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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, 1998 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
incorporation or organization) Identification No.)
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. [_]
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 19, 1999 was approximately $385,571,080.
As of March 19, 1999, there were 13,837,344 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.
1998 Form 10-K Annual Report
TABLE OF CONTENTS
Section Page
- ------- ----
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............................................................... 12
Government Regulations................................................................ 13
Research and Development.............................................................. 14
Competition........................................................................... 15
Environmental Matters................................................................. 20
Patents and Proprietary Rights........................................................ 20
Product Liability and Insurance....................................................... 21
Employees............................................................................. 22
Item 2. Properties ........................................................................... 22
Item 3. Legal Proceedings..................................................................... 23
Item 4. Submissions of Matters to a Vote of Security Holders.................................. 25
PART II ........................................................................................ 25
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters................................................................... 25
Item 6. Selected Financial Data............................................................... 26
Item 7. Management's Discussion And Analysis Of Financial
Condition And Results Of Operations................................................... 27
Item 7A.Quantitative and Qualitative Disclosures About Market Risk............................ 36
Item 8. Financial Statements and Supplementary Data........................................... 36
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure................................................... 36
ii
PART III ........................................................................................ 36
Item 10. Directors and Executive Officers of the Registrant................................... 36
Item 11. Executive Compensation............................................................... 37
Item 12. Security Ownership of Certain Beneficial Owners and Management....................... 37
Item 13. Certain Relationships and Related Transactions....................................... 37
PART IV ........................................................................................ 38
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K...................... 38
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) and Allogard(R)
Packaging are registered trademarks of Osteotech, Inc.; LUBBOC(R) AND LADDEC(R)
are registered trademarks of OST Developpement SA; SSCS(TM) 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 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 processed by
Osteotech 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").
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 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. We recently introduced the bio-d(TM) threaded cortical bone dowel for
spinal fusion which is processed in the Base Tissue segment. This bone dowel is
distributed by our clients, but unlike other tissue processed in this segment,
we market the bio-d(TM) threaded cortical bone dowel.
1
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 to orthopaedic and
dental implant manufacturers through operations based in Leiden, The
Netherlands. We also market and distribute non-allograft bone tissue spinal
implant products.
We estimate that the total bone graft market in the U.S. for 1998 was $487
million. 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 1998, to approximately $168
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 between 40% and 50% 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.
Osteotech processes allograft bone tissue for its clients which pay
Osteotech fees. 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.
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 distribution of processed bone tissue. Our contract with
ARC expires in December, 2006 and our contract with MTF expires in March, 2002.
These contracts solidified key donor availability for Osteotech processed
allograft bone tissue.
2
Osteotech markets the proprietary products in the Grafton(R) DBM segment
and the bio-d(TM) threaded cortical bone dowel in the Base Tissue segment
through independent agents and direct field sales personnel. The other products
processed 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 47% to $39,128,000 in 1998
and revenues in our Base Tissue segment increased 20% to $17,323,000 in 1998. We
expect that both our Grafton(R) DBM and Base Tissue segments will be important
contributors to the growth of our consolidated revenues and profits in 1999, as
processed allograft bone tissue forms continue to gain increased acceptance.
Strategy
Overview
o We intend to use our position as the leader in allograft bone tissue
processing to 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 tissues;
* expand the safety claims of these tissues using proprietary
processes; and
* continue to introduce new tissue forms with enhanced performance
profiles.
Grafton(R) DBM Segment
In the near term, we will continue to focus on marketing Grafton(R) DBM
through 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.
3
We expect to continue expansion of sales of Grafton(R) DBM through:
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 the continued market launch (which began in December 1998) throughout
1999 of the bio-d(TM) threaded cortical bone dowel and related
instrumentation as an alternative to metal threaded fusion cages and
pedicle screw fixation for certain spinal 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; and
o development of new allograft bone tissue products with enhanced
performance profiles.
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
powder manufacture;
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.
4
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. roll-out (which began in December 1998) throughout
1999 of the Segmented Spinal Correction System (SSCS(TM)), a load
sharing, low profile posterior lumbar and thoracic rod and hinged
screw 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 SSCS(TM) system, either alone or
in conjunction with each other. Spinal implant products 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 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.
Osteotech processes allograft bone tissue for its clients in both its
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
5
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.
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.
In our Base Tissue segment, we expect to begin to implement additional
processing technologies that, once fully implemented during 1999, will enable us
to expand our viral inactivation claims to include the mineralized
weight-bearing allograft bone tissue processed in this segment.
We believe that allograft bone tissue transplantation is one of the fastest
growing areas of transplant medicine. We estimate that in 1998 there were
approximately 494,100 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 $487 million. We estimate that the allograft
bone tissue portion of the total bone graft market in the U.S. increased 16% in
1998 to $168 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 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
6
o an increase in the availability of allograft bone tissue due to
improved recovery and processing techniques and an increase in bone
tissue donations.
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
to 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
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. Osteotech processes its clients' tissue
utilizing technology it has 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, Osteotech has 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
Osteotech's current 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.
7
In December, 1998 we began a region-by-region roll-out of our new bio-d(TM)
threaded cortical bone dowel for spinal fusion. We expect the roll-out to be
completed by the end of 1999. 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.
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 segment are also used in processing Grafton(R) DBM.
Osteotech has 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 three 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; and
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.
We expect that wider distribution and deeper market penetration by the
three forms 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, 1998, Grafton(R) DBM forms had been utilized in over 240,000
procedures.
8
Expansion of Allograft Bone Tissue Business in Europe
On June 25, 1998, we acquired a 5% interest in OST Developpement SA
("OST"), which is located in Clermont-Ferrand, France and, on January 25, 1999
(effective January 1, 1999), we acquired an additional 85% interest in OST. OST,
which primarily processes and manufactures products from bovine tissue for
orthopaedic and dental use, was originally founded to address the shortage of
safe and effective human allograft bone tissue in France and certain other
countries outside the United States. OST utilizes a proprietary processing
system, which includes validated viral inactivation steps, to produce LUBBOC(R)
bovine bone grafts for orthopaedic surgical procedure applications and LADDEC(R)
bovine bone grafts for dental surgical procedure applications. Each of these
biocompatible bone graft materials has received a European CE Mark and is
produced in an ISO certified plant.
It is our strategy to utilize OST's advanced processing systems and skilled
staff as a base of operations to expand Osteotech's human allograft bone tissue
business in Europe. We expect to first establish a strong market position in
France and use that as a base for expansion into the other major European
markets. OST is currently adapting its proprietary processing technology to an
automated, cost efficient system it is developing for the processing of human
allograft bone tissue. OST will initially use this system in our Base Tissue
segment to process human femoral heads recovered during hip replacement surgery
for distribution in France. At the same time, OST will continue to process and
distribute its LUBBOC(R) and LADDEC(R) bovine bone tissue grafts.
In the short term, we will expand the range of human allograft bone tissue
forms available to French surgeons by supplying Grafton(R) DBM and other
allograft bone tissue forms processed by Osteotech in the U.S. through the
OsteoBanque D'Auvergne tissue bank, with which OST has a long-term agreement to
provide tissue processing, logistical support and distribution services.
Concurrently, in connection with OsteoBanque D'Auvergne and other tissue
banks, we plan to help establish a cadaveric donor tissue recovery network in
medical centers throughout France and other European countries in order to meet
a growing European demand for allograft bone tissue. Beginning with France, we
plan to penetrate the European market on a country-by-country basis, with
Germany being the next major expansion opportunity. We have filed a product
master file in Germany to obtain approval to begin marketing and distribution of
Grafton(R) DBM and other forms of allograft bone tissue. We expect to work with
other European tissue bank organizations to distribute these tissues in Germany.
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
Osteotech's tissue processing technology meets this
9
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. Osteotech also supplies 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 the repair of bone
defects in dental applications.
Non-Allograft Bone Tissue Spinal Implants and Instruments
In the U.S. Osteotech markets implants and instrumentation for spinal
surgery through an exclusive distribution agreement with Heinrich C. Ulrich,
K.G. ("Ulrich"). Osteotech markets Ulrich's Zielke VDS System, an implant system
used by orthopaedic, spinal and neurological surgeons worldwide - often in
combination with allograft bone tissue grafts - for the anterior correction of
spinal deformities caused by disease, trauma and degeneration. We also market an
extensive line of more than 250 high quality, specialty surgical instruments
manufactured by Ulrich.
Osteotech plans to continue expanding its line of spinal implant devices
and instrumentation. One of Ulrich's spinal fixation systems, the SSCS(TM),
features a proprietary hinged screw design that allows for load sharing and
provides improved results in spinal fusion procedures. The product is being sold
in Germany, the U.K., and South Africa. The SSCS(TM) system received 510(k)
clearance in the U.S. in June, 1997. We introduced the SSCS(TM) system to U.S.
preceptors (a limited number of well-respected spinal surgeons) for clinical
evaluation during the second half of 1998 and initiated a region-by-region
product roll-out in the U.S. beginning in December, 1998. We expect to complete
the roll-out and have the SSCS(TM) system available to all U.S. surgeons by the
end of 1999.
10
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 facility in Leiden, The Netherlands has
received International Standardization Organization ("ISO") certification for
its quality systems used in the development and manufacture of ceramic products
and ceramic and titanium spray coatings.
