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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
|X| Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the Period Ended September 30, 2002
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 0-19278
OSTEOTECH, INC.
(Exact name of registrant as specified in its charter)
Delaware 13-3357370
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
51 James Way, Eatontown, New Jersey 07724
(Address of principal executive offices) (Zip Code)
(732) 542-2800
(Registrant's telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since
last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |X| No |_|
The number of shares of the registrant's common stock, $.01 par value,
outstanding as of October 31, 2002 was 16,988,865.
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
OSTEOTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(dollars in thousands)
September 30, December 31,
2002 2001
- -------------------------------------------------------------------------------------------------------
ASSETS
- -------------------------------------------------------------------------------------------------------
Current assets:
Cash and cash equivalents $ 14,990 $ 5,192
Short-term investments 3,948
Accounts receivable, net 9,653 15,093
Deferred processing costs 15,736 11,165
Inventories 7,073 8,803
Deferred income taxes 3,611 2,002
Prepaid expenses and other current assets 2,063 2,025
-----------------------------
Total current assets 57,074 44,280
Property, plant and equipment, net 55,114 56,736
Goodwill, net of accumulated amortization of $404 in 2002 and
$2,477 in 2001 1,669 2,910
Other assets 5,026 3,318
- -------------------------------------------------------------------------------------------------------
Total assets $ 118,883 $ 107,244
=======================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
- -------------------------------------------------------------------------------------------------------
Current liabilities:
Accounts payable and accrued liabilities $ 12,852 $ 17,311
Current maturities of long-term debt 2,661 2,530
-----------------------------
Total current liabilities 15,513 19,841
Long-term debt 16,587 18,683
Other liabilities 658 934
- -------------------------------------------------------------------------------------------------------
Total liabilities 32,758 39,458
- -------------------------------------------------------------------------------------------------------
Commitments and contingencies
Stockholders' equity:
Preferred stock, $.01 par value; 5,000,000 shares authorized;
no shares issued or outstanding
Common stock, $.01 par value; 70,000,000 shares authorized;
issued and outstanding 16,987,615 shares in 2002
and 14,098,264 shares in 2001 170 140
Additional paid-in capital 63,250 47,076
Accumulated other comprehensive loss (231) (653)
Retained earnings 22,936 21,223
- -------------------------------------------------------------------------------------------------------
Total stockholders' equity 86,125 67,786
- -------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $ 118,883 $ 107,244
=======================================================================================================
See accompanying notes to condensed consolidated financial statements.
-2-
OSTEOTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(dollars in thousands, except per share data)
Three Months Nine Months
Ended September 30, Ended September 30,
------------------------------- -------------------------------
2002 2001 2002 2001
- ------------------------------------------------------------------------------------------------------------------------------
Net revenues:
Service $ 18,190 $ 17,957 $ 59,878 $ 52,487
Product 1,501 1,161 4,907 3,046
------------ ------------ ------------ ------------
19,691 19,118 64,785 55,533
Cost of services 9,288 7,160 26,601 20,786
Cost of products 3,401 613 5,366 2,660
------------ ------------ ------------ ------------
12,689 7,773 31,967 23,446
------------ ------------ ------------ ------------
Gross profit 7,002 11,345 32,818 32,087
Marketing, selling, general and administrative 8,309 9,673 29,849 32,057
Research and development 1,002 1,130 2,990 3,302
------------ ------------ ------------ ------------
9,311 10,803 32,839 35,359
Litigation settlement charge (1,785)
------------ ------------ ------------ ------------
Operating income (loss) (2,309) 542 (1,806) (3,272)
Interest income (expense), net (162) 92 (782) 354
Gain on sale of patents 950
------------ ------------ ------------ ------------
Income (loss) from continuing operations
before income taxes (2,471) 634 (1,638) (2,918)
Income tax provision (benefit) (3,478) 353 (3,258) (787)
------------ ------------ ------------ ------------
Income (loss) from continuing operations 1,007 281 1,620 (2,131)
Income (loss) from discontinued operations,
net of loss on disposal of $291 in 2002 (49) 93 (74)
- ------------------------------------------------------------------------------------------------------------------------------
Net income (loss) $ 1,007 $ 232 $ 1,713 $ (2,205)
==============================================================================================================================
Earnings (loss) per share:
Basic:
Income (loss) from continuing operations $ .06 $ .02 $ .10 $ (.15)
Discontinued operations .01 (.01)
------------ ------------ ------------ ------------
Net income (loss) $ .06 $ .02 $ .11 $ (.16)
============ ============ ============ ============
Diluted:
Income (loss) from continuing operations $ .06 $ .02 $ .10 $ (.15)
Discontinued operations .01 (.01)
------------ ------------ ------------ ------------
Net income (loss) $ .06 $ .02 $ .11 $ (.16)
============ ============ ============ ============
Shares used in computing earnings (loss) per share:
Basic 16,916,152 14,045,427 15,542,076 14,023,012
Diluted 17,358,019 14,142,122 15,945,162 14,023,012
See accompanying notes to condensed consolidated financial statements.
-3-
OSTEOTECH, INC. AND Subsidiaries
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(dollars in thousands)
Nine Months Ended September 30, 2002 2001
- --------------------------------------------------------------------------------------------------------
Cash Flow From Operating Activities
Net income (loss) $ 1,713 $ (2,205)
Adjustments to reconcile income (loss)
to net cash provided by (used in) operating activities:
Depreciation and amortization 5,789 4,429
Litigation settlement charge 1,785
Deferred income taxes (2,273)
Gain on sale of patents (950)
Reversal of tax liability (2,557)
Changes in current assets and liabilities:
Accounts receivable 467 (4,453)
Deferred processing costs (4,214) (2,780)
Inventories 1,881 (3,690)
Prepaid expenses and other current assets (52) 2,941
Accounts payable and other liabilities (68) 4,358
- --------------------------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities 1,521 (1,400)
Cash Flow From Investing Activities
Capital expenditures (4,253) (7,979)
Proceeds from sale of land 1,500
Purchases of investments (3,948) (3,925)
Proceeds from sale of investments 3,886
Proceeds from sale of foreign operation 1,000
Proceeds from sale of patents 1,000
Other, net 81 (75)
- --------------------------------------------------------------------------------------------------------
Net cash used in investing activities (6,120) (6,593)
Cash Flow From Financing Activities
Proceeds from issuance of common stock 16,204 387
Proceeds from issuance of long-term debt 1,468
Principal payments on long-term debt (1,965) (188)
- --------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 14,239 1,667
Effect of exchange rate changes on cash 158 92
- --------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 9,798 (6,234)
Cash and cash equivalents at beginning of period 5,192 10,923
- --------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 14,990 $ 4,689
========================================================================================================
Supplementary cash flow data:
Cash paid during the period for interest, excluding amounts capitalized $ 996 $ 97
Cash paid during the period for taxes 1,226 962
Noncash investing activities:
Note receivable from sale of foreign operation $ 1,273 $
See accompanying notes to condensed consolidated financial statements
-4-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
reflect all adjustments (consisting only of normal recurring accruals and
certain non-cash charges as more fully discussed in Note 3 - "Continuing
Operations - Gains/Charges") considered necessary by management to present
fairly the consolidated financial position as of September 30, 2002, the
consolidated results of operations for the three-month and nine-month
periods ended September 30, 2002 and 2001 and the consolidated cash flows
for the nine-month periods ended September 30, 2002 and 2001. The results
of operations for the respective interim periods are not necessarily
indicative of the results to be expected for the full year. The December
31, 2001 financial information has been derived from the audited financial
statements for the year ended December 31, 2001. The condensed
consolidated financial statement should be read in conjunction with the
audited consolidated financial statements for the year ended December 31,
2001, which were included as part of Osteotech, Inc.'s (the "Company")
Annual Report on Form 10-K.
