security Agreement between Osteotech and +++++
United Jersey Bank/Central N.A. dated May 31, 1996
10.18 Fourth Amendment to Loan and Security Agreement between Osteotech and ++++++
Summit Bank dated July 28, 1997
10.19 Third Restated Equipment Promissory Note between Osteotech and Summit ++++++
Bank dated July 28, 1997
10.20 Second Restated Revolving Loan Promissory Note between Osteotech and ++++++
Summit Bank dated July 28, 1997
10.21 License & Option Agreement between HC Implants BV and Matrix Medical ++++++
Holdng BV dated June 6, 1997
10.22 Change in Control Agreement by and between Osteotech and Richard W. +++++++
Bauer ^
10.23 Change in Control Agreement by and between Osteotech and Michael J. +++++++
Jeffries ^
10.24 Change in Control Agreement by and between Osteotech and James L. +++++++
Russell ^
10.25 Change in Control Agreement by and between Osteotech and Roger +++++++
Stikeleather ^
10.26 Employment Agreement with Michael J. Jeffries dated January 1, 1998 ^ ^^
10.27 Employment Agreement with James L. Russell dated December 18, 1997 ^ ^^
10.28 The Management Performance Bonus Plan ^ ^^^
10.29 Employment Agreement with Richard Russo dated April 1, 1997 ^^^
10.30 Change in Control Agreement by and between Osteotech Inc. and Richard ^^^
Russo ^
10.31 Employment Agreement with Richard W. Bauer dated December 4, 1998 ^ ^^^
10.32 Employment Agreement with Arthur A. Alfaro dated September 13, 1999 ^ ^^^^
10.33 Change in Control Agreement by and between Osteotech Inc. and Arthur A. ^^^^
Alfaro
10.34 Settlement Agreement and General Release Between DePuy Acromed, Inc. and ^^^^
DePuy, Inc. and Osteotech, Inc.
10.35 Loan and Security Agreement among Summit Bank, Osteotech, Inc., ^^^^^
Osteotech Investment Corp. Cam Implants B.V., Cam Implants B.V.,
Osteotech/CAM Services B.V. and OST Developement dates June 10, 1999
21.1 Subsidiaries of the Registrant E-1
23.1 Consent of PricewaterhouseCoopers LLP E-2
27.0 Financial Data Schedule E-3
44
Exhibit Page
Number Description Number
- ------ ----------- ------
* Previously filed as exhibits to Osteotech's Annual Report
on Form 10-K for the fiscal year ended December 31, 1991
and incorporated herein by reference thereto.
** Previously filed as exhibits to Osteotech's Registration Statement on
Form S-1 (File No. 33-40463) and incorporated herein by reference
thereto.
*** Previously filed as exhibits to Osteotech's Registration Statement on
Form S-8 (File No. 33-44547) and incorporated herein by reference
thereto.
**** Previously filed as exhibits to Osteotech's Annual Report on Form 10-K
for the fiscal year ended December 31, 1992 and incorporated herein by
reference thereto.
***** Previously filed as exhibits to Osteotech's Annual Report on Form 10-K
for the fiscal year ended December 31, 1993 and incorporated herein by
reference thereto.
****** Previously filed as exhibits to Osteotech's Annual Report on Form 10-K
for the fiscal year ended December 31, 1994 and incorporated herein by
reference thereto.
******** Previously filed as exhibits to Osteotech's Annual Report on Form 10-K
for the fiscal year ended December 31, 1996 and incorporated herein by
reference thereto.
+ Previously filed as exhibits to Osteotech's Quarterly Report on Form
10Q for the quarter ended June 30, 1993 and incorporated herein by
reference thereto.
++ Previously filed as exhibits to Osteotech's Current Report on Form 8-K
filed with the Commission on May 26, 1992.
+++ Previously filed as exhibits to Osteotech's Quarterly Report on Form
10Q for the quarter ended June 30, 1994 and incorporated herein by
reference thereto.
++++ Previously filed as exhibits to Osteotech's Quarterly Report on Form
10Q for the quarter ended March 31, 1994 and incorporated herein by
reference thereto.
+++++ Previously filed as exhibits to Osteotech's Quarterly Report on Form
10Q for the quarter ended June 30, 1996 and incorporated herein by
reference thereto.
++++++ Previously filed as exhibits to Osteotech's Quarterly Report on Form
10Q for the quarter ended June 30, 1997 and incorporated herein by
reference thereto.
+++++++ Previously filed as exhibits to Osteotech's Quarterly Report on Form
10Q for the quarter ended September 30, 1997 and incorporated herein
by reference thereto.
^ Management contracts or compensatory plans and arrangements required
to be filed pursuant to Item 14(c).
45
Exhibit Page
Number Description Number
- ------ ----------- ------
^ ^ Previously filed as Exhibits to Osteotech's Annual Report on Form 10-K
for the fiscal year ended December 31, 1997 and incorporated herein by
reference thereto.
^^^ Previously filed as Exhibits to Osteotech's Annual Report on Form 10-K
for the fiscal year ended December 31, 1998 and incorporated herein by
reference thereto.
^^^^ Previously filed as exhibits to Osteotech's Quarterly Report on Form
10Q for the quarter ended June 30, 1999 and incorporated herein by
reference thereto.
^^^^^ Previously filed as exhibits to Osteotech's Quarterly Report on Form
10Q for the quarter ended September 30, 1999 and incorporated herein
by reference thereto.
# Previously filed as exhibits to Osteotech's Report on Form
8-A dated February 2, 1996 and incorporated herein by reference
thereto.
- - Copy omits information which is subject to confidential treatment.
(b) Reports on Form 8-K
None.
46
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Dated: March 30, 2000 OSTEOTECH, INC.
By: /s/Richard W. Bauer
--------------------------------------
Richard W. Bauer
Chief Executive Officer
(Principal Executive Officer) and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons in the capacities and on
the dates indicated:
Signature Title Date
- --------------------------------------------------------------------------------
/s/DONALD D. JOHNSTON Chairman of the March 30, 2000
- ------------------------ Board of Directors
Donald D. Johnston
/s/RICHARD W. BAUER Chief Executive Officer March 30, 2000
- ------------------------ (Principal Executive
Richard W. Bauer Officer and Director
/s/ARTHUR A. ALFARO President, Chief Operating March 30, 2000
- ------------------------ Officer and Director
Arthur A. Alfaro
/s/MICHAEL J. JEFFRIES Executive Vice President March 30, 2000
- ------------------------ Chief Financial Officer
Michael J. Jeffries (Principal Financial
Accounting Officer),
Secretary and Director
/s/KENNETH P. FALLON III Director March 30, 2000
- ------------------------
Kenneth P. Fallon III
/s/JOHN P. KOSTUIK Director March 30, 2000
- ------------------------
John P. Kostuik
/s/STEPHEN J. SOGIN Director March 30, 2000
- ------------------------
Stephen J. Sogin
47
OSTEOTECH, INC. AND SUBSIDIARIES
-------------------
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULES
Page
----
1. FINANCIAL STATEMENTS
Report of Independent Accountants...................................F-2
Consolidated Balance Sheets as of December 31, 1999 and 1998........F-3
Consolidated Statements of Operations
for the years ended December 31, 1999, 1998 and 1997.............F-4
Consolidated Statements of Changes in Stockholders' Equity
for the years ended December 31, 1999, 1998 and 1997.............F-5
Consolidated Statements of Cash Flows
for the years ended December 31, 1999, 1998 and 1997.............F-6
Notes to Consolidated Financial Statements..........................F-7
2. SCHEDULES
II. Valuation and Qualifying Accounts
for the years ended December 31, 1999, 1998 and 1997.........S-1
Report of Independent Accountants on Financial Statement Schedule...S-2
All schedules, except for those set forth above, have been omitted since the
information required is included in the financial statements or accompanying
notes or have been omitted as not applicable or not required.