In both the Grafton(R) DBM and Base Tissue segments Osteotech's 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
clients, all processed bone tissue is inspected and again tested for
microbiological contaminants by our quality assurance team.
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.
To our knowledge, none of the approximately 1.75 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. 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 in 1999 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.
11
Clients
Osteotech is the exclusive processor of allograft bone tissue for two large
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, fees are
paid to us 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 1998 MTF and ARC
accounted for approximately 56% and 39%, 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."
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
Osteotech believes 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, 1998, 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 to train 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, 1998, we had appointed 58 agencies which employ over 230 sales
representatives.
A small in-house marketing staff located at Osteotech's 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.
12
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.
Osteotech provides 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 processed by Osteotech, including Grafton(R) DBM, under
certain provisions (Section 361) of the Public 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 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 processed by Osteotech.
One set of new regulations has already been proposed via publication in the
Federal Register and additional proposed regulations are expected to be
published in the Federal Register in the future.
Allograft bone tissue and tissue processing operations are regulated in
most major countries, though with different regulations and standards in each
country. In France, where Osteotech's subsidiary OST is located, allograft bone
tissue is comprehensively regulated by special legislation. In Germany, such
products are regulated as pharmaceuticals.
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.
13
The spinal implants, manufactured by Ulrich and distributed by Osteotech in
the U.S., are regulated as medical devices under the Federal Food, Drug and
Cosmetic Act.
Osteotech's European HA plasma spray coating services meet existing
regulatory requirements in the specific countries where they are marketed.
Osteotech's 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. ISO certification for
production facilities were made mandatory in 1998 for companies that market or
distribute products within the European Union. The certification was awarded by
Tuv Product Service, GmbH of Munich, Germany, a leading Notified Body in medical
devices, following a series of audits. Notified Bodies are independent
organizations authorized by the European Union member countries to administer
the ISO certification process.
Ceramic products produced by Osteotech 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. Osteotech does
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 Osteotech 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 1998, 1997 and 1996, we spent approximately $4,610,000, $3,728,000
and $4,357,000, respectively, on research and development activities. The
majority of these expenditures were made in both 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.
14
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;
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 1998 to $168 million, comprising approximately 35% of the U.S. bone graft
market.
U.S. Bone Graft Market
1998
Specialty Graft Procedures(1) Allograft Market Size(2)
- --------- ---------------------- ------------------------
Spinal Fusions 249,500
General Orthopaedics 164,800
Craniomaxillofacial 79,800
--------
Total 494,100
Average Selling Price $ 985
Market Size (000) $486,689 $167,910 (34.5%)
- ----------
(1) Source: Osteotech estimates based on Orthopaedic News Network, Medical
Data International and MarketLine Data
(2) Source: Osteotech estimate
15
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 recently approved by
the FDA.
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.
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:
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
improved recovery and processing techniques and an increase in bone
tissue donations.
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, primarily bone tissue banks.
Autograft bone tissue has traditionally been the primary choice for surgeons and
we believe it still maintains an approximate 60% share of the U.S. bone graft
market. Due to factors such as the increased cost and potential complications
associated with
16
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. Osteotech has 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 three forms - gel,
flex and putty - and packaged in sterile, single patient delivery systems. With
the varying textural and handling characteristics of its three forms, Grafton(R)
DBM can be used in virtually all non-weight-bearing bone graft procedures and
has been used in over 240,000 procedures through December 31, 1998. Given its
osteoinductive and osteoconductive properties, Grafton(R) DBM has a distinct
advantage over synthetic bone void fillers, all of which are exclusively
osteoconductive.
Grafton(R) DBM vs. Competitive Synthetic Products
Mechanism(s) of Published Available
Bone Healing Applications Safety Data Forms
------------ ------------ ----------- -----
Grafton(R) Osteoinduction & All non-weight- Yes Gel
DBM Osteoconduction bearing bone graft Flex
procedures Putty
ProOsteon Osteoconduction Acute metaphysical Yes Blocks
(Interpore) fracture defects less Granules
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
17
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 250
(Osteotech) Osteoconduction o Gel
o Flex
o Putty
Dyna Graft Osteoconduction No DBM/Collagen 220
(Gen Sci/ o Matrix
DePuy Motech) DBM/Pluronic F-127
o Gel
o Putty
Osteofil Unknown No DBM/Unknown 250
(Reg. Tech/ o Paste
Sofamor Danek)
- -------------------------------------------------------------------------------------------------
(1) Source: Based upon Osteotech's Survey of Competition
Although it already occupies a dominant position in the U.S. market for
non-weight-bearing grafting materials, Grafton(R) DBM has significant
opportunities for growth. Currently, Grafton(R) DBM sales are almost exclusively
domestic. Osteotech estimates that Grafton(R) DBM was used in only 14% of the
total bone graft procedures performed in the U.S. during 1998. 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 Osteotech with an
opportunity in an area where it already has a sales presence.
18
Grafton(R) DBM Procedure Penetration
1998
-------------------------------------------
Grafton(R) DBM
-------------------------------------------
Percent
Specialty Potential(1) Actual(2) Penetration
- --------- ------------ --------- -----------
Spinal Fusions 249,500 41,694 16.7%
General Orthopaedics 164,800 22,707 13.8%
Craniomaxillofacial 79,800 4,396 5.5%
------- ------- ----
Total 494,100 68,797 13.9%
(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. 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 during 1999. In 1999 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.
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;
19
o expand our market differentiation through tissue performance
improvements, including line extensions of existing base allograft
bone tissue products and new product introductions such as the
bio-d(TM) threaded cortical bone dowel; and
o increase education of surgeons regarding the use of allograft bone
tissue through expanded grand rounds, seminars and workshops.
Other
Osteotech's 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, Osteotech also faces
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, certain of our competitors have greater
resources than we do, and there can be no assurance we will be able to compete
successfully.
Environmental Matters
Osteotech's 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.
Such waste is segregated by Osteotech and disposed of through a licensed
hazardous waste transporter in compliance with applicable regulations. The
production of HA powder at Osteotech's facility in The Netherlands generates
small amounts of hazardous waste, which is segregated by Osteotech and disposed
of through a licensed hazardous waste transporter. Although Osteotech believes
it is in compliance with applicable environmental regulations, the failure by
Osteotech 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 Osteotech's business.
Patents and Proprietary Rights
Osteotech considers its processing technology and procedures proprietary
and relies primarily on trade secrets to protect its technology and innovations.
Significant research and development activities have been conducted 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 Osteotech projects which have
been independently developed by the consultants or researchers at the medical
institutions.
At February 28, 1999, Osteotech held (i) 30 United States patents and eight
foreign patents relating to its aseptic processing technology and its transplant
support products, including eight United States Grafton(R) DBM patents and three
foreign Grafton(R) DBM patents, (ii) four United
20
States and six foreign patents relating to its biomaterials technology, (iii)
four United States and six foreign patent applications relating to aspects of
its processing technology and its osteogenic and other products under
development and (iv) three United States patent applications and three foreign
patent applications relating to its biomaterials technology. Osteotech believes
that its Grafton(R) DBM patents are significant in maintaining Osteotech's
competitive position. These patents expire on various dates ranging from 2009 to
2016. Osteotech's other patents expire at various dates ranging from 2007 to
2017.
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 Osteotech with sufficient protection in the case of an
infringement of its technology or that others will not independently develop
technology comparable or superior to Osteotech's. Osteotech is currently
involved in two 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 Osteotech's HA powder, medical devices developed
with Osteotech's biomaterials technology and medical devices manufactured by
others and distributed by Osteotech entail inherent risks of medical
complications for patients, and therefore may result in product liability claims
against Osteotech. Further, Osteotech's agreements with its bone tissue
processing clients provide for indemnification by Osteotech for liabilities
arising out of defects in allograft bone tissue caused as a result of processing
by Osteotech.
As a distributor of implants and instruments for spinal surgery, including
bone screws, manufactured by Ulrich, Osteotech has 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. See Item 3. "Legal
Proceedings."
Pursuant to its distribution agreement with Osteotech, Ulrich has agreed to
indemnify Osteotech for all costs and damages incurred by Osteotech in
connection with its distribution of products manufactured by Ulrich, except such
costs and damages which are caused by Osteotech's gross negligence or willful
misconduct or unauthorized claims made by Osteotech in marketing the products.
Ulrich maintains its own product liability insurance coverage. To date, Ulrich
has made indemnity payments to Osteotech for a portion of the costs incurred by
Osteotech in defending the lawsuits involving the Ulrich products distributed by
Osteotech. There can be no assurance that Osteotech will in fact be indemnified
by Ulrich for all such costs. See Note 8 of "Notes to Consolidated Financial
Statements."
Osteotech presently maintains product liability insurance in the amount of
$77 million per occurrence and per year in the aggregate. There can be no
assurance that Osteotech will be able to maintain such insurance in the future
or that such insurance will be sufficient to cover all liabilities.
21
Employees
At December 31, 1998, Osteotech had 290 employees, of whom 181 were engaged
in allograft bone tissue processing, ceramic plasma spray coating and the
manufacture of products; 27 were engaged in research and development; 44 were
engaged in education and marketing; and 38 were engaged in regulatory, finance
and administration. Osteotech's employees are not covered by any collective
bargaining agreement. Osteotech considers relations with its employees to be
good.