2. Recent Accounting Pronouncements
Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standard ("SFAS") No. 142, "Goodwill and Other Intangible
Assets". Pursuant to the provisions of SFAS No. 142, beginning in 2002 the
Company is no longer amortizing goodwill. Amortization of goodwill
included in continuing operations was $33,000 and $99,000 for the three
and nine months ended September 30, 2001, respectively. Discontinued
operations included $63,000 and $189,000 of goodwill amortization for the
three and nine months ended September 30, 2001, respectively. In addition,
in accordance with the transition provisions of SFAS No. 142, the Company
completed an evaluation of the carrying value of its goodwill as of
January 1, 2002 and determined that there was no impact on the Company's
consolidated financial statements as a result of such evaluation.
The Company's other intangibles, which have finite lives, have carrying
values of $2,005,000 and $1,854,000 as of September 30, 2002 and December
31, 2001, respectively, and are being amortized over their estimated
useful lives ranging from five to ten years.
The following table presents comparative data for the three and nine
months ended September 30, 2002 and 2001 to reflect the adoption of SFAS
No. 142 as of January 1, 2002:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------ ------------------------
(in thousands) 2002 2001 2002 2001
----------------------------------------------------------------------------------------------
Net income (loss) - as reported $ 1,007 $ 232 $ 1,713 $ (2,205)
Add back goodwill amortization 96 288
------------------------------------------------------
Net income (loss) - as adjusted $ 1,007 $ 328 $ 1,713 $ (1,917)
==============================================================================================
Basic earnings per share:
Net income (loss) - as reported $ .06 $ .02 $ .11 $ (.16)
Goodwill amortization .02
------------------------------------------------------
Net income (loss) - as adjusted $ .06 $ .02 $ .11 $ (.14)
==============================================================================================
Diluted earnings per share:
Net income (loss) - as reported $ .06 $ .02 $ .11 $ (.16)
Goodwill amortization .02
------------------------------------------------------
Net income (loss) - as adjusted $ .06 $ .02 $ .11 $ (.14)
==============================================================================================
-5-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
2. Recent Accounting Pronouncements (continued)
In June, 2002, the Financial Accounting Standards Board (FASB) issued SFAS
No. 146, "Accounting for Costs Associated with Exit or Disposal
Activities." SFAS No. 146 addresses recognition, measurement, and
reporting of costs associated with exit and disposal activities, including
restructuring activities. SFAS No. 146 is effective for fiscal years
beginning January 1, 2003. The Company does not expect the adoption of
this pronouncement to have a significant impact on its financial position,
results of operations or cash flow.
3. Continuing Operations - Gains/Charges
2002 Gains/Charges
In third quarter, 2002, the Company recorded pre-tax charges to costs of
service and products totaling $4,079,000 primarily related to reserves for
excess and obsolete metal spinal implants system inventories of
$2,145,000, excess and obsolete inventories for the Company's bio-d(R)
Threaded Cortical Bone Dowel of $1,094,000, which the Company has agreed
to remove from the market by January 31, 2003 in connection with the
patent lawsuit settlement with Medtronic earlier in 2002 (See below and
Note 8 - Commitments and Contingencies - "Litigation"), and an $840,000
charge for the estimated cost to rework tissue placed in quarantine in
third quarter 2002.
In 1997, the Company recorded liabilities of $2,557,000 relating to
certain tax items which were deducted in that year. In September, 2002,
the Company determined the liabilities were no longer required, and
therefore, recognized an income tax benefit related to releasing such
liabilities.
In May, 2002, the Company sold its PolyActive(TM) polymer biomaterials
technology and patents to IsoTis BV for $1,000,000. The Company recognized
a pretax gain of $950,000 in second quarter 2002 on this transaction. (See
Note 8 - Commitments and Contingencies - "License and Option Agreement").
In April, 2002, the Company settled the Medtronic Sofamor Danek, Inc.,
Sofamor Danek L.P. and Sofamor Holdings, Inc. v. Osteotech, Inc. lawsuit.
The Company recorded a pretax charge of $1,785,000 related to this
settlement. (See Note 8 - Commitments and Contingencies - "Litigation").
2001 Charges
In second quarter 2001, the Company recorded pretax charges totaling
$1,845,000 of which $655,000 has been recorded as cost of product and
$1,190,000 has been recorded as marketing, selling, general and
administrative expense. These charges were primarily to establish reserves
for excess inventory and instrumentation associated with spinal implant
systems.
4. Discontinued Operations
On July 10, 2002, the Company completed the sale of the business and
substantially all of the assets, including the assumption of certain
liabilities, of its operations located in Leiden, The Netherlands for
$1,000,000 in cash and a non-interest bearing note with a face value of
$1,500,000, which the
-6-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
4. Discontinued Operations (continued)
Company discounted based on the acquirer's incremental borrowing rate of
5.75%. The note is payable in increasing amounts on a quarterly basis
beginning in March, 2003 through December, 2006. The Company has retained
a security interest in all assets transferred to the acquirer and received
a second mortgage on the land and building the acquirer will occupy to
collateralize the note. For matters arising subsequent to the date of
closing, the Company has no on-going financial or operational
responsibilities with respect to the acquirer.
In addition to the net assets sold, which consist of accounts receivable,
inventories and prepaids and other current assets with an aggregate value
of $1,064,000, equipment with a net book value of $405,000 and current
liabilities of $146,000, the Company had goodwill of $1,241,000
attributable to these operations. The Company recorded a loss of $291,000
on the sale of this business in the second quarter of 2002 to reduce the
carrying value of the assets and liabilities to be sold to fair value.
This loss along with the net income (loss) of this operation prior to the
sale is reflected in the statements of operations as discontinued
operations. Prior periods have been reclassified to conform to this
presentation.
These operations represented the Company's ceramic and titanium plasma
spray coating services and products, which were previously reflected in
the Company's Other segment.
Revenues and net income (loss) on the operations sold were as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------------------
(in thousands) 2002 2001 2002 2001
---------------------------------------------------------------------------------
Revenues $ -- $ 509 $1,630 $ 1,628
==========================================
Net income (loss) from operations $ -- $ (49) $ 384 $ (74)
Loss on disposal (291)
------------------------------------------
Net income (loss) $ -- $ (49) $ 93 $ (74)
==========================================
5. Deferred Processing Costs
Deferred processing costs consist of the following:
September 30, December 31,
(in thousands) 2002 2001
------------------------------------------------------------------------------------
Unprocessed donor tissue to be distributed
by the Company $ 2,010 $ 492
Tissue in process 5,664 2,936
Processed implantable donor tissue to be distributed
by the Company 6,388 5,359
Processed implantable donor tissue held for clients 1,674 2,378
------------------------------------------------------------------------------------
$15,736 $11,165
====================================================================================
-7-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
6. Inventories
Inventories consist of the following:
September 30, December 31,
(in thousands) 2002 2001
-----------------------------------------------------------------------
Supplies $ 293 $ 245
Raw materials 650 784
Finished goods 6,130 7,774
-----------------------------------------------------------------------
$7,073 $8,803
=======================================================================
7. Debt and Financing Arrangements
The Company's Credit Facility, as amended, requires that it meet four
financial ratios on a quarterly basis. As of September 30, 2002, the
Company complied with three of the financial ratios, but did not comply
with the fourth financial ratio, the Earnings Before Interest, Taxes,
Depreciation and Amortization ("EBITDA") ratio. On November 13, 2002, the
Company's lender waived compliance with the EBITDA ratio for the quarter
ended September 30, 2002 and amended the requirements of the ratio for the
succeeding four fiscal quarters. In addition, the waiver and amendment
require the Company to meet a fifth financial ratio, the Quick Ratio, on a
prospective basis.
In June, 2002, the Company obtained an irrevocable standby letter of
credit from its lender with which it has a $5,000,000 revolving line of
credit to support the $1,900,000 ($1,504,000 is due as of September 30,
2002) due to Medtronic Sofamor Danek, Inc. pursuant to the settlement
agreement in connection with the Medtronic Sofamor Danek, Inc., Sofamor
Danek L.P. and Sofamor Holdings, Inc. v. Osteotech, Inc. lawsuit. (See
Note 8 - Commitments and Contingencies - "Litigation"). The commitment
under the standby letter of credit is $1,900,000, but such commitment
decreases over time based on a predetermined schedule concurrent with the
Company's monthly payments under the settlement. As of September 30, 2002,
the standby letter of credit has been reduced to $1,610,000. The amount
committed under the standby letter of credit reduces the Company's
availability under its revolving line of credit. As of September 30, 2002,
no amounts were outstanding under the revolving line of credit and
$3,390,000 was available.