F-1
REPORT OF INDEPENDENT ACCOUNTANTS
The Board of Directors and
Stockholders of Osteotech, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, changes in stockholders' equity and cash
flows present fairly, in all material respects, the financial position of
Osteotech Inc. and Subsidiaries (the "Company") at December 31, 1999 and 1998,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 1999, in conformity with accounting
principles generally accepted in the United States. These financial statements
are the responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States, which require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.
PricewaterhouseCoopers LLP
Florham Park, New Jersey
February 18, 2000, except as to certain
information presented in Note 11
for which the date is March 6, 2000
F-2
OSTEOTECH, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
December 31, 1999 1998
- --------------------------------------------------------------------------------------------
ASSETS
- --------------------------------------------------------------------------------------------
Current assets:
Cash and cash equivalents $ 16,770 $15,119
Short-term investments 3,946 2,922
Accounts receivable, less allowance of
$129 in 1999 and $148 in 1998 15,095 11,980
Deferred processing costs 5,310 2,620
Inventories 3,405 1,568
Deferred income taxes 931 723
Prepaid expenses and other current assets 4,856 2,190
------------------------
Total current assets 50,313 37,122
Property, plant and equipment, net 33,995 16,044
Excess of cost over net assets of business acquired, less
accumulated amortization of $2,089 in 1999 and $1,701 in 1998 3,682 1,997
Other assets 1,740 1,951
- --------------------------------------------------------------------------------------------
Total assets $ 89,730 $57,114
============================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
- --------------------------------------------------------------------------------------------
Current liabilities:
Accounts payable and accrued liabilities $ 13,231 $ 9,935
Notes payable 609
Current maturities of long-term debt and
obligations under capital leases 205
------------------------
Total current liabilities 13,231 10,749
Long-term debt 6,359
Other liabilities 734 435
- --------------------------------------------------------------------------------------------
Total liabilities 20,324 11,184
- --------------------------------------------------------------------------------------------
Commitments and contingencies
Stockholders' equity:
Preferred stock, $.01 par value; 5,676,595 shares
authorized; no shares issued or outstanding
Common stock, $.01 par value; 70,000,000 shares
authorized; issued and outstanding 14,194,126
shares in 1999 and 13,380,291 shares in 1998 140 133
Additional paid-in capital 48,837 37,332
Accumulated other comprehensive income (loss) (376) 11
Retained earnings 20,805 8,454
- --------------------------------------------------------------------------------------------
Total stockholders' equity 69,406 45,930
- --------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $ 89,730 $57,114
============================================================================================
The accompanying notes are an integral part of these consolidated
financial statements.
F-3
OSTEOTECH, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share data)
Year ended December 31, 1999 1998 1997
- ------------------------------------------------------------------------------------------------------------------
Net revenues:
Service $ 72,418 $ 58,077 $ 42,861
Product 3,074 1,000 1,800
License fee and other revenue 118 124 270
---------------------------------------------
75,610 59,201 44,931
Cost of services 22,004 16,844 14,487
Cost of products 1,905 795 1,348
---------------------------------------------
23,909 17,639 15,835
Gross profit 51,701 41,562 29,096
Marketing, general and administrative 28,343 20,671 16,381
Research and development 5,506 4,610 3,728
---------------------------------------------
33,849 25,281 20,109
---------------------------------------------
Income from litigation settlement 2,000
---------------------------------------------
Operating income 19,852 16,281 8,987
---------------------------------------------
Other income (expense):
Interest income 891 1,034 673
Interest expense (62) (83) (140)
Other 203 181 52
---------------------------------------------
1,032 1,132 585
---------------------------------------------
Income before income taxes 20,884 17,413 9,572
Income tax provision 8,533 7,109 3,886
- ------------------------------------------------------------------------------------------------------------------
Net income $ 12,351 $ 10,304 $ 5,686
==================================================================================================================
Net income per share:
Basic $ .88 $ .78 $ .46
Diluted $ .84 $ .73 $ .43
- ------------------------------------------------------------------------------------------------------------------
Shares used in computing net income per share:
Basic 14,024,468 13,259,784 12,389,124
Diluted 14,618,786 14,086,949 13,188,773
- ------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of these consolidated
financial statements.
F-4
OSTEOTECH, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(dollars in thousands)
Years ended December 31, 1999, 1998 and 1997
- ------------------------------------------------------------------------------------------------------------------------------------
Accumulated Retained
Common Stock Additional Other Earnings Total
------------------- Paid-In Comprehensive (Accumulated Stockholders'
Shares Amount Capital Income (Loss) Deficit) Equity
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1996 11,740,169 $117 $30,249 $(113) $(7,536) $22,717
Net income 5,686 5,686
Currency translation adjustments 38 38
-------
Comprehensive income 5,724
Exercise of stock options 858,147 9 2,949 2,958
Exercise of stock warrants 414,864 4 (4)
Common stock issued pursuant to
employee stock purchase plan 16,340 152 152
Tax benefits related to stock options 2,741 2,741
- --------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1997 13,029,520 130 36,087 (75) (1,850) 34,292
Net income 10,304 10,304
Currency translation adjustments 86 86
-------
Comprehensive income 10,390
Exercise of stock options 703,836 7 2,709 2,716
Common stock issued pursuant to
employee stock purchase plan 14,435 262 262
Tax benefits related to stock options 3,228 3,228
Repurchase of common stock (367,500) (4) (4,954) (4,958)
- --------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1998 13,380,291 133 37,332 11 8,454 45,930
Net income 12,351 12,351
Currency translation adjustments (387) (387)
-------
Comprehensive income 11,964
Exercise of stock options 791,512 7 4,553 4,560
Common stock issued pursuant to
employee stock purchase plan 22,323 410 410
Tax benefits related to stock options 6,542 6,542
- --------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1999 14,194,126 $140 $48,837 $(376) $20,805 $69,406
================================================================================================================================
The accompanying notes are an integral part of these consolidated
financial statements.
F-5
OSTEOTECH, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
Year ended December 31, 1999 1998 1997
- ----------------------------------------------------------------------------------------------------------
Cash Flow From Operating Activities
Net income $ 12,351 $ 10,304 $ 5,686
Adjustments to reconcile net income to net cash
Depreciation and amortization 3,298 2,403 2,065
Deferred income taxes (121) (272) 268
Changes in assets and liabilities:
Accounts receivable (2,876) (4,398) (1,329)
Inventories (1,393) (760) (84)
Deferred processing costs (2,690) (1,550) 152
Prepaid expenses and other current assets (2,457) 681 (1,133)
Accounts payable and other liabilities 1,805 1,930 939
- ----------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 7,917 8,338 6,564
Cash Flow From Investing Activities
Capital expenditures (18,743) (5,521) (5,323)
Acquisition of business (1,523)
Proceeds from sale of investments 10,610 6,914 6,418
Purchases of investments (11,634) (8,363) (5,904)
Increase in other assets (883) (830) (231)
- ----------------------------------------------------------------------------------------------------------
Net cash used in investing activities (22,173) (7,800) (5,040)
Cash Flow From Financing Activities
Proceeds from issuance of common stock 4,970 2,978 3,110
Income tax benefit related to stock options 6,542 3,228 2,741
Repurchase of common stock (4,958)
Proceeds from issuance of notes payable 116 864 871
Principal payments on notes payable (725) (862) (918)
Proceeds from issuance of long-term debt 6,359
Principal payments on long-term debt
and obligations under capital leases (1,332) (634) (756)
- ----------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 15,930 616 5,048
Effect of exchange rate changes on cash (23) 81 22
- ----------------------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents 1,651 1,235 6,594
Cash and cash equivalents at beginning of year 15,119 13,884 7,290
- ----------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 16,770 $ 15,119 $ 13,884
==========================================================================================================
The accompanying notes are an integral part of these consolidated
financial statements.