Item 2. Properties
Osteotech's 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 2008 and provides for a base annual rental of
approximately $264,000. This facility is occupied by Osteotech's corporate,
financial, administration, marketing, research and development, regulatory and
clinical affairs staff. Both the Grafton(R) DBM and Base Tissue segments utilize
this facility.
Osteotech's processing facility is located in approximately 44,000 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 Osteotech's option for an additional
five year term. Both the Grafton(R) DBM and Base Tissue segments utilize this
facility.
Osteotech's European subsidiaries engaged in the biomaterial business line
occupy a 21,000 square foot facility in Leiden, The Netherlands. The lease for
this facility expires in May 2008 and the annual rent is dfl 626,000
(approximately $333,000 at the December 31, 1998 exchange rate). We are
subleasing 2,200 square feet of this facility to an unrelated third party at an
annual rent of dfl 111,500 (approximately $59,000 at the December 31, 1998
exchange rate).
In 1997, Osteotech purchased approximately 13 acres of land surrounding its
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 first quarter of 2000. We intend to
finance 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
and with 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.
These loans are subject to the negotiation and execution of definitive loan
agreements.
22
Item 3. Legal Proceedings
GenSci Laboratories, Inc. v. Osteotech, Inc., Case No. SACV 9868 AHS Eex (C.D.
Cal.)
As previously reported, Osteotech filed suit on January 16, 1998 in the
United States District Court for the District of New Jersey against GenSci
Regeneration Sciences, Inc. and GenSci Laboratories, Inc. (collectively,
"GenSci") for patent infringement and GenSci filed suit on January 28, 1998
against Osteotech in the United States District Court for the Central District
of California for patent infringement, tortious interference with a business
expectancy, negligent interference with prospective economic advantage, inducing
breach of contract and a declaratory judgement of the invalidity of Osteotech's
patents U.S. Patent Nos. 5,284,655 and 5,290,558. On August 10, 1998 these cases
were consolidated into one case before the United States District Court for the
Central District of California under Case Number SACV 9868 AHS (EE x) (the
"Action").
In September, 1998 we commenced a third party action against DePuy Motech
Inc., alleging that DePuy Motech, Inc., through the marketing and distribution
of DynaGraft Gel and DynaGraft Putty, is acting jointly and severally with
GenSci in infringing on the claims of our patents. Although monetary damages
have been requested, an amount has not been specified.
Discovery on all of the claims asserted in this litigation has commenced
and is ongoing.
Osteotech has and will continue to vigorously defend any claims against it,
prosecute the claims it has asserted in the Action, and vigorously and
affirmatively protect its products and intellectual property to the fullest
extent possible under the law.
"O" Company, Inc. v. Osteotech, Inc., Case No. Civ. 98-981 BB/LFG (D.N.M.)
On August 14, 1998, Osteotech removed this action to the United States
District Court for the District of New Mexico, where it has been assigned Case
No. Civ. 98-981 BB/LFG. As previously reported, the plaintiffs in this action,
manufacturers and distributors of dental implants, alleged causes of action
claiming negligence, strict liability, breach of warranty, negligent
misrepresentation, fraud and violation of the New Mexico Unfair Trade Practices
Act, arising from allegedly defective ceramic coating and coating services
provided to plaintiffs by a subsidiary of Osteotech, Cam Implants BV. The
plaintiffs have demanded unspecified damages from Osteotech. On August 24, 1998,
Osteotech served and filed its answer, denying any and all liability in this
action. Based upon a motion made by Osteotech on March 16, 1999, the court
dismissed with prejudice plaintiffs' negligence and strict liability claims.
On November 5, 1998, Osteotech moved for summary judgment in its favor on
all of the claims alleged in this action, on the ground that all of plaintiffs'
claims are barred by their applicable statutes of limitations. The court has not
yet decided that motion. To date, the court has limited discovery in this action
to matters related to the statute of limitations issue.
23
Orthopaedic Bone Screw Products Liability Litigation
As of March 26, 1999, Osteotech remains a defendant in two previously
reported state court products liability actions involving orthopaedic bone
screws: Abercrombie v. Acromed Corp., CV-298393 (Ct. of Common Pleas, Cuyahoga
County, Ohio); and Ponder v. Synthes, Case No. 960602729 (Ct. of Common Pleas,
Philadelphia County, Pa.). The Ponder action remains stayed.
In Abercrombie, more than 1,800 of the original plaintiffs dismissed their
claims against Osteotech on October 28, 1998. On January 15, 1999, the nine
remaining plaintiffs moved to amend their complaint against the 28 remaining
defendants, including Osteotech, to assert claims of civil conspiracy.
Osteotech continues to believe that both actions are without merit and will
continue to vigorously defend both lawsuits.
Both of the actions seek monetary damages of no less than $50,000 per
plaintiff. The aggregate money damages eventually sought by all of the
plaintiffs and the related costs to defend such actions may be substantial.
Pursuant to Osteotech's distribution agreement with Ulrich, the manufacturer of
the spinal system distributed by Osteotech which is the basis for these two
actions against Osteotech, Ulrich has agreed to indemnify Osteotech for
liabilities incurred in connection with the distribution of Ulrich's products.
However, there can be no assurance that Ulrich will have the financial resources
necessary to comply with its indemnification obligations to Osteotech.
University of Florida Tissue Bank, Inc. v. Osteotech, Inc., Case No. 1:99cv33
MMP (N.D. Fla.)
On or about March 3, 1999, Osteotech received a complaint that was filed in
the United States District Court for the Northern District of Florida on
February 25, 1999. 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 Osteotech'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." Although monetary damages are
sought, an amount has not been specified.
Based upon reviews conducted by its outside patent counsel, Osteotech
believes that its bio-d(TM) threaded cortical bone dowel and Endodowel do not
infringe the patent asserted in the action. Osteotech intends to vigorously
defend the action.
24
Item 4. Submissions of Matters to a Vote of Security Holders
None.
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters
Osteotech's Common Stock has been traded on the Nasdaq Stock Market(R)
under the trading symbol "OSTE" since Osteotech's initial public offering in
July 1991.
The following table sets forth the high and low sale prices(1) for the
Common Stock for each of the fiscal quarters during the years ended December 31,
1998 and 1997 based on transaction data as reported by the Nasdaq Stock
Market(R).
Year Ended December 31, 1998 High Low
---- ---
First Quarter 19.50 14.67
Second Quarter 17.33 8.75
Third Quarter 19.83 11.67
Fourth Quarter 31.33 11.00
Year Ended December 31, 1997 High Low
---- ---
First Quarter 5.54 4.58
Second Quarter 7.17 4.75
Third Quarter 14.92 6.33
Fourth Quarter 21.83 11.33
(1) 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. The high and low
sales prices have been restated to give retroactive recognition to the
stock split for all periods presented.
As of March, 1999 there were 234 holders of record of Osteotech's Common
Stock. Osteotech believes that there are approximately 4,900 beneficial owners
of its Common Stock.
Osteotech has never paid a cash dividend and does not anticipate the
payment of cash dividends in the foreseeable future as earnings are expected to
be retained to finance Osteotech's growth. Declaration of dividends in the
future will remain within the discretion of Osteotech's Board of Directors,
which will review Osteotech's dividend policy from time to time.
25
Item 6. Selected Financial Data
Set forth below is the selected financial data for Osteotech for the five
fiscal years ended December 31, 1998. The following data should be read in
conjunction with Osteotech's 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 1998 1997 1996 1995 1994
-------- -------- -------- -------- --------
Net revenues $ 59,201 $ 44,931 $ 34,895 $ 27,934 $ 24,570
Costs and expenses(a) 42,920 35,944 33,146 27,696 23,935
Other income, net (b) 1,132 585 271 4,582 577
Income before income taxes 17,413 9,572 2,020 4,820 1,212
Net income (loss) 10,304 5,686 (324) 4,582 1,747
Net income (loss) per share (c)
Basic .78 .46 (.03) .39 .15
Diluted .73 .43 (.03) .38 .15
Dividends per share 0 0 0 0 0
Year End Financial Position
Working capital $ 26,373 $ 19,922 $ 12,273 $ 12,135 $ 9,010
Total assets 57,114 43,052 31,483 30,170 22,594
Long-term obligations 0 203 840 1,598 1,027
Stockholders' equity 45,930 34,292 22,717 22,594 17,096
(a) Costs and expenses include: (i) a charge to earnings in 1996 of $1,350,000
related to the restructuring of Osteotech's 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.
26
Item 7. Management's Discussion And Analysis Of Financial Condition And Results
Of Operations
For the Three Years Ended December 31, 1998, 1997 and 1996
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.
Net Income (Loss)
Consolidated net income for 1998 was $10,304,000 or $.73 diluted income per
share, compared to net income of $5,686,000 or $.43 diluted income per share in
1997 and a net loss of $324,000 or $.03 diluted loss per share in 1996.
Consolidated income before income taxes increased to $17,413,000 in 1998
compared to $9,572,000 in 1997 and $2,020,000 in 1996. Income before income
taxes in 1996 includes a charge to earnings of $1,350,000 related to the
restructuring of our operations located in Leiden, The Netherlands. See
"Provision for Restructuring" included below.
