UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d) of
The Securities Exchange Act of 1934
For the fiscal year ended December 31, 2002 Commission File Number 0-19278
OSTEOTECH, INC.
(Exact name of registrant as specified in its charter)
Delaware 13-3357370
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
51 James Way, Eatontown, New Jersey 07724
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (732) 542-2800
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock - $.01 Par Value
(Title of class)
Preferred Stock Purchase Rights
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes |X| No |_|
The aggregate market value of the voting and non-voting common equity,
held by non-affiliates of the registrant as of June 30, 2002 was approximately
$120,788,000.
The number of shares of the registrant's common stock, $.01 par value,
outstanding as of March 17, 2003 was 17,003,934.
The Index to Exhibits appears on page E-1.
Documents Incorporated by Reference
The registrant's definitive 2003 Proxy Statement, which will be filed
pursuant to Regulation 14A, is incorporated by reference into Items 10, 11, 12
and 15 of Part III of this Annual Report on Form 10-K.
OSTEOTECH, INC.
2002 Form 10-K Annual Report
TABLE OF CONTENTS
Section Page
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PART I
Item 1. Business 1
Item 2. Properties 30
Item 3. Legal Proceedings 31
Item 4. Submissions of Matters to a Vote of Security Holders 37
PART II
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters 38
Item 6. Selected Financial Data 40
Item 7. Management's Discussion And Analysis Of Financial
Condition And Results Of Operations 41
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 64
Item 8. Financial Statements and Supplementary Data 64
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 64
PART III
Item 10. Directors and Executive Officers of the Registrant 65
Item 11. Executive Compensation 65
Item 12. Security Ownership of Certain Beneficial Owners and Management 65
Item 13. Certain Relationships and Related Transactions 65
Item 14. Controls and Procedures 65
Item 15. Principal Accountant Fees and Services 66
PART IV
Item 16. Exhibits, Financial Statement Schedules and Reports on Form 8-K 67
ii
The following trademarks and service marks appear in this Annual Report:
Graftech(TM) Bio-Implants, Plexus(TM), OsteoActive(TM), Ovation(TM) Low Back
Fixation System, Sentinal(TM) Top Tightening Spinal System, Affirm(TM) Anterior
Cervical Plating System, Clear Bone(TM), and Grafton Plus(TM) DBM are trademarks
and Osteotech(R), Grafton(R) Demineralized Bone Matrix (DBM), bio-d(R)Threaded
Cortical Bone Dowel, and Allogard(R) Packaging are registered trademarks of
Osteotech, Inc.; D-MINsm is a service mark of Osteotech, Inc.; LUBBOC(R) AND
LADDEC(R) are registered trademarks of OST Developpement SA and OsteoPure(TM) is
a trademark of OST Developpement SA; Vertebral Body Replacement (VBR(TM)) is a
trademark of Heinrich C. Ulrich, K.G.; C3(TM) Anterior Cervical Plating System,
PLUS(TM) Pivot Link Universal System, and UNI-Thread(TM) Universal Thread Spinal
System are trademarks of SpineVision, Inc.
We maintain a website at www.osteotech.com to provide information to the
general public and our shareholders on our tissue forms, products, resources and
services along with general information on Osteotech and its management, career
opportunities, financial results and press releases. Copies of our most recent
Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q or our other
reports filed with the Securities and Exchange Commission, or SEC, can be
obtained, free of charge as soon as reasonably practicable after such material
is electronically filed with, or furnished to the SEC, from our Investor
Relations Department by calling 732-542-2800, through an e-mail request from our
website at www.osteotech.com/finrequest.htm, or through the SEC's website by
clicking the direct link from our website at www.osteotech.com/finrequest.htm or
directly from the SEC's website at www.sec.gov. Our website and the information
contained therein or connected thereto are not intended to be incorporated into
this Annual Report on Form 10-K.
iii
PART I
Item 1. Business
Information contained throughout this Annual Report contains
"forward-looking statements" which can be identified by the use of
forward-looking terminology such as "believes," "expects," "may," "will,"
"should," or "anticipates" or the negative thereof or variations thereon or
comparable terminology, or by discussions of strategy. No assurance can be given
that the future results covered by the forward-looking statements will be
achieved. Some of the matters set forth in the "Risk Factors" section of this
Annual Report and elsewhere in this Annual Report constitute cautionary
statements identifying factors with respect to such forward-looking statements,
including certain risks and uncertainties, that could cause results to vary
materially from the future results indicated in such forward-looking statements.
Other factors could also cause actual results to vary materially from the future
results indicated in such forward-looking statements.
Temporary Suspension of Base Tissue Segment Processing
On September 30, 2002, we voluntarily and temporarily suspended Base
Allograft Bone Tissue Segment, or Base Tissue Segment, processing due to higher
than normal incidence of sterility failures on finished forms of processed
allograft bone tissue, which occurred in our Eatontown facility, and
subsequently, in our Shrewsbury facility. In addition, 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 although all such tissue was tested and found to be sterile.
In October, 2002, we restarted Base Tissue Segment processing in our Shrewsbury
facility, and in November, 2002 we restarted Base Tissue Segment processing in
our Eatontown facility.
As a result of the temporary suspension of Base Tissue Segment processing,
we placed tissue processed in third quarter 2002 from 693 donors in quarantine.
We expect to rework and/or release all quarantined tissue in 2003. We will
invoice our clients/customers for this tissue when it is shipped. We have
estimated that the cost to rework this tissue is $840,000. 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, however, there can be no certainty that we will be able to
meet all such requirements or be able to rework this tissue for our estimated
cost.
See Item 7. "Management's Discussion and Analysis of Financial Condition
and Result of Operations" for a discussion of the financial impacts of this
temporary suspension of Base Tissue Segment processing.
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. These
1
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
2002. Revenues from this business were $1,630,000 in 2002 through the date of
sale, and $2,131,000 and $1,572,000 for the years ended December 31, 2001 and
2000, respectively. The business had net income of $384,000 in 2002 through the
date of the sale, but net losses of $370,000 and $392,000 for the years ended
December 31, 2001 and 2000, respectively.
Company Overview
We provide services and products primarily focused on the repair and
healing of the musculoskeletal system. These products and services are marketed
primarily to the orthopaedic, spinal, neurological, oral/maxillofacial, dental
and general surgery markets in the United States and Europe. Based on our
knowledge of the allograft bone tissue industry, we believe that we are the
world's largest processor and developer of human bone and bone connective
tissue, or allograft bone tissue forms. The allograft bone tissue we process is
procured by independent tissue banks or other Tissue Recovery Organizations, or
TRO's, primarily through the donation of tissue from deceased human donors and
is used for transplantation. We have two primary operating segments:
o the Grafton(R)Demineralized Bone Matrix (DBM) Segment, or the
Grafton(R)DBM Segment; and
o the Base Tissue Segment.
Our other products are aggregated under the category of "other."
In the Grafton(R) DBM Segment we process and market Grafton(R) DBM, which
domestically is distributed by our clients and us. Internationally Grafton(R)
DBM is distributed by agents and distributors. We also distribute Grafton(R) DBM
processed from allograft bone tissue recovered by TRO's on our behalf
domestically under our own label. Our distribution of Grafton(R) DBM under our
own label has represented an immaterial portion of our revenue through 2002. We
expect revenue generated from Grafton(R) DBM distributed by us under our own
label to represent a growing percentage of our domestic and international
Grafton(R) DBM revenues in the future, although we expect such revenues to
continue to be insignificant in 2003.
We process Grafton(R) DBM using our validated, advanced, proprietary
demineralization process. When applied to cortical bone, this process yields
allograft bone tissue which has osteoinductive (the process by which bone is
induced to grow) and osteoconductive (the matrix provided by allograft bone
tissue into which the host bone can grow) capabilities greater than currently
available forms of mineralized allograft bone tissue, and we believe, greater
than other competitive demineralized allograft bone tissue forms.
In the Base Tissue Segment, we process primarily mineralized
weight-bearing allograft bone tissue. Graftech(TM) Bio-implant spacers and ramps
for posterior and anterior spinal fusion procedures, which are included in this
segment, are marketed and generally distributed domestically by us and other
tissue forms processed in this Segment are generally marketed and
2
distributed domestically by our clients. To the extent that TRO's recover
allograft bone tissue on our behalf, we will process and distribute this tissue
either as bio-implants or other tissue forms primarily to domestic end-user.
Through 2002, our direct distribution of bio-implants and other tissue forms
processed from allograft bone tissue which has been recovered for us has not
represented a material portion of the Base Tissue Segment's revenue. However, we
expect revenue generated from bio-implants and other tissue forms processed from
allograft bone tissue recovered directly for us and distributed by us to
end-users to represent a growing percentage of our Base Tissue Segment revenues
in 2003 and beyond. In this segment, we also process through OST Developpement,
SA, or OST, our subsidiary located in Clermont-Ferrand, France, OsteoPure(TM)
Femoral head bone tissue, which we market and distribute internationally.
In April, 2002, pursuant to the settlement agreement with Medtronic
Sofamor Danek, Inc., Sofamor Danek L.P. and Sofamor Danek Holdings, Inc., we
agreed to cease processing, marketing, distributing, advertising and promoting
the bio-d(R) Threaded Cortical Bone Dowel, or bio-d(R), no later than January
31, 2003. In accordance with this settlement agreement, we completed the removal
of the bio-d(R) from the market on January 31, 2003. Revenues generated from
this tissue form were $1,216,000, or 1.5% of consolidated revenues in 2002. We
have been and expect to continue converting surgeons who were utilizing the
bio-d(R) to Graftech(TM) Bio-implant tissue forms.
We have leveraged our expertise in musculoskeletal tissue technology to
develop innovative processes and proprietary products that are widely used by
orthopaedic, spinal, neurological and oral/maxillofacial surgeons for: spinal
fusion procedures; to repair and replace bone loss caused by trauma or certain
disease states; to augment prosthetic implant procedures; and to replace damaged
ligaments and tendons.
In addition to our Grafton(R) DBM Segment and Base Tissue Segment, we
market and distribute, primarily in the United States, metal spinal implant
products, including: the Ovation(TM) Low Back Fixation System, or Ovation(TM), a
titanium, lumbosacral spine fixation system with an innovative polyaxial screw;
the Vertebral Body Replacement, or VBR(TM), a patented device approved as a
vertebral body replacement device intended for use in the thoracolumbar spine
(T1 - L5) to replace a collapsed, damaged or unstable vertebral body due to
tumor or trauma; and the Sentinal(TM) Top Tightening Spinal System, or
Sentinal(TM), a lateral linking, top loading, titanium screw and hook rod system
designed to stabilize the posterior elements of the thoracic, lumbar and sacral
spine. Beginning in fourth quarter 2001 through October 2002, we marketed and
distributed the Affirm(TM) Anterior Cervical Plating System, or Affirm(TM), a
contoured, low profile, titanium plating system designed to provide temporary
anterior internal fixation in the cervical spine. In October 2002, because of a
higher than normal level of complaints, we temporarily suspended the sale and
distribution of this system. We are currently uncertain about our ability to
reintroduce Affirm(TM) into the market. See Item 7. "Management's Discussion and
Analysis of Financial Condition and Results of Operations" for a discussion of
the purchase commitment associated with Sentinal(TM) and Affirm(TM).
On February 1, 2003, we entered into a three-year agreement with
SpineVision, S.A. and SpineVision, Inc., or collectively SpineVision, to
exclusively market and distribute in the United States and Puerto Rico
SpineVision's Plus(TM) Pivot Link Universal System, or Plus(TM) System,
3
C3(TM) Anterior Cervical Plating System, or C3(TM) System, and the
Uni-Thread(TM) Universal Thread Spinal System, or the Uni-Thread(TM) System. The
Plus(TM) System is a hook, rod and screw system that offers advanced features
for use in scoliosis, trauma and low back surgeries. The C3(TM) System is a
unique anterior plate system that is designed to aid in achieving fusion in the
cervical spine. The Uni-Thread(TM) System is a threaded pedicle screw system
that offers both polyaxial and lateral linking in one system designed to provide
stabilization of the spine in low back surgical procedures.
OST also processes, markets and distributes, primarily in Europe, Asia and
the Middle East, bovine bone tissue products which are utilized as bone graft
substitutes by surgeons.
We estimate that the total bone graft market in the U.S. for 2002 was
approximately $1.3 billion, which includes allograft bone tissue procedures,
synthetic graft substitutes and growth factors. We estimate that the allograft
bone tissue portion of the total bone graft market in the U.S. in 2002 was
approximately $508 million. The allograft bone tissue market is growing at a
substantially faster rate than the general bone grafting market, as allograft
bone tissue is increasingly becoming accepted as either an augment to, or a
surgical alternative to autograft procedures. Autograft bone tissue often
requires a second surgical procedure to harvest bone from the patient's own body
and, therefore, exposes the patient to increased risk associated with blood
loss, infection and chronic pain. We believe, increased use of allograft bone
tissue will continue as physicians become increasingly educated about the
benefits of allograft bone tissue. Moreover, we believe allograft bone tissue is
increasingly preferred for use in elderly patients, who often lack sufficient
quantity of their own harvestable bone for use in a procedure.
Based upon our knowledge of the allograft bone tissue industry, we
estimate that we process about 29% of the allograft bone tissue grafts
distributed in the U.S. We believe that our strong market position is
attributable to our proprietary product line; the expanded network of TRO's and
tissue banks supplying allograft bone tissue to us; our clients' national donor
recovery programs; our national sales and marketing organization; and the
substantial investment we have made in processing technology to ensure stringent
standards and rigorous quality control which, combined with extensive donor
screening and testing performed by our clients, has significantly reduced the
risk of transmission of infectious agents.
We operate under a number of different business models in the Grafton(R)
DBM and Base Tissue Segments based upon the distribution method used and for
whom the tissue is recovered. In the Grafton(R) DBM Segment, the majority of our
revenues are processing revenues generated from our clients in consideration for
processing and marketing Grafton(R) DBM on their behalf. In this business model
our clients distribute the Grafton(R) DBM to end users. A portion of our revenue
in the Grafton(R) DBM Segment is generated from our direct distribution through
sales agents and distributors of Grafton(R) DBM processed from allograft bone
tissue provided to us by our clients or from allograft bone tissue, which was
processed from donor tissue recovered directly for us by TRO's and certain
tissue banks. In this business model we reimburse our clients, TRO's and tissue
banks who recover allograft bone tissue on our behalf for their services. We
expect that the revenues generated by the latter business model will represent
an increasing portion of our revenues in the Grafton(R) DBM Segment in the
future. Beginning in 2003, we will
4
process a DBM carrier product for LifeNet, which will be marketed by DePuy
Orthopaedics, Inc. and DePuy Acromed, Inc., or collectively DePuy, and
distributed to end users by LifeNet.
In the Base Tissue Segment, the majority of our revenues are generated
from Graftech(TM) Bio-implants, which we processed for our clients, but marketed
and generally distributed by us to hospitals and surgeons through our sales
agents and distributors, or in certain cases distributed by our clients. We
generate revenues from our clients on a per donor basis for the processing of
our clients' donor tissue into non-proprietary standard allograft bone tissue
forms. We also distribute Graftech(TM) Bio-implants and non-proprietary standard
allograft bone tissue forms to hospitals and surgeons that were processed from
tissue that was recovered directly for us. We expect the revenues from our
distribution of Graftech(TM) Bio-implants and non-proprietary standard allograft
bone tissue forms processed from tissue that was recovered for us to increase in
the future.
In the United States we process allograft bone tissue pursuant to
contracts with a number of clients, including three large not-for-profit
organizations, American Red Cross Tissue Services, or ARC, Musculoskeletal
Transplant Foundation, or MTF, and LifeNet. Our clients are responsible for
donor procurement and generally for the distribution of the allograft bone
tissue we process for them. Our contract with ARC expires in December, 2006 and
our contract with MTF expires in December, 2008. In October, 2002, the ARC
processing agreement was amended, which among other items, removed the
requirements that ARC exclusively provide all tissue recovered by ARC to us for
processing and, in its place, provided that ARC provide a monthly minimum number
of donors to us for processing. Effective June 1, 2002, we entered into a new
processing agreement with MTF, under which MTF will supply a certain increasing
minimum annual amount of donor tissue for processing into non-proprietary
standard allograft bone tissue forms, Grafton(R) DBM and Graftech(TM)
Bio-implants, all of which will be distributed to hospitals and surgeons by MTF
under the MTF label, and provide an additional certain increasing minimum annual
amount of tissue from donors for us to process into non-proprietary standard
allograft bone tissue forms, Grafton(R) DBM and Graftech(TM) Bio-implants, all
of which will be distributed to hospitals and surgeons by us under our label.
This new processing agreement was entered into as part of the settlement of our
litigation with MTF. See Item 3 "Legal Proceedings."