F-6
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS
Osteotech, Inc. (the "Company") provides services and develops and markets
products to the orthopaedic, neurological, oral/maxillofacial, dental and
general surgery markets in the United States and Europe. The Company's
current technology, products and services, and those under development, are
focused primarily on the repair and healing of the musculoskeletal system.
Osteotech is engaged in the processing of human bone and bone connective
tissue (collectively, "allograft bone tissue") used for transplantation.
The Company has two primary operating segments: the Grafton(R)
Demineralized Bone Matrix (DBM) Segment (the "Grafton(R) DBM Segment") and
Base Allograft Bone Tissue Segment (the "Base Tissue Segment"). In addition
to these two primary segments, the Company provides ceramic and titanium
plasma spray coating services and ceramic products used as bone graft
substitutes to orthopaedic and dental implant manufacturers, markets and
distributes metal spinal implant products and processes, markets and
distributes bovine bone tissue products outside of the United States.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Consolidated Financial Statements
The consolidated financial statements include the accounts of Osteotech,
Inc., its majority-owned subsidiaries and joint ventures controlled by the
Company. Investments in less than 20% owned affiliates are accounted for on
the cost method. All intercompany transactions and balances are eliminated
in consolidation.
Revenue Recognition
The Company derives revenue from both sales of products and certain service
functions. Revenues are recognized when title passes to the customer or
when processed allograft bone tissue is returned to our clients.
License fee revenues is recognized when all significant contractual
obligations have been satisfied.
Cash Equivalents and Short-Term Investments
The Company considers all highly liquid investments with original
maturities of three months or less, when purchased, to be cash equivalents.
Investments with maturities in excess of three months but less than one
year are classified as short-term investments and are stated at cost, net
of any unamortized premiums or discounts, which approximates fair value.
Deferred Processing Costs
Costs related to allograft bone tissue processing in progress are deferred
until processed allograft bone tissue is released from final quality
assurance testing and shipped to clients.
Inventories
Inventories are stated at the lower of cost or market, with cost determined
under the first-in, first-out method.
F-7
48
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Major renewals and
betterments are capitalized while maintenance and repairs are expensed as
incurred. Interest is capitalized in connection with the construction of
major facilities. The capitalized interest is recorded as part of the
underlying asset and is amortized over the asset's estimated useful life.
The cost of leasehold improvements is amortized on the straight-line method
over the shorter of the lease term or the estimated useful life of the
asset. Depreciation is computed on the straight-line method over the
following estimated useful lives of the assets:
Building 15 years
Machinery and equipment 5 to 10 years
Computer hardware and software 5 years
Office equipment, furniture and fixtures 5 years
Loaner instruments 3 years
When depreciable assets are retired or sold, the cost and related
accumulated depreciation are removed from the accounts and any resulting
gain or loss is reflected in operations.
Whenever events and circumstances indicate that the carrying value of an
asset may not be recoverable, the Company reviews the carrying value of
property, plant and equipment for impairment.
Excess of Cost Over Net Assets of Business Acquired
The excess of cost over the net assets of business acquired ("goodwill") is
being amortized on a straight-line basis over 15 years. It is the Company's
policy to periodically review and evaluate whether there has been an
impairment in the value of goodwill. Factors considered in the valuation
include current operating results, trends, prospects and anticipated
undiscounted future cash flows.
Translation of Foreign Currency
Assets and liabilities of foreign subsidiaries are translated at rates of
exchange in effect at the close of the year. Revenues and expenses are
translated at the weighted average exchange rates during the year.
Translation gains and losses are included in other comprehensive income,
which is a separate component of stockholders' equity. Foreign currency
transaction gains and losses are included in other income.
Concentrations of Credit Risk
The Company provides credit, in the normal course of business, to tissue
banks and hospitals. The Company maintains an allowance for doubtful
accounts and charges actual losses to the allowance when incurred.
The Company invests the majority of its excess cash in U.S.
Government-backed securities and investment grade commercial paper of major
U.S. corporations. The Company does not believe it is exposed to any
significant credit risk on its cash equivalents and short-term investments.
F-8
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenue and expenses
during the reporting period. Actual results may differ from such estimates.
3. ACQUISITION OF OST DEVELOPPEMENT SA
Effective January 1, 1999, the Company completed the acquisition of a 90%
interest in OST Developpement SA ("OST"), a processor of bovine bone tissue
products which are marketed and distributed outside of the United States.
The aggregate purchase price paid consisted solely of cash consideration of
9,000,000 French Francs ("FRF") or approximately $1,594,700 of which
496,662 FRF or approximately $84,400 was paid in 1998. In addition, the
Company incurred approximately $372,600 of transaction costs of which
approximately $310,000 was incurred in 1998. The acquisition was accounted
for as a purchase and the consolidated financial statements include the
accounts of OST from January 1, 1999. The acquisition resulted in an excess
of cost over the fair value of net assets acquired of $2,073,000 which is
being amortized over 15 years. The Company also has the option to purchase
the remaining 10% of OST at a price to be determined at the time of
purchase.
4. ACQUISITION OF SPINAL FIXATION SYSTEM
In June, 1999, the Company acquired the Versalok(R) Low Back Fixation
System (the "Versalok(R) System"), including all patents, from Wright
Medical Technology, Inc. for $600,000. Pursuant to the terms of the
purchase agreement, the Company also purchased approximately $1,120,000 of
inventory, consisting primarily of finished goods. The $600,000 payment to
acquire the product rights and patents will be amortized using the
straight-line basis over five years.
5. INVENTORIES
Inventories consist of the following at December 31:
(in thousands) 1999 1998
--------------------------------------------------------------------------
Raw materials $ 912 $ 646
Finished goods 2,493 922
--------------------------------------------------------------------------
$ 3,405 $1,568
==========================================================================
F-9
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following at December 31:
(in thousands) 1999 1998
---------------------------------------------------------------------------
Land $ 2,262 $ 2,262
Building 279 279
Machinery and equipment 19,842 13,915
Computer hardware and software 3,191 2,215
Office equipment, furniture and fixtures 3,013 2,217
Loaner instruments 1,308 30
Equipment under capital lease 357
Leasehold improvements 6,340 4,915
Construction in progress 10,809 464
------------ ------------
47,044 26,654
Less accumulated depreciation
and amortization 13,049 10,610
---------------------------------------------------------------------------
$33,995 $16,044
===========================================================================
Accumulated depreciation and amortization above includes amortization on
equipment under capital lease of $323,000 in 1998.
During the fourth quarter of 1998, the Company commenced construction of a
new processing facility in Eatontown, New Jersey. The estimated aggregate
cost for the construction of the new facility including furniture, fixtures
and equipment is $32,000,000. At December 31, 1999, approximately
$10,272,000 has been incurred, of which approximately $51,000 represents
capitalized interest.