The following is a discussion of factors affecting results of operations
for the years ended December 31, 1998, 1997 and 1996.
Net Revenues
Consolidated net revenues in 1998 were $59,201,000, an increase of
$14,270,000 or 32% from 1997. 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 36%, and foreign revenues decreased 24% compared to 1997.
The decline in foreign revenues resulted primarily from decreased unit volume
for our ceramic products.
Grafton(R) DBM segment revenues in 1998 were $39,128,000, an increase of
$12,475,000 or 47% compared with the prior year, as a result of increased demand
for Grafton(R) DBM. Base Tissue segment revenues were $17,323,000, or 20% higher
than prior year revenues of $14,426,000, as a result of the increased unit
volume of allograft bone tissue which we processed for our clients.
Consolidated net revenues in 1997 were $44,931,000, an increase of
$10,036,000 or 29% over 1996 consolidated net revenues of $34,895,000. The
increase was principally due to higher revenues in the Grafton(R) DBM segment,
which increased 74% to $26,653,000 from $15,293,000 in 1996, as a result of
increased demand for Grafton(R) DBM. Domestic revenues, which consist
principally of revenues from the Grafton(R) DBM and Base Tissue segments,
increased 33% and foreign revenues decreased 8% compared to 1996. The decline in
foreign revenues resulted
27
primarily from a decrease in research grant revenues from the Dutch government,
as a result of the discontinuance of our PolyActive(TM) polymer research and
development program. See "Provision for Restructuring" below. During 1997, we
licensed out the patents and technology related to PolyActive(TM) and received
an upfront payment of $257,000, which partially offset the decline in grant
revenues. Additionally, foreign revenues in 1997 were unfavorably impacted 14%
as a result of the strength of the U.S. dollar compared to the Dutch Guilder.
However, the impact on consolidated net revenues was approximately 1%.
Base Tissue segment revenues decreased 3% in 1997 as compared with 1996. In
1997, we discontinued providing certain contract testing services to one of our
clients, which accounted for this decrease in revenues.
During 1998, 1997 and 1996, two of our clients in the Grafton(R) DBM and
Base Tissue segments accounted for 56% and 39%, 57% and 34% and 64% and 25%,
respectively, of consolidated net revenues. Effective in 1997, we entered into
new long-term exclusive processing agreements with both of these clients.
Costs of Services and Products
Costs of services as a percentage of service revenues was 29% in 1998, 34%
in 1997 and 39% in 1996. The decline in costs as a percentage of revenues
results from a shift in revenue mix toward services with higher gross margins,
operating efficiencies resulting from increased volume and an increase in fees
charged to our clients for Grafton(R) DBM. We expect that consolidated costs as
a percentage of consolidated revenues will increase approximately 2% in 1999 as
a result of increased processing expenses associated with the implementation of
viral inactivation technology in the Base Tissue segment.
Cost of products as a percentage of product revenues was 80% in 1998, 75%
in 1997 and 97% in 1996. The increase in costs in 1998 as a percentage of
revenues resulted principally from a decrease in revenues from certain ceramic
products and non-allograft bone tissue spinal implant products, while fixed
costs remained the same. The decline in costs as a percentage of revenue in 1997
resulted primarily from a shift in product mix toward products with higher gross
margins.
Marketing, General and Administrative Expenses
Marketing, general and administrative expenses increased $4,290,000 or 26%
in 1998 and $3,762,000 or 30% in 1997. The increases are primarily attributable
to the Grafton(R) DBM segment and result from expanded marketing and promotional
activities and increased agent commissions resulting from increased volume.
Additionally, corporate administrative costs increased compared with 1997,
principally as a result of higher outside professional costs.
28
Research and Development Expenses
Research and development expenses in 1998 increased $882,000 or 24% to
$4,610,000 from $3,728,000 in 1997. The increase was primarily attributable to
increased spending in the Base Tissue segment associated with the continued
development of a viral inactivation process and development of allograft tissue
products and services, including the bio-d(TM) threaded cortical bone dowel.
Research and development expenses in 1997 decreased $629,000 or 14% to
$3,728,000 from $4,357,000 in 1996. The decline results principally from the
discontinuance of our PolyActive(TM) polymer research and development program in
the fourth quarter of 1996. See "Provision for Restructuring" below.
Provision for Restructuring
In October 1996, we announced a plan to restructure our operations located
in Leiden, The Netherlands in order to focus those operations on: (i) providing
ceramic and titanium spray coating services and ceramic products to the
orthopaedic and dental markets and (ii) to pursue OEM business opportunities for
those technologies. In connection with the restructuring, we discontinued our
PolyActive(TM) polymer research and development program. As a result of the
restructuring, we recorded a pre-tax restructuring charge of $1,350,000, which
included $425,000 for employee termination costs, $541,000 for write-off of
equipment, intangible assets and inventory, $234,000 for costs associated with
the planned sub-leasing of office space in Leiden on which we have a long-term
lease, and $150,000 for other contractual obligations. See Note 4 of "Notes to
Consolidated Financial Statements."
Operating Income
Operating income increased $7,249,000 or 81% in 1998 and $7,238,000 or 414%
in 1997. The increase in both periods results primarily from improved operating
income in the Grafton(R) DBM segment resulting from increased revenues discussed
above. Grafton(R) DBM segment operating income increased $6,442,000 or 93% in
1998 and $4,241,000 or 156% in 1997. Operating income in 1997 also improved as a
result of the restructuring of the foreign operations in 1996. See "Provision
for Restructuring" above.
Other Income (Expense)
In 1998 and 1997, other income increased by $547,000 and $314,000 compared
to 1997 and 1996, respectively, due to higher invested cash and lower
outstanding debt balances.
Income Tax Provision
Our effective income tax rate was 41% in 1998 and 1997 and 116% in 1996.
The high effective income tax rate in 1996 was principally due to foreign losses
for which no current tax benefits were available. See Note 13 of "Notes to
Consolidated Financial Statements."
29
Liquidity and Capital Resources
At December 31, 1998, we had cash and short-term investments of $18,041,000
compared to $15,357,000 at December 31, 1997. We invest our excess cash in U.S.
Government-backed securities and investment grade commercial paper of major U.S.
corporations. Working capital increased $6,451,000 to $26,373,000 at December
31, 1998 compared to $19,922,000 at December 31, 1997. Accounts receivable at
December 31, 1998 increased $4,433,000 due to revenue increases.
Net cash provided by operating activities was $8,338,000 in 1998 compared
to $6,564,000 in 1997. The increase resulted primarily from improved earnings in
1998, partly offset by the increase in accounts receivable discussed above and
an increase in deferred processing costs. Cash used for capital expenditures in
1998 was $5,521,000 and resulted from our continued investment in facilities and
equipment needed for current and future business requirements. During the fourth
quarter of 1998, we commenced construction of a new processing facility in
Eatontown, New Jersey. See Item 2. "Properties." The estimated aggregate cost
for the construction of the facility, including furniture, fixtures and
equipment, is approximately $25,000,000, of which $21,500,000 we expect will be
funded by our current bank through a building mortgage loan and equipment line
of credit. The remaining balance of $3,500,000 will be funded through available
cash reserves or anticipated cash flow from operations. Net cash provided by
financing activities was $616,000 in 1998 compared to net cash provided by
financing activities of $5,048,000 in 1997. Both periods include proceeds from
stock option exercises and tax benefits resulting from these stock option
exercises. 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.
We presently have a loan and security agreement with a U.S. bank, which
provides for borrowings of up to $3,000,000 under a revolving line of credit and
$4,000,000 under an equipment line of credit. At December 31, 1998, $172,000 was
outstanding under the equipment line of credit and there were no borrowings
outstanding under the revolving line of credit. The existing credit facility
will be replaced in 1999 with a new credit facility that will include a
$5,000,000 revolving line of credit in addition to the $21,500,000 building
mortgage loan and equipment line of credit discussed above. Consummation of the
new credit facility is subject to negotiation and execution of a definitive
agreement. We also have a line of credit with a Dutch bank, which provides for
borrowings of up to dfl 5,000,000, or approximately $2,659,000 at the December
31, 1998 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 1998 and, therefore, we agreed with the bank
to limit our borrowings, if any, to no more than dfl 3,000,000, or approximately
$1,595,000 at the December 31, 1998 exchange rate. At December 31, 1998, there
were no borrowings outstanding under this credit line. See Note 11 of "Notes to
Consolidated Financial Statements."
At December 31, 1998 certain of our foreign-based subsidiaries have net
operating loss carryforwards aggregating $2,478,000 at the December 31, 1998
exchange rate ($324,000 with no
30
expiration date; $2,154,000 expiring 2004 through 2006). See Note 13 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.
Litigation
Osteotech is involved in various legal proceedings involving product
liability and patent infringement claims. For a complete discussion of these
matters, see Item 3. "Legal Proceedings" and Note 8 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 recognize the need to ensure that Year 2000 issues will not adversely
impact our operations and have identified our potential Year 2000 risk in three
categories: internal business software and hardware; internal non-financial
systems; and noncompliance by suppliers and customers.