In January, 2002, we entered into a five-year agreement with LifeNet, one
of the largest Organ Procurement Organizations, or OPO, based tissue banks and
processors in the United States. Under the terms of this agreement, LifeNet will
supply Allowash(TM) processed tissue to us and we will process the tissue into
our broad line of Graftech(TM) Bio-Implants. The label for all of those
bio-implants displays both the LifeNet name and the Osteotech Graftech(TM) brand
name. The bio-implants are marketed and distributed to hospitals and surgeons by
us on behalf of LifeNet.
Effective January 1, 2003, we entered into a five-year agreement with
DePuy and LifeNet for the processing and distribution to the United States
hospital market of a private label DBM carrier product. Under the terms of the
agreement, we will process the DBM carrier product to specifications determined
by LifeNet, from bone supplied by LifeNet. DePuy will market and promote the DBM
carrier product to surgeons performing trauma, joint revision and spinal
5
procedures and LifeNet will ship and invoice the product to hospitals and
surgeons. It is anticipated that the DBM carrier product will be introduced in
April, 2003, in gel and putty forms.
Additionally, we process allograft bone tissue for several smaller tissue
banks in the United States and Europe. The processed tissue forms are
distributed by either the client or by us depending on the individual client
agreements.
We market our proprietary allograft bone tissue forms such as Grafton(R)
DBM and our line of Graftech(TM) Bio-implants through independent agents and
direct field sales personnel. Generally, our clients market the non-proprietary
standard allograft bone tissue forms that we process in our Base Tissue Segment,
primarily using direct field personnel. The tissue forms we process in the Base
Tissue Segment are gaining wide acceptance among surgeons in a broad spectrum of
orthopaedic procedures due to their flexibility, unique handling characteristics
and ability to enhance bone growth.
Revenue in our Grafton(R) DBM Segment was $44,926,000 in 2002 as compared
to $43,637,000 in 2001, and revenue in our Base Tissue Segment was $32,115,000
in 2002 as compared to 2001 revenue of $27,692,000. See "Temporary Suspension of
Base Tissue Segment Processing" on page 1. We expect that both our Grafton(R)
DBM and Base Tissue Segments will continue to be important contributors to the
growth of our consolidated revenues and profits in 2003, as processed allograft
bone tissue forms continue to gain increased acceptance.
Information relating to our revenues for the years ended December 31,
2002, 2001 and 2000 by geographic area is summarized as follows:
(in thousands) United States Europe Consolidated
------------- ------ ------------
Revenues
For the year ended December 31,
2002 $78,576 $4,798 $83,374
2001 71,776 3,939 75,715
2000 71,468 2,643 74,111
For a discussion of (1) our long-lived assets as of December 31, 2002, 2001 and
2000 see Note 18 of "Notes to Consolidated Financial Statements" and (2) our
deferred tax assets for the years ended December 31, 2002, 2001 and 2000 see
Note 12 of "Notes to Consolidated Financial Statements".
6
Strategy
Overview
We intend to expand our business as follows:
o We intend to use our position as a leader in allograft bone tissue
processing and marketing to become a leading
orthopaedic/musculoskeletal company by continuing to bring to market
innovative and cost-effective allograft bone tissue forms and
non-allograft products.
o We will continue to educate the medical community and the general
public concerning the benefits of allograft bone tissue. We intend
to accomplish this by sponsoring workshops, conducting grand rounds
presentations, increasing our presence at conventions, publishing
clinical studies, white papers and articles and expanding our
medical education internet site.
o We intend to use our strong research and development capabilities
and expertise in musculoskeletal science to enhance the performance
of our existing allograft bone tissue forms; expand the safety
claims of these tissue forms using proprietary processes; and
continue to introduce new tissue forms with enhanced performance
profiles.
o We intend to add additional metal spinal implant systems to our
product line in order to provide the spinal surgeon with a greater
breadth of products.
o We intend to utilize our domestic and international marketing and
distribution network to enhance the market share of both our
allograft bone tissue forms and non-allograft product lines.
o To ensure that we have an adequate supply of allograft bone tissue
to meet the market demand for existing tissue forms that we process,
and for any new tissue forms that we may process, we intend to
continue to work with existing clients to expand the amount of
tissue they recover, obtain additional tissue bank clients and
contract directly with TRO's to obtain tissue on our behalf.
Grafton(R) DBM Segment
In the near term, we will continue to focus on marketing Grafton(R) DBM
domestically and internationally through our direct marketing organization, our
agent network and medical education programs. We will support these programs
through prospective clinical and outcome studies to further validate the
performance, utility and safety of our processed tissue. We will continue to
expand the Grafton(R) DBM tissue line by adding additional forms aimed at
competitive products, specific surgical applications and product enhancements
and improvements. In the first half of 2003, we expect to begin distribution of
Grafton(R) DBM Matrix
7
Strips, primarily for use in scoliosis procedures. This tissue form was designed
to be used with spinal metal deformity correction systems, such as the
SpineVision Plus(TM) Deformity System.
We are primarily focused on providing tissue forms for spinal surgical
applications. However, tissue forms, such as Grafton(R) DBM, have applications
across a broad range of orthopaedic surgical procedures. In order to expand the
use of our Grafton(R) DBM technology to those other areas of orthopaedic
surgery, we intend to establish relationships with existing and new partners to
provide private label DBM carrier products, which will utilize our proprietary
technology. Accordingly, effective January 1, 2003, we entered into a five-year
agreement with LifeNet and DePuy for the processing and distribution of a
private label DBM carrier product. It is anticipated that this product will be
introduced by DePuy into the general orthopaedic and spinal surgery markets in
April, 2003.
In addition, we expect to expand sales of Grafton(R) DBM by:
o providing the surgeon an expanded line of Graftech(TM) Bio-implants,
other allograft bone tissue forms and metal spine implant products,
which are usable with Grafton(R) DBM so that we can better meet the
needs of the surgeon;
o surgeon identified new procedures;
o surgeon oriented medical education programs;
o in-depth sales agent training programs;
o published clinical support;
o product line extensions;
o continued global expansion with an initial European focus; and
o continued expansion of the allograft bone tissue market both
domestically and internationally.
Base Tissue Segment
We expect to achieve continued growth in the Base Tissue Segment by the:
o introduction of additional Graftech(TM) Bio-implants and other
allograft bone tissue grafts with application in spinal and other
surgical procedures, which also have enhanced performance profiles;
o global expansion of non-proprietary standard allograft bone tissue
processing and distribution, initially in Europe;
o development of proprietary tissue processing technology through
internal research; and
8
o attainment of additional bone tissue processing clients and sources
of bone tissue, which will allow us to continue to meet and expand
demand for our Graftech(TM) Bio-implants.
Metal Spinal Implant Products
Our strategy in the metal spinal implant product lines is to:
o expand our metal implant product line, either through internal
development or acquisition or licensing of products from other
companies, in order to provide the surgeon with a more comprehensive
product line so that we will be able to meet all the surgical
implant needs of the surgeon;
o capitalize on high-growth opportunities in the domestic spinal
products market with innovative non-allograft bone tissue products;
and
o enter into agreements with other health care product companies to
utilize our technology and expertise in the non-allograft bone
tissue area for the development and manufacture of proprietary
product components.
Spinal Strategy
Our spinal strategy consists of two primary components involving our
Grafton(R) DBM and Base Tissue Segments and our metal spinal implant product
lines:
o continue the U.S. market penetration of our metal spinal implant
products; and
o market our Graftech(TM) Bio-implants and our metal spinal implant
products together with Grafton(R) DBM through our national sales
agency network.
Our intention is to market and distribute three complementary product
lines to meet surgeons' needs for non weight-bearing tissue grafting products
(Grafton(R) DBM), weight-bearing bio-implants (Graftech(TM) Bio-implants) and
metal stabilization devices. We will educate surgeons concerning the benefits of
using our product lines either alone or in conjunction with each other. Spinal
implant products, both allograft and non-allograft, which we add to our product
mix in the future will be included in this strategy.
Business Summary
Bone and related tissue transplants are often necessary to correct
deformities and repair and reconstruct defects caused by congenital
malformations, trauma, infections, cancer and other disease conditions. For
certain procedures, autograft bone tissue can be acquired from another part of
the patient's skeleton by an additional operative procedure. For a large number
of procedures for which autograft bone tissue is not feasible or desirable,
allograft bone tissue obtained from cadavers or surgical patient donors can be
utilized. Allograft bone tissue is
9
procured primarily from cadavers by a network of organ procurement organizations
and/or directly by tissue banks.
We process allograft bone tissue for our clients from allograft bone
tissue provided by our clients, and also for ourselves from allograft bone
tissue recovered by TRO's and tissue banks for us in both our Grafton(R) DBM and
Base Tissue Segments. Once processed, the allograft bone tissue is distributed
to surgeons and hospitals by our clients or us. The surgeons and hospitals pay
the fees established and charged by our clients or us. The surgeons and
hospitals in turn charge their patients for the various aspects of transplant
surgery performed by them, including standard charges established by the surgeon
or institution for each unit of processed allograft bone tissue used. The cost
to the patient for the processed allograft bone tissue is generally reimbursable
by medical insurance carriers as part of the overall cost of the procedure.
In both our Grafton(R) DBM and Base Tissue Segments, our processing yields
a wide array of freeze-dried, frozen and demineralized allograft bone tissue
forms that are used by orthopaedic, neurological, plastic, dental, periodontal
and oral/maxillofacial surgeons for:
o spinal fusion procedures;
o repair and replacement of bone loss caused by trauma or certain
disease states;
o augmentation of prosthetic implant procedures; and
o replacement of damaged ligaments and tendons.
We believe our processing methods, our clients' tissue recovery techniques
and the multiple screening and testing procedures employed, significantly reduce
the risk of transmission of infectious agents by the allograft bone tissue we
process.
In our Grafton(R) DBM Segment, we have a validated viral inactivation
process for our demineralized bone tissue. Studies completed by an independent
testing laboratory specializing in viral inactivation studies demonstrated that
this proprietary demineralization process virtually inactivates and eliminates
viruses such as HIV, hepatitis B, hepatitis C, cytomeglia and polio.
We are in the process of completing development of additional proprietary
processing technologies that, once fully implemented, will enable us to expand
our viral inactivation claims to include allograft bone tissue processed in our
Base Tissue Segment.
We believe that allograft bone tissue transplantation is one of the
fastest growing areas of transplant medicine. We estimate that in 2002 there
were approximately 1,643,000 grafting procedures in the U.S. for which allograft
bone tissue could have been utilized, representing an estimated available
allograft bone tissue market of approximately $1.3 billion. Currently, allograft
tissue competes with autograft bone tissue procedures and synthetic graft
substitutes for the total bone graft market in the United States. We estimate
that the allograft bone tissue portion of the total bone graft market in the
U.S. in 2002 was approximately $508 million. Industry data indicates that the
musculoskeletal surgical market is growing. We believe this will expand the
10
potential market for allograft bone tissue in both our Grafton(R) DBM and Base
Tissue Segments, due to a number of factors, including:
o increasing frequency of surgical procedures that incorporate bone
grafting techniques;
o the desire by surgeons to avoid the additional procedure needed to
acquire autograft bone tissue, which often increases operating time
and risks such as excessive blood loss, infection and chronic pain;
o a reduction in the possibility of transmission of infectious agents
and toxicity because of improved allograft bone tissue processing
techniques and donor screening;
o increased awareness by, and training of, the medical community with
respect to the use of allograft bone tissue;
o an increasing number of musculoskeletal surgical procedures which
require more bone tissue than can be obtained through autograft
procedures;
o an increase in the number of patients who do not possess the quality
of bone tissue required for autograft procedures as a result of the
general aging of the population; and
o an increase in the availability of allograft bone tissue due to
increased bone tissue donations and improved recovery and processing
techniques.
Allograft bone tissue is employed in surgical procedures because of its
biological and biomechanical properties. Bone from various locations in the body
can be processed to yield either dense cortical bone, porous cancellous bone or
units comprised of both cortical and cancellous bone. Cortical bone, the thick
outer portion of bone, provides biomechanical strength which allows the bone to
be weight-bearing, and therefore, is commonly used in surgery in the spine and
in the extremities and in other procedures requiring strong transplant material.
Cancellous bone, the spongy portion of bone tissue, is preferable for surgical
procedures, or aspects thereof, in which rapid penetration of new bone into the
pores of the bone graft, a process known as osteoconduction, is desirable but
where weight-bearing strength is not paramount. Therefore, cancellous bone is
often used to fill smaller areas of bone loss, spinal surgical procedures in the
cervical spine and to augment more extensive reconstructive procedures including
knee and hip replacements. Most procedures using allograft bone tissue, however,
employ a combination of cortical and cancellous bone in a variety of forms,
shapes and sizes.
Allograft Bone Tissue Processing
Grafton(R) DBM Segment
In addition to the proprietary procedures which are particular to the
processing of Grafton(R) DBM, the technologies used in processing allograft bone
tissue in the Base Tissue Segment are also used in processing Grafton(R) DBM.
The methods used to process Grafton(R)
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DBM have been validated as a viral inactivation process. This proprietary
process virtually inactivates and eliminates viruses such as HIV, hepatitis B,
hepatitis C, cytomeglia and polio.
We have developed an advanced proprietary demineralization process for
cortical bone which yields Grafton(R) DBM -- a form of allograft bone tissue
which can be used to aid in the formation of new bone through the processes of
osteoconduction and osteoinduction. Osteoconduction is the process of providing
the matrix into which bone will grow and osteoinduction is the process by which
bone is induced to grow. Cortical bone is believed to be the principal reservoir
for various factors which are instrumental in osteoinduction. These biological
properties of cortical bone, however, are inhibited by the bone's structure and
various minerals, lipids and other substances comprising the bone. Our process
removes these inhibiting factors.
In our Grafton(R) DBM Segment, we currently process seven forms of
Grafton(R) DBM:
o Grafton(R) DBM Gel - a gel-like substance with unique handling
characteristics which are useful in performing bone graft procedures
as part of spinal fusions, joint replacements and repairs of osseous
defects;
o Grafton(R) DBM Putty - a putty-like graft of entangled fibers of
demineralized bone, which is mixed easily with marrow and other
grafts, minimizes migration, can be molded easily and retains its
shape even in larger defects;
o Grafton(R) DBM Flex - a flexible "pressed fiber" form of
demineralized bone processed by utilizing a pressed fiber technique,
providing surgeons a pliable form of bone graft. It is available in
square or strip forms, conforms to the body's natural anatomy and
can be easily cut for precise adaptation to host bone;
o Grafton(R) DBF Matrix - a flexible "pressed fiber" form of
demineralized bone processed by utilizing a pressed fiber technique,
providing the surgeon with a pliable form of bone graft. It also
contains a "trough" into which the surgeon can place autologous bone
and bone marrow to aid in the osteoinduction process;
o Grafton(R) DBM Crunch - a ready-to-use mixture of demineralized bone
fibers and demineralized cortical cubes which packs and locks into
bone defects, providing structure and support to the graft site;
o Grafton Plus(TM) DBM - a ready-to-use putty-like paste of
demineralized bone containing a non-toxic starch carrier, which is
easily moldable into a variety of shapes and sizes and maintains its
characteristics even under vigorous irrigation; and
o Grafton(R) DBM Matrix Strips - a ready -to-use flexible "pressed
fiber" form of demineralized bone providing surgeons a pliable form
of bone graft. It is available in interlocking strips designed
specifically for posterior spinal fusions requiring grafting of
several levels of the spine. The tissue form is designated for use
in scoliosis procedures, but can be used in most spinal procedures.
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We expect that as we continue to educate surgeons about the capabilities
of our Grafton(R) DBM technology to stimulate bone growth in grafting procedures
on a cost-effective basis, we will achieve wider distribution and deeper market
penetration of Grafton(R) DBM utilizing our national network of independent
agents in combination with our direct marketing force, our expansion into
European markets and our marketing of Graftech(TM) Bio-implants and metal spinal
implant systems will drive the further growth in the use of Grafton(R) DBM
processed allograft bone tissue. Since its introduction in 1991 and through
December 31, 2002, Grafton(R) DBM forms have been utilized in approximately
590,000 procedures in the United States.
Effective January 1, 2003, we entered into a five-year agreement to
process a private label DBM carrier for LifeNet from bone supplied from LifeNet,
which will be distributed by LifeNet and marketed by DePuy.
Base Tissue Segment
Unlike organs which require transplantation within hours of recovery,
allograft bone tissue generally goes through a processing phase in which it is
cleaned, cut into different sizes and forms for specific surgical procedures,
preserved, packaged and labeled. We process the allograft bone tissue utilizing
technology we have developed which yields a wide array of freeze-dried and
frozen demineralized bone and connective tissue products. Frozen tissues include
whole bones and major sections thereof, bone segments, tendons and ligaments.
Freeze-dried bone tissues include various wedges, strips, struts, dowels,
cancellous cortical chips, blocks, strips and ribs.