8. Commitments and Contingencies
Service Agreements
On October 27, 2002, the Company and the American Red Cross ("ARC")
amended their ten-year processing agreement dated January 1, 1997. The
amendment, among other items, removes the requirement that ARC exclusively
provide all tissue recovered by ARC to the Company for processing and, in
its place, provides that ARC will provide a monthly minimum number of
donors to the Company for processing.
-8-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
8. Commitments and Contingencies (continued)
License and Option Agreement
In June, 1997, the Company entered into an exclusive worldwide License and
Option Agreement for its proprietary PolyActive(TM) polymer biomaterial
technology and patents (collectively, the "PolyActive technology") with
IsoTis BV ("IsoTis"), The Netherlands. IsoTis had an option to acquire the
PolyActive technology for approximately 1,815,000 euros (approximately
$1,582,000 at the March 31, 2002 exchange rate) expiring in June, 2003. On
April 8, 2002, the Company amended the License and Option Agreement to
reduce the option price for IsoTis to acquire the PolyActive technology to
$1,000,000. In conjunction with the execution of the amendment, IsoTis
elected to exercise its option to acquire the PolyActive technology. The
Company has recognized a pretax gain of $950,000 upon closing this
transaction in May, 2002.
Purchase Commitment
In February, 2001, the Company entered into an exclusive distribution
agreement with Alphatec Manufacturing, Inc. ("Alphatec") to market and
distribute a pedicle screw system and a cervical plating system in the
United States and Canada. Pursuant to the agreement, the Company agreed to
purchase $6,000,000 of inventory and instrumentation during the two-year
period beginning April 1, 2002. In October, 2002, pursuant to a letter
agreement, Alphatec waived the purchase commitment of $3,200,000 for the
first year of the commitment period (April 1, 2002 to March 31, 2003) for
a payment of $300,000. Such charge was recorded in the third quarter of
2002. The purchase commitment of $2,800,000 for the second year (April 1,
2003 to March 31, 2004) of the commitment period is still in effect.
Litigation
The following is a description of material developments that occurred
since the filing of the Company's Quarterly Report on Form 10-Q for the
quarter ended June 30, 2002 in lawsuits reported in the Company's Annual
Report on Form 10-K for the year ended December 31, 2001 and the Company's
Quarterly Reports on Form 10-Q for the quarters ended March 31, 2002 and
June 30, 2002. Additionally, the Company is party to other litigation
incidental to its business, none of which, individually or in the
aggregate, are expected to have a material adverse effect on the Company.
Medtronic Sofamor Danek, Inc., Sofamor Danek L.P. and Sofamor Holdings,
Inc. v. Osteotech, Inc.
In July, 1999, Medtronic Sofamor Danek, Inc., Sofamor Danek L.P. and
Sofamor Danek Holdings, Inc. (collectively, "Medtronic") sued the Company
in the United States District Court for the Western District of Tennessee
alleging that certain instruments and instrument sets relating to cortical
bone dowel products, including the bio-d(R) Threaded Cortical Bone Dowel
and Endodowel, manufactured, sold and/or otherwise distributed by the
Company infringe on certain claims of U.S. Patent Nos. 5,741,253,
5,484,437 and 6,096,038 which are owned by Medtronic.
-9-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
8. Commitments and Contingencies (continued)
In April, 2002, Medtronic and the Company settled this lawsuit (the
"Medtronic Settlement"). The Company agreed to pay an aggregate of
$1,900,000 to Medtronic in 24 equal monthly installments, without
interest, which payment obligation is supported by an irrevocable standby
letter of credit, and to cease processing, marketing, distributing,
advertising and promoting the bio-d(R) Threaded Cortical Bone Dowel no
later than January 31, 2003.
The Company recorded a charge of $1,785,000 in the second quarter of 2002
representing the present value of the amounts due under the Medtronic
Settlement. This charge is reflected as a litigation settlement charge in
the consolidated statements of operations.
Condos v. Musculoskeletal Transplant Foundation
In July, 2000, the Company was served with an action brought in the United
States District Court for the District of Utah against the Company and the
Musculoskeletal Transplant Foundation ("MTF"). The suit alleges causes of
action for strict liability, breach of implied warranty and negligence
arising from allegedly defective allograft bone tissue processed and/or
provided by defendants and allegedly implanted into plaintiff Chris Condos
during two spinal surgeries. In October, 2002, the parties reached a
provisional settlement and are awaiting the Court's approval of the terms
of the settlement. The Company's portion of the provisional settlement,
which was recorded in the third quarter of 2002, does not have a material
impact on the Company's results of operations or financial condition.
Criti-Cal, Inc. v. Osteotech, Inc.
In December, 2000, Criti-Cal, Inc. commenced an action in the Superior
Court for the State of California, Orange County, against the Company,
Second Act Medical, Inc. and Ronald Letner. As against the Company,
plaintiff alleges causes of action for breach of contract,
misappropriation of trade secrets, quantum meruit and violation of the
California Independent Wholesale Sales Representatives Contractual
Relations Act of 1990 arising from the termination of an agreement between
the Company and plaintiff. In October, 2002, the parties, including the
Company, reached an agreement in principle to settle this action. The
Company's portion of the settlement, which was recorded in the third
quarter of 2002, does not have a material impact on the Company's results
of operations or financial condition.
"O" Company, Inc. v. Osteotech, Inc.
In July, 1998, a complaint was filed against the Company in the Second
Judicial District Court, Bernallilo County, New Mexico, which alleges
negligence, strict liability, breach of warranties, negligent
mis-representation, fraud and violation of the New Mexico Unfair Trade
Practices Act arising from allegedly defective dental implant coating and
coating services provided to plaintiff by the Company's subsidiary,
Osteotech Implants BV, formerly known as CAM Implants BV. Plaintiffs are
seeking monetary damages in an amount to be determined at trial. The
Company successfully moved to dismiss plaintiffs' claims for negligence
and strict liability. Remaining are claims for breach of warranties,
negligent misrepresentation, fraud and violation of the New Mexico Unfair
Trade Practices Act. As to these remaining claims, in addition to denying
any and all liability, the Company had moved for summary judgment on the
basis that all of the claims are barred by their applicable
-10-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
8. Commitments and Contingencies (continued)
statutes of limitations. After discovery on matters relating to the
statute of limitations issue, the Company's summary judgment motion was
submitted. On October 22, 2002, the court issued a memorandum opinion and
order denying the Company's motion for summary judgment and plaintiffs'
cross-motion for summary judgment. Discovery on the merits of the
plaintiffs' case and scope of alleged damages, if any, will now commence.
The Company believes that the claims made against it in this action are
without merit and will continue to vigorously defend against such claims.
Hardman v. Nussbaum
The American National Red Cross ("ARC") notified the Company in the first
quarter of this year that a plaintiff had brought an action against it for
negligence relating to ARC's distribution of certain Grafton(R) DBM Putty
that was allegedly implanted in the plaintiff, Larry Hardman, during a
surgical procedure. On September 9, 2002, ARC notified the Company that
plaintiff intended to name the Company as a defendant in the Los Angeles
Superior Court action, however, the plaintiff has not yet served the
Company with a complaint. Until such time as the Company is served with
the complaint, the Company cannot evaluate the merits of this action.
Scroggins v. Zimmer Holdings, Inc.
On or about June 24, 2002, the Company received a complaint filed in the
United States District Court for the Eastern District of Louisiana against
numerous defendants, including the Company. The complaint alleges that
plaintiff received defective medical hardware in connection with a certain
hip replacement procedure in May, 1992, and that such hardware was
manufactured or distributed by certain of the defendants. The procedure
involved the use of allograft bone tissue processed by the Company and
provided by one of our clients. Plaintiff alleges personal injuries and
$1,000,000 in damages. The Company served its answer to the complaint on
August 30, 2002, and discovery in the case is about to commence.
The Company maintains a general liability insurance policy and has
notified the insurance company of this action. The insurance company has
agreed to defend this action.