Internal Business Software and Hardware
Several years ago we determined that our existing business information
systems were not adequate to support the anticipated growth in our business
operations and as a result purchased a fully integrated management information
system, which is Year 2000 compliant. Most of the new system is operational at
this time and the remainder of the system is scheduled to be operational in June
1999. The completion cost for implementation of the remaining software is not
expected to be material. All related hardware used to support internal business
software is currently Year 2000 compliant. As a result, we do not believe that
we require a contingency plan with respect to our internal business systems, and
therefore have not developed one. However, if we subsequently identify
significant risks we will develop contingency plans as deemed necessary at that
time.
31
Internal Non-financial Systems
We have completed our assessment of our internal non-financial systems,
such as office equipment, security systems and other business equipment, and
determined that minimal changes are required for Year 2000 compliance. We expect
to be in full compliance with our internal non-financial systems before the year
2000 and the cost to achieve such compliance is not expected to be material.
Noncompliance by Suppliers and Customers
We have initiated written communications with all of our significant
suppliers and customers to determine the extent to which we are vulnerable to
those third parties' failure to achieve Year 2000 compliance. We are currently
evaluating the responses and, if there are any affected suppliers and/or
customers, will develop contingency plans in order to minimize disruption to our
business operations. At this time we cannot estimate the additional cost, if
any, that may result from such contingency plans.
Risk of Non-Compliance
Based on the progress we have made in addressing Year 2000 issues, we do
not foresee significant risks associated with our Year 2000 compliance program
at this time. Although we expect to be compliant before the Year 2000, there is
no guarantee that these results will be achieved. Partial or total business
systems interruption or the inability of a significant supplier or customer to
achieve Year 2000 compliance could have a material adverse effect on our
business operations, financial condition, results of operations and business
prospects.
Risk Factors
Two primary clients 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 1998, MTF and ARC
accounted for approximately 56% and 39%, 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
32
demand for either allograft bone tissue or any allograft bone tissue-based
osteogenic materials we are developing. In the event that we are unable to
secure enough donors to meet our demands, our business, financial condition and
results of operations may suffer a material adverse effect.
Our revenues will depend upon reimbursement from public and private
insurers
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.
Medical community could choose not to use our allograft bone tissue
products
We believe the market for allograft bone tissue will continue to derive
from 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
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. Osteotech
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
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 Osteotech's 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.
33
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.
Inability to enforce our patents or findings that we infringe patents held
by others could damage our business
Osteotech considers its allograft bone tissue processing technology and
procedures proprietary and relies primarily on trade secrets and patents to
protect its 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, due to continuous changes as a result of research and
development, we could inadvertently infringe the patents of others. We are
currently involved in two lawsuits in which we are accused of infringing patents
held by others. See Item 3 "Legal Proceedings."
Firms with greater financial resources and lower costs present strong
competitive threat
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 60% 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.
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, there can be no assurance that we can continue to
compete successfully in the area of allograft bone tissue processing.
34
Competitive threat from alternate technologies
The primary advantage of synthetic bone substitutes 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.
Risk to spray coating and HA product operations of competition
Our 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 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 ceramic coating industry is highly competitive,
certain of our competitors have greater resources than we do, and we may be
unable to compete successfully.
Potential losses from product liability lawsuits
The testing and use of human allograft bone tissue 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 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
two lawsuits in which patients claim that they have suffered damages from the
implantation of allegedly defective spinal fixation devices. Although we believe
that we will ultimately prevail in these cases, litigation is subject to many
uncertainties and it is possible that some of the pending cases could be decided
against us. The ultimate outcome of the pending litigation or the costs of
contesting such suits could materially adversely affect our results of
operations or liquidity and capital resources if the ultimate liability exceeds
the amount that we recover from Ulrich pursuant to Ulrich's indemnification
obligation to us. We are unable to estimate the potential liability, if any,
that may result from the pending litigation and, accordingly, have made no
provision for any possible future liability in the consolidated financial
statements. See Item 3 "Legal Proceedings."
35
We presently maintain product liability insurance in the amount of $77
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 cover all
liabilities.
Potential lawsuit or governmental enforcement based on hazardous waste
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 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.
PART III
Item 10. Directors and Executive Officers of the Registrant
The section of Osteotech's 1999 Proxy Statement entitled "Election of
Directors" is incorporated herein by reference.
36
Item 11. Executive Compensation
The section of the 1999 Proxy Statement entitled "Executive Compensation"
is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The section of the 1999 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 the 1999 Proxy Statement entitled "Certain Relationships and
Related Transactions" is incorporated herein by reference.
37
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).
38
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 **
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 amended ^
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
39
Exhibit Page
Number Description Number
- ------ ----------- ------
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 Foundation and Osteotech-
10.16 Credit Agreement between Osteotech b.v. and ING Bank +++++
N.V. dated March 14, 1996
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 Holding 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 ^
40
Exhibit Page
Number Description Number
- ------ ----------- ------
10.26 Employment Agreement with Michael J. Jeffries dated @
January 1, 1998 ^
10.27 Employment Agreement with Roger C. Stikeleather dated @
January 1, 1998 ^
10.28 Employment Agreement with James L. Russell dated @
December 18, 1997 ^
10.29 The Management Performance Bonus Plan ^ E-2
10.30 Employment Agreement with Richard Russo E-14
dated April 1, 1997 ^
10.31 Change in Control Agreement by and between Osteotech E-24
Inc. and Richard Russo ^
10.32 Employment Agreement with Richard W. Bauer dated E-39
December 4, 1998 ^
21.1 Subsidiaries of the Registrant E-49
23.1 Consent of PricewaterhouseCoopers LLP E-50
27.0 Financial Data Schedule E-51
41
Exhibit
Number Description
- ------- -----------
* 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 10-Q 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 10-Q for the quarter ended June 30, 1994 and
incorporated herein by reference thereto
++++ Previously filed as exhibits to Osteotech's Quarterly Report
on Form 10-Q for the quarter ended March 31, 1994 and
incorporated herein by reference thereto.
42
Exhibit
Number Description
- ------- -----------
+++++ Previously filed as exhibits to Osteotech's Quarterly Report
on Form 10-Q for the quarter ended June 30, 1996 and
incorporated herein by reference thereto.
++++++ Previously filed as exhibits to Osteotech's Quarterly Report
on Form 10-Q for the quarter ended June 30, 1997 and
incorporated herein by reference thereto.
+++++++ Previously filed as exhibits to Osteotech's Quarterly Report
on Form 10-Q for the quarter ended September 30, 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, 1997 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.
^ Management contracts or compensatory plans and arrangements
required to be filed pursuant to Item 14(c)
(b) Reports on Form 8-K
None.
43
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, 1999 OSTEOTECH, INC.