The suitability of an allograft bone tissue is partly dependent on the
methods used in the processing of the tissue. Processing includes the removal of
certain portions of the allograft bone tissue in a manner which enables the
tissue to maintain as much of the native biological characteristics relating to
the use of such tissue in bone grafting procedures as possible. To provide
suitable allografts, we have developed techniques that minimize the use of
chemicals and procedures that might render the allograft bone tissue less
suitable for use as a graft. We process allograft bone tissue in a
microbially-controlled environment, substantially cleaner than that of a typical
hospital operating room, created through the use of advanced air filtration,
water distillation and mineral control systems and other "clean room"
techniques. In addition, we perform sterility testing procedures throughout the
processing of the tissue and up through final packaging and release. We believe
that our use of such clean room techniques, a controlled environment, in-line
disinfection and other technologies preserve the properties of the tissues that
make them suitable as grafts and address the medical community's and the general
public's perceptions and concerns regarding the possible transmission of
infectious disease and toxicity. Once processed using our current processing
methods, freeze-dried bone tissues may be stored for up to three years and
frozen bone tissues may be stored for up to five years before they must be used
or discarded.
In late 2000, we began to introduce Graftech(TM) Bio-Implants, including
the Graftech(TM) Posterior Ramp, Graftech(TM) Anterior Ramp, Graftech(TM)
Cervical Spacer, the Graftech(TM) Cortical Spacer and the Graftech(TM) Cervical
Dowel. In addition to our normal processing techniques, Graftech(TM)
Bio-Implants are processed using our OsteoActive(TM) Process which transforms
the
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typically non-osteoinductive weight bearing graft into an osteoinductive weight
bearing graft, thus allowing for faster incorporation of the graft into the host
bone. Additionally, these grafts are processed using a new technology which
allows it to be available in a non-frozen form. Previously, these types of
grafts were available only in a frozen form, often resulting in the surgeon
using more grafts to successfully perform a procedure than is necessary when a
non-frozen graft is used. It is expected that the use of non-frozen grafts will
thus significantly reduce the cost of the surgery. All of our bio-implant grafts
have been tested and shown to withstand loads comparable to those reported for
their respective indication in the spine. Additionally, these bio-implant grafts
can be used with Grafton(R) DBM. Therefore, the bio-implants will provide
structural support and, with Grafton(R) DBM added, will also aid in the fusion
process by inducing bone growth.
Tissue Supply Initiative
To ensure that we have adequate supply of allograft bone tissue to meet
the market demand for Graftech(TM) Bio-Implants, Grafton(R) DBM and
non-proprietary allograft bone tissue forms that we process and for any new
tissue forms that we may process in the future, we have been engaged in an
intense effort to solidify the relationships we have with existing clients who
provide donated allograft bone tissue to us for processing. We intend to
continue to expand the amount of donated allograft tissue available to us by
obtaining additional tissue bank clients and by contracting directly with TRO's
to obtain tissue on our behalf.
As a result of these efforts over the past two years, we have established
relationships with a number of new tissue bank clients and TRO's, significantly
increasing the amount of allograft bone tissue available to us for processing
into Grafton(R) DBM, Graftech(TM) Bio-implants and non-proprietary standard
allograft bone tissue forms.
In January, 2002, we entered into a five-year agreement with LifeNet, one
of the largest OPO based tissue banks and processors in the United States. Under
the terms of this Agreement, LifeNet will supply Allowash(TM) processed tissue
which we will process into our broad line of Graftech(TM) Bio-Implants. The
label for all bio-implants displays both the LifeNet name and the Osteotech
Graftech(TM) brand name and are marketed and distributed through our national
agent and direct sales organizations to hospitals and surgeons on behalf of
LifeNet.
Effective January 1, 2003, we entered into a five-year agreement with
DePuy and LifeNet for the processing and distribution to the United States
hospital market of a private label DBM carrier product. Under the terms of the
agreement, we will process the DBM carrier product to specifications determined
by LifeNet, from bone supplied by LifeNet. DePuy will market and promote the DBM
carrier product to surgeons performing trauma, joint revision and spinal
procedures and LifeNet will ship and invoice the product to hospitals and
surgeons. It is anticipated that the DBM carrier product will be introduced in
April, 2003, in gel and putty forms.
Effective June 1, 2002, we entered into a new processing agreement with
MTF, under which MTF will supply a certain increasing minimum annual amount of
donor tissue for processing into non-proprietary allograft bone tissue forms,
Grafton(R) DBM and Graftech(TM) Bio-implants, all of which will be distributed
to hospitals and surgeons by MTF, under the MTF label,
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and provide an additional certain increasing minimum annual amount of tissue for
us to process into non-proprietary allograft bone tissue forms, Grafton(R) DBM
and Graftech(TM) Bio-implants, all of which will be distributed to hospitals and
surgeons by us under our label.
In October, 2002, we amended our processing agreement with ARC, which
among other items, removed the requirements that ARC exclusively provide all
tissue recovered by ARC to us for processing and, in its place, provided that
ARC provide a monthly minimum number of donors to us for processing.
Further, we are developing a new processing technology, Plexus(TM), which
is designed to maximize the utilization of donated human tissue that can be
processed from a single donor's bone tissue. For example, utilizing the
Plexus(TM) Processing technology we expect to be able to use bone tissue that
was not otherwise available for weight bearing bio-implants for that purpose.
Additionally, we expect that the Plexus(TM) technology will result in
significantly more processed allograft bone tissue to be available for a broad
spectrum of surgical procedures. Bone tissue processed by use of the Plexus(TM)
technology may be classified by the FDA as either a medical device requiring
pre-market approval or as human cellular tissue. The regulatory status of each
product processed utilizing the Plexus(TM) Processing technology will be
determined as the product is designed.
Expansion of Allograft Bone Tissue Business in Europe
OST, our subsidiary located in Clermont-Ferrand, France, manufactures and
markets bovine tissue products for use as bone grafts in orthopaedic and dental
surgery. These products, marketed under the trade names of LUBBOC(R) and
LADDEC(R), were developed to address the shortage of safe and effective human
allograft bone grafts in France and other countries outside the United States.
In the future, as a complement to our human allograft bone tissue products, OST
will continue to market these products in certain markets.
We are expanding operations and staff at OST as we begin to use it as a
base for developing our human allograft bone tissue graft and tissue processing
business in Europe. OST has adapted its proprietary LUBBOC(R) and LADDEC(R)
processing technology to develop the OsteoPure(TM) Process for the processing of
human femoral heads recovered during hip replacement surgery. OST has concluded
an agreement with OsteoBanque D'Auvergne and other European based tissue banks
and further expects to enter into similar agreements with other European tissue
banks for the provision of tissue for the OsteoPure(TM) Process in the future.
Additionally, we are expanding the range of human allograft bone tissue grafts
available to orthopaedic and other surgeons in various countries in Europe by
supplying Grafton(R) DBM and non-proprietary allograft bone tissue grafts
processed in the U.S.
In conjunction with OsteoBanque D'Auvergne and other European tissue
banks, we plan to help establish a cadaveric tissue recovery network in medical
centers throughout France and other European countries in order to meet the
growing demand by European surgeons for safe human allograft bone tissue forms.
France will continue to be the prime base of operation in our efforts to expand
the distribution of our human allograft bone tissue grafts throughout Europe. We
will add facilities and staff to our current operations, as required, to support
this expansion.
15
In February, 2002, OST entered into a seven year agreement with the
Bulgarian National Center For Transplant Management Bultransplant and the
US-Bulgarian Fund For The Development of Medicine and Biotechnology, both of
which are agencies of the Bulgarian government responsible for overseeing all
activities in Bulgaria related to the recovery, processing and allocation of
human organs, tissues, cells and biomaterials for transplantation. Under this
agreement, OST will be exclusively responsible for the recovery and processing
of tissue, cells and biomaterials as well as the allocation and distribution of
these anatomical gifts throughout Europe and the rest of the world. The bone
tissue recovered under this agreement, which will meet all standards of AATB and
the FDA, will initially be processed at Osteotech's facility in New Jersey and
the resulting tissue forms will be distributed in Europe through OST's network
of distributors and agents. Once sufficient quantities of donated tissue are
obtained from this and other European sources and we reach capacity constraints
at our processing facilities in New Jersey, it is our intention to expand OST's
processing facility in Clermont-Ferrand to allow it to directly process the
European sourced tissue.
We believe the advantages of locating our European operations in France
are significant. The French market is one of the larger and more sophisticated
European markets for bone grafts. Also, French laws and regulations governing
tissue banking are well defined and the most advanced of all the major European
countries. Although tissue banking operations in France are generally restricted
to non-profit public health organizations approved by the government, French
regulations also provide for governmental approval of for-profit organizations
as tissue banks if these organizations are able to provide haute technicite
(high technology) unavailable in the non-profit sector. In 2001, the French
government awarded OST tissue bank status which will now enable us to operate
independently as an approved tissue bank in addition to providing contract
processing, marketing and management services to non-profit tissue banks.
Metal Spinal Implants and Instruments
The human spine is subjected to various loading conditions including
tension, compression, torsion, bending and combinations of all four. When the
spine has been injured by tumors, fractures, degenerative conditions or
deformities, stabilizing instrumentation is required to maintain surgical
correction of the condition during the healing and fusion process. We offer
several metal spinal implant systems to achieve these results.
Ovation(TM) is a lumbo-sacral spine fixation system with an innovative
polyaxial screw, which is marketed in combination with our allograft and other
non-allograft spinal products. Ovation(TM) is designed in a manner to allow the
sharing of the forces to which the spine is subjected with this system, which in
turn is thought to provide improved results in spinal fusion procedures.
In 2001, we began to market VBR(TM). This patented device, which we
distribute under an exclusive agreement with Heinrich C. Ulrich, K.G., or
Ulrich, of Ulm, Germany, the manufacturer of the product, has been cleared for
sale by the FDA to replace a collapsed, damaged or unstable vertebra due to a
tumor or trauma.
16
In February, 2001, we entered into a distribution agreement to market and
distribute Sentinal(TM) and Affirm(TM) in the United States and Canada. These
products are manufactured by Alphatec Manufacturing, Inc. The distribution
agreement is for an initial term of two (2) years beginning April, 2002.
Sentinal(TM) is a lateral linking, top loading, titanium screw and hook rod
system designed to stabilize the posterior elements of the thoracic, lumbar and
sacral spine. Affirm(TM) is a contoured, low profile, titanium plating system
designed to provide temporary anterior internal fixation in the cervical spine.
In October, 2002, because of a higher than normal level of complaints, we
temporarily suspended the sale and distribution of Affirm(TM). We are currently
uncertain about our ability to reintroduce Affirm(TM) into the market.
On February 1, 2003, we entered into a three-year agreement with
SpineVision, S.A. and SpineVision, Inc., or collectively SpineVision, to
exclusively market and distribute in the United States and Puerto Rico
SpineVision's Plus(TM) System, C3(TM) System, and the Uni-Thread(TM) System. The
Plus(TM) System is a hook, rod and screw system that offers advanced features
for use in scoliosis, trauma and low back surgeries. The C3(TM) System is a
unique anterior plate system that is designed to aid in achieving fusion in the
cervical spine. The Uni-Thread(TM) System is a threaded pedicle screw system
that offers both polyaxial and lateral linking in one system designed to provide
stabilization of the spine in low back surgical procedures.
We expect to continue to expand our metal spinal implant product line
through acquisition or licensing of technology and products so that we are able
to offer surgeons implant systems capable of solving a variety of spinal
problems.
Quality Assurance
We have stringent quality assurance programs in place covering all of our
lines of business, including our Grafton(R) DBM and Base Tissue Segments, and
our metal spinal implants and instruments. OST's processing facility in
Clermont-Ferrand, has received International Standardization Organization, or
ISO, certification for its quality systems and our facilities in the United
States are registered with the FDA and are accredited by the American
Association of Tissue Banks.
In both the Grafton(R) DBM and Base Tissue Segments, our allograft bone
tissue quality assurance program commences with the recovery of allograft bone
tissue which is procured under strict aseptic conditions. The tissue is
recovered primarily in hospitals and, to a lesser extent, coroners' facilities,
which have been prepared for recovery. Recovered allograft bone tissue is also
required to be sterilely wrapped and shipped in special containers. Upon receipt
of this tissue, a quarantine period is imposed to permit serologic and
microbiologic testing prior to release of allograft bone tissue for processing.
Upon satisfactory completion of all testing, the allograft bone tissue is
processed in a microbially-controlled environment. Under constant monitoring,
the allograft bone tissue is cleaned, soaked in antibiotics and alcohol and then
cut and shaped in accordance with our or our clients' specifications. Before
being released, our quality assurance team inspects and again tests all
processed bone tissue for microbiological contaminants.
As a result of our quality assurance operating and testing procedures, we
identified a higher than normal level of finished product sterility failures for
certain tissue processed in the
17
third quarter of 2002. Therefore, we voluntarily and temporarily suspended Base
Tissue Segment processing operations during a portion of the fourth quarter of
2002, and we placed tissue processed from 693 donors in quarantine and
voluntarily retrieved certain tissue from 15 whole donors and five individual
pieces of tissue from five different donors that had previously shipped to
clients. However, at no time did any tissue that was identified as being
contaminated ever leave our processing facilities.
We believe that the serologic screening of donors, the extensive screening
of donor profiles and medical histories performed by our clients and TRO's and
our processing technologies substantially reduce the likelihood of the presence
of infectious agents, including HIV and hepatitis viruses, in our processed
allograft bone tissue. Studies completed by an independent testing laboratory
specializing in viral inactivation studies demonstrated that our proprietary
demineralization process used in our Grafton(R) DBM Segment can virtually
inactivate and eliminate viruses such as HIV, hepatitis B, hepatitis C,
cytomeglia and polio.
In addition to the proprietary demineralization process used in our
Grafton(R) DBM Segment, we are developing additional processing technologies
that once fully implemented will enable us to expand our viral inactivation
claims to include virtually all of the allograft bone tissue we process in our
Base Tissue Segment. These proprietary, tissue-specific technologies are
expected to further enhance graft safety while maintaining the tissue's biologic
and physical properties.
To our knowledge, none of the approximately 2.9 million transplanted
grafts we have processed in our Grafton(R) DBM and Base Tissue Segments have
caused a confirmed transmission of infectious diseases. This record is due to
the rigorous donor screening and tissue recovery techniques used by our clients,
extensive donor testing, as well as our demanding quality assurance and
processing protocols.
Clients
During 2002, two of our clients, ARC and MTF individually accounted for
approximately 30% and 29% of our consolidated revenue, respectively. We receive
revenues in both our Grafton(R) DBM and Base Tissue Segments from each of these
clients. In the Base Tissue Segment, our clients pay us fees on a per donor
basis for processing, finishing and packaging our clients' mineralized,
weight-bearing allograft bone tissue and on a per unit basis for the processing
of bio-implants. In the Grafton(R) DBM Segment our clients pay us fees on a per
unit basis. We have processing agreements with ARC and MTF which run through
December 31, 2006 and December 31, 2008, respectively. See Note 13 of "Notes to
Consolidated Financial Statements".
Commencing in the first quarter of 2002, we began to receive allograft
bone tissue for processing from LifeNet under the terms of a five-year agreement
which will expire in January, 2007. The allograft bone tissue received from
LifeNet under this agreement will be processed in our Base Tissue Segment.
Effective January 1, 2003, we entered into a five-year agreement with LifeNet
and DePuy for the processing of LifeNet allograft bone tissue into a DBM carrier
product, which will be marketed by DePuy and distributed by LifeNet.
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In June, 2000, we entered into a five-year agreement with Bone Bank
Allografts, or BBA, to process donor allograft bone tissue procured by BBA and,
in December, 2000, we entered into a fifteen-year agreement with American Tissue
Services Foundation, or ATSF, to process donor allograft bone tissue procured by
ATSF. This tissue is processed in our Grafton(R) DBM and Base Tissue Segments.
We generally rely on our clients to obtain the donor allograft bone tissue
which we process and, generally, to distribute the processed allograft bone
tissue to hospitals and surgeons for transplantation. However, certain of our
clients are recovering tissue on our behalf which will be distributed and
invoiced directly by us to the hospitals and physicians. In the future, we
expect a significant portion of our processed tissue will be distributed in this
manner and a significant portion of our revenue will be derived in this manner.
We perform marketing services which generate demand for our proprietary
products. See "Education and Marketing."
In the fourth quarter of 1999, we commenced using the OsteoPure(TM) System
for processing allograft bone tissue grafts for French tissue bank clients and
we also concluded a contract with BioImplant Services of The Netherlands for
expanded distribution of Grafton(R) DBM in Europe. We began distribution of
Grafton(R) DBM in Europe in the first quarter of 2000.
Our metal spinal implant product customers generally purchase our services
and products pursuant to purchase orders or non-exclusive supply agreements
which are cancelable at any time by either party.
Education and Marketing
We believe the markets for processed allograft bone tissue will continue
to be general orthopaedic, spinal, neurological, and oral/maxillofacial surgical
specialties. Our future growth in these areas will depend upon availability of
adequate supplies of allograft bone tissue and a wider acceptance by these
specialties of the use of allograft bone tissue as an alternative to autograft
bone tissue and other available materials and treatments.