Litigation is subject to many uncertainties and management is unable to
predict the outcome of the pending suits and claims. It is possible that
the results of operations or liquidity and capital resources of the
Company could be adversely affected by the ultimate outcome of the pending
litigation or as a result of the costs of contesting such lawsuits. The
Company is currently unable to estimate the ultimate liability, if any,
that may result from the pending litigation and, accordingly, no material
provision for any liability (except for accrued legal costs for services
previously rendered) has been made for such pending litigation in the
consolidated financial statements. When the Company is reasonably able to
determine the probable minimum or ultimate liability, if any, that may
result from any of the pending litigation, the Company will record a
provision for such liability to the extent not covered by insurance.
-11-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
9. Stockholders' Equity
Common Stock
In May, 2002, the Company completed the sale of 2.8 million shares of its
common stock representing approximately 19.8% of the then outstanding
shares of common stock at $6.25 per share to a small group of investors in
a private placement transaction. The resale of these shares were
registered with the Securities and Exchange Commission in May, 2002. The
Company recognized net proceeds of $15,756,000 after deducting the fees
and expenses of the transaction.
Preferred Stock
On April 4, 2002, the Company reduced the number of authorized shares of
preferred stock to 5,000,000 shares from 5,675,595 shares. In accordance
with the Company's Restated Certificate of Incorporation, these 675,595
shares were previously converted to common stock, and therefore are no
longer available for issuance.
10. Foreign Net Operating Loss Carryforwards
In the second quarter of 2002, the Company utilized approximately
$2,000,000 of its historical net operating loss carryforwards relating to
its subsidiary in The Netherlands. Such net operating loss carryforwards
were utilized against the Company's tax gain on the foreign portion of the
gain on the sale of the PolyActive(TM) polymer biomaterial technology and
patents, the tax gain on the sale of the Company's operations in The
Netherlands and earnings from operations in 2002. Utilization of these net
operating loss carryforwards, which were recorded subject to a full
valuation allowance in prior periods, resulted in a reduction of
approximately $680,000 to income taxes otherwise payable in The
Netherlands.
11. Comprehensive Income
Comprehensive income for the three-month and nine-month periods ended
September 30, 2002 and 2001 were as follows:
Three months ended Nine months ended
September 30, September 30,
---------------------------------------------
(in thousands) 2002 2001 2002 2001
-----------------------------------------------------------------------------------
Net income (loss) $ 1,007 $232 $ 1,713 $(2,205)
Currency translation adjustments (35) 319 422 (115)
-----------------------------------------------------------------------------------
Comprehensive income (loss) $ 972 $551 $ 2,135 $(2,320)
===================================================================================
-12-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
12. Earnings (Loss) Per Share
The following table sets forth the computation of basic and diluted
earnings (loss) per share for the three-month and nine-month periods ended
September 30, 2002 and 2001:
Three Months Ended Nine Months Ended
September 30, September 30,
(dollars in thousands
except per share data) 2002 2001 2002 2001
--------------------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations $ 1,007 $ 281 $ 1,620 $ (2,131)
Discontinued operations (49) 93 (74)
------------------------------------------------------------------
Net income (loss) available to
common shareholders $ 1,007 $ 232 $ 1,713 $ (2,205)
==================================================================
--------------------------------------------------------------------------------------------------------------------
Denominator for basic earnings (loss)
per share, weighted average common
shares outstanding 16,916,152 14,045,427 15,542,076 14,023,012
Effect of dilutive securities, stock options 441,867 96,695 403,086
------------------------------------------------------------------
Denominator for diluted earnings (loss)
per share 17,358,019 14,142,122 15,945,162 14,023,012
==================================================================
--------------------------------------------------------------------------------------------------------------------
Basic earnings (loss) per share:
Income (loss) from continuing operations $ .06 $ .02 $ .10 $ (.15)
Discontinued operations .01 (.01)
------------------------------------------------------------------
Net income (loss) $ .06 $ .02 $ .11 $ (.16)
==================================================================
--------------------------------------------------------------------------------------------------------------------
Diluted earnings (loss) per share:
Income (loss) from continuing operations $ .06 $ .02 $ .10 $ (.15)
Discontinued operations .01 (.01)
------------------------------------------------------------------
Net income (loss) $ .06 $ .02 $ .11 $ (.16)
==================================================================
--------------------------------------------------------------------------------------------------------------------
For the nine months ended September 30, 2001, common equivalent shares,
consisting solely of stock options, are excluded from the calculation of
diluted loss per share as their effects are antidilutive. Weighted average
shares issuable upon the exercise of stock options which were not included
in the calculation of diluted earnings (loss) per share were 1,144,288 and
1,846,580, and 1,062,133 and 1,795,307 for the three and nine months ended
September 30, 2002 and 2001, respectively. Such shares were not included
because they were antidilutive.
-13-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
13. Operating Segments
Summarized in the table below is financial information for our reportable
segments after giving effect to the divestiture of the Company's
operations in The Netherlands for the three-month and nine-month periods
ending September 30, 2002 and 2001:
Three Months Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------
(dollars in thousands) 2002 2001 2002 2001
------------------------------------------------------------------------------------
Revenues:
Grafton(R) DBM Segment $ 10,917 $ 11,012 $ 34,558 $ 31,958
Base Tissue Segment 7,273 6,945 25,320 20,529
Other 1,501 1,161 4,907 3,046
------------------------------------------------------------------------------------
Consolidated $ 19,691 $ 19,118 $ 64,785 $ 55,533
====================================================================================
Operating income (loss):
Grafton(R) DBM Segment $ 3,647 $ 2,033 $ 8,163 $ 4,672
Base Tissue Segment (2,914) (628) (5,627) (3,670)
Other (3,042) (863) (4,342) (4,274)
------------------------------------------------------------------------------------
Consolidated $ (2,309) $ 542 $ (1,806) $ (3,272)
====================================================================================
Two of our clients, MTF and ARC, in the Grafton(R) DBM and Base Tissue
Segments together accounted for 55% and 74% of consolidated net revenues
during the three months ended September 30, 2002 and 2001, respectively.
For the nine months ended September 30, 2002 and 2001, these same two
clients accounted for 60% and 80%, respectively, of consolidated net
revenues.
14. Reclassifications
Certain prior year amounts have been reclassified to conform to the 2002
presentation.
-14-
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Information contained herein 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 our Annual Report on Form 10-K for the year ended December 31, 2001
constitute cautionary statements identifying factors with respect to such
forward-looking statements, including certain risks and uncertainties, that
could cause actual 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.
FOR THE THREE-MONTH AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2002 AND 2001
Temporary Suspension of Base Tissue Segment Processing
On September 30, 2002, we announced that we had voluntarily and temporarily
suspended Base Tissue Segment processing due to a higher than normal finished
product sterility failures, which occurred in our Eatontown facility, and
subsequently, in our Shrewsbury facility. Although all such tissue was tested
and found sterile, as a precaution, we also initiated a voluntary retrieval of
certain tissue from 15 whole donors and five individual pieces of tissue from
five different donors that had previously been shipped to clients. On October 9,
2002, we announced that we had restarted Base Tissue Segment processing in our
Shrewsbury facility, and announced on October 29, 2002 that we began processing
Grafton(R) DBM in our Eatontown facility the week of October 21, 2002. We expect
to begin partial Base Tissue Segment processing in the Eatontown facility the
second half of November, 2002.
As a result of the temporary suspension of Base Tissue Segment processing, we
have placed tissue processed in third quarter 2002 from 693 donors in
quarantine. We expect to rework this tissue over time and invoice our
clients/customers for this tissue as it is shipped. In order to successfully
rework this tissue, we will need to meet certain technical, scientific and
regulatory requirements. We believe that we will be able to meet such
requirements and we believe we will be able to rework this tissue for the costs
described below. However, there can be no certainty that we will be able to meet
all such requirements, or be able to rework this tissue for such estimated
costs.
These events have negatively impacted our third quarter 2002 operating results
and we expect these events will also negatively impact our fourth quarter 2002
operating results. We have estimated that third quarter 2002 Base Tissue Segment
revenues have been negatively impacted by $1,342,000 and we have recorded a
reserve of $840,000 in third quarter 2002 for the estimated cost to rework the
tissue in quarantine. We believe that fourth quarter 2002 Base Tissue Segment
revenues will be negatively impacted by an estimated $1,200,000 to $2,300,000.
