UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from____________ to ____________.
Commission File Number: 0-19961
ORTHOFIX INTERNATIONAL N.V.
(Exact name of registrant as specified in its charter)
Netherlands Antilles N/A
- ---------------------------------------- --------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
7 Abraham de Veerstraat
Curacao
Netherlands Antilles N/A
- ---------------------------------------- --------------------------------------
(Address of principal executive offices) (Zip Code)
599-9-4658525
- --------------------------------------------------------------------------------
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.10 par value
(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 at least the past 90 days.
Yes [ X ] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ X ] No [ ]
As of August 3, 2004, 15,560,403 shares of common stock were issued and
outstanding.
Table of Contents
Page
PART I FINANCIAL INFORMATION 3
Item 1. Condensed Financial Statements.................................3
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.......................15
Item 3. Quantitative and Qualitative Disclosure About Market Risk.....24
Item 4. Controls and Procedures.......................................25
PART II OTHER INFORMATION 26
Item 1. Legal Proceedings.............................................26
Item 4. Submission of Matters to a Vote of Security Holders...........27
Item 6. Exhibits and Reports on Form 8-K..............................28
SIGNATURES 29
Forward-Looking Statements
This Form 10-Q contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, which related to our
business and financial outlook and, which are based on our current expectations,
estimates, forecasts and projections. In some cases, you can identify
forward-looking statements by terminology such as "may," "will," "should,"
"expects," "plans," "anticipates," "believes," "estimates," "predicts,"
"potential" or "continue" or other comparable terminology. These forward-looking
statements are not guarantees of future performance and involve risks,
uncertainties, estimates and assumptions that are difficult to predict.
Therefore, actual outcomes and results may differ materially from those
expressed in these forward-looking statements. You should not place undue
reliance on any of these forward-looking statements. Further, any
forward-looking statement speaks only as of the date on which it is made. The
Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for
forward-looking statements to encourage companies to provide prospective
information about their companies without fear of litigation. We hereby take
advantage of the "safe harbor" provisions of the Private Securities Litigation
Reform Act in connection with the forward-looking statements included in this
document.
A number of important factors could cause actual results to differ
materially from those indicated by the forward-looking statements, including,
but not limited to, the risks described under Item 1 - "Business - Risk Factors"
in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003.
2
PART I FINANCIAL INFORMATION
Item 1. CONDENSED FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED BALANCE SHEETS
(U.S. Dollars, in thousands except share data)
June 30, December 31,
2004 2003
----------------- ----------------
(Unaudited) (Note 2)
Assets
Current assets:
Cash and cash equivalents.................................... $46,005 $33,559
Trade accounts receivable, net............................... 73,783 70,690
Inventories.................................................. 31,674 30,713
Deferred income taxes........................................ 3,978 3,978
Prepaid expenses and other................................... 9,904 8,928
----------------- ----------------
Total current assets........................................... 165,344 147,868
Securities and other investments............................... 4,700 5,775
Property, plant and equipment, net............................. 17,641 19,169
Patents and other intangible assets, net....................... 73,196 65,726
Goodwill, net.................................................. 162,889 168,397
Other long-term assets ........................................ 5,348 6,244
----------------- ----------------
Total assets................................................. $429,118 $413,179
================= ================
Liabilities and shareholders' equity
Current liabilities:
Bank borrowings.............................................. $1,999 $72
Current portion of long-term debt............................ 11,294 11,063
Trade accounts payable....................................... 10,101 11,569
Other current liabilities.................................... 23,067 30,236
----------------- ----------------
Total current liabilities.................................... 46,461 52,940
Long-term debt................................................. 93,872 99,072
Deferred income taxes.......................................... 17,861 16,642
Other long-term liabilities.................................... 3,783 3,749
----------------- ----------------
Total liabilities............................................ 161,977 172,403
----------------- ----------------
Contingencies (Note 15)
Shareholders' equity:
Common shares (15,437,225 and 14,980,010 shares issued
at June 30, 2004 and December 31, 2003, respectively)........ 1,544 1,498
Additional paid-in capital................................... 92,800 81,960
Retained earnings............................................ 164,143 147,924
Accumulated other comprehensive income....................... 8,654 9,394
----------------- ----------------
Total shareholders' equity................................... 267,141 240,776
----------------- ----------------
Total liabilities and shareholders' equity $429,118 $413,179
================= ================
The accompanying notes form an integral part of these condensed consolidated
financial statements.
3
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003
Three Months Ended Six Months Ended
------------------------------- -------------------------------
(Unaudited, U.S. Dollars, in thousands except share 2004 2003 2004 2003
and per share data)
-------------- ------------- -------------- -------------
Net sales.............................................. $70,794 $51,565 $141,533 $99,746
Cost of sales.......................................... 19,697 13,009 39,243 25,595
-------------- ------------- -------------- -------------
Gross profit....................................... 51,097 38,556 102,290 74,151
Operating expenses
Sales and marketing................................ 25,638 19,507 51,774 37,107
General and administrative......................... 7,418 5,118 14,667 10,099
Research and development........................... 2,694 2,128 6,010 4,258
Amortization of intangible assets.................. 1,813 119 3,145 397
KCI litigation costs............................... 332 1,264 704 2,126
-------------- ------------- -------------- -------------
37,895 28,136 76,300 53,987
-------------- ------------- -------------- -------------
Total operating income ............................ 13,202 10,420 25,990 20,164
Interest income (expense), net........................ (1,370) 18 (2,899) 78
Other income (expense), net........................... (173) 237 17 223
Gain (loss) in joint venture, net..................... (180) (231) 225 (603)
-------------- ------------- -------------- -------------
Income before income tax.......................... 11,479 10,444 23,333 19,862
Income tax expense..................................... (3,604) (3,949) (7,114) (7,414)
-------------- ------------- -------------- -------------
Net income ..................................... $7,875 $6,495 $16,219 $12,448
-------------- ------------- -------------- -------------
Net income per common share - basic.................... $0.52 $0.46 $1.07 $0.89
-------------- ------------- -------------- -------------
Net income per common share - diluted.................. $0.50 $0.44 $1.02 $0.85
-------------- ------------- -------------- -------------
Weighted average number of common shares - basic......
15,276,961 14,112,563 15,158,409 13,909,436
-------------- ------------- -------------- -------------
Weighted average number of common shares - diluted..... 15,872,346 14,753,417 15,826,981 14,628,146
-------------- ------------- -------------- -------------
The accompanying notes form an integral part of these condensed consolidated
financial statements.
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003
(Unaudited, U.S. Dollars, in thousands) 2004 2003
---------------- -----------------
Cash flows from operating activities:
Net income................................................. $16,219 $12,448
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization.............................. 7,181 3,193
Provision for doubtful accounts............................ 2,133 2,584
Loss on equity investments................................. 609 603
Tax benefit on non-qualified stock options................. 3,457 314
Deferred taxes............................................. (1,136) --
Gain on sale of assets and investments..................... (1,566) --
Other ..................................................... 1,072 108
Change in operating assets and liabilities:
Accounts receivable..................................... (5,205) (6,831)
Inventories............................................. (1,286) 509
Prepaid expenses and other.............................. (1,082) 653
Accounts payable........................................ (1,718) (1,901)
Current liabilities..................................... (2,495) 3,044
---------------- -----------------
Net cash provided by operating activities...................... 16,183 14,724
---------------- -----------------
Cash flows from investing activities:
Investments in affiliates and subsidiaries................ (2,081) (23,659)
Capital expenditures...................................... (3,355) (1,905)
Additions to intangible assets............................ (4,403) (289)
Proceeds from sale of joint venture....................... 1,300 --
Proceeds from sale of assets.............................. 1,578 --
Proceeds from settlement of distributor agreement......... 440 --
---------------- -----------------
Net cash used in investing activities.......................... (6,521) (25,853)
---------------- -----------------
Cash flows from financing activities:
Net proceeds from issuance of common stock................ 7,135 9,483
Repurchase of treasury shares............................. -- (4,395)
Payment of debt issuance costs............................ (529) --
Net repayment of loans and borrowings..................... (3,705) (4,809)
---------------- -----------------
Net cash provided by financing activities...................... 2,901 279
---------------- -----------------
Effect of exchange rate changes on cash........................ (117) 721
---------------- -----------------
Increase (decrease) in cash and cash equivalents............... 12,446 (10,129)
Cash and cash equivalents at the beginning of the year......... 33,559 48,813
---------------- -----------------
Cash and cash equivalents at the end of the period............. $46,005 $38,684
---------------- -----------------
The accompanying notes form an integral part of these condensed consolidated
financial statements.