As of December 31, 2002, in the United States, we employed 13 persons
engaged directly in efforts to educate surgeons as to the benefits and
applications of processed allograft bone tissue and eight employees engaged in
training our independent sales agents. We complement our direct sales
organization with a national network of independent sales agents who market
Grafton(R) DBM, Graftech(TM) Bio-implants and our non-allograft bone tissue
spinal implant products. These agents also educate the medical community about
processed allograft bone tissue. At December 31, 2002, we had appointed 37
agencies which employ 175 sales representatives.
Currently, a small group of marketing and sales employees of OST located
in Clermont-Ferrand, France markets and sells our OsteoPure(TM) Femoral head and
cancellous bone grafts, Grafton(R) DBM and other human allograft tissue products
in conjunction with a network of independent agents and distributors we have
retained, including DePuy International, LTD, or DePuy International. In early
2002, OST entered into a two-year marketing services and logistics support
agreements with DePuy International. DePuy International will be OST's exclusive
sales
19
agent for Grafton(R) DBM tissue in the United Kingdom, Germany and Switzerland.
The agreements are automatically renewable every two years unless terminated by
either party. OST's staff also markets and sells our LUBBOC(R) and LADDEC(R)
Bovine bone grafts to orthopaedic surgeons and dentists.
Government Regulations
Our products and our tissue banking activities are regulated in the United
States by the U.S. Food and Drug Administration, or the FDA, and certain state
agencies. Outside the United States, our products and tissue-banking activities
are regulated by federal agencies of the respective countries. Each country
maintains its own regulatory system for tissue-based products and tissue banking
activities. European countries maintain a shared regulatory system for medical
devices.
United States
Our products are extensively regulated by federal and, in certain states,
by state agencies in the United States. Failure to comply with these
requirements may subject us to administrative or judicial sanctions, such as the
FDA's refusal to clear pending applications, warning letters, product recalls,
product seizures, total or partial suspension of production or distribution,
civil penalties, injunctions and/or criminal prosecution.
In the United States, the allograft bone tissues that we process are
regulated by the FDA as human tissue-based products under section 361 of the
Public Health Service Act, and under certain circumstances, may be regulated as
a medical device under the Food, Drug, and Cosmetic Act.
FDA regulations do not require that human tissue-based products be cleared
or approved before they are marketed. We are, however, required to register and
list these products with the FDA and to comply with regulations concerning
tissue donor screening and testing, and related procedures and record keeping.
The FDA periodically inspects tissue processors to determine compliance with
these requirements. The FDA has proposed, but not yet finalized, "Good Tissue
Practice" regulations that would impose requirements on the manufacture of human
tissue-based products, including tissue recovery, donor screening, donor
testing, processing, storage, labeling, packaging, and distribution. The human
tissue-based product category is a relatively new one in FDA regulations, and it
is possible that the FDA will change its approach to human tissue-based products
in general or to particular categories of products to require FDA clearance or
approval or otherwise restrict distribution.
In October, 2002, the FDA completed an inspection of our facilities
related to our voluntary and temporary suspension of certain of our tissue
processing operations and retrieval of certain Base Tissue Segment donor tissue.
At the conclusion of the inspection, the FDA made two observations in a Form
483, which is a document that specifies objectionable conditions and practices
noted by the FDA investigator. We have put into place the necessary corrective
action programs to address the FDA observations. The FDA subsequently responded
to our submissions and noted that the corrective actions taken appear to be
adequate and appropriate.
20
We anticipate that the FDA will continue to monitor our activities in the future
with regard to our corrective action programs.
The metal spinal implant products that we distribute in the United States
are regulated by the FDA as medical devices. Medical devices generally require
FDA approval or clearance before they may be marketed. There are two processes
by which medical devices can receive approval or clearance. Some products may
qualify for clearance under the 510(k) process, in which the manufacturer or
processor demonstrates that its product is substantially equivalent to another
lawfully marketed product (i.e., that it has the same intended use and is as
safe and effective as a lawfully marketed product and does not raise different
questions of safety and effectiveness as the lawfully marketed product). 510(k)
submissions usually include safety and performance data, and in some cases, the
submission must include clinical data. Marketing may commence if and when FDA
issues a letter finding substantial equivalence. All of the metal spinal implant
systems that we distribute are being marketed pursuant to 510(k) clearances.
If a medical device does not qualify for the 510(k) process, the product
may not be distributed until a premarket approval application has been approved
by the FDA. Premarket approval applications must demonstrate product safety and
effectiveness. A premarket approval application is typically a complex
submission, usually including the results of preclinical and clinical studies.
The manufacturer must also pass a premarket inspection of its compliance with
FDA's Quality Systems regulation. Marketing may commence if and when the FDA
issues a premarket approval.
After premarket clearance or approval has been obtained, manufacturers and
marketers of medical devices are subject to postmarketing requirements. For
example, a manufacturer's quality control and manufacturing procedures and its
facilities must conform to FDA's Quality System Regulation, which governs, for
instance, design, manufacture, packaging, labeling, installation, and servicing
of medical devices. Certain adverse events and product malfunctions must be
reported to the FDA, and product labeling and promotion must comply with FDA
requirements. The FDA periodically inspects facilities to determine compliance
with these requirements.
We market Grafton(R) DBM as a human tissue-based product pursuant to an
August, 1995 designation from the FDA. In March, 2002, the FDA informed us that
the agency is changing the regulatory status of Grafton(R) DBM and will
henceforth regulate it as a medical device. We believe the FDA's change in its
position regarding Grafton(R) DBM results from its decision to regulate all
demineralized bone with a carrier, including those processed and marketed by
certain of our competitors, as medical devices. We communicated to the FDA that
we believe its initial designation of Grafton(R) DBM as a human tissue-based
product was and still is correct. In this regard, we have provided information
to the FDA that we believe should cause the FDA to reconsider the position it
has expressed in its March, 2002 letter as it relates to Grafton(R) DBM. On
February 26, 2003, we met with representatives of the FDA to present our facts
and views. Communication and interaction with the FDA on this issue are
continuing. If we are unsuccessful in our effort, we will be required to obtain
a medical device approval or clearance for Grafton(R) DBM, and to comply with
medical device postmarketing obligations. We believe that Grafton(R) DBM will be
eligible for 510(k) clearance, but we cannot be sure that we will not be
required to
21
obtain premarket approval, or that the FDA will issue any clearance or approval
in a timely fashion, or at all.
We also market Grafton Plus(TM) DBM as a human tissue-based product. The
FDA's determination regarding Grafton(R) DBM is also likely to be applied to
Grafton Plus(TM) DBM. If the FDA maintains its position that all products
consisting of demineralized bone with a carrier should be regulated as a medical
device, we would also be required to obtain FDA clearance or approval for
Grafton Plus(TM) DBM and any other DBM carrier product we may process, including
pursuant to our agreement with LifeNet and DePuy, and to comply with other
medical device requirements for that product.
The procurement and transplantation of allograft bone tissue is subject to
federal law pursuant to the National Organ Transplant Act, or NOTA, a criminal
statute which prohibits the purchase and sale of human organs used in human
transplantation, including bone and related tissue, for "valuable
consideration." NOTA permits reasonable payments associated with the removal,
transportation, processing, preservation, quality control, implantation and
storage of human bone tissue. We provide services in all of these areas, with
the exception of removal and implantation. We make payments to certain of our
clients and TRO's for their services related to their recovering tissue on our
behalf.
The procurement of human tissue is also subject to state anatomical gift
acts and some states have statutes similar to NOTA. In addition, some states
require that tissue processors be licensed by the state. Failure to comply with
state laws could also result in enforcement action against us.
International
Allograft bone tissue and tissue banking activities, such as tissue
donation and recovery and tissue processing, are regulated in virtually all
countries in which we operate outside the United States. The regulatory schemes
and specific requirements for these products and activities vary from
country-to-country. There are no common or harmonized regulatory approvals or
programs for these products and activities, such as there are for medical
devices marketed in the European Union. We believe that we comply with the
national regulations in the countries in which we currently operate or in the
countries we plan to operate in the future, although there can be no assurances
that we will be able to do so in the future.
In 2001, France authorized our French subsidiary, OST, to operate as a
tissue bank. This authorization was based on OST's satisfaction of certain
requirements, such as high technology. This authorization was granted for a
period of five years. At the end of this initial five-year period, OST can
reapply to have the authorization renewed. Without this authorization, OST will
not be able to operate its tissue bank in France or to directly distribute or
import into France, human tissue based products. We cannot be certain that OST
will be able to obtain a renewal of its authorization to operate as a tissue
bank on a timely basis, or will be able to obtain such authorization.
22
The European Commission is working on the development and adoption of a
common regulatory program for human tissue based products and tissue banking. We
believe that an eventual adoption of such a common regulatory program is likely
though not imminent. There can be no assurance that we would be able to meet the
requirements of any such regulatory program once it is adopted.
ISO certification for production facilities was made mandatory in 1998 for
companies that market or distribute products within the European Union. OST's
processing facility located in Clermont-Ferrand, France has received ISO 9002
certification for the quality systems used in the manufacture of bovine tissue
products. Upon receiving certification, a company may apply for a CE Mark for
its device products, thus allowing for the sale of the products throughout the
European Union. The LUBBOC(R) and LADDEC(R) Bovine Grafts produced and marketed
by OST are regulated as medical devices in Europe and most other international
markets in which these products are marketed.
Research and Development
During 2002, 2001, and 2000 we spent approximately $3,927,000, $4,372,000,
and $5,547,000, respectively, on research and development activities. The
majority of these expenditures were made in our Grafton(R) DBM and Base Tissue
Segments. We are engaged in continuing research and development efforts in the
allograft bone tissue processing field which include our continuing efforts to
improve upon and maintain the safety and performance of the processed allograft
bone tissue, increase the amount of transplantable allograft bone tissue derived
from each donor, reduce processing costs through efficiency advances and develop
new forms of allograft bone tissue.
Competition
Market Overview
The bone grafting market is an extension of the general orthopaedic
surgery market, as bone grafts are used adjunctively in a broad range of
reconstructive orthopaedic surgical procedures such as the repair of fractures
and skeletal defects, spinal and joint arthrodeses, and revision arthroplasties.
These procedures are performed by virtually all orthopaedic subspecialties and
by neurosurgeons, some plastic surgeons and certain other surgical specialties.
Dental and other oral maxillofacial procedures are not considered to be a
primary portion of the bone graft market, but are instead considered to
constitute a secondary market. Three basic categories of products or
alternatives currently compete in the bone graft market:
o autograft bone tissue;
o allograft bone tissue; and
o synthetic bone void fillers.
A fourth product category, growth factor products, is still in the
investigational stage. One such growth factor, Osteogenic Protein 1, or OP-1,
has recently received humanitarian device exemption status, or HDE status, from
the FDA for use as an alternative to autograft in long-bone nonunions where use
of autograft is unfeasible and alternative treatments have failed. In addition,
23
in July, 2002, the FDA approved the InFuse(TM) Bone Graft, or InFuse(TM), a
combination of an absorbable collagen sponge and rhBMP-2. InFuse(TM) is limited
to use in single level lumbar, anterior procedures with the LT-Cage(TM) Lumbar
Tapered Fusion Device.
We estimate that total domestic allograft bone tissue sales in 2002 was
$508 million, comprising approximately 40% of the U.S. bone graft market.
U.S. Bone Graft Market
2002
Specialty Graft Procedures(1) Allograft Market Size(1)
- --------- ------------------- ------------------------
Spinal Fusions 328,000
General Orthopaedics 238,000
Craniomaxillofacial 77,000
-----------
Total 643,000
Average Selling Price2 $ 1,994
-----------
Market Size (000) $ 1,282,000 $508,000 (40%)
(1) Source: Datamonitor, "Market Dynamics: Bone Substitutes and Growth
Factors"
(2) Source: Osteotech estimate
The number of bone graft procedures is forecast to increase during the
next five years due to an expected increase in the number of reconstructive
orthopaedic surgical procedures utilizing bone grafts, particularly in spinal
procedures using bio-implants, pedicle screw implants and spinal cages.
Factors producing the continued growth in the number of reconstructive
orthopaedic surgical procedures that incorporate a bone graft include the
following:
o the aging of the U.S. population;
o improving success rates for surgical procedures that involve a bone
graft procedure;
o development of less invasive reconstructive orthopaedic surgical
procedures that will be used in a wider patient population; and
o the increasing number of revision, spinal fusion and joint
arthroplasty procedures resulting from a more active and longer
living U.S. population.
While the general bone graft market has experienced growth in recent
years, we estimate that allograft bone tissue sales have increased at a
significantly higher rate than the general bone graft market. This displacement
trend is expected to continue as physicians gain confidence in, and experience
with, allograft bone tissue. Some of the factors contributing to the increased
use of allograft bone tissue include:
24
o the desire by surgeons to avoid the additional procedure needed to
acquire autograft bone tissue, which often increases costs due to
additional operating time, medical supplies and extended hospital
stay, and patient risks due to excessive blood loss, infection,
chronic pain and morbidity;
o increased awareness by, and training of, the medical community with
respect to the use and safety of processed allograft bone tissue;
o an increase in the number of patients who do not possess the quality
of bone tissue required for autograft procedures as a result of the
general aging of the population; and
o an increase in the availability of allograft bone tissue due to an
increase in bone tissue donations and to improved recovery and
processing techniques.
Competitive Overview
In both our Grafton(R) DBM and Base Tissue Segments we compete in the bone
graft market with autograft bone tissue, allograft bone tissue processed by
others and synthetic bone void fillers. Autograft bone tissue has traditionally
been the primary choice for surgeons and we believe it still maintains an
approximate 49% share of the U.S. bone graft market. Due to factors such as the
increased cost and potential complications associated with an additional
procedure needed to acquire autograft bone tissue, more surgeons are beginning
to choose allograft bone tissue over autograft bone tissue for their bone
grafting needs.
Grafton(R) DBM Segment
We have been successful in persuading many surgeons to switch to Osteotech
processed allograft bone tissue through the introduction of our proprietary
tissue processing technology. We have expanded the applications of allograft
bone tissue through Grafton(R) DBM, a proprietary form of allograft bone tissue.
The demineralization process used in Grafton(R) DBM removes most of the
minerals, thus exposing the proteins that promote bone growth (osteoinduction)
and creating a latticework for new bone (osteoconduction). Grafton(R) DBM has a
validated viral inactivation process for HIV, hepatitis B and C, cytomeglia and
polio. Grafton(R) DBM is produced in forms such as gel, flex, putty, crunch, and
DBF Matrix, and is packaged in sterile, single patient delivery systems. In
February, 2002, we introduced Grafton Plus(TM) DBM, which contains a carrier
made from starch instead of glycerol. In the first half of 2003, we expect to
begin distribution of Grafton(R) DBM Matrix Strips. With the varying textural
and handling characteristics of its forms, Grafton(R) DBM can be used in
virtually all non-weight-bearing bone graft procedures and has been used in
approximately 590,000 procedures through December 31, 2002.
Given its osteoinductive and osteoconductive properties, Grafton(R) DBM
has a distinct advantage over synthetic bone void fillers, all of which are
exclusively osteoconductive.
25
Grafton(R) DBM's advantages over synthetic grafting materials in the
market for non-weight-bearing applications include:
o superior handling and performance qualities, including providing a
matrix for bone to grow into and inducing bone to grow; and
o the suitability of Grafton(R) DBM for all non-weight-bearing bone
graft procedures versus the limited applications of competitive
products.
In recent years, Grafton(R) DBM has faced increasing competitive
pressures, which we expect will continue in the future, as more companies have
developed products with characteristics similar to Grafton(R) DBM. Certain of
these competitors have, in turn, partnered with large orthopaedic and spine
companies to market the competitors' products. Many of these companies have
research and development, marketing and other resources that are significantly
greater than ours. They also offer a full line of metal implants and other
products used in spinal surgeries, which could give them a competitive advantage
over us since they can offer surgeons a more complete line of products then we
currently can.
Grafton(R) DBM primarily competes with DBM products including:
DynaGraft(R) II, OrthoBlast(TM) II and Accell(TM), manufactured and distributed
by GenSci; Osteofil(TM), processed by Regeneration Technologies, Inc. and
distributed by Medtronic Sofomor Danek; AlloMatrix(R) and Ignite(TM),
manufactured and distributed by Wright Medical Technologies, Inc.; InterGro(TM),
processed and distributed by Interpore Cross International; and DBX(R),
processed by MTF and distributed by Synthes Spine.
To counter this competition, we have expanded our line of Grafton(R) DBM
in order to offer the surgeon the ability to expand the type of procedures that
DBM grafting materials can be used in. Additionally, we introduced Grafton
Plus(TM) DBM in February, 2002, which offers improved handling characteristics.
We have also expanded our Graftech(TM) Bio-implant line with which Grafton(R)
DBM is used and also expanded our line of metal spinal implant devices. When
taken together, we are now able to provide the spinal surgeon with the full
range of products needed to achieve the outcomes the surgeon is seeking for the
patient.