By: /s/Richard W. Bauer
----------------------------
Richard W. Bauer
President, 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 Board March 30, 1999
- ------------------------ of Directors
Donald D. Johnston
/s/RICHARD W. BAUER President, Chief March 30, 1999
- ------------------------ Executive Officer
Richard W. Bauer (Principal Executive
Officer) and Director
/s/MICHAEL J. JEFFRIES Executive Vice March 30, 1999
- ------------------------ President, Chief
Michael J. Jeffries Operating Officer,
Chief Financial Officer
(Principal Financial
Accounting Officer),
Secretary and Director
/s/STEPHEN J. SOGIN Director March 30, 1999
- ------------------------
Stephen J. Sogin
/s/KENNETH P. FALLON III Director March 30, 1999
- ------------------------
Kenneth P. Fallon III
/s/JOHN P. KOSTIUK Director March 30, 1999
- ------------------------
John P. Kostiuk
44
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, 1998 and 1997..........F-3
Consolidated Statements of Operations
for the years ended December 31, 1998, 1997 and 1996...............F-4
Consolidated Statements of Changes in Stockholders' Equity
for the years ended December 31, 1998, 1997 and 1996...............F-5
Consolidated Statements of Cash Flows
for the years ended December 31, 1998, 1997 and 1996...............F-6
Notes to Consolidated Financial Statements............................F-7
2. SCHEDULES
II. Valuation and Qualifying Accounts
for the years ended December 31, 1998, 1997 and 1996...........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, 1998 and 1997,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles. 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 generally accepted auditing
standards 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
Princeton, New Jersey
February 25, 1999 except as to information presented
in Note 21 for which the date is March 16, 1999
F-2
OSTEOTECH, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
December 31, 1998 1997
- ----------------------------------------------------------------------------------------
ASSETS
- ----------------------------------------------------------------------------------------
Current assets:
Cash and cash equivalents $ 15,119 $ 13,884
Short-term investments 2,922 1,473
Accounts receivable, less allowance of
$148 in 1998 and $147 in 1997 11,980 7,547
Deferred processing costs 2,620 1,070
Inventories 1,568 792
Deferred income taxes 723 457
Prepaid expenses and other current assets 2,190 2,860
-------------------
Total current assets 37,122 28,083
Property, plant and equipment, net 16,044 11,650
Excess of cost over net assets of business acquired, less
accumulated amortization of $1,701 in 1998 and $1,449 in 1997 1,997 2,249
Other assets 1,951 1,070
- ----------------------------------------------------------------------------------------
Total assets $ 57,114 $ 43,052
========================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
- ----------------------------------------------------------------------------------------
Current liabilities:
Accounts payable and accrued liabilities $ 9,935 $ 6,919
Notes payable 609 608
Current maturities of long-term debt and
obligations under capital leases 205 634
-------------------
Total current liabilities 10,749 8,161
Long-term debt and obligations under capital leases 203
Other liabilities 435 396
- ----------------------------------------------------------------------------------------
Total liabilities 11,184 8,760
- ----------------------------------------------------------------------------------------
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; 20,000,000 shares
authorized; issued and outstanding 13,380,291
shares in 1998 and 13,029,520 shares in 1997 133 130
Additional paid-in capital 37,332 36,087
Accumulated other comprehensive income (loss) 11 (75)
Retained earnings (accumulated deficit) 8,454 (1,850)
- ----------------------------------------------------------------------------------------
Total stockholders' equity 45,930 34,292
- ----------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $ 57,114 $ 43,052
========================================================================================
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, 1998 1997 1996
- -----------------------------------------------------------------------------------------------------
Net revenues:
Service $ 58,077 $ 42,861 $ 31,717
Product 1,000 1,800 2,481
License fee 124 257
Grant 13 697
-----------------------------------------------
59,201 44,931 34,895
Costs and expenses:
Cost of services 16,844 14,487 12,406
Cost of products 795 1,348 2,414
Marketing, general and administrative 20,671 16,381 12,619
Research and development 4,610 3,728 4,357
Provision for restructuring 1,350
-----------------------------------------------
42,920 35,944 33,146
Operating income 16,281 8,987 1,749
Other income (expense):
Interest income 1,034 673 448
Interest expense (83) (140) (232)
Other 181 52 55
-----------------------------------------------
1,132 585 271
Income before income taxes 17,413 9,572 2,020
Income tax provision 7,109 3,886 2,344
- -----------------------------------------------------------------------------------------------------
Net income (loss) $ 10,304 $ 5,686 $ (324)
=====================================================================================================
Net income (loss) per share:
Basic $ .78 $ .46 $ (.03)
Diluted $ .73 $ .43 $ (.03)
- -----------------------------------------------------------------------------------------------------
Shares used in computing net income (loss) per share:
Basic 13,259,784 12,389,124 11,881,737
Diluted 14,086,949 13,188,773 11,881,737
- ----------------------------------------------------------------------------------------------------
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, 1998, 1997 and 1996
- ------------------------------------------------------------------------------------------------------------------------------------
Accumulated Retained
Common Stock Additional Other Earnings Total
--------------------- Paid-In Comprehensive (Accumulated Stockholders'
Shares Amount Capital Income (Loss) Deficit) Equity
====================================================================================================================================
Balance at December 31, 1995 as previously reported 7,198,179 $ 72 $ 29,782 $ (48) $ (7,212) $ 22,594
Three for two stock split effective March 5, 1999 3,599,090 36 (36)
==================================================================================================================================
Balance at December 31, 1995 10,797,269 108 29,746 (48) (7,212) 22,594
Net loss (324) (324)
Currency translation adjustments (65) (65)
- ----------------------------------------------------------------------------------------------------------------------------------
Comprehensive loss (389)
Exercise of stock options 128,799 1 317 318
Exercise of stock warrants 787,806 8 (8)
Common stock issued pursuant to
employee stock purchase plan 26,295 120 120
Tax benefits related to stock options 74 74
==================================================================================================================================
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
====================================================================================================================================
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, 1998 1997 1996
- -----------------------------------------------------------------------------------------------------
Cash Flow From Operating Activities
Net income (loss) $ 10,304 $ 5,686 $ (324)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 2,403 2,065 2,679
Deferred income taxes (272) 268 804
Provision for doubtful accounts 17
Provision for restructuring 1,350
Changes in assets and liabilities:
Accounts receivable (4,398) (1,329) (1,738)
Inventories (760) (84) 197
Deferred processing costs (1,550) 152 (245)
Prepaid expenses and other current assets 681 (1,133) 7
Accounts payable and other liabilities 1,930 939 1,234
- -----------------------------------------------------------------------------------------------------
Net cash provided by operating activities 8,338 6,564 3,981
Cash Flow From Investing Activities
Capital expenditures (5,521) (5,323) (2,079)
Proceeds from sale of investments 6,914 6,418 10,867
Purchases of investments (8,363) (5,904) (7,935)
Increase in other assets (830) (231) (300)
- -----------------------------------------------------------------------------------------------------
Net cash provided by (used in) investing activities (7,800) (5,040) 553
Cash Flow From Financing Activities
Proceeds from issuance of common stock 2,978 3,110 432
Income tax benefit related to stock options 3,228 2,741 74
Repurchase of common stock (4,958)
Proceeds from issuance of notes payable 864 871 829
Principal payments on notes payable (862) (918) (821)
Principal payments on long-term debt
and obligations under capital leases (634) (756) (800)
- -----------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities 616 5,048 (286)
Effect of exchange rate changes on cash 81 22 254
- -----------------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents 1,235 6,594 4,502
Cash and cash equivalents at beginning of year 13,884 7,290 2,788
- -----------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 15,119 $ 13,884 $ 7,290
=====================================================================================================
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 to orthopaedic and dental implant
manufacturers and markets and distributes non-allograft bone tissue spinal
implant products.
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
Revenue is recognized at the time the Company ships processed allograft
bone tissue or products to its clients.
License fee revenues is recognized when all significant contractual
obligations have been satisfied.
Grant revenues are recognized when earned. Grant revenues are considered to
be earned in the period that qualifying research and development
expenditures are incurred and reflected in the Consolidated Statements of
Operations.
Cash Equivalents and Short-Term Investments
The Company considers all highly liquid investments with original
maturities of three months or less 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.
Inventories
Inventories are stated at the lower of cost or market, with cost determined
under the first-in, first-out method.
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.
F-7
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 less accumulated
depreciation and amortization. Major renewals and betterments are
capitalized while maintenance and repairs are expensed as incurred. The
cost of equipment under capital lease and 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 3 to 10 years
Computer hardware and software 5 years
Office equipment, furniture and fixtures 5 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.
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.
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.
F-8
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. CHANGES IN ACCOUNTING POLICIES
Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130"). SFAS 130 establishes standards for reporting and display of
comprehensive income and its components in the financial statements.
Comprehensive income consists of net income and other gains and losses
affecting stockholders' equity that, under generally accepted accounting
principles, are excluded from income. For the Company, such items consist
solely of foreign currency translation adjustments. The adoption of SFAS
130 did not have a material effect on primary financial statements, but did
affect the presentation of the accompanying Consolidated Statement of
Changes in Stockholders' Equity.
On January 1, 1998, the Company adopted Statement of Financial Accounting
Standards No. 131, "Disclosures about Segments of an Enterprise and Related
Information" ("SFAS 131"). SFAS 131 establishes standards for the way that
public business enterprises report information about operating segments in
annual financial statements and requires that those enterprises report
selected information about operating segments in interim financial reports
issued to shareholders. It also establishes standards or related
disclosures about products and services, geographic areas, and major
customers. Financial statement disclosures for prior periods are required
to be restated. The adoption of SFAS 131 did affect the way the Company
reports information about its operating segments. The information for 1997
and 1996 has been restated to conform to the 1998 presentation.
4. RESTRUCTURING OF THE NETHERLANDS OPERATIONS
In October, 1996, the Company announced a plan to restructure its
non-allograft bone tissue operations located in Leiden, The Netherlands. In
connection with the restructuring, the Company discontinued its
PolyActive(TM) polymer research and development program, and recorded a
pre-tax charge to earnings of $1,350,000 which included $425,000 for
employee termination costs, $541,000 for write-off of equipment, intangible
assets and inventory, $234,000 for costs associated with the planned
sub-leasing of office space in Leiden on which the Company has a long-term
lease and $150,000 for other contractual obligations.
5. ACQUISITION
In June, 1998, the Company acquired a 5% interest in OST Developpement S.A.
("OST"), for 496,662 French Francs ("FRF") or approximately $84,400. OST is
a processor of bovine bone grafts for orthopaedic and dental use. The
acquisition was accounted for on the cost method. Subsequently, in January
1999, the Company acquired an additional 85% interest for FRF 8,503,338 or
approximately $1,510,000, bringing its ownership to 90%. The Company also
has the option to purchase the remaining 10% of OST at a price to be
determined at the time of purchase.
During 1998, the Company made interest bearing loans to OST aggregating FRF
2,300,000 or $396,000 at the December 31, 1998 exchange rate, to support
its capital expenditure and working capital requirements.
F-9
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. INVENTORIES
Inventories consist of the following at December 31:
(in thousands) 1998 1997
---------------------------------------------------------------------------
Raw materials $ 646 $ 475
Finished goods 922 317
---------------------------------------------------------------------------
$1,568 $ 792
===========================================================================
7. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following at December 31:
(in thousands) 1998 1997
---------------------------------------------------------------------------
Land $ 2,262 $ 1,961
Building 628 201
Machinery and equipment 13,945 9,431
Computer hardware and software 1,774 1,504
Office equipment, furniture and fixtures 2,217 1,696
Equipment under capital lease 798 635
Leasehold improvements 5,030 4,784
------- -------
26,654 20,212
Less accumulated depreciation
and amortization 10,610 8,562
---------------------------------------------------------------------------
$16,044 $11,650
===========================================================================
Accumulated depreciation and amortization above includes amortization on
equipment under capital lease of $323,000 and $234,000 in 1998 and 1997,
respectively.