5
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: BUSINESS
Orthofix International N.V. and its subsidiaries (the "Company") is a
multinational corporation principally involved in the design, development,
manufacture, marketing and distribution of medical equipment, principally for
the orthopedic product market.
NOTE 2: BASIS OF PRESENTATION
The accompanying unaudited Condensed Consolidated Financial Statements have
been prepared in accordance with accounting principles generally accepted in the
United States for interim financial information and with the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X. Pursuant to these rules and
regulations, certain information and note disclosures, normally included in
financial statements prepared in accordance with accounting principles generally
accepted in the United States, have been condensed or omitted. In the opinion of
management, all adjustments (consisting of normal recurring items) considered
necessary for a fair presentation have been included. Operating results for the
six months ended June 30, 2004 are not necessarily indicative of the results
that may be expected for the year ending December 31, 2004. The balance sheet at
December 31, 2003 has been derived from the audited financial statements at that
date but does not include all of the information and footnotes required by
accounting principles generally accepted in the United States for complete
financial statements. For further information, refer to the Consolidated
Financial Statements and Notes thereto of our Annual Report on Form 10-K for the
year ended December 31, 2003 and our Quarterly Report on Form 10-Q for the
quarter ended March 31, 2004.
NOTE 3: INVENTORY
Inventories are as follows:
June 30, December 31,
(In thousands) 2004 2003
------------------- ------------------
Raw materials $6,469 $6,153
Work-in-process 2,594 2,453
Finished goods 13,529 13,437
Field inventory 5,332 5,202
Consignment inventory 7,904 7,124
Less reserve for obsolescence (4,154) (3,656)
------------------- ------------------
$31,674 $30,713
------------------- ------------------
6
NOTE 4: ACQUISITIONS
On December 30, 2003, the Company purchased 100% of the stock of Breg, Inc.
(Breg) for a purchase price of $150 million plus closing adjustments and
acquisition costs. The acquisition and related costs were financed with $110
million of senior secured bank debt, cash on hand and the issuance of 731,715
shares of Orthofix common stock.
The acquisition was accounted for using the purchase method in accordance
with Statement of Financial Accounting Standards No. 141 "Business
Combinations". The allocation of the purchase price has been performed based on
assignment of fair values to assets acquired and liabilities assumed. Fair
values are based, in part, on appraisals performed by an independent appraisal
firm.
The purchase price for the acquisition is preliminary and is subject to
potential upward or downward adjustments based on the final working capital
adjustment and transaction costs. Based on information obtained during the
period, the preliminary purchase price allocation of Breg was adjusted,
resulting in a reduction in the carrying amount of goodwill.
A preliminary allocation of the purchase price as of June 30, 2004 reflects
the following:
Working capital, other than cash $14,351
Fixed assets acquired 5,569
Identifiable intangible assets (definite lived) 41,501
Identifiable intangible assets (indefinite lived) 23,900
Deferred tax liability (16,629)
Goodwill 88,545
--------------
Total purchase price $157,237
==============
In first quarter 2004, the Company purchased a distributor in Puerto Rico
for $1.4 million, which consisted of $1.1 million in cash and $0.3 million of
assumed liabilities. The preliminary purchase price included approximately $0.9
million of working capital and $0.5 million of goodwill. The operations of the
acquired distributor are included in the accompanying consolidated statement of
operations from the date of acquisition.
NOTE 5: GOODWILL
The change in the net carrying value of goodwill for the period ended
June 30, 2004 is as follows:
(In thousands)
Balance at December 31, 2003 $168,397
Acquisitions 532
Adjustments to Breg goodwill (See Note 4) (5,967)
Foreign currency effects (73)
----------------
Balance at June 30, 2004 $162,889
================
7
NOTE 6: INTANGIBLES
During the six month period ended June 30, 2004, the Company purchased the
intellectual property of the Gotfried Percutaneous Compression Plating (PC.C.P)
System for approximately $4.0 million. Additions to intangibles also included
$6.1 million which was a reallocation of the purchase price from goodwill to
definite lived intangible assets related to the distribution network acquired as
a part of the Breg acquisition (See Note 4).
NOTE 7: COMMON SHARES
For the six months ended June 30, 2004, the Company issued 457,215 shares
of common stock upon the exercise of outstanding stock options and warrants for
proceeds of $7.1 million.
NOTE 8: COMPREHENSIVE INCOME
Other comprehensive income includes foreign currency translation
adjustments and unrealized gains/losses on available-for-sale securities, net of
tax. During the three and six month periods ended June 30, 2003, the Company
reclassified $1.0 million and $2.7million, respectively, of foreign currency
translation impact on goodwill that is denominated in a non-U.S. dollar
currency, from comprehensive income to goodwill. These reclassifications had no
impact on the results of operations or cash flows of the Company. Total
comprehensive income combines reported net income and other comprehensive
income.
(In thousands) Three Months Ended Six Months Ended
June 30, June 30,
--------------------------------- -------------------------------
2004 2003 2004 2003
-------------- --------------- ------------ --------------
Net income $7,875 $6,495 $16,219 $12,448
Other comprehensive income:
Unrealized loss on
marketable Securities,
net of taxes -- (49) -- (103)
Unrealized gain on derivative
instrument (See Note 13) 70 -- 70 --
Foreign currency translation
adjustment (714) 4,008 (810) 6,085
-------------- --------------- ------------ --------------
Total comprehensive income $7,231 $10,454 $15,479 $18,430
-------------- --------------- ------------ --------------
8
NOTE 9: BUSINESS SEGMENT INFORMATION
Prior to the acquisition of Breg, the Company managed its operations as two
geographic business units: the Americas and International plus Group Activities.
Presently, the Company's operations are managed as three business segments
(Americas Orthofix, Americas Breg, and International Orthofix) plus Group
Activities. Americas Orthofix consists of the operations, existing prior to the
acquisition of Breg, which are in the United States, Mexico, Brazil, and Puerto
Rico. Americas Breg consists of Breg, Inc., which was acquired December 30,
2003. Breg, based in Vista, California, designs, manufactures and distributes
orthopedic products for post-operative reconstruction and rehabilitative patient
use and sells its products through a network of domestic and international
independent distributors. International Orthofix consists of operations,
existing prior to the acquisition of Breg, which are located in the rest of the
world plus independent distribution operations. Group Activities are comprised
of the Parent's operating expenses and identifiable assets.
For the three month period ended June 30:
External Sales Intersegment Sales
--------------------------------- -------------------------------
(In thousands) 2004 2003 2004 2003
--------------- --------------- -------------- ---------------
Americas Orthofix $31,134 $29,666 $430 $192
Americas Breg 16,412 -- 93 --
International Orthofix 23,248 21,899 14,301 12,521
--------------- --------------- --------------- ---------------
Total $70,794 $51,565 $14,824 $12,713
=============== =============== =============== ===============
For the six month period ended June 30:
External Sales Intersegment Sales
--------------------------------- -------------------------------
(In thousands) 2004 2003 2004 2003
--------------- --------------- -------------- ---------------
Americas Orthofix $60,927 $56,362 $843 $349
Americas Breg 33,271 -- 93 --
International Orthofix 47,335 43,384 30,546 25,065
-------------- -------------- -------------- ----------------
Total $141,533 $99,746 $31,482 $25,414
=============== =============== =============== ===============
For the three and six month periods ended June 30:
9
Three Months Ended Six Months Ended
Operating Income (Expense) June 30, June 30,
------------------------------- -------------------------------
(In thousands) 2004 2003 2004 2003
------------- -------------- ------------ ---------------
Americas Orthofix $7,415 $7,255 $13,507 $13,358
Americas Breg 2,224 -- 4,528 --
International Orthofix 5,292 3,001 10,566 7,918
Group Activities (1,021) (1,050) (2,083) (2,071)
Eliminations (708) 1,214 (528) 959
------------- -------------- ------------ ---------------
Total $13,202 $10,420 $25,990 $20,164
============= ============== ============ ===============
The following table presents identifiable assets by segment, excluding
intercompany balances and investments in consolidated subsidiaries. The December
31, 2003 balances have been reclassified to conform to the current period
presentation.