Results of Operations
Critical Accounting Policies and Estimates
In December, 2001, the Securities and Exchange Commission issued Release No.
33-8040, "Cautionary Advice Regarding Disclosure About Critical Accounting
Policies." Critical accounting policies are those that involve subjective or
complex judgments, often as a result of the need to make estimates. The
-15-
following areas all require the use of judgments and estimates: product returns,
bad debts, inventories including purchase commitments, deferred processing costs
including rework reserves, intangible assets, income taxes and contingencies and
litigation. Estimates in each of these areas are based on historical experience
and various assumptions that we believe are appropriate. Actual results may
differ from these estimates. Our accounting practices are discussed in more
detail in "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and Note 2 of "Notes to Consolidated Financial
Statements" in our Annual Report on Form 10-K for the year ended December 31,
2001.
Income from Continuing Operations
Consolidated income from continuing operations was $1,007,000 or $.06 diluted
earnings per share and $1,620,000 or $.10 diluted earnings per share for the
three and nine months ended September 30, 2002, respectively, compared to
consolidated income from continuing operations of $281,000 or $.02 diluted
earnings per share and a consolidated loss from continuing operations of
$2,131,000 or $.15 diluted loss per share in the same respective periods last
year. The three months ended September 30, 2002 included after tax charges of
$504,000 for the estimated cost to rework the tissue from donors placed in
quarantine in the third quarter of 2002 and $1,943,000 for excess and obsolete
inventory related to spinal implant systems, including the bio-d(R) Threaded
Cortical Bone Dowel, which we have agreed to remove from the market by January
31, 2003 in connection with a lawsuit settlement, offset by recognition of an
income tax benefit of $2,557,000 related to liabilities for tax benefits
recorded in 1997 that are no longer required. In addition to the items discussed
above, the nine months ended September 30, 2002 include an after tax charge of
$1,071,000 associated with the Medtronic litigation settlement and an after tax
gain of $830,000 related to the sale of the PolyActive(TM) polymer biomaterial
technology and patents to IsoTis BV. The nine months ended September 30, 2001
included a charge of $1,107,000, net of tax, primarily to establish reserves for
excess inventory and instrumentation associated with spinal implant systems.
Discontinued Operations
On July 10, 2002, we completed the sale of the business and substantially all of
the assets, including the assumption of certain liabilities, of our operations
in Leiden, The Netherlands for $1,000,000 in cash and a non-interest bearing
note with a face value of $1,500,000, which we discounted based on the
acquirer's incremental borrowing rate of 5.75%. These operations represented our
ceramic and titanium plasma spray coating services and products. We recognized a
loss on the sale of this business of $291,000 in the second quarter of 2002.
Revenues from this business were $509,000 for the three months ended September
30, 2001, and $1,630,000 and $1,628,000 for the nine months ended September 30,
2002 and 2001, respectively. The business had net income of $384,000 in 2002
through the date of sale, compared to a net loss of $49,000 and $74,000 in the
three and nine months ended September 30, 2001, respectively.
Net Income (Loss)
Consolidated net income in the third quarter of 2002 was $1,007,000 or $.06
diluted net income per share compared to consolidated net income of $232,000 or
$.02 diluted net income per share in the third quarter of 2001. Consolidated net
income for the nine months ended September 30, 2002 was $1,713,000 or $.11
diluted net income per share compared to a consolidated net loss of $2,205,000
or $.16 diluted net loss per share for the nine months ended September 30, 2001.
The following is a discussion of factors affecting results of continuing
operations after giving effect to the divestiture of the operations of our
subsidiary in The Netherlands for the three-month and nine-month periods ended
September 30, 2002 and 2001.
-16-
Net Revenues
Consolidated net revenues increased 3% in the third quarter of 2002 to
$19,691,000, compared to consolidated revenues of $19,118,000 in the
corresponding period in 2001. The increase in 2002 was principally due to higher
revenues in bio-implants and in other product lines primarily as a result of
increased unit volume, and to a lesser extent, as a result of price increases
effective January 1, 2002, partially offset by a slight decline in Grafton(R)
Segment unit volume. Revenues in the third quarter of 2002 were also negatively
impacted by an estimated $1,342,000 due to the temporary suspension of Base
Tissue Segment processing and by a decline in the number of donors processed.
Domestic net revenues increased 3% in the third quarter of 2002 to $18,489,000
from $18,031,000 in the corresponding period in 2001. The increase in domestic
revenues was due primarily to increased unit volume and increased pricing in
bio-implants and spinal metal implants, partially offset by a 47% decrease in
base allograft tissue processing revenue due to the temporary suspension of base
tissue processing and a decrease in the number of donors processed.
Foreign-based revenues increased 11% to $1,202,000 in the third quarter of 2002
from $1,087,000 in the same period in 2001. The increase in foreign-based
revenues was primarily as a result of increased base tissue processing fees and
increased unit sales volume in OsteoPure(TM) Femoral Head processing and bovine
products, partially offset by a decline in Grafton(R) DBM unit volume due to the
restructuring of our European distribution network.
Consolidated net revenues increased 17% for the nine months ended September 30,
2002 to $64,785,000, compared to consolidated revenues of $55,533,000 in the
corresponding period in 2001. The increase in 2002 was principally due to higher
revenues in all segments primarily as a result of increased unit volume, and to
a lesser extent, as a result of price increases effective January 1, 2002.
Domestic net revenues increased 16% in the nine months ended September 30, 2002
to $61,212,000 from $52,558,000 in the corresponding period in 2001. The
increase in domestic revenues was due primarily to increased unit volume in
Grafton(R) DBM, bio-implants and spinal metal implants and increased pricing in
Grafton(R) DBM and bio-implants, partially offset by a 25% decline in base
allograft tissue processing revenue due to the temporary suspension of base
tissue processing and a decrease in the number of donors processed in 2002
compared to 2001. Foreign-based revenues increased 20% to $3,573,000 in the nine
months ended September 30, 2002 from $2,975,000 in the same period in 2001. The
increase in foreign-based revenues was due to increased unit sales volume in
principally all product lines.
Grafton(R) Demineralized Bone Matrix ("DBM") Segment, or Grafton(R) DBM Segment,
revenues of $10,917,000 in the third quarter of 2002 were relatively flat with
revenues of $11,012,000 in the same period in 2001. Grafton(R) DBM Segment
revenues increased $2,600,000 or 8% to $34,558,000 in the nine months ended
September 30, 2002 from $31,958,000 in the nine months ended September 30, 2001.
Domestic Grafton(R) DBM Segment revenues of $10,343,000 in the third quarter of
2002 were flat compared to revenues of $10,341,000 in the prior year period and
increased 9% to $33,003,000 in the nine months ended September 30, 2002 compared
to the same period in 2001. For the nine months ended September 30, 2002,
domestic Grafton(R) DBM revenues increased due to increased unit sales volume
and the effects of a January 1, 2002 price increase. Foreign-based Grafton(R)
DBM revenues declined 14% in the third quarter of 2002 and declined 3% in the
nine months ended September 30, 2002 compared to the corresponding periods in
the prior year due to the restructuring of our distribution network in certain
European countries.
Base Tissue Segment revenues increased 5% to $7,273,000 in the third quarter of
2002 from $6,945,000 in the corresponding period in 2001. The increase is
principally the result of a 70% increase in bio-implant revenues, partially
offset by a 46% decrease in base tissue processing revenues resulting from the
temporary suspension of base tissue processing and a decline in donors processed
for our clients. Base Tissue Segment
-17-
revenues increased 23% in the nine months ended September 30, 2002 compared to
the same period in 2001, principally as a result of a 91% increase in
bio-implant revenues, partially offset by a 23% decrease in base tissue
processing revenues resulting primarily from the temporary suspension of base
tissue processing and a decline in donors processed for our clients. The
increase in bio-implant revenues is primarily due to increased unit volume in
2002 compared to 2001 when several bio-implant tissue forms were in a launch
mode, the ability to charge higher unit sale prices as a result of our direct
distribution of principally all of those units to hospitals, and the effects of
a January 1, 2002 price increase.