7. ACCOUNTS PAYABLE AND accrued LIABILITIES
Accounts payable and accrued liabilities consist of the following at
December 31:
(in thousands) 1999 1998
---------------------------------------------------------------------------
Trade accounts payable $ 5,532 $ 2,752
Accrued compensation 548 790
Accrued taxes payable 3,170 3,190
Other accrued liabilities 3,981 3,203
---------------------------------------------------------------------------
$13,231 $ 9,935
===========================================================================
F-10
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. LEASING TRANSACTIONS
The Company leases office and production facilities and equipment under
various operating lease agreements which have non-cancelable terms through
May 2008. The leases for office and production facilities include renewal
provisions at the Company's option. Additionally, certain of the leases
contain purchase options.
Future minimum lease commitments as of December 31, 1999 are as follows:
Operating
Year Leases
------------------------------------------------------
(in thousands)
2000 $ 1,137
2001 1,093
2002 986
2003 927
2004 and thereafter 3,524
---------------
Total minimum lease payments $ 7,667
===============
Rental expense was $1,157,000, $1,013,000 and $1,013,000 for the years
ended December 31, 1999, 1998 and 1997, respectively.
9. DEBT AND FINANCING ARRANGEMENTS
In June, 1999, the Company replaced its domestic lines of credit with a new
credit facility which includes a $5,000,000 unsecured revolving line of
credit, a $4,500,000 building mortgage loan and a $17,000,000 equipment
line of credit. The revolving line of credit is committed through May 31,
2001. Interest is payable monthly on the outstanding amount. In the absence
of default, the Company has the option to convert the revolving line of
credit to a term-loan and the outstanding unpaid balance as of May 31, 2001
will be repayable in forty-eight equal monthly installments of principal
together with accrued interest. An unused facility fee of .25% is payable
on the unused portion of the revolving loan. The mortgage loan will be
drawn down upon completion of the Company's new allograft tissue processing
facility currently under construction and will be secured by the building
which will house the new processing facility and the land on which the
building is located. The mortgage loan will be repayable in 120 equal
monthly installments of principal and interest based on a twenty-year
mortgage amortization schedule. Upon the 120th payment, the full amount of
the unpaid principal will be due and payable. The equipment line of credit
is secured by equipment and other capital expenditures purchased using the
proceeds of such line, with advances of up to 80% of the cost thereof. Upon
expiration of an initial drawdown period, which expires December, 2000, the
equipment line of credit will be repayable in equal monthly installments of
principal and interest based on a seven-year amortization schedule. During
the drawdown period interest only will be payable under the equipment line
of credit.
F-11
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. DEBT AND FINANCING ARRANGEMENTS (continued)
Pursuant to the terms of the loan and security agreement (the "Agreement"),
the Company is required to meet certain financial covenants regarding
minimum working capital, tangible net worth and interest coverage. In
addition, the Agreement contains limitations on sales of assets other than
in the ordinary course of business and additional indebtedness. At December
31, 1999, there was $4,500,000 and $1,859,327 outstanding under the
revolving line of credit and the equipment line of credit.
The Company has a line of credit with a Dutch bank which provides for
borrowing up to dfl 5,000,000, or approximately $2,285,000 at the December
31, 1999 exchange rate. Borrowings under this credit line bear interest at
the bank's prime rate plus a margin of 2.25%. Under certain circumstances
the Company may elect to utilize a rate based on the Amsterdam Interbank
Offered Rate (AIBOR) plus a margin of .75%. Analysis of the Company's
financial position and anticipated cash flow indicated that it most likely
would not be necessary to utilize a significant portion of this line of
credit in 1998 and, therefore, the Company agreed with the bank to limit
its borrowings, if any, to be no more than dfl 3,000,000, or approximately
$1,371,000 at the December 31, 1999 exchange rate. At December 31, 1999 and
1998, there were no borrowings under this line of credit.
The Company also has a line of credit with a French bank which provides for
borrowings up to FRF 1,750,000 or approximately $269,000 at the December
31, 1999 exchange rate. At December 31, 1999 there were no borrowings under
this line of credit.
The weighted average interest rate on short-term notes payable outstanding
was 6.87% in 1998.
Long-term debt consists of the following at December 31:
(in thousands) 1999 1998
---------------------------------------------------------------------------
Bank loan collateralized by equipment, repayable
in monthly installments of $49 plus accrued
interest at the bank prime rate plus .25%
(8.00% at December 31, 1998) $ 172
Domestic bank line of credit, interest due
monthly at the bank prime rate minus .75%
(7.75% at December 31, 1998) 4,500
Domestic bank equipment line of credit,
interest due monthly at the bank prime rate minus .50%
(8.00% at December 31, 1999) 1,859
---------------------------------------------------------------------------
Less current portion 172
---------------------------------------------------------------------------
$ 6,359 $ 0
===========================================================================
F-12
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. INCOME TAXES
The income tax provision is summarized as follows at December 31:
(in thousands) 1999 1998 1997
---------------------------------------------------------------------------
Current:
Federal $ 7,307 $ 5,893 $2,958
State 1,347 1,488 660
---------------------------------------------------------------------------
8,654 7,381 3,618
-----------------------------
Deferred:
Federal (148) (151) 217
State 27 (121) 51
---------------------------------------------------------------------------
(121) (272) 268
-----------------------------
Income tax provision $ 8,533 $ 7,109 $3,886
===========================================================================
The difference between income tax expense and the expected tax which would
result from the use of the Federal statutory income tax rate is as follows:
(in thousands) 1999 1998 1997
---------------------------------------------------------------------------
Computed tax at statutory Federal rate $ 7,309 $ 5,920 $3,254
State income taxes, net of Federal benefit 1,129 931 522
Amortization of excess of cost over
fair value of assets acquired 136 86 86
Other (41) 172 24
---------------------------------------------------------------------------
Income tax provision $ 8,533 $ 7,109 $3,886
===========================================================================
Loss before income taxes from foreign operations was $591,000 in 1999 and
$266,000 in 1998 respectively. The components of the deferred tax assets
and deferred tax liabilities are as follows at December 31:
(in thousands) 1999 1998
---------------------------------------------------------------------------
Deferred Tax Assets:
Net operating loss carryforwards
Federal $ 282 $ 279
Foreign 1,408 991
State 25 43
Tax credits 41 106
Other 1,034 932
---------------------------------------------------------------------------
2,790 2,351
Less valuation allowance 1,749 1,520
---------------------------------------------------------------------------
Deferred tax assets 1,041 831
---------------------------------------------------------------------------
Deferred Tax Liabilities:
Other 504 415
---------------------------------------------------------------------------
Deferred tax liabilities 504 415
---------------------------------------------------------------------------
Net deferred tax asset $ 537 $ 416
===========================================================================
F-13
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. INCOME TAXES (continued)
In 1999, the Company increased its valuation allowance as a result of
foreign losses for which the realization of future tax benefits is
uncertain.
Certain of the Company's subsidiaries have foreign net operating loss
carryforwards aggregating $3,556,000 ($364,000 with no expiration date;
$3,192,000 expiring 2004 through 2007).
At December 31, the Company had prepaid Federal and state taxes of
approximately $2,987,000 in 1999 and $946,000 in 1998.
11. COMMITMENTS AND CONTINGENCIES
Service Agreements
Osteotech is the exclusive processor of allograft bone tissue for large
national and international clients. The Company provides these processing
services pursuant to long-term service agreements. Osteotech's agreements
with its clients generally provide for cross-indemnification against
liability arising out of performance of the agreements. Effective January
1, 1997 the Company entered into a new ten-year processing agreement with
one of its major allograft bone tissue processing clients, the American Red
Cross Tissue Services ("ARC") and effective April 1, 1997 the Company
entered into a new five-year processing agreement with its other major
client, the Musculoskeletal Transplant Foundation ("MTF").