Notwithstanding the increasing competition, Grafton(R) DBM has significant
opportunities for growth. Currently, Grafton(R) DBM sales are primarily
domestic. We estimate that Grafton(R) DBM was used in only 14% of the total bone
graft procedures performed in the U.S. during 2002. We estimate the potential
non-domestic bone graft market to be at least as large as that of the U.S.
market. The European market, in particular, provides us with an opportunity in
an area where we already have a sales presence. We currently market Grafton(R)
DBM in 11 European countries.
26
Grafton(R) DBM U.S. Procedure Penetration
2002
---------------------------
Grafton(R) DBM
---------------------------
Percent
Specialty Potential(1) Actual(2) Penetration
- --------- ------------ --------- -----------
Spinal Fusions 328,000 38,129 11.6%
General Orthopaedics 238,000 40,386 17.0%
Craniomaxillofacial 77,000 12,500 16.2%
------- ------ -----
Total 643,000 91,015 14.2%
(1) Source: Datamonitor, "Market Dynamics: Bone Substitutes and Growth
Factors"
(2) Source: Osteotech estimate
Base Tissue Segment
Allograft bone tissue is still the only alternative to autograft bone
tissue for bone grafting procedures which require weight-bearing tissue. We plan
to continue to differentiate our Base Tissue Segment operations from those of
other allograft bone tissue processors by expanding our viral inactivation claim
to include our mineralized weight-bearing bone tissue and through continued
technological advances. Our Graftech(TM) Bio-implants face significant
competition from bio-implants processed by other tissue banks and processors
such as MTF and Regeneration Technologies, Inc. and are marketed by companies
such as Medtronic Sofamor Danek and Synthes Spine which have larger marketing
forces and significantly greater resources then we have. Typically,
weight-bearing tissues are not osteoinductive. In late 2001, we introduced our
OsteoActive(TM) surface treatment of weight-bearing bone tissue. Application of
this process to weight-bearing tissue allows the surface of the tissue to become
osteoinductive, allowing for faster incorporation of the tissue into a patient's
own bone, thereby aiding the process of spinal fusions. We also introduced our
non-frozen version of weight-bearing tissue which allows these grafts to be
stored on the shelf instead of in freezers and for the surgeon to be more
precise in selecting the grafts he will use in a procedure, thus reducing the
number of grafts a hospital must purchase. Once we are able to use our new
Plexus(TM) Processing technology on a commercial basis, of which there can be no
assurance, it should allow us to utilize more of the available allograft bone
tissue in the future for weight-bearing grafts, thus increasing the availability
of such grafts. All of these innovations will continue to differentiate
Osteotech processed bone from our competitors and, we believe, increase the
demand for our processed tissue in the future.
In this segment, we process both our non-proprietary allograft bone tissue
forms and Graftech(TM) Bio-implants. In the fourth quarter 2000, we began the
limited market introduction of the Graftech(TM) Bio-implant line of spacers and
ramps for posterior and anterior lumbar spinal fusion procedures and for
cervical spinal fusion procedures. The Graftech(TM) Bio-implant tissue forms
became available nationally over the course of 2001. We market and generally
distribute these bio-implants.
In order to maintain our leading position in the allograft bone tissue
processing market and to encourage more surgeons to switch from autograft bone
tissue to our processed allograft bone tissue, we plan to:
o leverage our knowledge of allograft bone tissue processing to expand
our proprietary tissue safety claims to our weight-bearing
mineralized allograft bone tissue;
27
o expand our external scientific presence through publication and
presentation of clinical research and outcome studies;
o continue to expand our market differentiation through tissue
performance improvements, including line extensions of existing base
allograft bone tissue products and new product introductions; and
o increase education of surgeons regarding the use of allograft bone
tissue through expanded grand rounds, seminars, workshops and the
internet.
The various national markets in Europe for bone grafts are currently
dominated by the use of autograft and synthetic bone graft substitutes.
Autograft remains the bone graft of choice due to surgeons' attitudes and
concerns about bone graft safety and performance. There is also a significant
number of surgeons who have not yet become aware of the safety and performance
advantages of processed allografts and who continue to use unprocessed
autografts. Our OsteoPure(TM) Process, Grafton(R) DBM, Graftech(TM) Bio-implants
and non-proprietary allograft bone tissue forms are designed to address these
needs. However, other firms have developed or are developing allograft bone
tissue grafts and allograft bone tissue-based products to also address these
needs. Tissue Bank of France, a unit of Groupe Lepine of France and Tutogen,
Inc. of Germany, offers allograft bone tissue grafts which directly compete with
the OsteoPure(TM) Processed human femoral head tissue grafts in certain European
countries. Also, several U.S. tissue bank organizations have formed strategic
alliances with orthopaedic device firms to market allograft bone tissue grafts
in European markets.
Metal Spinal Implants and Instruments
Although we have not been a significant competitor in the metal spinal
implant market to date, we are expanding into this market, which is highly
competitive.
Environmental Matters
Our allograft bone tissue processing in both the United States and Europe
generates waste which, in the United States, is classified as medical waste
and/or hazardous waste under regulations promulgated by the United States
Environmental Protection Agency and the New Jersey Department of Environmental
Protection. We segregate our waste materials and dispose of them through a
licensed hazardous waste transporter in compliance with applicable regulations.
In OST's processing facility in Clarmont-Ferrand, France, we segregate both
bovine and human tissue waste and dispose of it in a manner specified by the
appropriate regulatory authorities responsible for environmental matters in
France. Although we believe we are in compliance with applicable environmental
regulations, the failure to fully comply with any such regulations could result
in the imposition of penalties, fines and/or sanctions which could have a
material adverse effect on our business.
28
Patents and Proprietary Rights
We consider our processing technology and procedures proprietary and rely
primarily on trade secrets to protect our technology and innovations.
Significant research and development activities have been conducted on our
behalf by consultants employed by third parties or in conjunction with
unaffiliated medical institutions. Accordingly, disputes could arise in the
future concerning the proprietary rights to information applied to our projects
which have been independently developed by the consultants or researchers at the
medical institutions.
At February 28, 2003, we held an aggregate of 115 United States patents
and patent applications and 180 foreign patents and patent applications
consisting of: (i) 47 United States patents and 32 foreign patents relating to
our aseptic processing technology and our transplant support products, including
16 United States Grafton(R) DBM patents and 9 foreign Grafton(R) DBM patents,
(ii) 4 United States and 4 foreign patents relating to our biomaterials
technology, (iii) 49 United States and 126 foreign patent applications relating
to aspects of our processing technology and our osteogenic and other products
under development, (iv) 4 United States patent applications and 5 foreign patent
applications relating to our biomaterials technology, (v) 3 United States
patents related to instrumentation, and (vi) 8 United States patent applications
and 13 foreign patent applications relating to instrumentation. We believe that
our Grafton(R) DBM patents are significant in maintaining our competitive
position. These patents expire on various dates ranging from 2009 to 2020. Our
other patents expire at various dates ranging from 2007 to 2021.
We can not assure you that any pending patent applications will result in
issued patents or that any currently issued patents, or patents which may be
issued, will provide us with sufficient protection in the case of an
infringement of our technology or that others will not independently develop
technology comparable or superior to ours.
Product Liability and Insurance
The testing and use of allograft bone tissue and the implantation of
medical devices developed with our biomaterials technology and medical devices
manufactured by others and distributed by us entail inherent risks of medical
complications for patients, and therefore may result in product liability claims
against us. Further, our agreements with our bone tissue processing clients
provide them with indemnification by us for liabilities arising out of defects
in allograft bone tissue caused as a result of processing performed by us.
We presently maintain product liability insurance in the amount of $35
million per occurrence and per year in the aggregate. We cannot assure you that
we will be able to maintain such insurance in the future or that such insurance
will be sufficient to cover the amount of claims asserted against us on all
types of liabilities. We have had product liability claims asserted against us
in certain pending lawsuits. See Item 3. "Legal Proceedings" and Note 13 of
"Notes to Consolidated Financial Statements."
Employees
At December 31, 2002, we had 338 employees, of whom 204 were engaged in
allograft bone tissue processing and the manufacture of products; 26 were
engaged in research and development; 50 were engaged in education, sales and
marketing; and 58 were engaged in
29
regulatory, finance and administration. Our employees are not covered by any
collective bargaining agreement. We consider relations with our employees to be
good.
Item 2. Properties
Our principal executive offices are located in an approximately 38,000
square foot building in Eatontown, New Jersey, which is occupied pursuant to a
lease which expires in December, 2004 and provides for a base annual rental of
approximately $264,000. This facility is occupied by our corporate, financial,
administration, marketing, research and development, regulatory and clinical
affairs staff.
In 1997, we purchased land adjacent to our Eatontown, New Jersey facility.
We have completed the construction and validation of a new 73,000 square foot
processing facility built on this land, which is utilized primarily by the
Grafton(R) DBM and Base Tissue Segments. We began occupying this facility in the
fourth quarter of 2001 and fully occupied it by June, 2002. We have financed the
construction of this facility with a $4.5 million mortgage loan and a $17.0
million equipment term loan from our bank, which is secured, in part, by the
equipment purchased with the proceeds from this loan facility and through our
cash reserves and cash generated by operations. This facility is held by us
subject to a mortgage which secures the mortgage loan, our equipment term loan
and a $5 million revolving line of credit.
Our processing facility located in Shrewsbury, New Jersey is approximately
45,000 square feet and is occupied pursuant to a lease that expires in October,
2008, which provides for a base annual rental of approximately $247,000 through
October 2003 and $309,000 for the remaining term of the lease. The lease is
renewable at our option for an additional five-year term. Both the Grafton(R)
DBM and Base Tissue Segments were utilizing this facility. In 2003, since we
have completed the move of our processing operations into our new facility, we
intend to use this facility for certain processing steps and for certain
non-processing activities. In addition, we rent 4,600 square feet of space in
Eatontown, New Jersey principally as warehouse space for our non-allograft bone
tissue spinal implant products. The lease expires in January 2005 and provides
for base annual rental of approximately $27,000.
Our subsidiary in France, OST, which is engaged in the production,
processing and distribution of bovine bone graft substitute products and human
allograft tissue products, occupies an 11,000 square foot facility in
Clermont-Ferrand, France. The lease for this facility expires in June, 2005 and
has an annual rent of 85,000 Euros (approximately $90,000 at the December 31,
2002 exchange rate). We have the option to acquire the building and related land
for the fair market value of the property at the time of purchase as determined
by an independent appraisal. OST also occupies a 3,100 square foot facility
which it utilizes for the activities of its tissue bank, OsteoCentre Europe, at
an annual rental of 29,000 Euros (approximately $31,000). The lease on this
facility expires in December, 2009.
30
Item 3. Legal Proceeding
GenSci Regeneration Laboratories, Inc. v. Osteotech, Inc.; Osteotech, Inc.
v. GenSci Regeneration Sciences, Inc.
In January, 1998, we filed a patent infringement action against GenSci
Regeneration Laboratories, Inc. ("GenSci Labs") and GenSci Regeneration
Sciences, Inc. ("GenSci Sciences", collectively, "GenSci") alleging that GenSci
violated claims of one of our patents involving Grafton(R) Demineralized Bone
Matrix (DBM) process. Approximately two weeks after our filing, GenSci Labs
filed a suit against us alleging that our Grafton(R) DBM Flex tissue form
infringes two patents assigned to GenSci Labs in addition to allegations against
us for tortious interference with a business expectancy, negligent interference
with a prospective economic advantage and inducing breach of contract and
seeking a declaratory judgment of the invalidity of our patents U.S. Patent Nos.
5,284,655 (the "655 Patent") and 5,290,558 (the "558 Patent") covering
Grafton(R) DBM. In February, 1998, GenSci Labs amended its complaint alleging
essentially the same causes of action but adding a third patent to the
allegation of patent infringement. In August, 1998, the actions were
consolidated into one case before the United States District Court for the
Central District of California. In April, 2000, GenSci Labs and GenSci Sciences
agreed to dismiss with prejudice all of GenSci's patent infringement claims
against us. Between September, 1998 and September, 2001, there were numerous
amendments to the complaints of both parties and both parties filed numerous
motions with the Court.
On October 31, 2001, the trial commenced in the United States District
Court for the Central District of California. In November, 2001, the jury
returned a verdict that the 558 Patent and the 655 Patent are valid and that
GenSci infringed on both patents through their sales of the DynaGraft(TM) Gel
and Putty products. In arriving at its verdict, the jury rejected all of
GenSci's defenses.
In December 2001, we were awarded damages in the amount of $17,533,634 for
GenSci's infringement of our patents. This damage award will be reduced by the
$3.0 million previously paid by DePuy in 2000 and 1999 in settlement of our
claims against DePuy in this lawsuit. We have not recognized any portion of the
net award of $14,533,634 in our financial statements. On December 21, 2001,
GenSci filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy
Code.
GenSci Orthobiologics, Inc. v. Osteotech, Inc.
On March 6, 2000, GenSci Orthobiologics, Inc. ("GenSci") filed a complaint
in the United States District Court for the Central District of California
against us, alleging unlawful monopolization, attempt to monopolize the market
for demineralized bone matrix and for entering agreements in restraint of trade,
in violation of Sections 1 and 2 of the Sherman Antitrust Act and Section 3 of
the Clayton Act; and that we engaged in unlawful and unfair business practices
in violation of Section 17200 of the California Unfair Competition Law. GenSci
has alleged that we have monopoly power in the market for demineralized bone
matrix products in the United States, and has engaged in anticompetitive conduct
by improperly asserting our patents through patent infringement actions, seeking
to have the Food and Drug Administration remove certain of
31
GenSci's products from the market, restricting competitors' access to raw
materials, interfering with GenSci's arrangements to manufacture demineralized
bone matrix implants, interfering with GenSci's marketing and distribution
arrangements, and disparaging GenSci's products.
GenSci seeks compensatory, incidental, consequential, and punitive damages
in an unspecified amount, and injunctive relief to stop us from restricting the
tissue banks for which it processes tissue from supplying processed
demineralized bone matrix to our competitors and distributing the demineralized
bone matrix implant products of our competitors. GenSci had previously asserted
certain of these allegations in its patent litigation with us in the Central
District of California federal court.
In April, 2000, we reached an agreement with GenSci whereby tort claims
that were dismissed from the patent litigation would be transferred to this
action and this action was stayed pending completion of our patent infringement
case against GenSci. On December 20, 2001, GenSci filed a bankruptcy petition
with the United States Bankruptcy Court for the Central District of California.
GenSci has not sought relief from the automatic stay to pursue this action.
We believe the claims made in this lawsuit are without merit and intend to
vigorously defend against these claims.
Osteotech, Inc. v. GenSci Orthobiologics, Inc.
On October 25, 2000, we filed suit against GenSci Orthobiologics, Inc.
("GenSci"), in the United States District Court for the Central District of
California, alleging that GenSci's demineralized bone matrix materials sold
under the name Orthoblast, infringe our U.S. Patent No. 5,290,558 and infringe
the re-examined claims of our U.S. Patent No. 5,676,146. Our complaint seeks
injunctive relief, treble damages, costs and attorneys' fees.
In its Second Amended Answer and Counterclaim filed in March, 2001, GenSci
denies infringement, asserts a number of affirmative defenses, and asserts a
counterclaim seeking a declaratory judgment that the patents-in-suit are
invalid, not infringed and/or unenforceable, together with costs and attorneys'
fees.
We intend to pursue our claims against GenSci and vigorously defend
against the counterclaims. On December 20, 2001, GenSci filed a bankruptcy
petition with the United States Bankruptcy Court for the Central District of
California. As a result, this suit is currently stayed.
"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 misrepresentation, fraud, and
violation of the New Mexico Unfair Trade Practices Act arising from allegedly
defective dental implant coating and coating services provided to plaintiffs by
our subsidiary, Osteotech Implants BV, formerly known as Cam Implants BV.
Plaintiffs have demanded unspecified monetary damages. In August, 1998, we
removed this action to the United
32
States District Court for the District of New Mexico and filed and served our
answer, denying any and all liability in this action, and moved to dismiss five
of the seven claims alleged against us. In March, 1999, the court dismissed with
prejudice the plaintiff's negligence and strict liability claims. As to the
remaining claims, we, in addition to denying any and all liability, have moved
for summary judgment on the basis that all of the remaining 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.
On February 13, 2003, we filed another motion for summary judgment on the basis
that plaintiffs sued the wrong party. The motion has not yet been fully briefed
and submitted to the court. Discovery on matters relating to the merits of the
plaintiffs' claims and scope of alleged damages, is in progress.
We believe that the claims made against us in this action are without
merit and will continue to vigorously defend against such claims.
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, "Danek") 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, or
bio-d(R)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 Danek.