Revenue from other product lines increased 29% in the third quarter of 2002 to
$1,501,000 from $1,161,000 in the same period in 2001. In the nine months ended
September 30, 2002, revenues from other product lines increased $1,861,000 or
61% to $4,907,000 from $3,046,000 in 2001. Metal spinal implant systems revenues
increased 34% and 81%, and bovine tissue product revenues increased 9% and 20%,
in the three and nine months ended September 30, 2002, respectively, compared to
the corresponding periods in 2001. The increases principally resulted from
improved unit sales volume.
Two of our clients in the Grafton(R) DBM and Base Tissue Segments, the
Musculoskeletal Transplant Foundation and the American Red Cross ("ARC"),
accounted for 55% and 74% of consolidated net revenues during the three months
ended September 30, 2002 and 2001, respectively. In the nine months ended
September 30, 2002 and 2001 these same two clients accounted for 60% and 80%,
respectively, of consolidated net revenues. We have processing agreements with
each of these clients, which expire in December, 2008 and December, 2006,
respectively.
On October 27, 2002, we amended our ten-year processing agreement dated January
1, 1997 with ARC. The amendment, among other items, removes the requirement that
ARC exclusively provide all tissue recovered by ARC to us for processing and, in
its place, provides that ARC will provide a monthly minimum number of donors to
us for processing.
In October, 2002, because of a higher than normal level of complaints, we
temporarily suspended the sale and distribution of the Affirm(TM) Cervical Plate
system. We expect to re-initiate sales of this system in the near future.
Revenues from the sale of this system were $404,000 and $58,000 in the three
months ended September 30, 2002 and 2001, respectively, and were $1,133,000 and
$58,000 in the nine months ended September 30, 2002 and 2001, respectively.
Gross Profit
Gross profit as a percentage of net revenues was 36% in the third quarter of
2002 compared to 59% in the third quarter of 2001 and was 51% for the nine
months ended September 30, 2002 compared to 58% in the corresponding period in
the prior year. Gross profit was negatively impacted for the three months and
nine months ended September 30, 2002 by pre-tax charges of $4,079,000 for the
estimated cost to rework the tissue from donors placed in quarantine in the
third quarter of 2002 and for excess and obsolete inventory related to spinal
implant systems and the decline in base tissue processing revenues due to the
temporary suspension of base tissue processing and a decline in donors processed
for our clients. Gross profit in 2001 was negatively impacted by reserves of
$655,000 for excess and obsolete metal spinal implant inventories.
Marketing, Selling, General and Administrative Expenses
Marketing, selling, general and administrative expenses decreased 14% in the
third quarter 2002 to $8,309,000 from $9,673,000 in the corresponding period in
2001 and decreased 7% to $29,849,000 in the nine months ended September 30, 2002
from $32,057,000 in the same period in 2001. The decreases in marketing,
selling, general and administrative expenses in both periods relates mainly to
decreased costs
-18-
associated with our funding of the American Tissue Services Foundation,
decreased legal fees as a result of the settlement of a number of our lawsuits,
decreased marketing costs due to the launch in 2001 of new bio-implant tissue
forms, which increased 2001 marketing costs, and in 2001 a provision of
$1,190,000 for reserves primarily for excess instrument sets associated with
spinal implant systems.
Research and Development Expenses
Consolidated research and development expenses decreased 11% in the third
quarter of 2002 to $1,002,000 from $1,130,000 in the same period in 2001, and
decreased 9% in the nine months ended September 30, 2002 to $2,990,000 from
$3,302,000 in the nine months ended September 30, 2001. The decreases in both
periods were primarily related to the completion of development of bio-implant
tissue forms, which were launched in 2001, and Grafton Plus(TM) DBM, which was
launched in the first quarter of 2002, as well as the completion of new
processing technology and packaging, which were implemented in 2001.
Litigation Settlement Charge
In April, 2002, we settled a patent lawsuit and agreed to pay an aggregate of
$1,900,000 in 24 equal monthly installments, without interest. We recorded a
charge of $1,785,000 related to this settlement representing the present value
of the amounts due. (See Note 8 of "Notes to Condensed Consolidated Financial
Statements").
Operating Income (Loss)
We incurred a consolidated operating loss in the third quarter of 2002 of
$2,309,000 compared to consolidated operating income in third quarter 2001 of
$542,000. The consolidated operating loss for the nine months ended September
30, 2002 was $1,806,000 compared to a consolidated operating loss of $3,272,000
in the nine months ended September 30, 2001. Included in 2002 are reserves of
$4,079,000 for the estimated costs to rework the tissue from donors quarantined
in the third quarter of 2002 and for excess and obsolete inventory related to
spinal implant systems, and the aforementioned litigation settlement charge of
$1,785,000, while 2001 included provisions of $1,845,000 for excess inventory
and instrumentation for spinal implant systems.
Grafton(R) DBM Segment operating income increased $1,614,000 in the third
quarter of 2002 to $3,647,000 from $2,033,000 in the corresponding period in
2001. The increase results principally from improved absorption of fixed costs,
decreased legal fees, lower research and development costs associated with the
development of Grafton Plus(TM) DBM, which was launched in the first quarter of
2002, and decreased marketing and selling costs. Operating income for the nine
months ended September 30, 2002 was $8,163,000, an increase of $3,491,000 from
operating income of $4,672,000 in the nine months ended September 30, 2001. The
increase results principally from an increase in gross profit margins due to
increased revenue volume and improved absorption of fixed costs, decreased legal
fees, and lower research and development costs associated with the development
of Grafton Plus(TM) DBM, which was launched in the first quarter of 2002.
We incurred an operating loss in the Base Tissue Segment in the third quarter of
2002 of $2,914,000 compared to an operating loss of $628,000 in the same period
in 2001. In the nine months ended September 30, 2002, we incurred an operating
loss of $5,627,000 compared to an operating loss of $3,670,000 in the same
period in 2001. The operating loss in the third quarter and in the nine months
ended September 30, 2002 resulted primarily from the litigation settlement
charge, reserves of $840,000 for the estimated cost to rework the tissue for
donors placed in quarantine and $1,094,000 for excess and obsolete
-19-
bio-d(R) Threaded Cortical Bone Dowel inventory, increased legal fees associated
with the patent lawsuits that were settled in the second quarter, and the
decline in base allograft tissue processing revenue, partially offset by
increased bio-implant revenues and lower costs for marketing, selling and
promotional activities primarily due to incurring the costs to launch the new
bio-implant tissue forms in 2001.
Operating losses associated with other revenues were $3,042,000 and $863,000 in
the third quarter of 2002 and 2001, respectively. In the nine months ended
September 30, 2002, we incurred an operating loss of $4,342,000 compared to an
operating loss of $4,274,000 in the same period in 2001. The operating loss in
both periods of 2002 is principally due to $2,145,000 of reserves for excess and
obsolete inventories and product lines that have not achieved revenue levels
sufficient to absorb fixed costs, partially offset by a reduction in our funding
of the American Tissue Services Foundation. The operating loss in 2001 included
reserves of $1,020,000 for excess inventory and instrumentation associated with
metal spinal implant systems.
Other Income (Expense)
Interest expense, net of interest income, was $162,000 and $782,000 in the third
quarter and nine months ended September 30, 2002, respectively, compared to
interest income, net of interest expense, of $92,000 and $354,000 in the
corresponding periods in 2001. In 2002, interest expense on long-term debt, is
partially offset by interest income, which is lower than historical levels as a
result of a decline in interest rates and lower average cash balances available
for investment. In 2001, interest income exceeded interest expense due to higher
average cash balances available for investment and because the majority of our
interest costs were capitalized in connection with the construction of our new
allograft tissue processing facility. In late 2001, we began to charge such
interest costs to earnings since the facility was substantially complete.
In May, 2002, we completed the sale of the PolyActive(TM) polymer biomaterial
technology and patents to IsoTis BV for $1,000,000 in cash. We recognized a
$950,000 gain on this transaction after deducting costs and expenses.