Customers of the Company's other products and services generally purchase
such products and services pursuant to purchase orders or non-exclusive
supply agreements which are cancelable at any time by either party.
License and Option Agreement
In June, 1997, the Company entered into an exclusive worldwide license
agreement for its proprietary PolyActive(TM) polymer biomaterial technology
and patents with IsoTis BV (formerly Matrix Medical BV), The Netherlands.
Pursuant to the terms of the agreement, the Company received an up front
license payment of 500,000 Dutch Guilders ("dfl") or approximately $257,000
in 1997 and two additional license payments of dfl 250,000 or approximately
$124,000 in 1998, and approximately $118,000 in 1999, which were recognized
as license fee revenue. Additionally, IsoTis BV has an option to acquire
the technology for dfl 4-million (approximately $1,828,000 at the December
31, 1999 exchange rate) commencing in the third year of the agreement and
extending through the sixth year of the agreement.
Throughout the term of the agreement, which is the longer of ten years from
the first commercial sale of product or the life of the patents, the
Company will receive a royalty of 5% of net sales, declining to 2% of net
sales if the option to purchase the technology is exercised. Further, the
agreement requires IsoTis BV to achieve certain milestones during the first
three years of the agreement. Failure to do so will result in its loss of
exclusive rights to the patents and technology. Through December 31, 1999,
IsoTis has achieved all milestones associated with the agreement.
F-14
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. COMMITMENTS AND CONTINGENCIES (continued)
Litigation
GenSci Regeneration Laboratories, Inc. v. Osteotech, Inc.; Osteotech, Inc.
v. GenSci Regeneration Sciences, Inc.
In January, 1998, the Company filed a patent infringement action against
GenSci Regeneration Laboratories, Inc. ("GenSci Labs") and GenSci
Regeneration Sciences, Inc. ("GenSci Sciences") alleging that the GenSci
parties violated claims of one of the patents involving the Company's
Grafton(R) Demineralized Bone Matrix (DBM) process. Approximately two weeks
after Osteotech's filing, GenSci Labs filed a suit against the Company
alleging infringement of two patents assigned to GenSci Labs in addition to
tortious interference with a business expectancy, negligent interference
with a prospective economic advantage and inducing breach of contract and
seeking a declaratory judgment of the invalidity of the Company's patents
U.S. Patent Nos. 5,284,655 and 5,290,558 covering Grafton(R) DBM. In
February, 1998, GenSci Labs amended its complaint alleging essentially the
same causes of action but adding a third patent to the allegation of patent
infringement. In August, 1998, the actions were consolidated into one case
before the United States District Court for the Central District of
California.
In September, 1998, GenSci Labs served an amended complaint, which
asserted, in addition to the previously asserted claims, claims of false
advertising under Federal law. In September, 1998, the Company served its
answer to this amended complaint, asserted counterclaims against GenSci
Labs and served a third-party complaint against GenSci Sciences, and DePuy
AcroMed, Inc.("DePuy"). The Company's counterclaims and third party
complaint accused the GenSci parties of infringing a second Company patent,
in addition to the patent referred to above, and accused the DePuy and
GenSci parties of acting jointly and severally in infringing on the claims
of both patents.
In May, 1999, GenSci Labs amended its complaint to allege that in addition
to the Company's Grafton(R) DBM Flex product, the Company's Grafton(R) DBM
Gel and Putty products infringe on GenSci Lab's patents at issue. GenSci
Labs also amended its complaint to modify its false advertising claim,
alleging that in addition to the Company, individuals acting on the
Company's behalf engaged in false advertising. The Company filed and served
its answer and counterclaims to the amended complaint in May, 1999.
In November, 1999, the Company settled all claims which it had filed
against DePuy. As part of the settlement, DePuy has agreed to stop selling
the GenSci products accused of infringing the Company's patents, no later
than February 4, 2001 and to pay the Company $3,000,000. A payment of
$2,000,000 was received in the fourth quarter of 1999 and payments of
$250,000 each will be made at the end of each quarter in 2000 unless DePuy
discontinues selling the GenSci products during the year, at which time
DePuy would not be obligated for payments beyond the quarter in which it
stopped selling the GenSci products.
Discovery on all of the claims asserted in this litigation is ongoing. The
Company believes that the claims made against it by the GenSci parties are
without merit and will continue to vigorously defend any claims against it,
prosecute the claims it has asserted in this action, and vigorously and
affirmatively protect its products and intellectual property to the fullest
extent possible under the law.
F-15
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. COMMITMENTS AND CONTINGENCIES (continued)
GenSci Orthobiologics, Inc. v. Osteotech, Inc.
On March 6, 2000, GenSci Orthobiologics, Inc. ("GenSci") filed a complaint
in the United States District Court for the Central District of California
against Osteotech, alleging unlawful monopolization and attempt to
monopolize the market for demineralized bone matrix and for entering
agreements in restraint of trade, in violation of sections 1 and 2 of the
Sherman Antitrust Act and Section 3 of the Clayton Act; and for unlawful
and unfair business practices in violation of section 17200 of the
California Unfair Competition Law. GenSci has alleged that Osteotech has
monopoly power in the market for demineralized bone matrix products in the
United States, and has engaged in anticompetitive conduct by improperly
asserting its patents through patent infringement actions, seeking to have
the Food and Drug Administration remove certain of GenSci's products from
the market, restricting competitors' access to raw materials, interfering
with GenSci's arrangements to manufacture demineralized bone matrix
implants, interfering with GenSci's marketing and distribution
arrangements, and disparaging GenSci's products. GenSci seeks compensatory,
incidental, consequential, and punitive damages in an unspecified amount,
and injunctive relief to stop Osteotech from restricting the tissue banks
for which it processes tissue from (a) supplying processed demineralized
bone matrix to Osteotech's competitors and (b) distributing the
demineralized bone matrix implant products of Osteotech's competitors. Many
of these allegations were previously asserted by GenSci in its ongoing
patent litigation with Osteotech in the Central District of California
federal court.
The Company believes the claims made in this lawsuit are without merit and
intend to vigorously defend against these claims.
University of Florida Tissue Bank, Inc. v. Osteotech, Inc.
In February, 1999, a complaint was filed against the Company in the United
States District Court for the Northern District of Florida. This action,
which has been brought by plaintiffs, University of Florida Tissue Bank,
Inc., Regeneration Technologies, Inc., Sofamor Danek Group, Inc., and
Sofamor Danek L.P. alleges that Company's bio-d(TM) threaded cortical bone
dowel and Endodowel infringe on the claims of U.S. Patent No. 5,814,084,
entitled "Diaphysical Cortical Dowel." In April, 1999, plaintiffs filed an
amended complaint adding a claim for patent infringement against the
Company with respect to US Patent No. 5,814,084, entitled "Bone Grafting
Units", which is owned by plaintiff University of Florida Tissue Bank, Inc.
In May, 1999, the Company filed its answer and counterclaim seeking
declaratory judgment that the patents in question in this action are
invalid and otherwise not infringed by the Company. Although the plaintiffs
seek monetary damages, an amount has not been specified. In May, 1999,
plaintiffs filed their reply to the Company's counterclaims.
Discovery on all of the claims asserted in this litigation is ongoing. The
Company believes that the claims made against it in this action are without
merit and will continue to vigorously defend against such claims.
F-16
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. COMMITMENTS AND CONTINGENCIES (continued)
Medtronic Sofamor Danek, Inc., Sofamor Danek L.P. and Sofamor Holdings,
Inc. v. Osteotech, Inc.