In April, 2002, this lawsuit (the "Medtronic Settlement") was settled. We
agreed to pay an aggregate of $1,900,000 to Medtronic in 24 equal monthly
installments, without interest, and supported by an irrevocable standby letter
of credit, and to cease processing, marketing, distributing, advertising and
promoting of the bio-d(R) by January 31, 2003. In accordance with the Medtronic
settlement, we completed the removal of the bio-d(R) from the market on January
31, 2003. In addition, Medtronic agreed to discontinue its participation in the
lawsuit brought by the University of Florida Tissue Bank, Inc., Regeneration
Technologies, Inc., Sofamor Danek Group, Inc. and Sofamor Danek L.P. (see
"University of Florida Tissue Bank, Inc. v. Osteotech, Inc."), to neither fund
nor voluntarily assist RTI or any other party to continue to pursue this suit
against us, and to contact RTI, inform it of the terms of this settlement and
recommend to RTI to accept the terms of this settlement in complete resolution
of its suit against us.
We recorded a charge of $1,785,000 in the second quarter of 2002
representing the present value of the amounts due to Medtronic under this
settlement. This charge is reflected as a litigation settlement charge in the
consolidated statements of operations.
33
University of Florida Tissue Bank, Inc. v. Osteotech, Inc.
In February, 1999, Southeast Tissue Alliance, formerly known as the
University of Florida Tissue Bank, Inc. ("Southeast"), Regeneration
Technologies, Inc. ("RTI"), Sofamor Danek Group, Inc. and Sofamor Danek L.P.
filed a complaint against us in the United States District Court for the
Northern District of Florida alleging that our bio-d(R)infringed on the claims
of U.S. Patent Nos. 5,814,084, 4,950,296 and 6,096,081.
In April, 2002 Medtronic settled its portion of this lawsuit with us
pursuant to the Medtronic Settlement discussed above. In June, 2002, Southeast
and RTI settled their portions of this lawsuit with us under the same terms as
the Medtronic Settlement without any additional monetary payments.
Regner v. Inland Eye & Tissue Bank of Redlands; Thacker v. Inland Eye &
Tissue Bank of Redlands; Savitt v. Doheny Eye and Tissue Bank; Sorrels, Decker
and Blake v. Inland Eye & Tissue Bank, et. al.
We are a defendant, with several other defendants, in three actions
pending in the Superior Court for the State of California, Los Angeles County.
One of the suits seeks class action status and initially alleged causes of
action based on a violation of the California Business and Professional Code
Section 17200, as well as a number of common law causes of action, including
negligence, deceit, and intentional and negligent infliction of emotional
distress. Through dismissals, either by the Court or voluntarily by plaintiffs,
only the California Business and Professional Code claims, which are based on
the allegation that defendants are engaging in the activity of buying or selling
organs or tissue for valuable consideration or profit, and certain negligence
claims remain with respect to the actions. It appears that plaintiffs are
seeking class action status and injunctive relief and "restitution" with respect
to their California Business and Professional Code claims. To the extent any of
the other causes of action lie against us, plaintiffs are seeking damages in an
unspecified amount. Although this litigation has been pending for some time,
significant discovery has only recently commenced. Plaintiffs filed a motion for
leave to file a Fourth Amended Complaint to allow the adding of two additional
class representatives and to make other changes to the complaint, which motion
was denied without prejudice on February 3, 2003. Plaintiffs' counsel have
recently indicated that, rather than seek to amend the Regner complaint, they
plan to file three new actions on behalf of three plaintiffs alleging claims
similar to those asserted in the Regner case. We also expect the court to set a
schedule for a class certification motion in the near future.
On March 24, 2003, we were served with a new similar action, Sorrels,
Decker and Blake v. Inland Eye & Tissue Bank, et al. This action purports to be
a class action and alleges violations of Section 17200 and negligence against
us.
We believe that the claims made against us in this action are without
merit and will continue to vigorously defend against such claims.
34
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. 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 the case was formally
dismissed on December 30, 2002. 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 operation or financial condition.
Musculoskeletal Transplant Foundation v. Osteotech, Inc.
In October, 2000, the Musculoskeletal Transplant Foundation ("MTF") and
Synthes Spine Company, L.P. ("Synthes") commenced an action against us in the
United States District Court for the District of New Jersey. Plaintiffs sought a
declaratory judgment that their manufacture, use, sale and/or offer for sale of
their demineralized bone matrix products, known as DBX(R), do not infringe on
the claims of our U.S. Patent Nos. 5,290,558 and 5,284,655, and that the Patents
are invalid and unenforceable.
By agreement dated June 1, 2002, the parties have settled this action. The
settlement included the execution of a new processing agreement between MTF and
us, an agreement by MTF and Synthes not to challenge the validity or
enforceability of any claims related to the aforementioned patents, and we
granted MTF and Synthes a non-exclusive, worldwide license under the
aforementioned patents to sell, distribute, import and/or export certain bone
filler products, including MTF's DBX(R) product, that are comprised of
demineralized and/or partially demineralized bone powder in carriers.
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 alleged 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 plaintiff and us. In October, 2002, the parties reached an agreement 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.
Younger v. Hayes Medical Center, Inc.
In April, 2001, we were served in an action brought in the Twentieth
Judicial District Court in Ellis County, Kansas against Hayes Medical Center,
Inc., MTF, Metropath, Inc. and us. With respect to us, the suit alleged a cause
of action for negligence in connection with allegedly defective allograft bone
tissue provided by defendants and allegedly implanted in plaintiff during a
surgical procedure. In May, 2002, plaintiff voluntarily dismissed this action
without prejudice.
35
Wright Medical Technology, Inc. v. Osteotech, Inc.
In June, 2001, Wright Medical Technology, Inc. ("Wright") filed a
complaint against us in the United States District Court for New Jersey, which
alleged claims for false advertising, and related causes of action concerning
certain statements allegedly made by us regarding a FDA Warning Letter received
by Wright with respect to a tissue product marketed by Wright.
On June 14, 2002, the parties settled this action. The settlement of this
action did not have a material impact on our results of operations or financial
condition.
Hardman v. Nussbaum
ARC notified us in the first quarter of 2002 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. On December 2, 2002, ARC moved for summary judgment dismissing all
of plaintiff's claims. After ARC filed its summary judgment papers, the
plaintiff voluntarily dismissed ARC from the case.
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 other than us. 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. On November 14, 2002, the Court entered a scheduling order setting
forth the pertinent deadlines to which the parties must adhere. Plaintiff missed
a February 7, 2003 deadline for submitting expert reports. We moved to strike
all expert testimony on behalf of plaintiff due to plaintiff's failure to
provide the expert reports within the time specified in the Court's scheduling
order. On February 19, 2003, plaintiff's attorney moved to withdraw as counsel
of record. On February 20, 2003, the Court ordered that plaintiff's attorney be
permitted to withdraw as counsel of record.
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.
Other than the foregoing matters, we are not a party to any material
pending legal proceeding. Litigation is subject to many uncertainties and we are
unable to predict the outcome of the pending suits and claims. 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. We are unable to estimate the
potential liability, if any, that may result from the pending litigation.
36
Item 4. Submissions of Matters to a Vote of Security Holders
None.
37
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters
Our Common Stock has been listed on the Nasdaq Stock Market(R) under the
trading symbol "OSTE" since our initial public offering in July 1991.
The following table sets forth the high and low sale prices for the Common
Stock for each of the fiscal quarters during the years ended December 31, 2002
and 2001 based on transaction data as reported by the Nasdaq Stock Market(R).
Year Ended December 31, 2002 High Low
- ---------------------------- ------ -----
First Quarter $ 9.37 $5.75
Second Quarter $ 8.29 $6.39
Third Quarter $11.01 $5.16
Fourth Quarter $ 6.92 $4.59
Year Ended December 31, 2001 High Low
- ---------------------------- ------ -----
First Quarter $ 7.44 $4.50
Second Quarter $ 6.00 $4.00
Third Quarter $ 5.20 $2.13
Fourth Quarter $ 6.35 $2.91
As of March 17, 2003, there were 337 holders of record of Osteotech Common
Stock. We believe that there are approximately 5,200 beneficial owners of our
Common Stock.
We have never paid a cash dividend and do not anticipate the payment of
cash dividends in the foreseeable future as earnings are expected to be retained
to finance our growth. Declaration of dividends in the future will remain within
the discretion of our Board of Directors, which will review our dividend policy
from time to time. Our loan agreement with our bank prohibits us from paying any
cash dividend without the written consent of the bank.
38
We have three stock option plans all of which have been approved by our
shareholders. Two of the plans, the 1991 Stock Option Plan and the 1991
Independent Directors Stock Option Plan, do not have any shares available to
grant new options and all shares underlying outstanding options that expire or
are forfeited prior to exercise are cancelled upon return to these plans. See
Note 14 of "Notes to Consolidated Financial Statements." The following table
sets forth certain information relative to our stock option plans.
Number of securities
remaining available
Number of securities to be for future issuance under
issued upon exercise of Weighted-average exercise equity compensation plans
outstanding options, price of outstanding (excluding securities
Plan Category warrants and rights options, warrants and rights reflected in column (a))
- ------------- -------------------------- ---------------------------- ------------------------
(a) (b) (c)
Equity compensation plans
approved by security holders 2,405,312 $9.26 150,105
--------- ----- -------
Equity compensation plans not
approved by security holders
--------- ----- -------
Total 2,405,312 $9.26 150,105
--------- ----- -------
39
Item 6. Selected Financial Data
Set forth below is the selected financial data for the five fiscal years
ended December 31, 2002. The following data should be read in conjunction with
our consolidated financial statements and related notes thereto contained
elsewhere herein and "Management's Discussion and Analysis of Financial
Condition and Results of Operations." All per share data have been adjusted for
the three-for-two stock split in the form of a 50% stock dividend we effected in
March, 1999.
Selected Financial Data
(dollars in thousands except per share
data)
For the Year ended December 31, 2002 2001 2000 1999 1998
------- ------- ------- ------- -------
Consolidated Results of Operations
Net revenues $83,374 $75,715 $74,111 $73,642 $57,076
Gross profit 36,788 42,410 47,474 50,639 40,473
Operating expenses 42,183 48,677 40,199 32,705 23,869
Income (charge) from
litigation settlement (1,785) 0 1,000 2,000 0
Operating income (loss) (7,180) (6,267) 8,275 19,934 16,604
Other income, net 29 129 1,019 1,133 978
Income (loss) from continuing
operations before income taxes (7,151) (6,138) 9,294 21,067 17,582
Income (loss) from continuing operations (1,437) (4,040) 5,220 12,534 10,473
Income (loss) from continuing
operations per share
Basic (.09) (.29) .37 .89 .79
Diluted (.09) (.29) .37 .85 .74
Dividends per share 0 0 0 0 0
Year End Financial Position
Working capital $41,919 $24,439 $29,123 $37,082 $26,373
Total assets 115,085 107,244 104,438 89,730 57,114
Long-term obligations, net of current
portion 15,922 18,683 19,930 6,359 0
Stockholders' equity 83,495 67,786 71,851 69,406 45,930
In 2002 and 2001, we recorded certain gains and charges that are detailed
in Note 4 of the "Notes to Consolidated Financial Statements." In July, 2002, we
completed the sale of the business and substantially all of the assets,
including the assumption of certain liabilities, of our operations located in
Leiden, The Netherlands. See Note 5 of "Notes to Consolidated Financial
Statements." The consolidated statements of operations for all periods have been
restated to reflect this divestiture as a discontinued operation.
40
Item 7. Management's Discussion And Analysis Of Financial Condition And Results
Of Operations
For the Three Years Ended December 31, 2002, 2001, and 2000
Results of Operations
Overview
We provide services and products primarily focused on the repair and
healing of the musculoskeletal system. Based on our knowledge of the allograft
bone tissue industry, we believe that we are the world's largest processor and
developer of human bone and bone connective tissue. The allograft bone tissue we
process is procured by independent tissue banks and other Tissue Recovery
Organizations, or TRO's, primarily through the donation of tissue from deceased
human donors and is used for transplantation. We process allograft bone tissue
for our clients from allograft bone tissue provided by them, and also for us
from allograft bone tissue recovered by TRO's for us in both our Grafton(R) DBM
Segment and Base Tissue Segment.
We provide services and technology associated with making human tissue
safe for transplantation. We also develop and process tissue forms for use in a
variety of surgical procedures. While we perform the medical education to teach
surgeons about the uses of these tissue forms, prior to 2001 these tissue forms
were generally distributed to hospitals and surgeons by our tissue bank clients.
Commencing in the first half of 2001, and expanding throughout the
remainder of 2001 and throughout 2002, we began to distribute tissue forms
directly to hospitals and surgeons. We expect to continue to expand our direct
distribution efforts in 2003 and beyond. As a result, we expect that revenues
from direct distribution of tissue will continue to grow over the next several
years. In turn, we expect that as revenues grow from this distribution strategy,
we expect to experience a positive impact on gross profit margins and operating
income because although we will incur recovery costs in connection with tissue
we distribute directly, we will not share a portion of the invoice price on
these tissue forms with our tissue bank clients as we do with the tissue that we
process for them, but they distribute. For the years ended December 31, 2002 and
2001, 61% and 79%, respectively, of our consolidated revenues were generated
from processing tissue that our tissue bank clients distributed.
This change in distribution methodology has impacted our liquidity and
cash flow. We have had to make additional investments in inventories and
deferred processing costs to support our direct distribution efforts, and expect
to make additional investments in inventory and deferred processing costs, as
necessary, to support our efforts to expand direct distribution. As a greater
percentage of our revenues are generated from direct shipments to hospitals and
surgeons, which typically pay invoices slower than our historical tissue bank
customer base, we expect that our days sales in accounts receivable will
increase slightly.
Exclusive of the funds we raised in the sale of 2.8 million shares of
common stock in the second quarter of 2002, which generated net proceeds of
$15,756,000, in 2002 and 2001 we
41
experienced a decrease in available cash, cash equivalents and short-term
investments due to our continued investments in our business and from operating
losses incurred in 2002 and 2001. (See "Liquidity and Capital Resources" and
Note 14 of "Notes to Consolidated Financial Statements.") We expect to continue
to make investments in our business to support our direct distribution efforts
and future programs and initiatives, which may further deplete our available
cash balances. We believe that our available cash, cash equivalents and
short-term investments, available lines of credit and anticipated future cash
flow from operations will be sufficient to meet our forecasted cash needs in
2003. However, we may seek additional funding to meet the needs of our long-term
strategic plan. There can be no assurance that such additional funds will be
available, or if available, that such funds will be available on favorable
terms.
Critical Accounting Policies and Estimates
Our discussion and analysis of financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of our financial statements requires us to make
estimates and judgments that effect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates and may adjust them
based upon the latest information available to us. These estimates generally
include those related to product returns, bad debts, inventories including
purchase commitments, deferred processing costs including rework reserves,
intangible assets, income taxes and contingencies and litigation. We base our
estimates on historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying value of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from
these estimates.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements.
o We maintain allowances for doubtful accounts, primarily for our
direct distribution accounts, for estimated losses resulting from
the inability of our customers to make required payments. If the
financial condition of our customers were to deteriorate, resulting
in an impairment of their ability to make payments, additional
allowances may be required.
o We record reductions to revenue for estimated product and allograft
bone tissue form returns based upon historical experience. If future
returns are less than our historical experience, a reduction in
estimated reserves would increase revenue. Alternatively, should
returns exceed historical experience, additional allowances would be
required, which would reduce revenue.
o We write down inventory and deferred processing costs for estimated
excess, obsolescence or unmarketable products and allograft bone
tissue forms equal to the difference between cost and the estimated
market value based upon assumptions about future demand and market
conditions. Excess and obsolescence could occur from
42
numerous factors, including, but not limited to, the competitive
nature of the market, technological change and changes in surgeon
preference. If actual market conditions are less favorable than
those projected by management, additional write-downs may be
required. In addition, we provide reserves, if any, for the
difference between our contractual purchase commitments and our
projected purchasing patterns based upon the maintenance of adequate
inventory levels and forecasted revenues. If actual revenue is less
favorable than those forecasted by management, additional reserves
may be required; alternatively, if revenue is stronger than
forecasted by management, such reserves would be reduced.
o We depreciate/amortize our property, plant and equipment based upon
our estimate of the respective asset's useful life. In addition, we
evaluate impairments of our property, plant and equipment based upon
an analysis of estimated undiscounted future cash flows. If the
Company determines that a change is required in the useful life of
an asset, future depreciation/amortization is adjusted accordingly.
Alternatively, should we determine that an asset has been impaired,
an adjustment would be charged to income based on its fair market
value, or discounted cash flows if the fair market value is not
readily determinable, reducing income in that period.
o We record a valuation allowance to reduce our deferred tax assets to
the amount that is more likely than not to be realized. While we
have considered future taxable income, in the event we were to
determine that we would be able to realize our deferred tax assets
in the future in excess of our net recorded amount, an adjustment to
the deferred tax asset would increase income in the period such
determination was made. Likewise, should we determine that we would
not be able to realize all or part of our net deferred tax asset in
the future, an adjustment to the deferred tax asset would be charged
to income in the period such determination was made.
o We accrue current and future tax liabilities based upon levels of
taxable income, tax planning strategies and assessments of the
timing of taxability of tax attributes. While we have considered
current tax laws in establishing our tax liabilities, in the event
we were to settle our tax liabilities for less than amounts accrued
we would increase income in the period such determination was made.