Identifiable Assets
June 30, December 31,
(In thousands) 2004 2003
------------------ -----------------
Americas Orthofix $107,825 $103,493
Americas Breg 176,456 181,298
International Orthofix 153,706 137,011
Group activities 7,800 5,036
Eliminations (13,555) (13,659)
------------------ ----------------
Total $432,232 $413,179
=================== =================
NOTE 10: INCOME TAXES
The difference between the reported provision for income taxes and a
provision computed by applying the statutory rates applicable to each subsidiary
of the Company is primarily attributable to the Company's tax holiday benefit in
the Seychelles. The Company's effective tax rate benefited from the tax planning
associated with the acquisition of Breg and an increase in earnings in
jurisdictions with lower tax rates.
NOTE 11: DISPOSITION OF ASSETS
In March 2004, the Company sold a portion of its investment in OrthoRx to
its partner in the joint venture, Ferrer Freeman & Co. The sale, combined with
not electing to participate in the next round of financing, reduced the
Company's ownership in OrthoRx to approximately 21%. The Company recorded a gain
on the sale of the investment of approximately $0.8 million, which is reported
as other income.
During the same period, the Company also sold its one-half interest in a
property as part of its plan to consolidate its United Kingdom facilities. The
sale resulted in a gain of approximately $0.6 million, which is reported as
other income. This facility was purchased by a company owned by Mr. Robert
Gaines-Cooper, Chairman of the Company's Board of Directors. The fair value of
this facility was determined by two independent appraisal firms and the amount
paid approximates fair value.
10
NOTE 12: EARNINGS PER SHARE
For the three and six month periods ended June 30, 2004 and 2003, there
were no adjustments to net income (the numerators) for purposes of calculating
basic and diluted net income per common share. The following table sets forth a
reconciliation of the denominators in computing earnings per share in accordance
with Statement of Financial Accounting Standards No. 128, 'Earnings Per Share':
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------ --------------------------------
2004 2003 2004 2003
------------- ------------- ------------- ---------------
Weighted average common shares - basic 15,276,961 14,112,563 15,158,409 13,909,436
Effect of diluted securities:
Stock options 595,385 640,854 668,572 718,710
------------- ------------- ------------- ---------------
Weighted average common shares - diluted 15,872,346 14,753,417 15,826,981 14,628,146
------------- ------------- ------------- ---------------
The Company did not include 200,000 options in the diluted shares
outstanding calculation for the three and six month periods ended June 30, 2004
because their inclusion would have been antidilutive or because their exercise
price exceeded the average market price of our common stock during the period.
For the three and six month periods ended June 30, 2003, the Company did not
include in the diluted shares outstanding calculation 70,966 and 71,212 options,
respectively, because their inclusion would have been antidilutive.
11
NOTE 13: STOCK BASED COMPENSATION
The Company accounts for stock based awards to employees under the
intrinsic value method in accordance with APB 25 "Accounting for Stock Issued to
Employees." For the three and six month periods ended June 30, 2004, $146,750
and $293,500, respectively, of compensation expense was recognized relating to
options granted at exercise prices lower than the fair market value of the
underlying stock on the date of grant. No compensation expense was recorded for
the three and six month periods ended June 30, 2003. In accordance with
Statement of Financial Accounting Standards (SFAS) No. 148, "Accounting for
Stock Based Compensation Transition and Disclosure and Amendment of FASB
Statement No. 123", the Company has provided the Company's pro forma net income
and net income per common share for the three and six month periods ended June
30, 2004 and 2003 as if the Company had accounted for its employee stock option
plans under the fair value method. The Company used the same pricing model and
assumptions that were used in the Annual Report on Form 10-K for the year ended
December 31, 2003. For purposes of pro forma disclosures, the estimated fair
value of the options is amortized to expense over the options' vesting period.
Three Months Ended Six Months Ended
June 30, June 30,
(In thousands, except per share data) 2004 2003 2004 2003
------------- ------------- ----------- ---------------
Net income
As reported $7,875 $6,495 $16,219 $12,448
Add: Stock-based employee compensation
expense included in reported net
income, net of related tax effects 90 -- 180 --
Less: Total stock-based employee
compensation expense determined
under fair value method for all
awards net of tax (616) (584) (1,287) (1,170)
------------- ------------- ----------- ---------------
Pro forma $7,349 $5,911 $15,112 $11,278
Net income per common share - basic
As reported $0.52 $0.46 $1.07 $0.89
Pro forma $0.48 $0.42 $1.00 $0.81
Net income per common share - diluted
As reported $0.50 $0.44 $1.02 $0.85
Pro forma $0.46 $0.40 $0.95 $0.77
12
NOTE 14: DERIVATIVE INSTRUMENT
The Company makes use of interest rate swap agreements to manage its
exposure to fluctuations in interest rates. SFAS No. 133 "Accounting for
Derivative Instruments and Hedging Activities" requires the recognition of all
derivatives in the balance sheet as either assets or liabilities measured at
fair value. The statement also requires a company to recognize changes in the
derivative's fair value currently in earnings unless it meets specific hedge
accounting criteria. If the derivative is designated as a cash flow hedge, the
effective portions of changes in fair value of the derivative are recorded in
other comprehensive earnings and are recognized in the income statement when the
hedged item affects earnings.
The Company has formally documented the relationship between the
hedging instrument and hedged item, as well as its risk-management objective and
strategy for undertaking the hedge transaction. In addition, the Company
formally assesses (both at the hedge's inception and on an ongoing basis)
whether the derivative that is used in the hedging transaction has been
effective in offsetting changes in the cash flows of the hedged item and whether
such derivative may be expected to remain effective in future periods. If it is
determined that a derivative is not (or has ceased to be) effective as a hedge
the Company will discontinue the related hedge accounting prospectively. Such a
determination would be made (1) when the derivative is no longer effective in
offsetting changes in the cash flows of the hedged item; (2) the derivative
expires or is sold, terminated, or exercised; or (3) management determines that
designating the derivative as a hedging instrument is no longer appropriate.
Ineffective portions of changes in the fair value of cash flow hedges are
recognized in earnings.
During the second quarter of 2004, the Company entered into an interest
rate swap agreement (the "Swap") to manage its interest rate exposure related to
the Company's $110 million credit facility entered into on December 30, 2003.
The Swap, in place at June 30, 2004, provides for the Company to pay a fixed
interest rate of 3.16% plus a margin (2.75% as of June 30, 2004) on a notional
amount of $50 million that is effective until June 27, 2007. Under the Swap the
Company will receive interest at floating rates based on LIBOR plus a margin
(2.75% as of June 30, 2004).
The Swap is designated as a cash flow hedge and, at June 30, 2004, is
determined to be effective. At June 30, 2004, the fair value of the derivative
was approximately $70,000 and has been included in other current assets. The net
unrealized gain of approximately $70,000 has been included in other
comprehensive income for the three and six months ended June 30, 2004. The fair
value of the swap is the estimated amount the Company would pay or receive to
terminate the agreement at the reporting date.
NOTE 15: CONTINGENCIES
Litigation
The Company, in the normal course of its business, is involved in various
lawsuits from time to time. In addition, the Company is subject to certain other
contingencies discussed below:
On December 4, 1998, the special committee, or the Review Committee,
established to determine the amount of any contingent contract rights under the
Merger Agreement, dated May 8, 1995, between Orthofix International and American
Medical Electronics, or AME, in settlement of all claims of the holders of
record of AME common stock and the options and warrants to acquire such stock as
of August 21, 1995, unanimously determined that Orthofix International would pay
to the AME record holders an earnout of $500,000 plus interest and 12% of the
net recovery received from the resolution in 2000 of a litigation against
Biomet, Inc. and Electro Biology, Inc., up to a maximum of $5,500,000, plus
interest. The Review Committee has not calculated the amount of the capped
figure, but Orthofix International believes is the amount to be between $5.0
million and $5.5 million. An arbitrator acting under the auspices of the
American Arbitration Association, or AAA, subsequently entered a consent award
based on the Review Committee's determination.
On January 29, 1999, two couples who owned shares of AME common stock
commenced a civil action in Colorado federal court against Orthofix Inc. and the
members of the Review Committee and sought, among other relief, the maximum
earnout and bonus under the Merger Agreement of $18 million plus interest. The
plaintiffs also
13
sought to represent all AME record holders. Clarence Frere, Louise Frere, Joseph
Mooibroek, and Marla B. Mooibroek, individually and on behalf of all others
similarly situated v. Orthofix Inc., Arthur Schwalm, Robert Gaines-Cooper, James
Gero, and John and Jane Does One (1) Through Four (4), No. 99-S-445 (D. Colo.).
In a related action, commenced on June 2, 1999, the same plaintiffs filed a
motion in the United States District Court for the Southern District of New York
and sought to intervene in the AAA arbitration and vacate the consent award.