In July, 1999, Medtronic Sofamor Danek Inc., Sofamor Danek L.P. and Sofamor
Danek Holdings, Inc. ("Danek") sued Osteotech in the United States District
Court for the Western District of Tennessee alleging that instruments,
instrument sets and cortical bone dowel products, manufactured, sold and/or
otherwise distributed by the Company infringe on certain claims of U.S.
Patent Nos. 5,741,253, entitled "Method for Inserting Spinal Implants", and
5,484,437, entitled "Apparatus and Method of Inserting Spinal Implants",
which are owned by Danek. In September, 1999, the Company filed its answer
and counter claims seeking a declaratory judgement that the patents in
question in this action are invalid and otherwise not infringed by the
Company. Plaintiffs filed their reply to the counterclaims in October,
1999.
Discovery on all of the claims asserted in this litigation is ongoing. The
Company believes that the claims made against it in this action are without
merit and will continue to vigorously defend against such claims.
Orthopaedic Bone Screw Products Liability Litigation
Osteotech remains a defendant in one previously reported state court
products liability action involving orthopaedic bone screws: Ponder v.
Synthes. With respect to the Company and numerous other defendants, the
case remains stayed.
The Company believes that the claims made against it in this action are
without merit and will continue to vigorously defend against such claims.
"O" Company, Inc. v. Osteotech, Inc.
In July, 1998, a complaint was filed against the Company in the Second
Judicial District Court, Bernallilo County, New Mexico, which alleges
negligence, strict liability, breach of warranty, negligent
misrepresentation, fraud, and violation of the New Mexico Unfair Trade
Practices Act arising from allegedly defective dental implant coating and
coating services provided to plaintiffs by a subsidiary of the Company, Cam
Implants BV. Plaintiffs have demanded unspecified monetary damages. In
August, 1998, the Company removed this action to the United States District
Court for the District of New Mexico and filed and served its answer,
denying any and all liability in this action, and moved to dismiss five of
the seven claims alleged against it. In March, 1999, the court dismissed
with prejudice the plaintiff's negligence and strict liability claims.
Remaining are claims for breach of warranty, negligent misrepresentation,
fraud, and violation of the New Mexico Unfair Trade Practices Act. As to
those claims, the Company has moved for summary judgement on the basis that
all of the remaining claims are barred by their applicable statutes of
limitations. At plaintiffs' request, the court permitted limited discovery
on the matters related to the statute of limitations issue, which is
ongoing.
The Company believes that the claims made against it in this action are
without merit and will continue to vigorously defend against such claims.
F-17
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. COMMITMENTS AND CONTINGENCIES (continued)
Medtronic Sofamor Danek, Inc. v. Arthur Alfaro
In September, 1999, Medtronic Sofamor Danek, Inc. ("Medtronic"), sued
Arthur A. Alfaro, a former Division President of Medtronic and currently
the Company's President and Chief Operating Officer, in the Chancery Court
of Tennessee for the Thirtieth Judicial District at Memphis, seeking to
enjoin Mr. Alfaro from using or disclosing to any third party, including
the Company, alleged confidential information or trade secrets of Medtronic
and from working for the Company for a period of twelve months. In
September, 1999, the Court issued a temporary restraining order prohibiting
Mr. Alfaro from issuing or divulging any confidential information or trade
secrets of Medtronic to any third party. In October, 1999, Mr. Alfaro filed
and served his answer, denying any and all liability. In November, 1999,
Mr. Alfaro and Medtronic reached a settlement of this action, and the
action has been dismissed. Pursuant to an employment agreement between Mr.
Alfaro and the Company, the Company paid Mr. Alfaro's legal fees and costs
in connection with this action.
Litigation is subject to many uncertainties and management is unable to
predict the outcome of the pending suits and claims. It is possible that
the results of operations or liquidity and capital resources of the Company
could be adversely affected by the ultimate outcome of the pending
litigation or as a result of the costs of contesting such lawsuits. The
Company is unable to estimate the potential liability, if any, that may
result from the pending litigation and, accordingly, no provision for any
liability (except for accrued legal costs) has been made in the
consolidated financial statements.
12. STOCKHOLDERS' EQUITY
Common Stock
In June, 1999, the stockholders of the Company approved an amendment to the
Certificate of Incorporation increasing the number of authorized shares of
Common Stock from 20,000,000 to 70,000,000.
Preferred Stock
The authorized capital of the Company includes 5,675,595 shares of
Preferred Stock, the rights and provisions of which will be determined by
the Board of Directors at the time any such shares are issued, if at all.
No shares of Preferred Stock were issued or outstanding at December 31,
1999 and 1998.
Stock Split
On February 11, 1999, the Board of Directors authorized a three-for-two
stock split in the form of a 50% stock dividend that was distributed on
March 19, 1999 to stockholders of record on March 5, 1999. As a result of
this action 54 fractional shares were not distributed. Stockholders' equity
has been restated to give retroactive recognition to the stock split for
all periods presented. In addition, all references in the financial
statements to shares, per share data, stock option data and market prices
of the Company's common stock have been restated.
F-18
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. STOCKHOLDERS' EQUITY (continued)
Stock Options
The Company has two stock option plans under which stock options may be
granted: the 1991 Stock Option Plan (the "1991 Plan") and the 1991
Independent Directors Stock Option Plan (the "Directors Plan").
The 1991 Plan, as amended, authorizes the grant of up to 4,220,648 shares
of the Company's common stock in the form of incentive stock options or
non-qualified stock options to employees and consultants. Incentive stock
options may be granted at prices not less than 100% of the fair market
value at the date of option grant. Options generally become exercisable in
ratable installments over a four-year period, with unexercised options
expiring no later than ten years from the date of grant. In June, 1999, the
stockholders of the Company authorized an amendment to the 1991 Plan
limiting the number of shares issuable under options that may be granted to
any individual to an aggregate of 500,000 shares per year.
The Directors Plan, as amended, authorizes the grant of up to 750,000
shares of the Company's common stock to members of the Board of Directors
who are not officers or employees of the Company. Option exercise prices
equal 100% of the fair market value on the date of grant. Options issued
prior to July 1, 1997 become exercisable in ratable installments over four
years with unexercised options expiring five years from the vesting date.
Effective July 1, 1997, the Directors Plan was amended to provide for
options issued to become 100% exercisable on the first anniversary of the
date of grant with unexercised options expiring ten years from the date of
grant.