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 $25 million.
8. 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"). 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 plasma spray coating services generally purchase
such services pursuant to purchase orders or non-exclusive supply
agreements which are cancelable at any time by either party.
F-10
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. COMMITMENTS AND CONTINGENCIES (continued)
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 an additional license payment of dfl 250,000 or approximately
$124,000 in 1998, which were recognized as license fee revenue. IsoTis BV
is required to make an additional license payment of dfl 250,000 or
approximately $133,000 at the December 31, 1998 exchange rate in June,
1999. Additionally, IsoTis BV has an option to acquire the technology for
dfl 4-million (approximately $2.1 million at the December 31, 1998 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.
Product Liability Litigation
The Company is a defendant in two state court product liability actions in
which patients claim that they have suffered damages from the implantation
of orthopaedic bone screws allegedly distributed by the Company. One of the
actions is stayed. Management believes that the suits and claims are
without merit and will continue to defend such actions vigorously. It is
the Company's position that either a device distributed by the Company was
not implanted in the patient, or that if the allegations in the complaints
regarding the use of the device are assumed to be true, the device was used
in a manner which was contrary to the use approved by the FDA and the
Company's written warnings concerning use. Pursuant to its distribution
agreement with the Company, the manufacturer of the spinal fixation
devices, Heinrich C. Ulrich, KG ("Ulrich") has agreed to indemnify the
Company for all costs, and damages incurred by the Company in connection
with its distribution of products manufactured by Ulrich, except such costs
and damages which are caused by the Company's gross negligence, willful
misconduct or unauthorized claim made by the Company in marketing the
products. In connection with this indemnification, the Company received
$62,000 from Ulrich in 1998 and $16,000 in 1997 as reimbursement for legal
costs incurred.
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. On
August 14, 1998, the Company removed this action to the United States
District Court for the District of New Mexico. On August 24, 1998, the
Company 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.
On November 5, 1998, the Company moved for summary judgment in its favor on
all of the claims alleged in this action, on the ground that all of
plaintiffs' claims are barred by their applicable statutes of limitations.
To date the Court limited discovery in this action to matters related to
the statue of limitations issue. The Company believes that the claims
against it are without merit and will continue to vigorously defend against
such claims. See Note 21 "Subsequent Events."
F-11
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. COMMITMENTS AND CONTINGENCIES (continued)
Patent Litigation
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 patent 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 two of the
Company's patents 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. The actions
have been consolidated into one lawsuit. 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 Motech, Inc. 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 Motech, Inc. and GenSci parties of acting
jointly and severally in infringing on the claims of both patents.
Discovery has commenced and is ongoing. The Company has and will continue
to vigorously defend any claims against it and prosecute the claims it has
asserted against the GenSci and DePuy parties.
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 Osteotech'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." Although monetary damages
are sought, an amount has not been specified. Based upon reviews conducted
by its outside patent counsel, Osteotech believes that its bio-d(TM)
threaded cortical bone dowel and Endodowel do not infringe the patent
asserted in the action. Osteotech intends to vigorously defend the 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.
F-12
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. LEASING TRANSACTIONS
The Company leases office and production facilities and equipment under
various capital and 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, 1998 are as follows:
Capital Operating
Year Leases Leases
---------------------------------------------------------------------------
(in thousands)
1999 $ 34 $ 1,045
2000 1,024
2001 988
2002 964
2003 and thereafter 4,702
--------------------
Total minimum lease payments 34 $ 8,723
=======
Less amount representing interest 1
-----------------------------------------------------------
Present value of minimum lease payments $ 33
===========================================================
Rental expense was $1,013,000, $1,013,000 and $1,045,000 for the years
ended December 31, 1998, 1997 and 1996, respectively.
10. STOCKHOLDERS' EQUITY
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,
1998 and 1997.
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. 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.
F-13
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. STOCKHOLDERS' EQUITY (Continued)
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 1998, 1997 and 1996 is as follows:
1998 1997 1996
------------------------------------------------------------------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
------------------------------------------------------------------------------------------------------------------------
Outstanding at January 1, 2,524,011 $ 5.41 2,628,815 $ 3.88 2,373,244 $ 3.61
Granted 491,250 18.55 826,688 8.12 455,250 4.96
Exercised 703,836 3.86 858,147 3.45 128,799 2.47
Canceled or expired 30,693 4.29 73,345 4.13 70,880 4.22
------------------------------------------------------------------------------------------------------------------------
Outstanding at December 31, 2,280,732 $ 9.35 2,524,011 $ 5.41 2,628,815 $ 3.88
------------------------------------------------------------------------------------------------------------------------
Exercisable at December 31, 1,310,544 $ 6.41 1,678,523 $ 5.76 1,514,318 $ 3.70
------------------------------------------------------------------------------------------------------------------------
Available for grant at
December 31, 1,047,000 1,507,482 761,618
------------------------------------------------------------------------------------------------------------------------
Weighted average fair value of
options granted during the period $ 11.03 $ 4.91 $ 2.35
------------------------------------------------------------------------------------------------------------------------
The following table summarizes the information about stock options
outstanding at December 31, 1998:
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 1998 Life (Years) Price 1998 Exercise Price
------------------------------------------------------------------------------------------------------------------
$ .44 to $ 4.63 678,154 6 $ 3.75 428,342 $ 3.76
4.67 to 6.67 487,236 8 5.94 269,361 5.79
8.17 to 13.00 676,592 9 8.89 612,841 8.53
15.75 to 21.59 438,750 10 19.32
------------------------------------------------------------------------------------------------------------------
$ .44 to $21.59 2,280,732 8 $ 9.35 1,310,544 $ 6.41
==================================================================================================================
F-14
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. STOCKHOLDERS' EQUITY (continued)
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 (loss) and net income (loss) 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) 1998 1997 1996
---------------------------------------------------------------------------
Net income (loss)
As reported $ 10,304 $ 5,686 $ (324)
Pro forma 8,155 1,726 (865)
Net income (loss) per share
As reported
Basic $ .78 $ .46 $ (.03)
Diluted .73 .43 (.03)
Pro forma
Basic $ .61 $ .14 $ (.07)
Diluted $ .58 .12 (.07)
---------------------------------------------------------------------------
The pro forma effect on net income (loss) for 1998, 1997 and 1996 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.
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:
1998 1997 1996
---------------------------------------------------------------------------
Expected life (years) 8 7 6
Risk free interest rate 4.5%-5.7% 5.8%-6.6% 6.6%
Volatility factor 50.0% 50.0% 50.0%
Dividend yield 0.0% 0.0% 0.0%
---------------------------------------------------------------------------
F-15
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. STOCKHOLDERS' EQUITY (continued)
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, 1996, 1997
and 1998 is summarized as follows:
Convertible Preferred
Stock Warrants
--------------------- Common
Series Series Stock
A D Warrants
- --------------------------------------------------------------------------------
Outstanding at December 31, 1995 144,515 347,136 851,757
Exercised 127,785 23,564 656,211
- --------------------------------------------------------------------------------
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
- --------------------------------------------------------------------------------
Exercise price $ 0.02 $ 3.72 $ 0.02
Expiration date 2000
- --------------------------------------------------------------------------------
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.
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, 1998, 266,883 shares were available for future offerings under
this plan.
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 the Company's 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.
F-16
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. STOCKHOLDERS' EQUITY (continued)
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. Each Right
entitles the stockholder to purchase from the Company one one-hundredth of
a preferred share at a price of $35.00 per 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 February 12, 2006. 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.
11. DEBT AND FINANCING ARRANGEMENTS
The Company has a loan and security agreement with a U.S. bank which
provides for borrowing up to $3,000,000 under a revolving line of credit
and $4,000,000 under an equipment line of credit. The annual interest rate
on revolving loan advances is based upon the bank's prime rate whereas the
annual rate of interest on equipment advances is based upon the bank's
prime rate plus a margin of .25%. Borrowings under the equipment line of
credit are repayable over a 48 month term and are collateralized by
equipment purchased with such borrowings. The Company is required under the
agreement to maintain certain financial ratios and meet certain net worth
and indebtedness tests. An annual commitment fee of .25% is payable on the
unused portion of the revolving line of credit. At December 31, 1998 and
1997, $172,000 and $709,000, respectively, was outstanding under the
equipment line of credit and there were no borrowings under the revolving
line of credit.
In December, 1998, the Company received a commitment from the bank for a
new credit facility which will replace the current facilities. The new
credit facility will include a $5,000,000 revolving line of credit and a
$21,500,000 building mortgage loan and equipment line of credit which the
Company will use to fund the planned construction of a new processing
facility. Consummation of the new credit facility is subject to negotiation
and execution of a definitive agreement.
The Company has a line of credit with a Dutch bank which provides for
borrowing up to dfl 5,000,000, or approximately $2,659,000 at the December
31, 1998 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
$1,595,000 at the December 31, 1998 exchange rate. At December 31, 1998 and
1997, there were no borrowings under this line of credit.