Clarence Frere, Louise Frere, Joseph Mooibroek, and Marla B. Mooibroek,
individually and on behalf of all others similarly situated v. Orthofix Inc.,
Arthur Schwalm, Robert Gaines-Cooper, James Gero, and John and Jane Does One (1)
Through Four (4), No. 99 Civ. 4049 (S.D.N.Y.). The two actions were consolidated
in New York and Orthofix International was added as a party.
The New York federal courts resolved the two consolidated actions in
favor of the Company and its subsidiary. On July 12, 2002, the trial court
denied the plaintiff's motion to vacate the consent award. On May 21, 2003, the
trial court denied plaintiffs' motion for leave to file a second amended
complaint and dismissed the earnout and bonus action in its entirety with
prejudice. On appeal, on March 12, 2004, the United States Court of Appeals for
the Second Circuit summarily affirmed the judgment in favor of the Company and
its subsidiary. The time within which the plaintiffs could have requested
further review in the United States Supreme Court expired on June 10, 2004.
The Company anticipates that the Review Committee will meet soon to
review and approve the amount of the settlement payment. The Company expects to
pay the appropriate amount within 30 days after it receives the Review
Committee's approval. The Company has previously reserved approximately $5.2
million plus accrued interest for the settlement of this matter.
Novamedix, a subsidiary of the Company, filed an action on February 21,
1992 against Kinetic Concepts Inc. ("KCI") alleging infringement of the patents
relating to Novamedix's A-V Impulse System product, breach of contract, and
seeks damages relating to past infringement, breach of contract, and unfair
competition. KCI has filed counterclaims alleging that Novamedix engaged in
inequitable conduct before the United States Patent and Trademark Office and
fraud as to KCI and that Novamedix engaged in common law and statutory unfair
competition against KCI. KCI withdrew several of its counterclaims, but
continues to assert affirmative defenses contending that the patents are
invalid, unenforceable, and not infringed. KCI also seeks monetary damages,
injunctive relief, costs, attorney's fees, and other unspecified relief. During
2002, the United States Patent and Trademark Office issued re-examination
certificates validating four U.S. vascular patents owned by us. The U.S.
District Court in San Antonio, Texas restored the litigation to active status.
KCI sought to add a charge of infringement against Novamedix under a recently
issued KCI patent but that request was denied on procedural grounds. KCI retains
the right to seek enforcement of its patent in a separate proceeding. A portion
of any amounts received by the Company will be payable to former owners of
Novamedix under the original purchase agreement.
In management's opinion, based upon information available to date, the
Company is not currently involved in any other legal proceeding, individually or
in the aggregate, that will have a material effect on the financial position,
liquidity or operating results of the Company.
Concentrations of credit risk
There have been no material changes from the information provided in the
Company's Annual Report on Form 10-K for the year ended December 31, 2003.
14
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis addresses our liquidity, financial
condition, and the results of our operations for the three and six months ended
June 30, 2004 compared to our results of operations for the three and six months
ended June 30, 2003. These discussions should be read in conjunction with our
historical consolidated financial statements and related notes thereto and the
other financial information included in this Form 10-Q and in our Annual Report
on Form 10-K for the year ended December 31, 2003.
General
We are a diversified orthopedic products company offering a broad line of
minimally invasive surgical, as well as non-surgical, products for the spine,
reconstruction and trauma Market Sectors. Our products are designed to address
the lifelong bone-and-joint health needs of patients of all ages, helping them
achieve a more active and mobile lifestyle. We design, develop, manufacture,
market and distribute medical equipment used principally by musculoskeletal
medical specialists for orthopedic applications. Our main products are external
and internal fixation devices used in fracture treatment, limb lengthening and
bone reconstruction, non-invasive stimulation products used to enhance the
success rate of spinal fusions and to treat non-union fractures, and bracing
products used for ligament injury prevention, pain management and protection of
surgical repair to promote faster healing. Our products also include a device
for enhancing venous circulation, cold therapy, other pain management products,
bone cement and devices for removal of the bone cement used to fix artificial
implants, a bone substitute compound and airway management products.
We have administrative and training facilities in the United States, the
United Kingdom and Italy and manufacturing facilities in the United States, the
United Kingdom, Italy, Mexico and the Seychelles. We directly distribute our
products in the United States, the United Kingdom, Ireland, Italy, Germany,
Switzerland, Austria, France, Belgium, Mexico, Brazil and Puerto Rico. In
several of these and other markets, we also distribute our products through
independent distributors.
Our condensed consolidated financial statements include the financial
results of the Company and our wholly owned and majority-owned subsidiaries and
entities over which we have control. All intercompany accounts and transactions
are eliminated in consolidation. The equity method of accounting is used when a
company has influence over significant operating decisions but does not hold
control. Under the equity method, original investments are recorded at cost and
adjusted by the Company's share of undistributed earnings or losses of these
companies. All material intercompany transactions and profits associated with
the equity investees are eliminated in consolidation.
Our reporting currency is the United States dollar. All balance sheet
accounts, except shareholders' equity, are translated at the period end exchange
rates, and revenue and expense items are translated at weighted average rates of
exchange prevailing during the period. Gains and losses resulting from foreign
currency transactions are included in other income (expense). Gains and losses
resulting from the translation of foreign currency financial statements are
recorded in the accumulated other comprehensive income (loss) component of the
shareholders' equity.
Our financial condition, results of operations and cash flows are not
significantly impacted by seasonality trends. In addition, we do not believe our
operations will be significantly affected by inflation. However, in the ordinary
course of business, we are exposed to the impact of changes in interest rates
and foreign currency fluctuations. Our objective is to limit the impact of such
movements on earnings and cash flows. In order to achieve this objective, we
seek to balance non-dollar income and expenditures. We do not ordinarily use
derivative instruments to hedge foreign exchange exposure.
Prior to the acquisition of Breg, Inc. (Breg) in December 2003, we managed
our operations as two geographic business units: the Americas and International
plus Group Activities. Presently, our operations are managed as three business
segments (Americas Orthofix, Americas Breg and International Orthofix) plus
Group Activities. Americas Orthofix consists of the operations, existing prior
to the acquisition of Breg, which are in the United States, Mexico,
15
Brazil, and Puerto Rico. Americas Breg consists of Breg's domestic and
independent international distributor operations. International Orthofix
consists of operations, existing prior to the acquisition of Breg, which are
located in the rest of the world including independent export distribution
operations. Group Activities are comprised of the Parent's operating expenses
and identifiable assets.
Revenues
Our revenues are generally derived from two primary sources: sales of
orthopedic and non-orthopedic products. Sales of orthopedic products are made
into three Market Sectors, Spine, Reconstruction, and Trauma, which together
accounted for 93% and 92% of our total net sales in the three and six months
ended June 30, 2004, as compared to 91% and 90% of our total net sales for the
same periods in the prior year. Sales of non-orthopedic products, including the
airway management products, woman's care and other products, accounted for 7%
and 8% of our total net sales in the three and six months ended June 30, 2004,
as compared to 9% and 10% of our total net sales for the same periods in the
prior year.
The following tables display the net sales by geographic destination, net
sales by business segment, net of intercompany eliminations, and net sales by
each of our Market Sectors for the three and six months ended June 30, 2004 and
2003. We provide net sales by geographic destination and by Market Sector for
informational purposes only. We maintain our books and records by business
segment.