Should we determine it would cost us more to settle our tax
liabilities, an adjustment would be charged to income thus reducing
income in that period.
o Litigation is subject to many uncertainties and management is unable
to predict the outcome of the pending suits or claims. When we are
reasonably able to determine the probable minimum or ultimate
liability, if any, that may result from any of the pending
litigation, we will record a provision for such liability, and if
appropriate, will reduce such liability to the extent covered by
insurance. If the outcome or resolution of the pending suit or claim
is for amounts greater than we have accrued, an adjustment will be
charged to income in the period the determination is made.
Alternatively, should the suit or claim be for less than we have
accrued, we would increase income in the period the determination is
made.
43
Temporary Suspension of Base Tissue Segment Processing
On September 30, 2002, we voluntarily and temporarily suspended Base
Tissue Segment processing due to higher than normal incidence of sterility
failures on finished forms of processed allograft bone tissue, which occurred in
our Eatontown facility, and subsequently, in our Shrewsbury facility. In
addition, 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 although all such
tissue was tested and found sterile. In October, 2002, we restarted Base Tissue
Segment processing in our Shrewsbury facility, and in November, 2002 we
restarted Base Tissue Segment processing in our Eatontown facility.
As a result of the temporary suspension of Base Tissue Segment processing,
we placed tissue processed in third quarter 2002 from 693 donors in quarantine.
We expect to rework and/or release all quarantined tissue in 2003. We will
invoice our clients and/or our customers for this tissue when it is shipped. We
have estimated that the cost to rework this tissue is $840,000. 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, however, there can be no certainty that we will be able to
meet all such requirements or be able to rework this tissue for our estimated
cost.
These events have negatively impacted our 2002 operating results. We have
estimated that third quarter 2002 Base Tissue Segment revenues were negatively
impacted by approximately $1,300,000 and gross profit was impacted by the lost
revenues and by the $840,000 estimated cost to rework the tissue in quarantine.
We have estimated that fourth quarter 2002 Base Tissue Segment revenues were
negatively impacted by approximately $1,100,000, while gross profit was impacted
by the lost revenues and the effects of negative production variances, which we
estimate were approximately $3,000,000.
Income (Loss) from Continuing Operations
We incurred a consolidated loss from continuing operations in 2002 of
$1,437,000 or $.09 diluted loss per share compared to a consolidated loss from
continuing operations of $4,404,000 or $.29 diluted loss per share in 2001 and
consolidated income from continuing operations of $5,220,000 or $.37 diluted
income per share in 2000. The loss from continuing operations 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; a reserve of $647,000 for the
penalty associated with metal spinal implants, primarily Affirm(TM), that we do
not expect to purchase, which are subject to purchase commitments; $2,801,000
for excess and obsolete inventory related to spinal implant systems, including
the bio-d(R) Threaded Cortical Bone Dowel, which we removed from the market on
January 31, 2003 in connection with the lawsuit settlement with Medtronic, Inc.;
and $1,071,000 associated with payment to Medtronic in connection with the
litigation settlement; partially offset by the recognition of an income tax
benefit of $2,557,000 related to liabilities for tax benefits recorded in 1997
that are no longer required 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 loss from continuing operations in 2001 includes after tax charges of:
44
$1,107,000 related to provisions for excess inventory and instrument sets for
spinal implant systems; $1,372,000 for equipment which is no longer utilized in
the processing of allograft tissue; and $420,000 primarily for severance costs
associated with the departure of an executive officer. Income from continuing
operations in 2000 included an after tax gain of $600,000 related to the patent
litigation settlement with DePuy AcroMed, Inc. ("DePuy").
The consolidated loss from continuing operations before income taxes was
$7,151,000 in 2002 and $6,138,000 in 2001 compared to income from continuing
operations before taxes of $9,294,000 in 2000.
Discontinued Operations
On July 10, 2002, effective June 30, 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 $1,630,000 in 2002
through the date of sale and were $2,131,000 and $1,572,000 in 2001 and 2000,
respectively. The business had net income of $384,000 in 2002 through the date
of sale, compared to a net loss of $370,000 and $392,000 in 2001 and 2000,
respectively.
Net Income (Loss)
We had a consolidated net loss in 2002 of $1,344,000 or $.08 diluted net
loss per share compared to a consolidated net loss of $4,410,000 or $.31 diluted
net loss per share in 2001 and consolidated net income in 2000 of $4,828,000, or
$.34 diluted net income per share.
The following is a discussion of factors affecting results of operations
for the years ended December 31, 2002, 2001, and 2000 after giving effect to the
divestiture of the operations of our subsidiary in The Netherlands.
Net Revenues
Consolidated net revenues increased 10% in 2002 to $83,374,000 compared to
consolidated revenues of $75,715,000 in 2001. The increase in 2002 was
principally due to higher revenues in all segments mainly as a result of
increased volume, and to a lesser extent by price increases effective January 1,
2002. This increase was achieved even though revenues were constrained by the
temporary suspension of Base Tissue Segment processing operations and from
placing tissue in quarantine that otherwise would have been released and
invoiced to our clients, and by the suspension of sales of Affirm(TM). Domestic
net revenues increased 9% in 2002 to $78,576,000 from $71,776,000 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 29% decline in base
allograft tissue processing revenues due to the temporary suspension of base
tissue processing and a
45
decrease in the number of donors processed for our clients in 2002 compared to
2001 and by the suspension of sales of Affirm(TM). Foreign-based revenues
increased 22% in 2002 to $4,798,000 from $3,939,000 in 2001. The increase in
foreign-based revenues was due to increased unit sales volume in all product
lines. Consolidated net revenues in 2001 increased 2% to $75,715,000 compared to
consolidated revenues of $74,111,000 in 2000. The increase in 2001 was
principally due to higher revenues in bio-implants and product lines in other
revenue mainly as a result of increased volume, partially offset by a decrease
in Grafton(R) DBM revenues as a result of reduced unit sales volume and a
decrease in base tissue processing revenues as a result of processing 33% fewer
donors in 2001 compared to 2000. Domestic net revenues increased slightly in
2001 to $71,776,000 from $71,468,000 in 2000. Foreign-based revenues increased
49% to $3,939,000 in 2001 from $2,643,000 in 2000. The increase in foreign-based
revenues was primarily a result of increased unit sales volume in all product
lines.
Grafton(R) DBM Segment revenues increased 3% in 2002 to $44,926,000 from
$43,637,000 in 2001 primarily due to increased world-wide unit volume and the
impact of 2002 price increases. Domestic Grafton(R) DBM Segment revenues
increased 3% in 2002 to $42,883,000 from 2001 revenues of $41,683,000.
Foreign-based Grafton(R) DBM Segment revenues increased 5% in 2002 to $2,043,000
from $1,954,000 in 2001. Grafton(R) DBM Segment revenues in 2001 of $43,637,000
decreased 4% from revenues of $45,226,000 in 2000. Foreign-based Grafton(R) DBM
Segment revenues increased 119% in 2001 to $1,954,000 from $891,000 in 2000,
principally due to an increase in unit sales volume. Domestic Grafton(R) DBM
Segment revenues decreased 6% to $41,683,000 in 2001 from $44,335,000 in 2000.
In 2001, domestic Grafton(R) DBM Segment revenues were negatively impacted by a
decrease in unit sales volume as a result of increased competition. In 2002 and
2001, Grafton(R) DBM faced, and we expect it will continue to face, increasing
competition as more companies develop and market products with characteristics
similar to Grafton(R) DBM.
Base Tissue Segment revenues increased 16% to $32,115,000 in 2002 from
$27,692,000 in 2001. The increase is principally the result of a 70% increase in
bio-implant revenues and a 19% increase in OsteoPure(TM) Femoral head processing
revenues, partially offset by a 26% decrease in base tissue processing revenues
resulting from the temporary suspension of base tissue processing and a decrease
in the number of donors processed for our clients in 2002 compared to 2001. The
increase in bio-implant revenues is principally 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 surgeons, and
the effects of the January 1, 2002 price increases. Base Tissue Segment revenues
increased 6% to $27,692,000 in 2001 from $26,204,000 in 2000. The increase is
principally the result of a 225% increase in bio-implant revenues and a 29%
increase in OsteoPure(TM) Femoral head processing revenues, partially offset by
a 31% decrease in base tissue processing revenues resulting from a decline in
the number of donors processed for our clients. The increase in bio-implant
revenues is principally due to increased unit volume and the ability to charge
higher unit sale prices as a result of our direct distribution of some of those
units to hospitals.
Revenues from other product lines increased 44% in 2002 to $6,333,000 from
$4,386,000 in 2001. The increase principally resulted from improved volume in
spinal metal implant systems
46
and bovine products. Revenues from other product lines increased 64% in 2001 to
$4,386,000 from $2,681,000 in 2000. The increase principally resulted from
improved volume in spinal metal implant systems and bovine products.
During 2002, 2001, and 2000, two of our clients, MTF and ARC, in the
Grafton(R) DBM and Base Tissue Segments together accounted for 59%, 77%, and 92%
of consolidated net revenues, respectively. We have processing agreements with
each of these clients, which expire in December, 2008 and December, 2006,
respectively. See Item 1. "Clients" and Note 13 of "Notes to Consolidated
Financial Statements" for more information on these processing agreements.
Gross Profit
Gross profit as a percentage of net revenues was 44% in 2002, 56% in 2001,
and 64% in 2000. The decline in gross profit as a percentage of revenues in 2002
compared to 2001 is primarily due to: (i) pre-tax charges of $6,588,000 for the
estimated cost to rework the tissue from donors placed in quarantine in 2002,
excess and obsolete inventory related to spinal implant systems and reserves for
metal spinal implants that we do not expect to purchase, which are subject to a
firm purchase commitments; (ii) the decline in base tissue processing revenues
due to the temporary suspension of base tissue processing; (iii) the decline in
donors processed for our clients; and (iv) the negative impact of
underabsorption of production variances in the fourth quarter due to lower than
normal allograft bone tissue processing levels due to the temporary suspension
of base tissue processing in our two production facilities. The decline in gross
profit as a percentage of revenues in 2001 compared to 2000 principally resulted
from: (i) our direct distribution efforts which reduced gross profit margin by
two percentage points in 2001 as a result of incurring additional costs
equivalent to the incremental revenue we are recognizing from these efforts;
(ii) the negative impact of underabsorption of fixed costs due to increased
capacity as a result of our new processing facility, a 33% decline in the number
of donors processed, costs associated with implementation of new processing
technologies, and bio-implant and metal spinal implant product lines that have
not yet achieved revenue levels sufficient to fully absorb production costs;
(iii) a decline in base tissue processing revenue as a result of a 33% decline
in the number of donors processed; (iv) charges for excess metal spinal implant
inventory of $655,000; and (v) a $2,287,000 charge for equipment which will no
longer be utilized in our processing of allograft tissue.
We believe that the continued expansion of our direct distribution efforts
will have a positive impact on our gross profit margins because although we will
incur recovery costs in connection with tissue we distribute directly, we will
not share a portion of the invoice price with our tissue bank clients as we do
with tissue that we process for them and which they distribute. In addition, we
continue to develop and implement programs to improve gross profit margin
through cost cutting initiatives, efficiency gains and reductions in the cost of
materials. However, we cannot provide any assurance that any of these programs
will be successful.
Marketing, Selling, General and Administrative Expenses
Marketing, selling, general and administrative expenses decreased 14% in
2002 to $38,256,000 from $44,305,000 in 2001. In 2001, marketing, selling,
general and administrative
47
expenses were 28% higher than 2000 expenses of $34,652,000. The decrease in 2002
relates mainly to: (i) decreased legal fees due to the settlement of a number of
our lawsuits in late 2001 and 2002, see Item 3. "Legal Proceedings" and Note 13
of "Notes to Consolidated Financial Statements" for a discussion of the
settlement of lawsuits; (ii) a rescission in our funding of the American Tissue
Services Foundation; (iii) decreased marketing costs due to the launch in 2001
of new bio-implant tissue forms, which increased 2001 marketing costs; and (iv)
in 2001 provisions of $1,190,000 for reserves primarily for excess instruments
sets associated with spinal implant systems and $700,000 for severance costs
primarily related to the departure of an executive officer. The increase in 2001
over 2000 relates mainly to: (i) activities to secure additional sources of
donated allograft tissue resulting in expenditures of $2,714,000, which included
provisions related to our funding of the American Tissue Services Foundation;
(ii) increased legal fees in connection with various lawsuits to which we were a
party; (iii) increased costs related to marketing, selling and promotional
activities associated with Grafton(R) DBM and the new bio-implant tissue forms;
(iv) a provision of $1,190,000 for excess instrument sets associated with spinal
implant systems; and (v) a $700,000 provision for severance costs related
primarily to the departure of an executive officer.
Research and Development Expenses
Consolidated research and development expenses decreased 10% in 2002 to
$3,927,000 from $4,372,000 in 2001. Research and development expenses in 2001
decreased 21% from 2000 research and development expenses of $5,547,000. The
decrease in 2002 from 2001 and 2001 from 2000 principally related to the
completion of the development of bio-implant tissue forms, which were launched
in 2001, but the development costs were recognized in 2001 and 2000; the
completion of new processing technology and packaging, which were implemented in
2001; and the completion of development of Grafton Plus(TM) DBM, which was
launched in the first quarter of 2002.
Income (Charge) From Litigation Settlement
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 Item 3. " Legal Proceedings" and Note 13 of "Notes to
Consolidated Financial Statements".
In November, 1999, we settled all claims which we had filed against DePuy
in the patent infringement lawsuit against GenSci Labs and GenSci Sciences. As
part of the settlement, DePuy agreed to stop selling the GenSci products accused
of infringing our patents no later than February 4, 2001 and to pay us
$3,000,000. We received payments and recognized income of $250,000 in each
quarter of 2000. The remaining portion of the settlement of $2,000,000 was
received in 1999.
Operating Income (Loss)
We incurred a consolidated operating loss in 2002 of $7,180,000 compared
to a consolidated operating loss of $6,267,000 in 2001. Grafton(R) DBM Segment
operating income
48
increased 40% in 2002 to $9,836,000 from $7,014,000 in 2001. The increase in
Grafton(R) DBM Segment operating income results principally from: (i) decreased
legal fees due to the resolution of lawsuits in late 2001 and second quarter
2002; (ii) increased revenue levels; (iii) lower research and development costs
associated with the development of Grafton Plus(TM) DBM, which was launched in
the first quarter of 2002; and (iv) lower marketing and selling costs. We
incurred an operating loss in the Base Tissue Segment of $9,165,000 in 2002
compared to an operating loss of $7,979,000 in 2001. The Base Tissue Segment
operating loss principally resulted from: (i) the underabsorption of production
variances due to lower than normal allograft bone tissue processing levels as a
result of the temporary suspension of base tissue processing in our two
production facilities; (ii) the decline in base tissue processing revenues due
to the temporary suspension of base tissue processing and a decline in the
number of donors processed for our clients; (iii) reserves of $840,000 related
to the estimated cost to rework tissue from donors placed in quarantine; (iv)
costs associated with the settlement of the patent litigation regarding the
bio-d(R) Threaded Cortical Bone Dowel, including the cost of excess inventory of
$1,094,000 and the litigation settlement charge of $1,785,000; (iv) increased
legal fees; and (vi) a decline in donor processing revenue. Operating losses
associated with other revenues were $7,851,000 and $5,302,000 in 2002 and 2001,
respectively. The operating loss in 2002 increased over the operating loss in
2001 principally as a result of provisions of $4,654,000 for excess inventory
and instrumentation for metal spinal implant systems and reserves related to the
penalty associated with metal spinal implants, primarily Affirm(TM), that we do
not expect to purchase, which are subject to a purchase commitments, partially
offset by a decline in our funding of the American Tissue Services Foundation.
We incurred a consolidated operating loss in 2001 of $6,267,000 compared
to consolidated operating income of $8,275,000 in 2000. Grafton(R) DBM Segment
operating income decreased 38% in 2001 to $7,014,000 from $11,389,000 in 2000.
The decrease in Grafton(R) DBM Segment operating income resulted principally
from: (i) increased costs associated with marketing, selling and promotional
activities; (ii) increased legal fees; (iii) reduced revenue levels; and (iv) a
decrease in patent litigation settlement payments of $1,000,000. We incurred an
operating loss in the Base Tissue Segment of $7,979,000 in 2001 compared to
operating income of $694,000 in 2000. The operating loss in the Base Tissue
Segment principally resulted from: (i) lower gross margins due to our direct
distribution activities; (ii) a decline in donor processing revenue; (iii) the
underabsorption of processing costs; (iv) increased legal fees; (v) provisions
for excess instrument sets and equipment which will no longer be utilized in our
production process; and (vi) increased costs for marketing, selling and
promotional activities primarily associated with bio-implants. Operating losses
associated with other revenues were $5,302,000 and $3,808,000 in 2001 and 2000,
respectively. The operating loss in 2001 increased over the operating loss in
2000 principally as a result of provisions for excess inventory and
instrumentation for metal spinal implant systems and reserves for our funding of
the American Tissue Services Foundation.