Stock option activity for the years 1999, 1998 and 1997 is as follows:
1999 1998 1997
--------------------- ---------------------- ----------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
-----------------------------------------------------------------------------------------------------------------------
Outstanding at January 1, 2,280,732 $9.35 2,524,011 $ 5.41 2,628,815 $3.88
Granted 404,500 18.17 491,250 18.55 826,688 8.12
Exercised 791,566 5.76 703,836 3.86 858,147 3.45
Canceled or expired 27,144 16.40 30,693 4.29 73,345 4.13
----------------------------------------------------------------------------------------------------------------------
Outstanding at December 31, 1,866,522 $11.93 2,280,732 $ 9.35 2,524,011 $5.41
----------------------------------------------------------------------------------------------------------------------
Exercisable at December 31, 995,529 $8.35 1,310,544 $ 6.41 1,678,523 $5.76
----------------------------------------------------------------------------------------------------------------------
Available for grant at
December 31, 669,644 1,047,000 1,507,482
----------------------------------------------------------------------------------------------------------------------
Weighted average fair value of
options granted during the period $10.35 $11.03 $4.91
----------------------------------------------------------------------------------------------------------------------
F-19
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. STOCKHOLDERS' EQUITY (continued)
The following table summarizes the information about stock options
outstanding at December 31, 1999:
Options Outstanding Options Exercisable
--------------------------------------------- ------------------------------------
Weighted
Number Average Weighted Number
Outstanding at Remaining Average Exercisable at Weighted
Range of December 31, Contractual Exercise December 31, Average
Exercise Prices 1999 Life (Years) Price 1999 Exercise Price
-------------------------------------------------------------------------------------------------------------
$ 2.33 to $ 4.67 333,271 5.8 $ 4.09 284,897 $ 4.13
5.00 to 6.67 232,251 6.5 6.11 110,564 6.05
8.50 to 12.63 693,750 8.3 9.97 488,125 8.85
13.00 to 18.75 259,375 9.1 16.04 33,750 15.76
20.66 to 21.59 273,375 8.7 20.68 78,193 20.68
34.37 to 37.88 74,500 9.4 37.06
-------------------------------------------------------------------------------------------------------------
$ 2.33 to $37.88 1,866,522 7.8 $11.93 995,529 $ 8.35
=============================================================================================================
The Company has adopted the "disclosure only" provisions of Statement of
Financial Accounting Standards No. 123, Accounting for Stock Based
Compensation ("SFAS 123") and, accordingly, no compensation cost has been
recognized in the Statements of Operations. Pro forma information regarding
net income and net income per share is required by SFAS 123, and has been
determined as if the Company accounted for its stock options under the Fair
Value Method of that Statement. For purposes of the pro forma disclosures,
the estimated fair value of the options is amortized to expense over the
options' vesting period. Pro forma information follows:
(dollars in thousands except per share data) 1999 1998 1997
---------------------------------------------------------------------------
Net income
As reported $12,351 $10,304 $ 5,686
Pro forma 10,927 9,032 3,334
Net income per share
As reported
Basic $ .88 $ .78 $ .46
Diluted .84 .73 .43
Pro forma
Basic $ .78 $ .68 $ .27
Diluted .75 .64 .23
---------------------------------------------------------------------------
The pro forma effect on net income for 1999, 1998 and 1997 is not
representative of the pro forma effect on net income in future years
because, in accordance with FAS 123, it does not take into consideration
pro forma compensation expense related to grants made prior to 1995.
F-20
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. STOCKHOLDERS' EQUITY (continued)
The fair value for the option grants was estimated at the date of grant
using the Black-Scholes option-pricing model with the following
weighted-average assumptions:
1999 1998 1997
---------------------------------------------------------------------------
Expected life (years) 5 8 7
Risk free interest rate 6.1% 5.1% 6.2%
Volatility factor 60.0% 50.0% 50.0%
Dividend yield 0.0% 0.0% 0.0%
--------------------------------------------------------------------------
Stock Warrants
As part of financing and contract arrangements, the Company has, at certain
times, issued warrants to purchase its Convertible Preferred Stock and
Common Stock. Warrant activity for the years ended December 31, 1997, 1998
and 1999 is summarized as follows:
Convertible Preferred
Stock Warrants
-------------------------- Common
Series Series Stock
A D Warrants
--------------------------------------------------------------------------------
Outstanding at December 31, 1996 16,730 323,572 195,546
Exercised 16,730 323,114 195,546
--------------------------------------------------------------------------------
Outstanding at December 31, 1997 0 458 0
--------------------------------------------------------------------------------
Outstanding at December 31, 1998 0 458 0
--------------------------------------------------------------------------------
Outstanding at December 31, 1999 0 458 0
--------------------------------------------------------------------------------
Exercise price $ 0.02 $ 3.72 $ 0.02
--------------------------------------------------------------------------------
Convertible Preferred Stock warrants are immediately convertible into
Common Stock upon exercise on a share for share basis. Warrants are
exercised through the payment of cash or under a cashless exercise. Under
the cashless exercise method, the number of shares issued upon exercise of
such warrant is determined by calculating the aggregate number of shares
represented by the warrants using the closing price of the Company's Common
Stock on the exercise date, deducting the aggregate exercise cost and
dividing the net remaining amount by the market value per share on the
exercise date. The outstanding warrants as of December 31, 1999 expire in
May, 2000.
Stock Purchase Plan
The 1994 Employee Stock Purchase Plan provides for the issuance of up to
375,000 shares of Common Stock. Eligible employees may purchase shares of
the Company's Common Stock through payroll deductions of 1% to 7 1/2% of
annual compensation. The purchase price for the stock is 85% of the fair
market value of the stock on the last day of each calendar quarter. At
December 31, 1999, 244,560 shares were available for future offerings under
this plan.
F-21
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. STOCKHOLDERS' EQUITY (continued)
Stock Repurchase Program
In June 1998, the Board of Directors of the Company authorized the
repurchase and retirement of up to $5,000,000 of common stock through open
market purchases. During August 1998, the Company completed this program
and had repurchased and retired 367,500 shares of common stock at a cost of
$4,958,000.
Stockholder Rights Agreement
In January, 1996, the Board of Directors of the Company unanimously adopted
a stockholder rights agreement (the "Rights Agreement") declaring a
dividend of one preferred stock purchase right (the "Right") for each
outstanding share of common stock as of February 12, 1996. Upon the
occurrence of certain events, each Right entitles the stockholder to
purchase from the Company one one-hundredth of a preferred share at a price
of $170.00 per one one-hundredth of a preferred share, subject to
adjustment. The Rights will not be exercisable or separable from the common
shares until ten business days after a person or group acquires or tenders
for 20% or more of the Company's outstanding common shares ("triggering
event"). The Rights Agreement also provides that, after a triggering event
occurs, the Rights convert into a Right to buy common stock and entitle its
holder to receive upon exercise that number of common shares having a
market value of two times the exercise price of the Right. In the event the
Company is acquired in a merger or other business combination transaction,
each Right will entitle its holder to receive upon exercise of the Right,
at the Right's then current exercise price, that number of the acquiring
company's common shares having a market value of two times the exercise
price of the Right. The Company is entitled to redeem the Rights at a price
of $.01 per Right at any time prior to their becoming exercisable, and the
Rights expire on March 31, 2009. The Rights Agreement was adopted to
maximize the value of all stockholders' ownership interest in the Company
by establishing a deterrent to abusive takeover tactics sometimes used in
challenges for corporate control.
13. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
(in thousands) 1999 1998 1997
---------------------------------------------------------------------------
Cash paid during the year for taxes $4,476 $ 2,120 $ 1,071
Cash paid during the year for interest 33 50 101
Acquisition of business:
Fair value of assets acquired 2,563
Liabilities assumed 2,669
14. SUPPLEMENTAL STATEMENT OF OPERATIONS INFORMATION
Maintenance and repairs expense for the years ended December 31, 1999, 1998
and 1997 was $2,240,000, $1,344,000 and $1,164,000 respectively.
Depreciation and amortization expense related to property, plant and
equipment for the years ended December 31, 1999, 1998 and 1997 was
$2,745,000, $2,050,000 and $1,699,000 respectively.
F-22
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
15. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings (loss) per share:
Year Ended
-------------------------------------------------
(dollars in thousands except per share data) 1999 1998 1997
-------------------------------------------------
Net income available to common
Shareholders $ 12,351 $ 10,304 $ 5,686
-------------------------------------------------------------------------------------------------------------------
Denominator for basic earnings per share:
Weighted average:
Common shares outstanding 14,024,468 13,259,784 12,215,736
Nominal warrants outstanding(a) 173,388
-------------------------------------------------
14,024,468 13,259,784 12,389,124
Effect of dilutive securities:
Stock options 593,933 826,810 732,935
Warrants 385 355 66,714
-------------------------------------------------
Denominator for diluted earnings per share 14,618,786 14,086,949 13,188,773
-------------------------------------------------------------------------------------------------------------------
Basic earnings per share $ .88 $ .78 $ .46
-------------------------------------------------------------------------------------------------------------------
Diluted earnings per share $ .84 $ .73 $ .43
-------------------------------------------------------------------------------------------------------------------
(a) Nominal warrants are warrants with an exercise price of $.02.