Geographic Destination:
Three Months Ended June 30,
(In thousands) 2004 2003
----------------------------- ------------------------------
Percent of Percent of
Net Sales Total Net Sales Net Sales Total Net Sales
---------- --------------- ----------- ----------------
Americas $50,997 72% $34,522 67%
International 19,797 28% 17,043 33%
---------- --------------- ----------- ----------------
Total $70,794 100% $51,565 100%
========== =============== =========== ================
Six Months Ended June 30,
(In thousands) 2004 2003
----------------------------- ------------------------------
Percent of Percent of
Net Sales Total Net Sales Net Sales Total Net Sales
---------- --------------- ----------- ----------------
Americas $102,305 72% $65,724 66%
International 39,228 28% 34,022 34%
---------- --------------- ----------- ----------------
Total $141,533 100% $99,746 100%
========== =============== =========== ================
16
Business Segment:
Three Months Ended June 30,
(In thousands) 2004 2003
----------------------------- ------------------------------
Percent of Percent of
Net Sales Total Net Sales Net Sales Total Net Sales
---------- --------------- ----------- ----------------
Americas Orthofix $31,134 44% $29,666 58%
Americas Breg 16,412 23% -- -- %
International Orthofix 23,248 33% 21,899 42%
---------- --------------- ----------- ----------------
Total $70,794 100% $51,565 100%
========== =============== =========== ================
Six Months Ended June 30,
(In thousands) 2004 2003
----------------------------- ------------------------------
Percent of Percent of
Net Sales Total Net Sales Net Sales Total Net Sales
---------- --------------- ----------- ----------------
Americas Orthofix $60,927 43% $56,362 57%
Americas Breg 33,271 24% -- -- %
International Orthofix 47,335 33% 43,384 43%
---------- --------------- ----------- ----------------
Total $141,533 100% $99,746 100%
========== =============== =========== ================
Market Sector:
Three Months Ended June 30,
(In thousands) 2004 2003
----------------------------- ------------------------------
Percent of Percent of
Net Sales Total Net Sales Net Sales Total Net Sales
---------- --------------- ----------- ----------------
Orthopedic
Spine $20,238 29% $20,361 39%
Reconstruction 29,150 41% 12,303 24%
Trauma 16,135 23% 14,275 28%
---------- --------------- ----------- ----------------
Total Orthopedic 65,523 93% 46,939 91%
Non-Orthopedic 5,271 7% 4,626 9%
---------- --------------- ----------- ----------------
Total $70,794 100% $51,565 100%
========== =============== =========== ================
17
Six Months Ended June 30,
(In thousands) 2004 2003
----------------------------- ------------------------------
Percent of Percent of
Net Sales Total Net Sales Net Sales Total Net Sales
---------- --------------- ----------- ----------------
Orthopedic
Spine $39,858 28% $38,673 38%
Reconstruction (1) 59,254 42% 24,725 25%
Trauma (1) 31,438 22% 26,851 27%
---------- --------------- ---------- ----------------
Total Orthopedic 130,550 92% 90,249 90%
Non-Orthopedic 10,983 8% 9,497 10%
---------- --------------- ----------- ----------------
Total $141,533 100% $99,746 100%
========== =============== =========== ================
- --------------------------------------------------------------------------------
Note 1: The six months ended June 30, 2004 contains a first quarter reclass of
$407 from trauma to reconstruction.
The following table presents certain items in our statements of operations
as a percentage of net sales for the periods indicated:
Three Months Ended June 30, Six Months Ended June 30,
---------------------------- ---------------------------
2004 2003 2004 2003
---- ---- ---- ----
(%) (%) (%) (%)
Net sales........................... 100 100 100 100
Cost of sales....................... 28 25 28 26
Gross profit........................ 72 75 72 74
Operating expenses
Sales and marketing .............. 36 38 37 37
General and administrative........ 10 10 10 10
Research and development.......... 4 4 4 4
Amortization of intangible assets. 3 1 2 1
Litigation costs.................. -- 2 1 2
Total operating income.............. 19 20 18 20
Net income.......................... 11 13 11 12
Six Months Ended June 30, 2004 Compared to Six Months Ended June 30, 2003
Sales - Net sales increased 42% to $141.5 million for the first six months of
2004, which included $33.3 million of net sales attributable to Americas Breg,
compared to $99.7 million for the first six months of 2003. The impact of
foreign currency increased sales by $3.8 million during the first six months of
2004 as compared to the first six months of 2003.
Net sales in Americas Orthofix, primarily within the United States,
increased to $60.9 million in the first six months of 2004 compared to $56.4
million in the first six months of 2003, an increase of 8%. Americas Orthofix
represented 43% of total net sales during the first six months of 2004 and 57%
of total net sales for the same period of 2003. The increase in sales was
primarily the result of an increase in sales of stimulators for long bone
applications and external fixators used in the reconstruction and trauma
markets, partially offset by minimal growth in spine market products as a result
of reimbursement issues associated with EZ Brace and Orthotrac and reduced
growth of spinal stimulators.
18
Net sales in Americas Breg for the first six months of 2004 were $33.3
million, which represented 24% of total net sales during the first six months of
2004. Breg was acquired on December 30, 2003; therefore there are no sales for
Americas Breg for the comparable period of the prior year. However, on a pro
forma year-over-year basis, Americas Breg sales grew 12% in the first six months
of 2004 compared to the first six months of 2003.
Net sales in International Orthofix increased 9% to $47.3 million in the
first six months of 2004 compared to $43.4 million in the first six months of
2003. The primary contributors were increased sales of external fixation
products, strong start-up sales of the PC.C.P hip fracture system and growth of
non-orthopedic airway management products, partially offset by a decrease in
sales of the AV Impulse, primarily the Impad component, due to inventory
balancing by its primary customer in the United States. The impact of foreign
currency increased International Orthofix sales for the first six months of 2004
by $3.8 million as compared to the same period of the prior year.
By Market Sector, sales of spine products increased 3% to $39.9 million in
the first six months of 2004 compared to $38.7 million in the first six months
of 2003. Sales of stimulation products for spine applications, the main
component of our Spine Market Sector, increased 5%, which included the impact of
the renewed Medtronic Sofamor Danek distribution agreement. This Market Sector
was negatively impacted by reimbursement issues relating to our Orthotrac and EZ
Brace products. A change in the reimbursement code of the EZ Brace product has
had a negative impact of approximately $0.7 million on period-over-period sales
for this product. Reimbursement issues and increased competitive activity for
spinal stimulators could negatively impact growth, while the pending approval of
a stimulator for cervical applications could positively impact growth in this
Market Sector in future periods.
Sales of our reconstruction products increased 140% to $59.3 million in the
first six months of 2004 compared to $24.7 million in the first six months of
2003. This increase is primarily attributable to the sales of Breg products,
which are classified as reconstruction products, which totaled $33.1 million in
the first six months of 2004. Sales of our external fixation products used in
reconstruction applications increased 34%, which also contributed to the
period-over-period growth in this Market Sector. Growth in this Market Sector
has been negatively impacted in the first six months of 2004 compared to 2003 by
a decrease of 9% in the AV Impulse systems sales as discussed above.
Sales of our trauma products increased 17% to $31.4 million in the first
six months of 2004 compared to $26.9 million in the first six months of 2003.
This Sector benefited from a modest 11% growth in sales of external fixation
products used for trauma applications, a 22% growth in sales of stimulation
products used for long bone applications, and strong start-up sales of the
PC.C.P hip fracture system.
Sales of our non-orthopedic products grew 16% to $11.0 million in the first
six months of 2004 compared to $9.5 million in the first six months of 2003.
This Market Sector continues to be driven by the airway management products,
including a new single use version, which we distribute in the United Kingdom,
Ireland and Italy.
Gross Profit - Our gross profit increased 38% to $102.3 million in the first six
months of 2004, from $74.2 million in the first six months of 2003. The increase
was primarily due to an increase of 42% in net sales, including the addition of
Breg sales. Gross profit as a percent of net sales in the first six months of
2004 was 72.3% compared to 74.3% in the first six months of 2003, reflecting the
impact of the inclusion of Breg with lower gross profit margins relative to pre
Breg gross profit margins, purchase accounting and foreign currency. Although
currency contributed $3.8 million to sales growth, the year-over-year
appreciation of the Euro and the Great Britain Pound against the U.S. Dollar was
detrimental to our gross profit and gross profit margin in those situations
where we produce products in Euros or Pounds and sell them in U.S. Dollars.
Sales and Marketing Expenses - Sales and marketing expenses, which include
commissions, royalties and bad debt provision, generally increase and decrease
in relation to sales. Sales and marketing expenses increased $14.7 million to
$51.8 million in the first six months of 2004 from $37.1 million in the first
six months of 2003, an increase of 40% on a net sales increase of 42% over the
same period. The incremental increase is primarily the result of the addition of
Breg marketing and sales, for which there are no comparable costs in the first
six months of the prior year, and the impact of foreign currency. Sales and
marketing expense as a percent of net sales decreased to 36.6% in the first six
months of 2004 from 37.2% in the same period of 2003. The decrease as a percent
of net sales is primarily associated with our new Breg segment, which carries a
lower sales and marketing expense as a percent of net sales than the Company has
experienced in prior years.
19
General and Administrative Expense - General and administrative expense
increased $4.6 million in the first six months of 2004 to $14.7 million from
$10.1 million in the first six months of 2003. This increase is primarily
attributable to the addition of general and administrative expenses of Breg for
which there are no comparable costs in the same period of the prior year,
purchase accounting adjustments from the acquisition of Breg for the
depreciation of step-up in the value of fixed assets acquired, and the
acquisition of a Puerto Rico distributor, for which there are also no comparable
costs in the same period of the prior year. The expense remained constant as a
percent of net sales at 10% for both periods.