Income Tax Provision
For the three months and nine months ended September 30, 2002, we recognized an
income tax benefit from continuing operations primarily due to losses incurred
in our domestic operation and our ability to utilize previously unrecognized net
operating loss carryforwards, which carry a full valuation allowance, to offset
foreign income and the reversal of liabilities for previously deferred income
tax benefits of $2,557,000 that are no longer required. In addition, we did not
record an income tax provision for discontinued operations due to our ability to
utilize additional foreign net operating loss carryforwards to offset taxable
income.
In the nine months ended September 30, 2002, historical foreign net operating
loss carryforwards of approximately $2,000,000 (tax effect of approximately
$680,000) were utilized to offset foreign taxable income.
Liquidity and Capital Resources
At September 30, 2002 we had cash, cash equivalents and short-term investments
of $18,938,000 compared to $5,192,000 at December 31, 2001. We invest excess
cash in U.S. Government-backed securities and investment grade commercial paper
of major U.S. corporations. Working capital increased $17,122,000 to $41,561,000
at September 30, 2002 compared to $24,439,000 at December 31, 2001. The increase
resulted primarily from net proceeds received from the sale of 2.8 million
shares of common stock, proceeds from
-20-
the sale of the PolyActive(TM) polymer biomaterial technology and patents, the
sale of operations of our subsidiary in The Netherlands and a decline in
accounts payable and accrued expenses.
Net cash provided by operating activities was $1,521,000 in the nine months
ended September 30, 2002 compared to net cash used in operating activities of
$1,400,000 in the corresponding period in the prior year. The increase resulted
primarily from improved profitability compared to the prior year. Beginning in
the second quarter of 2001, we began to distribute tissue forms directly to
surgeons and hospitals. This change in distribution methodology has impacted our
liquidity and cash flow. We have made additional investments in deferred
processing costs to support our direct sales efforts, and may make additional
investments in inventory and deferred processing costs, as necessary, to support
our future efforts.
Cash used in investing activities decreased to $6,120,000 in the nine months
ended September 30, 2002 from $6,593,000 in the nine months ended September 30,
2001. The decrease is principally due to a decrease in capital expenditures to
$4,253,000 in 2002 from $7,979,000 in 2001 as a result of reduced spending on
the construction of our new allograft tissue processing facility, proceeds from
the sale of the PolyActive(TM) polymer biomaterial technology and patents of
$1,000,000 and proceeds of $1,000,000 from the sale of our operation in The
Netherlands, partially offset by the purchase of short term investments of
$3,948,000.
Net cash provided by financing activities was $14,239,000 in the nine months
ended September 30, 2002 compared to $1,667,000 in the same period in 2001,
primarily due to the sale of 2.8 million shares of common stock, which generated
$15,756,000 net cash to us after deducting fees and expenses of the offering.
We have a Credit Facility with a U.S. bank that includes: a $5,000,000 revolving
line of credit, a building mortgage loan and an equipment term loan. At
September 30, 2002, there were no borrowings under the revolving line of credit,
$4,274,000 was outstanding under the building mortgage loan and $14,974,000 was
outstanding under the equipment term loan. In September, 2002 to support the
$1,900,000 due under the settlement of certain patent litigation (See Note 8 of
"Notes to Condensed Consolidated Financial Statements" - "Litigation - Medtronic
Sofamor Danek, Inc., Sofamor Danek L.P. and Sofamor Holdings, Inc. v. Osteotech,
Inc."), we provided an irrevocable standby letter of credit in an original
amount of $1,900,000. As of September 30, 2002, the standby letter of credit has
been reduced to $1,610,000. Amounts committed under this standby letter of
credit decrease over time based on a predetermined schedule concurrent with our
monthly payments under the settlement and reduce the amounts available under the
revolving line of credit. As of September 30, 2002, no amounts were outstanding
under the revolving line of credit and $3,390,000 was available.
Our Credit Facility, as amended, requires us to meet four financial ratios on a
quarterly basis. As of September 30, 2002, we complied with three of the
financial ratios, but did not comply with the fourth financial ratio, the
Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA") ratio.
On November 13, 2002, our lender waived compliance with the EBITDA ratio for the
quarter ended September 30, 2002 and amended the requirements of the ratio for
the succeeding four fiscal quarters. In addition, the waiver and amendment
require us to meet a fifth financial ratio, the Quick Ratio, on a prospective
basis.
In February, 2001, we entered into a distribution agreement to market and
distribute a pedicle screw system and a cervical plating system. This agreement
requires us to make minimum purchase commitments of $6,000,000 over the two-year
period beginning on April 1, 2002. In October, 2002, pursuant to a letter
agreement, the purchase commitment of $3,200,000 for the first year of the
commitment period (April 1, 2002 to March 31, 2003) has been waived for a
payment of $300,000. The purchase commitment of $2,800,000 for the second year
(April 1, 2003 to March 31, 2004) of the commitment period is still in effect.
-21-
As of September 30, 2002, there were no material changes in our contractual
obligations or long-term debt from that disclosed in our Annual Report on Form
10-K for the year ended December 31, 2001, except for the impacts related to our
purchase commitment discussed in the previous paragraph. See Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations, Liquidity and Capital Resources" in our Annual Report on Form 10-K
for the year ended December 31, 2001.
We believe that our cash and cash equivalents and available lines of credit,
together with anticipated future cash flows from operations, will be sufficient
to meet our forecasted cash needs for the next twelve months. However, we expect
to continue to make investments in our business, which we expect will deplete a
portion of our cash reserves. 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, or if available, that such funds will be
available on favorable terms.
Impact of Inflation and Foreign Currency Exchange Fluctuations
Results of operations for the periods discussed above have not been materially
affected by inflation or foreign currency fluctuations.
Litigation
Osteotech, Inc. is involved in various legal proceedings involving product
liability and patent infringement claims. For a discussion of these matters see,
Note 8 of "Notes to Condensed Consolidated Financial Statements", PART II., ITEM
1. LEGAL PROCEEDINGS, our Annual Report on Form 10-K for the year ended December
31, 2001 and our Quarterly Reports on Form 10-Q for the quarters ended March 31,
2002 and June 30, 2002. 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.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For information regarding our exposure to certain market risks, see Item 7A,
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK, in our Annual Report
on Form 10-K for the year ended December 31, 2001. There have been no
significant changes in our market risk exposures from the fiscal 2001 year-end.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures
Under the supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, we evaluated the
effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rule 13(a)-14(c) under the Exchange Act) as of a date
(the "Evaluation Date") within 90 days prior to the filing date of this report.
Based upon that evaluation, the Chief Executive Officer and Chief Financial
Officer concluded that, as of the Evaluation Date, our disclosure controls and
procedures were effective in timely alerting them to the material information
relating to us required to be included in our periodic SEC filings.
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Changes in internal controls
There were no significant changes made in our internal controls during the
period covered by this report or, to our knowledge, in other factors that could
significantly affect these controls subsequent to the date of their last
evaluation.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The following is a description of material developments that occurred since the
filing of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2002
in lawsuits reported in the Company's Annual Report on Form 10-K for the year
ended December 31, 2001 and the Company's Quarterly Reports on Form 10-Q for the
quarters ended March 31, 2002 and June 30, 2002. Additionally, we are party to
other litigation incidental to our business, none of which, individually or in
the aggregate, are expected to have a material adverse effect.
Medtronic Sofamor Danek, Inc., Sofamor Danek L.P. and Sofamor Holdings, Inc. v.
Osteotech, Inc.
In July, 1999, Medtronic Sofamor Danek, Inc., Sofamor Danek L.P. and Sofamor
Danek Holdings, Inc. (collectively, "Medtronic") sued us in the United States
District Court for the Western District of Tennessee alleging that certain
instruments and instrument sets relating to cortical bone dowel products,
including the bio-d(R) Threaded Cortical Bone Dowel and Endodowel, manufactured,
sold and/or otherwise distributed by us infringe on certain claims of U.S.
Patent Nos. 5,741,253, 5,484,437 and 6,096,038 which are owned by Medtronic.
In April, 2002, the parties settled this lawsuit (the "Medtronic Settlement").