16. OPERATING SEGMENTS
Effective January 1, 1998, the Company adopted SFAS 131 (see Note 3). Prior
year information has been restated to present the Company's two reportable
business segments: the Grafton(R) DBM Segment and Base Tissue Segment. The
Grafton(R) DBM Segment engages in the processing and marketing Grafton(R)
DBM. Grafton(R) DBM is processed using the Company's advanced proprietary
demineralization process. The Base Tissue Segment engages in the processing
of primarily mineralized weight-bearing allograft bone tissue which is
generally marketed by the Company's clients.
The accounting policies of the reportable segments are the same as those
described in the Summary of Significant Accounting Policies. The Company
evaluates the performance of its operating segments based on revenue
performance and operating results. The Company does not produce information
about assets for its operating segments, and accordingly no asset
information is presented in the table below. All corporate related expenses
are allocated to operating segments and geographic areas in determining
operating income (loss) of the respective segments.
F-23
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
16. OPERATING SEGMENTS (continued)
Summarized financial information concerning the Company's reportable
segments is shown in the following table. The "Other" column includes
information for other business units below the quantitative thresholds. The
Company's other business units engage in providing ceramic and titanium
plasma spray coating services and ceramic products to orthopaedic and
dental implant manufacturers, marketing and distributing metal spinal
implant products and processing, marketing and distributing bovine bone
products outside of the United States.
Grafton(R) Base
DBM Tissue
(in thousands) Segment Segment Other Consolidated
------------------------------------------------------------------------------------------------------
Revenues:
1999 $45,136 $25,751 $ 4,723 $75,610
1998 39,128 17,323 2,750 59,201
1997 26,653 14,426 3,852 44,931
------------------------------------------------------------------------------------------------------
Operating income (loss):
1999 $17,063 $6,434 $(3,645) $19,852
1998 13,404 4,170 (1,293) 16,281
1997 6,962 2,686 (661) 8,987
------------------------------------------------------------------------------------------------------
Depreciation and
amortization:
1999 $ 1,203 $ 1,153 $ 942 $ 3,298
1998 1,180 742 481 2,403
1997 799 740 526 2,065
------------------------------------------------------------------------------------------------------
Financial information by geographic area is summarized as follows:
(in thousands) United States Europe Consolidated
---------------------------------------------------------------------------
Revenues
1999 $71,517 $ 4,093 $75,610
1998 56,876 2,325 59,201
1997 41,887 3,044 44,931
Long-lived Assets
1999 $32,068 $ 1,927 $33,995
1998 15,449 595 16,044
1997 11,023 627 11,650
F-24
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
16. OPERATING SEGMENTS (continued)
Two of the Company's customers individually comprise 10% or more of the
Company's consolidated net revenues. Revenues by customer, which are
reported as part of the Company's Grafton(R) DBM and Base Tissue Segments,
are as follows:
(in thousands) 1999 1998 1997
---------------------------------------------------------------------
Revenues
MTF $42,095 $33,286 $25,731
ARC 28,436 23,020 15,442
---------------------------------------------------------------------
$70,531 $56,306 $41,173
=====================================================================
17. RETIREMENT BENEFITS
The Company has a 401(k) plan which covers substantially all full time U.S.
employees. The Company has agreed to contribute an amount equal to 25% of
each participant's contribution. A participant's contribution may not
exceed 15% of annual compensation, or the maximum allowed by the Internal
Revenue Code, if less than 15% of compensation. Provisions of the plan
include graduated vesting over five years of service. Total Company
contributions for the years ended December 31, 1999, 1998 and 1997 were
$287,000, $221,000 and $161,000 respectively.
Certain of the Company's foreign subsidiaries provide retirement benefits
to their employees through the purchase of non-participating annuity
contracts. The expenses for these contracts were $53,000, $88,000 and
$56,000 for the years ended December 31, 1999, 1998 and 1997.
The Company does not maintain any other pension or post retirement plans.
18. RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform with the 1999
presentation.
F-25
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
19. QUARTERLY FINANCIAL DATA (unaudited)
The following is a summary of the unaudited quarterly results for the years
ended December 31, 1999 and 1998:
Quarter Ended
(dollars in thousands ----------------------------------------------------
except per share data) March 31 June 30 Sept. 30 Dec. 31
-----------------------------------------------------------------------------------------
1999
Net revenues $18,688 $19,720 $17,469 $19,733
Cost of services and products 5,857 6,115 5,643 6,294
Net income (a) 3,158 3,344 3,248 2,601
Net income per share (a)
Basic $ .23 $ .24 $ .23 $ .18
Diluted .22 .23 .22 .18
-----------------------------------------------------------------------------------------
1998
Net revenues $13,475 $15,254 $14,283 $16,189
Cost of services and products 4,227 4,639 4,142 4,631
Net income 2,106 2,429 2,618 3,151
Net income per share
Basic $ .16 $ .18 $ .20 $ .23
Diluted .15 .17 .19 .22
-----------------------------------------------------------------------------------------
(a) Pretax results of operations in 1999 include income from litigation
settlement of $2,000,000 of which $1,750,000 was recognized in the
third quarter and $250,000 in the fourth quarter.
F-26
SCHEDULE II
OSTEOTECH, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
Additions
Balance At ------------------------------ Balance At
Beginning Charged To Charged End
Of Period Expenses To Other Deductions Of Period
-----------------------------------------------------------------------------------
For the year ended December 31, 1999:
Allowance for doubtful accounts $ 148 $ (3)(a) $ (10)(b) $ (6)(e) $ 129
Valuation allowance for deferred
tax asset 1,520 416(d) (123)(b) (64)(e) 1,749
For the year ended December 31, 1998:
Allowance for doubtful accounts 147 (3)(a) 6(b) (2)(e) 148
Valuation allowance for deferred
tax asset 1,187 272(d) 61(b) 0 1,520
For the year ended December 31, 1997:
Allowance for doubtful accounts 163 0 (11)(b) (5)(e) 147
Valuation allowance for deferred
tax asset 4,530 (40)(d) (131)(b) (3,172)(e) 1,187
(a) Represents recovery on previously written-off accounts receivable.
(b) Represents foreign currency translation adjustments.
(c) Represents the write-off of accounts receivable.
(d) Represents the tax effect of temporary differences.
(e) Represents recognition of a deferred tax asset.
S-1
Report of Independent Accountants on
Financial Statement Schedule
To the Board of Directors of Osteotech, Inc.
Our audits of the consolidated financial statements referred to in our report
dated February 18, 2000, except as to certain information presented in Note 11
for which the date is March 6, 2000, appearing on page F-2 of this 1999 Form
10-K also included an audit of the Financial Statement Schedule listed in Item
14(a)(2) of this 1999 Form 10-K. In our opinion, this Financial Statement
Schedule presents fairly, in all material respects, the information set forth
therein when read in conjunction with the related consolidated financial
statements.
PricewaterhouseCoopers LLP
Florham Park, New Jersey
February 18, 2000, except as to certain
information presented in Note 11
for which the date is March 6, 2000
S-2