F-17
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. DEBT AND FINANCING ARRANGEMENTS (continued)
The weighted average interest rate on short-term notes payable outstanding
was 6.87% in 1998 and 5.75% in 1997.
Long-term debt consists of the following at December 31:
(in thousands) 1998 1997
---------------------------------------------------------------------------
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 $ 709
Less current portion 172 537
---------------------------------------------------------------------------
$ 0 $ 172
===========================================================================
12. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable and accrued liabilities consist of the following at
December 31:
(in thousands) 1998 1997
---------------------------------------------------------------------------
Trade accounts payable $2,752 $1,410
Accrued compensation 790 819
Accrued research and development 290 1,046
Accrued taxes payable 3,190 1,465
Other accrued liabilities 2,913 2,179
---------------------------------------------------------------------------
$9,935 $ 6,919
===========================================================================
13. INCOME TAXES
The income tax provision is summarized as follows at December 31:
(in thousands) 1998 1997 1996
--------------------------------------------------------------------------
Current:
Federal $ 5,893 $ 2,958 $ 1,338
State 1,488 660 470
--------------------------------------------------------------------------
7,381 3,618 1,808
---------------------------------------
Deferred:
Federal (151) 217 508
State (121) 51 28
--------------------------------------------------------------------------
(272) 268 536
---------------------------------------
Income tax provision $ 7,109 $ 3,886 $ 2,344
==========================================================================
F-18
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. INCOME TAXES (continued)
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) 1998 1997 1996
---------------------------------------------------------------------------
Computed tax at statutory Federal rate $ 5,920 $ 3,254 $ 687
State income taxes 931 522 352
Amortization of excess of cost over
fair value of assets acquired 86 86 86
Net operating losses for which no tax
benefit is currently available 149 101 1,184
Other 23 (77) 35
---------------------------------------------------------------------------
Income tax provision $ 7,109 $ 3,886 $ 2,344
===========================================================================
Loss before income taxes from foreign operations was $266,000 in 1998 and
$2,952,000 in 1996 respectively. The components of the deferred tax assets
and deferred tax liabilities are as follows at December 31:
(in thousands) 1998 1997
---------------------------------------------------------------------------
Deferred Tax Assets:
Net operating loss carryforwards
Federal $ 279 $ 277
Foreign 991 844
State 43 42
Tax credits 106
Other 932 559
---------------------------------------------------------------------------
2,351 1,722
Less valuation allowance 1,520 1,187
---------------------------------------------------------------------------
Deferred tax assets 831 535
---------------------------------------------------------------------------
Deferred Tax Liabilities:
Other 415 391
---------------------------------------------------------------------------
Deferred tax liabilities 415 391
---------------------------------------------------------------------------
Net deferred tax asset $ 416 $ 144
===========================================================================
In 1998, 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 $2,478,000 ($324,000 with no expiration date;
$2,154,000 expiring 2004 through 2006), of which approximately $148,000
were acquired in connection with an acquisition.
F-19
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
(in thousands) 1998 1997 1996
---------------------------------------------------------------------------
Cash paid during the year for taxes $2,120 $1,071 $1,120
Cash paid during the year for interest 50 101 188
15. SUPPLEMENTARY STATEMENT OF OPERATIONS INFORMATION
Maintenance and repairs expense for the years ended December 31, 1998, 1997
and 1996 was $1,344,000, $1,164,000 and $981,000 respectively. Depreciation
and amortization expense related to property, plant and equipment for the
years ended December 31, 1998, 1997 and 1996 was $2,050,000, $1,699,000 and
$2,020,000 respectively.
16. EARNINGS (LOSS) 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) 1998 1997 1996
- -----------------------------------------------------------------------------------------------
Net income (loss) available to common
Shareholders $ 10,304 $ 5,686 $ (324)
==============================================================================================
Denominator for basic earnings (loss) per share:
Weighted average:
Common shares outstanding 13,259,784 12,215,736 11,604,129
Nominal warrants outstanding(a) 173,388 277,608
------------------------------------------
13,259,784 12,389,124 11,881,737
Effect of dilutive securities:
Stock options 827,072 732,935
Warrants 93 66,714
------------------------------------------
Denominator for diluted earnings (loss) per share 14,086,949 13,188,773 11,881,737
==============================================================================================
Basic earnings (loss) per share $ .78 $ .46 $ (.03)
==============================================================================================
Diluted earnings (loss) per share $ .73 $ .43 $ (.03)
==============================================================================================
(a) Nominal warrants are warrants with an exercise price of $.02.
F-20
OSTEOTECH, INC. AND Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
17. 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 weight-bearing mineralized 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.
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 to orthopaedic and dental implant
manufacturers and marketing and distributing non-allograft bone tissue
spinal implant products.
Grafton(R) Base
DBM Tissue
(in thousands) Segment Segment Other Consolidated
- --------------------------------------------------------------------------------
Revenues:
1998 $39,128 $17,323 $ 2,750 $59,201
1997 26,653 14,426 3,852 44,931
1996 15,293 14,921 4,681 34,895
- --------------------------------------------------------------------------------
Operating income (loss):
1998 $13,404 $ 4,170 $(1,293) $16,281
1997 6,962 2,686 (661) 8,987
1996 2,721 3,150 (4,122) 1,749
- --------------------------------------------------------------------------------
Depreciation and amortization:
1998 $ 1,180 $ 742 $ 481 $ 2,403
1997 799 740 526 2,065
1996 875 1,121 683 2,679
- --------------------------------------------------------------------------------
F-21
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
17. OPERATING SEGMENTS (Continued)
Financial information by geographic area is summarized as follows:
(in thousands) United States Europe Consolidated
---------------------------------------------------------------------------
Revenues
1998 $56,876 $ 2,325 $59,201
1997 41,887 3,044 44,931
1996 31,582 3,313 34,895
Long-lived Assets
1998 $17,090 $ 2,774 $19,864
1997 12,049 2,920 14,969
1996 8,256 3,296 11,552
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) 1998 1997 1996
---------------------------------------------------------------------------
Revenues
MTF $33,286 $25,731 $22,224
ARC 23,020 15,442 8,735
---------------------------------------------------------------------------
$56,306 $41,173 $30,959
===========================================================================
18. 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, 1998, 1997 and 1996 were
$221,000, $161,000 and $133,000 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 $88,000, $56,000 and
$31,000 for the years ended December 31, 1998, 1997 and 1996.
The Company does not maintain any other pension or post retirement plans.
F-22
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
19. RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform with the 1998
presentation.
20. QUARTERLY FINANCIAL DATA (unaudited)
The following is a summary of the unaudited quarterly results for the years
ended December 31, 1998 and 1997:
Quarter Ended
---------------------------------------------
(dollars in thousands except per share data) March 31 June 30 Sept. 30 Dec. 31
- -------------------------------------------------------------------------------------------
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
- ------------------------------------------------------------------------------------------
1997
Net revenues $10,084 $10,703 $11,933 $12,211
Cost of services and products 3,872 3,936 4,217 3,810
Net income 832 1,403 1,608 1,843
Net income per share
Basic $ .07 $ .11 $ .13 $ .14
Diluted .07 .11 .12 .13
21. SUBSEQUENT EVENTS
On February 11, 1999, the Board of Directors authorized a three-for-two
stock split in the form of a 50% stock dividend to be distributed on March
19, 1999 to stockholders of record on March 5, 1999. 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.
In connection with the product liability action pending in the United
States District Court for the District of New Mexico (See Note 8
"Commitments and Contingencies"), on March 16, 1999, the court dismissed
with prejudice the plaintiffs negligence and strict liability claims.
F-23
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, 1998:
Allowance for doubtful accounts $ 147 $ (3)(a) $ 6 (b) $ (2)(c) $ 148
Valuation allowance for deferred
tax asset 1,187 333 (d) 1,520
For the year ended December 31, 1997:
Allowance for doubtful accounts 163 (11)(b) (5)(c) 147
Valuation allowance for deferred
tax asset 4,530 (171)(d) (3,172)(e) 1,187
For the year ended December 31, 1996:
Allowance for doubtful accounts 179 17 (10)(b) (23)(c) 163
Valuation allowance for deferred
tax asset 3,134 1,396 (d) 4,530
(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 25, 1999, except as to information presented in Note 21 for which
the date is March 16, 1999 appearing on page F-2 of this 1998 Form 10-K also
included an audit of the Financial Statement Schedule listed in Item 14(a)(2) of
this 1998 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
Princeton, New Jersey
February 25, 1999, except as to information presented
in Note 21 for which the date is March 16, 1999
S-2
EXHIBIT INDEX
Location of Exhibit in
Exhibit Sequential Numbering
Number Description System
- ------ ----------- ------
10.29 The Management Performance Bonus Plan E-2
10.30 Employment Agreement with Richard Russo dated E-14
April 1, 1997
10.31 Change in Control Agreement by and between E-24
Osteotech, Inc. and Richard Russo
10.32 Employment Agreement with Richard W. Bauer E-39
dated December 4, 1998
21.1 Subsidiaries of the Registrant E-49
23.1 Consent of PricewaterhouseCoopers LLP E-50
27.0 Financial Data Schedule E-51
E-1