Research and Development Expense - Research and development expense increased
$1.8 million in the first six months of 2004 to $6.0 million from $4.3 million
in the first six months of 2003 and remained constant as a percent of net sales
at 4%. Approximately $1.5 million of this increase is attributable to the Breg
acquisition, for which there were no comparable expenses for the same period of
2003.
Amortization of Intangible Assets - Amortization of intangible assets was $3.1
million in the first six months of 2004 compared to $0.4 million for the same
period of 2003. The increase in amortization expense of approximately $2.5
million was due to the amortization recorded for the distribution network
acquired in the Breg acquisition.
KCI Litigation Expense - Based on an assessment of the merits of the Kinetics
Concepts Inc. (KCI) case (further described in Note 14 "Contingencies" of Item
1. "Condensed Financial Statements"), we incurred $0.7 million in litigation
costs in the first six months of 2004, compared to $2.1 million in the same
period of 2003.
Interest Income (Expense), net - Interest income (expense), net was an expense
of $2.9 million in the first six months of 2004 compared to income of $0.1
million in the first six months of 2003. We incurred interest expense on
borrowings under our senior secured term loan of approximately $2.8 million
which included the amortization of debt costs. Additional interest expense of
$0.2 million was incurred on borrowings under a line of credit in Italy,
partially offset by interest income on cash deposits of $0.1 million.
Other Income (Expense), net - Other income (expense), net was income of $17,000
in the first six months of 2004 compared to an expense of $0.2 million in the
first six months of 2003. The change is attributable to various income and
expense items that occurred during the first six months of 2004 for which there
was no comparable activity for the same period of the prior year. In the first
six months of 2004, we sold our interest in a property as part of our plan to
consolidate our United Kingdom facilities that resulted in a gain of
approximately $0.6 million. We also incurred foreign exchange losses of $0.5
million in the first six months of 2004 compared to a gain of $0.2 million in
the same period of 2003 both principally as a result of the impact of foreign
currency movements on the carrying value of current assets and current
liabilities held by foreign subsidiaries.
Gain (Loss) in Joint Venture, net - Gain (loss) in joint venture, net was income
of $0.2 million in the first six months of 2004 compared to an expense of $0.6
million in the first six months of 2003. During the first six months of 2004, we
sold part of our ownership in the OrthoRx joint venture to our partner Ferrer
Freedman & Company that resulted in a gain of approximately $0.8 million. This
gain was partially offset by our portion of the joint venture's operating losses
for the first six months of 2004 of approximately $0.6 million, which resulted
in a net gain associated with OrthoRx of $0.2 million for the first six months
of 2004 compared to a net loss of $0.6 million for the same period of the prior
year.
Income Tax Expense - In the first six months of 2004 and 2003, the effective tax
rate was 30.5% and 37.3%, respectively. The effective tax rate in the first six
months of 2004 benefited from the following: (i) the non-taxable gain recorded
on our sale of OrthoRx; (ii) lower spending on the KCI case (which occurs in a
low tax jurisdiction); and (iii) inherent tax benefits resulting from the
financing structure of our senior secured term loan obtained in conjunction with
the Breg acquisition.
Net Income - Net income for the first six months of 2004 was $16.2 million, or
$1.07 per basic share and $1.02 per diluted share, compared to $12.4 million, or
$0.89 per basic share and $0.85 per diluted share, for the first six months of
2003, an increase in net income of 30%. The weighted number of basic common
shares outstanding was 15,158,409 and 13,909,436 during the first six months of
2004 and 2003, respectively. The weighted number of
20
diluted common shares outstanding was 15,826,981 and 14,628,146 during the first
six months of 2004 and 2003, respectively.
Three Months Ended June 30, 2004 Compared to Three Months Ended June 30, 2003
Sales - Net sales increased 37% to $70.8 million for the second quarter of
2004 compared to $51.6 million for the second quarter of 2003. The impact of
foreign currency increased sales by $1.5 million during the second quarter of
2004 as compared to the same period of the prior year.
Net sales in the Americas Orthofix, primarily the United States, increased
to $31.1 million in the second quarter of 2004 compared to $29.7 million in the
second quarter of 2003, an increase of 5%. Americas Orthofix represented 44% of
total net sales during the second quarter of 2004 and 58% of total net sales for
the same period of 2003. The increase in sales was primarily the result of an
increase in sales of stimulators used for long bone applications and external
fixators used in the reconstruction and trauma markets. Net sales in spine
market products were negatively impacted by reimbursement issues associated with
EZ Brace and Orthotrac and only a 1% growth in stimulators used in spinal
applications in the second quarter of 2004 as compared to the same period of the
prior year.
Net sales in Americas Breg for the second quarter of 2004 were $16.4
million, which represented 23% of total net sales for the second quarter of
2004. Breg was acquired on December 30, 2003; therefore there are no sales for
Americas Breg for the comparable period of 2003. However, on a pro forma
year-over-year basis, Americas Breg sales grew 10% in the second quarter of 2004
compared to the same period in 2003.
Net sales in International Orthofix increased 6% to $23.2 million in the
second quarter of 2004 compared to $21.9 million in 2003. International Orthofix
experienced growth in its external fixation products, PC.C.P hip fracture system
and growth in non-orthopedic airway management products, but experience a
decrease of 13% in sales of its AV Impulse system, primarily the Impad
component, due to inventory balancing by its primary customer in the United
States. The impact of foreign currency increased International Orthofix sales by
$1.3 million during the second quarter of 2004 as compared to the same period of
the prior year.
By Market Sector, sales of spine products remained flat, at $20.2 in the
second quarter of 2004 compared to $20.4 million in the second quarter of 2003.
Sales of stimulation products for spine applications, the main component of our
Spine Market Sector, increased 1%. This Market Sector was negatively impacted by
reimbursement issues relating to our Orthotrac and EZ Brace products. A change
in the reimbursement code of the EZ Brace product has had a negative impact of
approximately $0.3 million on quarter-over-quarter sales in this Market Sector.
Reimbursement issues and increased competitive activity for spinal stimulators
could negatively impact growth while the pending approval of a stimulator for
cervical applications could positively impact the growth in this Market Sector
in future periods.
Sales of our reconstruction products increased 137% to $29.2 million in the
second quarter of 2004 compared to $12.3 million in the second quarter of 2003.
This increase is primarily attributable to the sales of Breg products, which are
classified as reconstruction products, which totaled $16.4 million in the second
quarter of 2004. Sales of our external fixation products used in reconstruction
applications increased 28% which also contributed to the period-over-period
growth of this Market Sector. Growth in this Market Sector was negatively
impacted in the second quarter of 2004 compared to 2003, by a decrease of 13% in
AV Impulse system sales as discussed above.
Sales of our trauma products increased 13% to $16.1 million in the second
quarter of 2004, compared to $14.3 million in the second quarter of 2003. This
Market Sector benefited from a modest 8% growth in sales of external fixation
products, a strong 19% growth in sales of stimulation products used for long
bone applications, and strong start-up sales of the PC.C.P hip fracture system.
Sales of our non-orthopedic products grew 14% to $5.3 million in the second
quarter of 2004 compared to $4.6 million in the second quarter of 2003. The
increase was primarily due to the growth in sales of airway management products,
including a new single use version, which we distribute in the United Kingdom,
Ireland and Italy.
21
Gross Profit - Our gross profit increased 33% to $51.1 million in the second
quarter of 2004, from $38.6 million in the second quarter of 2003. The increase
was primarily due to the increase of 37% in net sales including the addition of
Breg sales. Gross profit as a percent of net sales in the second quarter 2004
was 72.2% compared to 74.8% in 2003, reflecting the inclusion of Breg with lower
gross profit margins and product mix, primarily lower spinal stimulation and AV
Impulse Impad sales, as a percent of net sales in the second quarter of 2004
compared to the same period of 2003. Although the impact of foreign currency
contributed $1.5 million to sales growth, the year over year appreciation of the
Euro and the Great Britain Pound against the U.S. Dollar was detrimental to our
gross profit and gross profit margin in those situations where we produce
products in Euros or Pounds and sell them in U.S. Dollars.