We agreed to pay an aggregate of $1,900,000 to Medtronic in 24 equal monthly
installments, without interest, which payment obligation is supported by an
irrevocable standby letter of credit, and to cease processing, marketing,
distributing, advertising and promoting the bio-d(R) Threaded Cortical Bone
Dowel no later than January 31, 2003.
Condos v. Musculoskeletal Transplant Foundation
In July, 2000, we were served with an action brought in the United States
District Court for the District of Utah against us and the Musculoskeletal
Transplant Foundation ("MTF"). The suit alleges causes of action for strict
liability, breach of implied warranty and negligence arising from allegedly
defective allograft bone tissue processed and/or provided by defendants and
allegedly implanted into plaintiff Chris Condos during two spinal surgeries. In
October, 2002, the parties reached a provisional settlement and are awaiting the
Court's approval of the terms of the settlement. Our portion of the provisional
settlement, which was recorded in the third quarter of 2002, does not have a
material impact on our results of operations or financial condition.
Criti-Cal, Inc. v. Osteotech, Inc.
In December, 2000, Criti-Cal, Inc. commenced an action in the Superior Court for
the State of California, Orange County, against us, Second Act Medical, Inc. and
Ronald Letner. As against us, plaintiff alleges causes of action for breach of
contract, misappropriation of trade secrets, quantum meruit and violation of
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the California Independent Wholesale Sales Representatives Contractual Relations
Act of 1990 arising from the termination of an agreement between the plaintiff
and us. In October, 2002, the parties reached an agreement in principle to
settle this action. Our portion of the settlement, which was recorded in the
third quarter of 2002, does not have a material impact on our results of
operations or financial condition.
"O" Company, Inc. v. Osteotech, Inc.
In July, 1998, a complaint was filed against us in the Second Judicial District
Court, Bernallilo County, New Mexico, which alleges negligence, strict
liability, breach of warranties, negligent mis-representation, fraud and
violation of the New Mexico Unfair Trade Practices Act arising from allegedly
defective dental implant coating and coating services provided to plaintiff by
our subsidiary, Osteotech Implants BV, formerly known as CAM Implants BV.
Plaintiffs are seeking monetary damages in an amount to be determined at trial.
We successfully moved to dismiss plaintiffs' claims for negligence and strict
liability. Remaining are claims for breach of warranties, negligent
misrepresentation, fraud and violation of the New Mexico Unfair Trade Practices
Act. As to these remaining claims, in addition to denying any and all liability,
we had moved for summary judgment on the basis that all of the claims are barred
by their applicable statutes of limitations. After discovery on matters relating
to the statute of limitations issue, our summary judgment motion was submitted.
On October 22, 2002, the court issued a memorandum opinion and order denying our
motion for summary judgment and plaintiffs' cross-motion for summary judgment.
Discovery on the merits of the plaintiffs' case and scope of alleged damages, if
any, will now commence.
We believe that the claims made against us in this action are without merit and
will continue to vigorously defend against such claims.
Hardman v. Nussbaum
The American National Red Cross ("ARC") notified us in the first quarter of this
year that a plaintiff had brought an action against it for negligence relating
to ARC's distribution of certain Grafton(R) DBM Putty that was allegedly
implanted in the plaintiff, Larry Hardman, during a surgical procedure. On
September 9, 2002, ARC notified us that plaintiff intended to name us as a
defendant in the Los Angeles Superior Court action, however, the plaintiff has
not yet served us with a complaint. Until such time as we are served with the
complaint, we cannot evaluate the merits of this action.
Scroggins v. Zimmer Holdings, Inc.
On or about June 24, 2002, we received a complaint filed in the United States
District Court for the Eastern District of Louisiana against numerous
defendants, including us. The complaint alleges that plaintiff received
defective medical hardware in connection with a certain hip replacement
procedure in May, 1992, and that such hardware was manufactured or distributed
by certain of the defendants. The procedure involved the use of allograft bone
tissue processed by us and provided by one of our clients. Plaintiff alleges
personal injuries and $1,000,000 in damages. We served our answer to the
complaint on August 30, 2002, and discovery in the case is about to commence.
We maintain a general liability insurance policy and have notified the insurance
company of this action. The insurance company has agreed to defend this action.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits (numbered in accordance with Item 601 of Regulation S-K)
Exhibit Page
Number Description Number
------ ----------- ------
3.1 Restated Certificate of Incorporation of Osteotech, as amended ^
3.2 Third Amended and Restated Bylaws of Osteotech ^
3.4 Certificate of Retirement and Prohibition of Reissuance of ^^
Shares of Osteotech, Inc., dated April 4, 2002
4.3 Rights Agreement dated as of February 1, 1006 between ^
Osteotech, Inc. and Registrar and Transfer Co., as amended
10.59 Asset Purchase Agreement between Cam Implants B.V. and Cam ^^
Acquisition B.V. dated July 10, 2002 []
10.61 Form of Change in Control Agreement with Executive Officers, *
except Marc Burel
10.62 Employment Agreement, as amended, with Marc Burel dated April *
18, 2000
10.63 Change in Control Agreement by and between Osteotech, Inc. and *
Marc Burel dated April 18, 2000 (superceded by the Change in
Control Agreement dated September 8, 2002 included as Exhibit
10.64)
10.64 Change in Control Agreement by and between Osteotech, Inc. and *
Marc Burel dated September 8, 2002
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted *
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted *
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
[] Copy omits information for which confidential treatment has been
requested.
* Filed herewith
^ Previously filed as an exhibit to the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 2001 and incorporated herein by
reference thereto.
^^ Previously filed as an exhibit to the Company's Quarterly Report on Form
10-Q for the quarter ended June 30, 2002 and incorporated herein by
reference thereto.
(b) Reports on Form 8-K
On September 30, 2002, we filed with the Commission a Current Report on
Form 8-K to announce that we had temporarily and voluntarily suspended
Base Tissue Segment processing operations at our Eatontown and Shrewsbury
facilities and initiated a voluntary retrieval of tissue from 15 donors.
On July 31, 2002, we filed with the Commission a Current Report on Form
8-K to announce our second quarter operating results.
On July 25, 2002, we filed with the Commission a Current Report on Form
8-K to announce that we had sold the operations of our subsidiary in
Leiden, The Netherlands.
On July 9, 2002, we filed with the Commission a Current Report on Form 8-K
to announce that our French subsidiary, OST Developpement SA, had entered
into marketing services and logistics support
-25-
agreements with DePuy International, Ltd. ("DePuy") to establish DePuy as
our exclusive sales agent for Grafton(R) Demineralized Bone Matrix grafts
in the United Kingdom, Germany and Switzerland.
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.
Date: November 14, 2002 Osteotech, Inc.
----------------------------------
(Registrant)
By: /S/ Richard W. Bauer
----------------------------------
Richard W. Bauer
President, Chief Executive Officer
(Principal Executive Officer)
Date: November 14, 2002 By: /S/ Michael J. Jeffries
----------------------------------
Michael J. Jeffries
Executive Vice President,
Chief Financial Officer
(Principal Financial Officer and
Chief Accounting Officer)
-26-
Certification Pursuant To
18 U.S.C. ss. 1350,
As Adopted Pursuant To
Section 302 of the Sarbanes-Oxley Act of 2002
I, Richard W. Bauer, certify that:
1. I have reviewed this quarterly report of Osteotech, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary in
order to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which the
quarterly report is being prepared;
b) evaluated the effectiveness of the issuer's disclosure controls and
procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
November 14, 2002 /S/ Richard W. Bauer
-----------------------------------
Richard W. Bauer
President, Chief Executive Officer
(Principal Executive Officer)
Certification Pursuant To
18 U.S.C. ss. 1350,
As Adopted Pursuant To
Section 302 of the Sarbanes-Oxley Act of 2002
I, Michael J. Jeffries, certify that:
1. I have reviewed this quarterly report of Osteotech, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary in
order to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which the
quarterly report is being prepared;
b) evaluated the effectiveness of the issuer's disclosure controls and
procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
November 14, 2002 /S/ Michael J. Jeffries
----------------------------------
Michael J. Jeffries
Executive Vice President,
Chief Financial Officer
(Principal Financial Officer and
Chief Accounting Officer)