Sales and Marketing Expenses - Sales and marketing expenses, which include
commissions, royalties and bad debt provision, generally increase and decrease
in relation to sales. Sales and marketing expense increased $6.1million to $25.6
million in the second quarter of 2004 from $19.5 million in the second quarter
of 2003, an increase of 31% on a net sales increase of 37% over the same period.
The incremental increase is primarily the result of the addition of Breg
marketing and sales costs, for which there are no comparable costs in the second
quarter of the prior year, and foreign currency. Sales and marketing expense as
a percent of net sales decreased to 36.6% in the second quarter of 2004 from
37.8% in the same period of 2003. The decrease as a percent of net sales is
primarily associated with our new Breg segment, which carries a lower sales and
marketing expense as a percent of net sales than Orthofix has experienced in
prior years.
General and Administrative Expense - General and administrative expense
increased $2.3 million in the second quarter of 2004 to $7.4 million from $5.1
million in the second quarter of 2003. This increase is primarily attributable
to the addition of general and administrative expenses of Breg, for which there
are no comparable costs in the same period of the prior year, purchase
accounting adjustments from the acquisition of Breg for the depreciation of
step-up in the value of fixed assets acquired, and the acquisition of a Puerto
Rico distributor, for which there are also no comparable costs in the same
period of the prior year. The expense remained constant as a percent of net
sales at approximately 10% for both periods.
Research and Development Expense - Research and development expense increased
$0.6 million in the second quarter of 2004 to $2.7 million from $2.1 million in
the second quarter of 2003 and remained constant as a percent of net sales at
4%. The incremental increase is attributable to the Breg acquisition, for which
there were no comparable expenses for the same period of 2003.
Amortization of Intangible Assets - Amortization of intangible assets was $1.8
million in the second quarter of 2004 compared to $0.1 million for the same
period of 2003. The increase in amortization expense of approximately $1.4
million was due to the amortization recorded for the distribution network
acquired in the Breg acquisition.
KCI Litigation Expense - Based on an assessment of the merits of the Kinetics
Concepts Inc. (KCI) case (further described in Note 14 "Contingencies" of Item
1. "Condensed Financial Statements"), we incurred $0.3 million in litigation
costs in the second quarter of 2004, compared to $1.3 million in the same period
of 2003.
Interest Income (Expense), net - Interest income (expense), net was an expense
of $1.4 million in the second quarter of 2004 compared to income of $18,000 in
the second quarter of 2003. We incurred interest expense on borrowings under our
senior secured term loan of approximately $1.4 million which included the
amortization of debt costs. Additional interest expense of $0.1 million was
incurred on borrowings under a line of credit in Italy.
Other Income (Expense), net - Other income (expense), net was an expense of $0.2
million in the second quarter of 2004 compared to income of $0.2 million in the
second quarter of 2003. The change is attributable to foreign exchange losses in
the second quarter of 2004 compared to foreign exchange gains in the same period
of 2003 on the revaluation of current assets and liabilities denominated in the
Great Britain Pound and Euro held by foreign subsidiaries.
Gain (Loss) in Joint Venture - Gain (loss) in joint venture, net was a loss of
$0.2 million in the second quarter of 2004 and 2003.
22
Income Tax Expense - In the second quarters of 2004 and 2003, the effective tax
rate was 31.4% and 37.8%, respectively. The effective tax rate in the second
quarter of 2004 benefited from the following: i) lower spending on the KCI case
(which occurs in a low tax jurisdiction); and ii) inherent tax benefits
resulting from the financing structure of our senior secured term loan obtained
in conjunction with the Breg acquisition.
Net Income - Net income for the second quarter of 2004 was $7.9 million, or
$0.52 per basic share and $0.50 per diluted share, compared to $6.5 million, or
$0.46 per basic share and $0.44 per diluted share, for the second quarter of
2003, an increase in net income of 21%. The weighted number of basic common
shares outstanding was 15,276,961 and 14,112,563 during the second quarter of
2004 and 2003, respectively. The weighted number of diluted common shares
outstanding was 15,872,346 and 14,753,417 during the second quarter of 2004 and
2003, respectively.
Liquidity and Capital Resources
Cash and cash equivalents were $46.0 million at June 30, 2004 compared to
$33.6 million at December 31, 2003, an increase of $12.4 million.
Net cash provided by operating activities was $16.2 million for the first
six months of 2004 compared to $14.7 million for the first six months of 2003,
an increase of $1.5 million. Net cash provided by operating activities is
comprised of net income, non-cash items and changes in working capital. Net
income increased approximately $3.8 million to $16.2 million in the first six
months of 2004 from $12.4 million in the first six months of 2003. Non-cash
items increased $4.9 million in the first six months of 2004 compared to the
first six months of 2003, primarily as a result of the increased depreciation
and amortization expense associated with the application of purchase accounting
to the assets acquired in the Breg acquisition. Working capital accounts
consumed $11.8 million of cash in the first six months of 2004, principally as a
result of increases in accounts receivable and inventory to support additional
sales and reduced accounts payable and liabilities. This compares to a use of
cash of $4.5 million during the same period of 2003. Performance indicators of
our two primary working capital accounts, accounts receivable and inventory,
reflect days sales in receivables of 95 days at June 30, 2004 compared to 106
days at June 30, 2003 and inventory turnover of 2.5 times at June 30, 2004
compared to 2.2 times at June 30, 2003.
Net cash used in investing activities was $6.5 million during the first six
months of 2004, compared to $25.9 million during the first six months of 2003.
During the first six months of 2004, we paid $1.1 million as part of the
consideration for the purchase of a Puerto Rican distributor, invested $7.8
million in capital expenditures, which included a payment of $4.0 million to
purchase the technology of the PC.C.P hip fracture system. During the first six
months of 2004 we received $1.3 million from the sale of shares in the OrthoRx
joint venture, $1.6 million from the sale of a facility in the UK, and $0.4
million from a contract settlement in Mexico. During the first six month of
2003, we purchased the remaining 48% minority interest in our UK distribution
company for $20.6 million, invested $1.5 million to take an equity interest in
Innovative Spinal Technologies (IST), invested an additional $1.5 million in the
OrthoRx joint venture, and invested $2.2 million in capital expenditures.
Net cash provided by financing activities was $2.9 million in the first six
months of 2004 compared to $0.3 million for the same period in 2003. In the
first six months of 2004, we received proceeds of $7.1 million from the issuance
of 457,215 shares of our common stock upon the exercise of stock options and
warrants. In the first six month of 2004, we also had net borrowings of $2.0
million on a line of credit in Italy used to finance working capital. Further,
in the first six months of 2004, we repaid approximately $5.5 million against
the principal of the senior secured term loan obtained to help finance the Breg
acquisition, paid $0.2 million against other outstanding debt and paid $0.5
million for costs associated with obtaining the senior secured term loan, which
will be amortized over the term of the credit facility.
When we acquired Breg on December 30, 2003, one of our wholly owned
subsidiaries, Colgate Medical Limited ("Colgate"), entered into a new senior
secured bank credit facility with a syndicate of financial institutions to
finance the transaction. The senior secured bank facility provides for (1) a
five-year amortizing term loan facility of $110 million, the proceeds of which
were used for partial payment of the purchase price of Breg, and (2) a five-year
revolving credit facility of $15.0 million. As of June 30, 2004 and as of August
4, 2004, we had no amounts.
23
outstanding under the revolving credit facility. Obligations under the senior
secured bank facility have a floating interest rate of LIBOR or prime rate plus
a margin that is adjusted quarterly based on Colgate's leverage ratio. In May
2004 we entered into an interest rate swap agreement in which we swapped $50.0
million of our variable rate debt for a fixed rate of 3.16% plus a margin equal
to the margin under the credit agreement, currently 2.75%. The fixed rate under
the swap as of June 30, 2004 was 5.91%. The interest rate swap is a three year
fully amortized agreement. Our effective interest rate as of June 30, 2004 on
our senior secured debt was 5.1%. Orthofix and each of Colgate's direct and
indirect subsidiaries, including Orthofix Inc. and Breg, have guaranteed the
obligations of Colgate under the senior secured bank facility. The obligations
of Colgate under the senior secured bank facility and Colgate's subsidiaries
under their guarantees are secured by the pledge of their respective assets.
Certain of our other subsidiaries have also guaranteed the obligations of
Colgate under the senior secured bank facility on a limited recourse basis.
In addition to scheduled debt repayments of $11.0 million in 2004, our
senior secured bank facility requires us to make mandatory prepayments with (a)
the excess cash flow (as defined in the credit agreement) of Colgate and its
subsidiaries in an amount initially equal to 75% of the excess annual cash flow
of Colgate and its subsidiaries, reducing to 50% upon the attainment of a
leverage ratio of less than or equal to 1.50 to 1.00, (b) the net cash proceeds
of any debt issuance by Colgate and its subsidiaries or any equity issuance by
us or Colgate or any of its subsidiaries, (c) the net cash proceeds of asset
dispositions over a minimum threshold or (d) unless reinvested, insurance
proceeds or condemnation awards.
The credit agreement relating to the senior secured bank facility contains
customary negative covenants applicable to Colgate and its subsidiaries,
including restrictions on indebtedness, liens, dividends and mergers and sales
of assets. The credit agreement also contains certain financial covenants,
including a fixed charge coverage ratio, an interest coverage ratio and a
leverage ratio applicable to Colgate and its subsidiaries on a consolidated
basis, and a leverage ratio applicable to Orthofix and its subsidiaries on a
consolidated basis. The Company has assessed its compliance with the financial
covenants as of June 30, 2004, on a pro forma basis, as required by the credit
agreement, noting it is in compliance with all financial covenants.
At June 30, 2004, we had outstanding borrowings of $2.0 million and unused
available lines of credit of approximately $8.5 million under a line of credit
established in Italy to finance the working capital of our Italian operations.
The terms of the line of credit give us the option to borrow amounts in Italy at
rates determined at the time of borrowing.
We continue to search for viable acquisition candidates that would expand
our worldwide presence as well as additional products appropriate for current
distribution channels. An acquisition of another company or product line by us
could result in our incurrence of additional debt and contingent liabilities.
We believe that current cash balances together with projected cash flows
from operating activities, the unused revolving credit facility and available
Italian line of credit, the exercise of stock options, and our remaining
available debt capacity are sufficient to cover anticipated operating capital
needs and research and development costs over the near term.
Contractual Obligations
During the three and six month periods ended June 30, 2004, there were no
material changes in the contractual obligations specified in our Annual Report
on Form 10-K for the year ended December 31, 2003.
Item 3. Quantitative and Qualitative Disclosure About Market Risk
There have been no material changes from the information provided in our
Annual Report on Form 10-K for the year ended December 31, 2003.
24
Item 4. Controls and Procedures
As of June 30, 2004, we performed an evaluation under the supervision and with
the participation of our management, including the Chief Executive Officer and
Chief Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures. Based on the evaluation, our management,
including the Chief Executive Officer and Chief Financial Officer, concluded
that our disclosure controls and procedures were adequate and effective as of
the end of the period covered by this report. During the quarterly period
covered by this report, there were no changes in our internal controls over
financial reporting that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.
25
PART II OTHER INFORMATION
Item 1. Legal Proceedings
On December 4, 1998, the special committee, or the Review Committee,
established to determine the amount of any contingent contract rights under the
Merger Agreement, dated May 8, 1995, between Orthofix International and American
Medical Electronics, or AME, in settlement of all claims of the holders of
record of AME common stock and the options and warrants to acquire such stock as
of August 21, 1995, unanimously determined that Orthofix International would pay
to the AME record holders an earnout of $500,000 plus interest and 12% of the
net recovery received from the resolution in 2000 of a litigation against
Biomet, Inc. and Electro Biology, Inc., up to a maximum of $5,500,000, plus
interest. The Review Committee has not calculated the amount of the capped
figure, but Orthofix International believes is the amount to be between $5.0
million and $5.5 million. An arbitrator acting under the auspices of the
American Arbitration Association, or AAA, subsequently entered a consent award
based on the Review Committee's determination.
On January 29, 1999, two couples who owned shares of AME common stock
commenced a civil action in Colorado federal court against Orthofix Inc. and the
members of the Review Committee and sought, among other relief, the maximum
earnout and bonus under the Merger Agreement of $18 million plus interest. The
plaintiffs also sought to represent all AME record holders. Clarence Frere,
Louise Frere, Joseph Mooibroek, and Marla B. Mooibroek, individually and on
behalf of all others similarly situated v. Orthofix Inc., Arthur Schwalm, Robert
Gaines-Cooper, James Gero, and John and Jane Does One (1) Through Four (4), No.
99-S-445 (D. Colo.). In a related action, commenced on June 2, 1999, the same
plaintiffs filed a motion in the United States District Court for the Southern
District of New York and sought to intervene in the AAA arbitration and vacate
the consent award. Clarence Frere, Louise Frere, Joseph Mooibroek, and Marla B.
Mooibroek, individually and on behalf of all others similarly situated v.
Orthofix Inc., Arthur Schwalm, Robert Gaines-Cooper, James Gero, and John and
Jane Does One (1) Through Four (4), No. 99 Civ. 4049 (S.D.N.Y.). The two actions
were consolidated in New York and Orthofix International was added as a party.
The New York federal courts resolved the two consolidated actions in
favor of the Company and its subsidiary. On July 12, 2002, the trial court
denied the plaintiff's motion to vacate the consent award. On May 21, 2003, the
trial court denied plaintiffs' motion for leave to file a second amended
complaint and dismissed the earnout and bonus action in its entirety with
prejudice. On appeal, on March 12, 2004, the United States Court of Appeals for
the Second Circuit summarily affirmed the judgment in favor of the Company and
its subsidiary. The time within which the plaintiffs could have requested
further review in the United States Supreme Court expired on June 10, 2004.
The Company anticipates that the Review Committee will meet soon to
review and approve the amount of the settlement payment. The Company expects to
pay the appropriate amount within 30 days after it receives the Review
Committee's approval. The Company has previously reserved approximately $5.2
million plus accrued interest for the settlement of this matter.
26
Item 4. Submission of Matters to a Vote of Security Holders
The Annual General Meeting of Shareholders of the Company was held on June 29,
2004. The total number of commons shares eligible to vote as of the record date,
May 10, 2004, was 15,241,362 and according to the Company's Articles of
Association, 7,620,681 constituted a quorum.
At the Annual General Meeting:
1. The following persons were elected as Directors of the Company for a
one year term expiring at the Annual General Meeting in 2005:
Name Votes For Votes Withheld
------------------------------------------------ ------------------- -------------------
Jerry Benjamin 13,260,537 232,715
Peter Clarke 13,236,167 257,085
Alberto D'Abreu de Paulo 13,421,784 71,468
Charles Federico 13,236,817 256,435
Robert Gaines-Cooper 13,236,817 256,435
James Gero 13,424,663 68,589
Frederik Hartsuiker 13,260,537 232,715
Peter Hewett 13,236,817 356,435
John Littlechild 13,260,537 232,715
Walter Von Wartburg 13,451,549 41,703
Edgar Wallner 13,236,417 256,835
2. The 2004 Long-Term Incentive Plan was approved by a vote of 8,424,108
in favor, 2,511,654 against, and 55,318 abstaining. There were
2,502,172 broker non-votes;
3. An amendment to the Articles of Association of the Company to increase
the maximum number of shares common stock available for issuance from
30,000,000 to 50,000,000 was adopted and approved by a vote of
13,099,073 in favor, 383,464 against and 10,715 abstaining;
4. An amendment to the Articles of Association of the Company to reflect
changes in Netherlands Antilles law or to update and clarify certain
provisions of the Articles of Association was adopted and approved by a
vote of 13,377,353 in favor, 36,042 against and 79,857 abstaining;
5. The audited Financial Statements for the year ended December 31, 2003
were adopted and approved by a vote of 13,449,913 in favor, 28,916
against and 14,523 abstaining; and
27
6. The selection of Ernst & Young LLP to act as independent auditors for
the Company and its subsidiaries for the fiscal year ending December
31, 2004 was ratified by a vote of 11,966,838 in favor, 1,520,013
against and 6,401 abstaining.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit
Number Description
31.1* Rule 13a - 14(a)/15d - 14(a) Certification of Chief
Executive Officer.
31.2* Rule 13a - 14(a)/15d - 14(a) Certification of Chief
Financial Officer.
32.1* Section 1350 Certification of Chief Executive
Officer.
32.2* Section 1350 Certification of Chief Financial
Officer.
____________________________
* Filed herewith.
(b) Reports on Form 8-K
None.
28
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
ORTHOFIX INTERNATIONAL N.V.
Date: August 6, 2004 By: /s/ CHARLES W. FEDERICO
--------------------------------
Name: Charles W. Federico
Title: Chief Executive Officer and
President
Date: August 6, 2004 By: /s/ THOMAS HEIN
--------------------------------
Name: Thomas Hein
Title: Chief Financial Officer
29