Other Income (Expense)
Other expense was $29,000 in 2002 compared to other income of $129,000 in
2001. The decrease was associated with an increase in interest expense on our
long-term debt as a result of higher interest rates and the recognition of
interest expense on the debt for a full year in 2002 as
49
compared to only a portion of the year in 2001 as the interest costs were
capitalized during the construction of our new allograft processing facility and
a decline in interest income as a result of lower interest rates, partially
offset by the $950,000 gain on the sale of the PolyActive(TM) polymer
biomaterial technology and patents. In 2001, other income decreased $890,000 to
$129,000 from $1,019,000 in 2000. The decrease was principally due to lower
interest income as a result of a decline in interest rates and lower average
cash balances available for investment and interest expense on our long-term
debt. Prior to 2001, 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.
Income Tax Provision
In 2002 and 2001, we provided a benefit for income taxes primarily due to
losses in our domestic operations and our ability to carryback and carryforward
these losses. We did not recognize any income taxes on foreign income in 2002
due primarily to our ability to utilize previously unrecognized foreign net
operating loss carryforwards, which carry a full valuation allowance. In
addition, we reversed liabilities for previously deferred tax benefits of
$2,557,000 that are no longer required. In 2002, we utilized approximately
$2,000,000 of historical foreign net operating loss carryforwards to offset
foreign taxable income. In 2001, no income tax benefit was recorded for foreign
losses, principally as a result of the uncertainty of realization of such future
tax benefits.
Our effective income tax rate in 2000 was 46%. The effective income tax
rate exceeded the federal statutory income tax rate principally due to the
non-recognition for tax purposes of foreign operating losses and the impact of
domestic state income taxes.
Liquidity and Capital Resources
At December 31, 2002 we had cash and short-term investments of $13,988,000
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 $17,480,000 to $41,919,000 at December
31, 2002 compared to $24,439,000 at December 31, 2001. The increase resulted
primarily from the net proceeds received from the sale of 2.8 million shares of
our common stock, proceeds from the sale of the PolyActive(TM) polymer
biomaterial technology and patents and the sale of the operations of our
subsidiary in The Netherlands.
Net cash used in operating activities was $1,633,000 in 2002 and
$2,019,000 in 2001. The decrease resulted primarily from the decline in our net
loss in 2002 compared to 2001 and improved collections on accounts receivable,
partially offset by reductions in accounts payable and accrued expenses.
Cash used in investing activities increased to $7,242,000 in 2002 from
$5,360,000 in 2001. The increase is principally due to our net purchases of
short-term investments, partially offset by proceeds from the sale of the
PolyActive(TM) polymer biomaterial technology and patents, the sale of the
operations of our subsidiary in The Netherlands and a decrease in capital
expenditures to
50
$4,911,000 in 2002 from $8,955,000 in 2001 due to reduced spending on the
construction of our new allograft tissue processing facility.
Net cash provided by financing activities in 2002 was $13,654,000, an
increase of $12,028,000 from $1,627,000 in 2001. In 2002, we sold 2.8 million
shares of common stock, which in addition to the exercise of stock options and
sales pursuant to our employee stock purchase plan, generated net proceeds of
$16,284,000. We made $2,629,000 in principal payments pursuant to our long-term
debt.
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 December 31, 2002, $4,214,000 was outstanding under the building mortgage
loan and $14,369,000 was outstanding under the equipment term loan. In 2002, to
support the $1,900,000 due under the settlement of certain patent litigation, we
provided a declining irrevocable standby letter of credit in an original amount
of $1,900,000. (See Item 3. "Legal Proceedings" and Note 13 to "Consolidated
Financial Statements.") As of December 31, 2002, the standby letter of credit
has been reduced to $1,386,000. Amounts committed under this standby letter of
credit decreased over time based on a predetermined schedule concurrent with our
monthly payments under the settlement and reduced the amounts available under
the revolving line of credit. As of December 31, 2002, no amounts were
outstanding under the revolving line of credit and $3,614,000 was available.
In March, 2003, the Credit Facility was amended, to permanently waive our
non-compliance with the interest coverage ratio for the quarter ended December
31, 2002. In addition, if available cash, cash equivalents and short-term
investments decline below $10.0 million at the end of any calendar month, the
amendment gives the bank, at its option, the right to obtain a security interest
in our general intangibles, including, but not limited to, our patents and
patent applications.
The Credit Facility, as amended, is collateralized by domestic accounts
receivable, domestic inventory, the new allograft tissue processing facility,
including all equipment and improvements therein, and a pledge of 65% of our
ownership in our foreign subsidiaries. The Credit Facility, as amended, imposes
on us certain restrictive operating and financial covenants, including a
restriction on our paying cash dividends, a restriction on our incurring or
maintaining additional indebtedness, a restriction on our selling of assets or
engaging in mergers or acquisitions and limitations on our ability to make cash
advances in excess of certain amounts without the prior consent of the bank to
our foreign operations or investments. The Credit Facility also includes
subjective acceleration provisions. Such provisions are based upon, in the
reasonable opinion of the bank, the occurrence of any adverse or material change
in the condition or affairs, financial or otherwise, of our business, which
impairs the interests of the bank. Due to our expectation of improved financial
performance and our expected compliance with our bank covenants in 2003, we
continue to classify the long-term portion of our outstanding bank debt as
long-term. However, there can be no assurance that our financial performance
will improve or that we will comply with our bank covenants. The bank has the
right to approve, in advance, the form and substance of any equity capital
transaction, except for a common stock transaction resulting in the issuance of
less than 20% of our total issued and outstanding capital stock as of the date
of such transaction.
51
Failure to comply with any of these restrictions could result in a default
under this loan facility. Following a default, the bank may determine not to
make any additional financing available under the revolving line of credit,
could accelerate the indebtedness under the revolving credit facility, the
equipment loan and/or the mortgage, and could foreclose on the real and personal
property securing the loans.
At December 31, 2002, we had Federal net operating loss carryforwards of
$1,293,000, which expire in varying amounts beginning in 2007 through 2021, and
state net operating loss carryforwards of $8,801,000, primarily to offset New
Jersey taxable income, which expire in varying amounts beginning in 2007 through
2016. We have provided valuation allowances for $768,000 in Federal, and a
corresponding amount of state, net operating loss carryforwards due to the
uncertainty of realizing future tax benefits from these net operating loss
carryforwards. In addition, we have Federal research and development credits of
$288,000, which expire in varying amounts beginning in 2021 through 2022, and
state research and development and manufacturing credits of $748,000, primarily
to offset New Jersey income taxes, which expire in varying amounts beginning in
2005 through 2009. At December 31, 2002, certain of our foreign-based
subsidiaries have net operating loss carryforwards aggregating $6,606,000
expiring in varying amounts beginning 2004 through 2010. We have not recognized
any benefit from these net operating loss carryforwards in the consolidated
financial statements because realization of the future tax benefits is
uncertain. See Note 12 of "Notes to Consolidated Financial Statements."
In February, 2001, we entered into a distribution agreement with Alphatec
Manufacturing, Inc., or Alphatec, to market 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. A
penalty of 50% of any shortfall in the purchase commitment is required to be
paid at the end of the first year of the commitment period and quarterly
beginning in the second year of the commitment period. 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. 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. In October, 2002, because of a higher than normal level of
complaints, we suspended the sale and distribution of Affirm(TM). Due to the
continued uncertainty surrounding the re-introduction of Affirm(TM) into the
market, we have established a provision for all implant inventory and
instrumentation of $1,430,000. In addition, due to this uncertainty, we have
estimated that we will not purchase sufficient quantities of inventory to meet
the aforementioned purchase commitment. Accordingly, we have recorded a reserve
of $1,079,000 in 2002 for the estimated penalty for the second year commitment.
The following table summarizes our contractual obligations at December 31,
2002, and the effects such obligations are expected to have on our liquidity and
cash flow in future periods.
Less Than After
(In thousands) Total One Year 1-3 Years 3 Years
------- --------- --------- -------
Long-term debt $18,583 $2,661 $ 5,322 $10,600
Non-cancelable operating lease obligations 3,122 797 1,251 1,074
Medtronic litigation settlement payments 1,267 950 317
Purchase commitment(1) 1,721 1,291 430
------- ------ ------- -------
$24,693 $5,699 $ 7,320 $11,674
======= ====== ======= =======
(1) Represents forecasted purchases and the estimated penalty of
$1,079,000 associated with a failure to meet the minimum purchase
requirements. Assumes the purchases and penalties are satisfied
ratably over the commitment period.
52
Exclusive of the funds we raised in the sale of 2.8 million shares of
common stock in the second quarter of 2002, which generated net proceeds of
$15,756,000, in 2002 and 2001, we experienced a decrease in available cash, cash
equivalents and short-term investment due to our continued investments in our
business and the operating losses incurred in 2002 and 2001. We expect to
continue to make investments in our business to support our direct distribution
efforts and future programs and initiatives, which may further deplete our
available cash balances. We believe that our available cash, cash equivalents
and short-term investments, available lines of credit and anticipated future
cash flow from operations will be sufficient to meet our forecasted cash needs
in 2003. Our future liquidity and capital requirements will depend upon numerous
factors, including:
o additional investments, if any, in inventories and deferred
processing costs to support our direct distribution efforts;
o the progress of our product development programs and the need and
associated costs relating to regulatory approvals, if any, which may
be needed to commercialize some of our products under development,
or those commercialized whose regulatory status may change; and
o the resources we devote to the development, manufacture and
marketing of our services and products.
We may seek additional funding to meet the needs of our long-term
strategic plan. We can provide no assurance that such additional funds will be
available, or if available, that such funds will be available on favorable
terms.
Recent Accounting Developments
Effective January 1, 2002, we 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 we are no longer amortizing
goodwill. Amortization of goodwill included in continuing operations was
$132,000 and $136,000 for the years ended December 31, 2001 and 2000,
respectively. Discontinued operations included $252,000 of goodwill amortization
for each of the years ended December 31, 2001 and 2000. In addition, in
accordance with the transition provisions of SFAS No. 142, we completed an
evaluation of the carrying value of our goodwill as of January 1, 2002 and
determined that there was no impact on our consolidated financial statements as
a result of such evaluation.
In June, 2002, the Financial Accounting Standards Board 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,
53
including restructuring activities. SFAS No. 146 is effective for fiscal years
beginning January 1, 2003. We do not expect the adoption of this pronouncement
to have a significant impact on our financial position, results of operations or
cash flows.
In November, 2002, the Financial Accounting Standards Board, or FASB,
issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others, an interpretation of SFAS Statements No. 5, 57 and 107 and Rescission of
FASB Interpretation No. 34", or FIN 45. FIN 45 clarifies the requirements of
SFAS No. 5, "Accounting for Contingencies," relating to the guarantor's
accounting for, and disclosure of, the issuance of certain types of guarantees.
The disclosure requirements of FIN 45 are effective for financial statements of
interim or annual periods after December 15, 2002. The disclosure provisions
have been implemented and no disclosures were required in 2002. The provisions
for initial recognition and measurement are effective on a prospective basis for
guarantees that are issued or modified after December 31, 2002, irrespective of
the guarantor's year-end. FIN 45 requires that upon issuance of a guarantee, the
entity must recognize a liability for the fair value of the obligation it
assumes under that guarantee. Adoption of FIN 45 in 2003 has not and is not
expected to have a material effect on our results of operations, cash flows or
financial position.
In January, 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities - an interpretation of ARB No. 51,"
or FIN 46, which addresses consolidation of variable interest entities. FIN 46
expands the criteria for consideration in determining whether a variable
interest entity should be consolidated by a business entity, and requires
existing unconsolidated variable interest entities (which include, but are not
limited to, Special Purpose Entities, or SPEs) to be consolidated by their
primary beneficiaries if the entities do not effectively disperse risks among
parties involved. This interpretation applies immediately to variable interest
entities created after January 31, 2003, and to variable interest entities in
which an enterprise obtains an interest after that date. It applies in the first
fiscal year or interim period beginning after June 15, 2003, to variable
interest entities in which an enterprise holds a variable interest that it
acquired before February 1, 2003. We do not currently have any SPE's or variable
interest entities, therefore, the adoption of FIN 46 is not expected to have any
impact on our results of operations, cash flows or financial position.
Impact of Inflation and Foreign Currency Exchange Fluctuations
The results of operations for the periods discussed have not been
materially affected by inflation or foreign currency fluctuations.
Litigation
We are involved in various legal proceedings involving product liability
and other matters and claims. For a complete discussion of these matters see,
Item 3. "Legal Proceedings" and Note 13 of "Notes to Consolidated Financial
Statements." It is possible that our results of operations or liquidity and
capital resources could be adversely affected by the ultimate outcome of the
pending litigation or as a result of the costs of contesting such lawsuits.
54
Risk Factors
We may need to secure additional financing to fund our long-term strategic
plan.
Exclusive of the funds we raised in the sale of the 2.8 million shares of
common stock in the second quarter of 2002, which generated net proceeds of
$15,756,000, in 2002 and 2001, we experienced a decrease in available cash, cash
equivalents and short-term investments due to our continued investments in our
business and from operating losses incurred in 2002 and 2001. We expect to
continue to make investments in our business to support our direct distribution
efforts and future programs and initiatives, which may further deplete our
available cash balances. We believe that our available cash, cash equivalents,
and short-term investments, available lines of credit and anticipated future
cash flow from operations will be sufficient to meet our forecasted cash needs
in 2003. Our future liquidity and capital requirements will depend upon numerous
factors, including
o additional investments, if any, in inventories and deferred
processing costs to support our direct distribution efforts;
o the progress of our product development programs and the need and
associated costs relating to regulatory approvals, if any, which may
be needed to commercialize some of our products under development,
or those commercialized whose regulatory status may change; and
o the resources we devote to the development, manufacture and
marketing of our services and products.
We may need to raise additional funds through the issuance of equity
and/or debt financing in private placements or public offerings to provide funds
to meet the need of our long-term strategic plan. Additional funds may not be
available, or if available, may not be available on favorable terms. Further
equity financings, if obtained, may substantially dilute the interest of our
pre-existing shareholders. Any additional debt financings may contain
restrictive terms that limit our operating flexibility. As a result, any future
financings could have a material adverse effect on our business, financial
condition or results of operations.
Failure to comply with covenants under our loan and security agreement
could materially adversely impact our business, financial condition and results
of operations.
We have amended our loan and security agreement and mortgage to obtain a
waiver of a breach of a financial covenant for the year ended December 31, 2002,
to provide revised financial covenants, to grant additional security and to
extend our revolving line of credit through April, 2004. This loan facility
provides a revolving credit facility, an equipment loan and a mortgage. It also
imposes on us certain restrictive operating and financial covenants. The
covenants significantly limit or prohibit, among other things, our ability to
advance or incur additional indebtedness, create liens on our assets, pay
dividends, sell assets, engage in mergers or acquisitions, or make investments
without the consent of the bank. Failure to comply with any of these
restrictions could result in a default under this loan facility. The loan
facility also includes subjective acceleration provisions. Such provisions are
based upon, in the reasonable opinion of the bank, the occurrence of any adverse
or material change in our condition or affairs, financial or
55
otherwise, which impairs the interests of the bank. Following a default, the
lender may determine not to make any additional financing available under the
revolving line of credit, could accelerate the indebtedness under the revolving
credit facility, the equipment loan and/or the mortgage, and could foreclose on
the real and personal property securing the loans. Foreclosure would adversely
affect our continued operations and our ability to repay the indebtedness under
the loan facility. We may not have the funds to repay the debt upon
acceleration. Even if available, the terms of any additional debt or equity
financing that we may incur could restrict our operational flexibility and
thereby adversely affect our business, results of operations and financial
condition.
Our cash flows are expected to be adversely impacted by our focus on
direct distribution.
Commencing in the first half of 2001, we began to distribute tissue forms
directly to surgeons and hospitals. We expect to continue to expand our direct
distribution efforts to surgeons and hospitals in 2003 and beyond. As a result,
we expect that revenues from direct distribution of tissue will grow
significantly as a percentage of our consolidated revenues over the next several
years. This change in distribution methodology has impacted and is expected to
continue to have an impact on our cash flow. As a greater percentage of our
revenues are generated from direct shipments to hospitals and other healthcare
providers, which typically pay invoices slower than our historical customer
base, we expect that our days sales in accounts receivable may increase
slightly.
We are dependent upon two primary clients who together provide a majority
of our revenues.
We are the processor of allograft bone tissue for large national and
international not-for-profit organizations. During 2002, MTF and ARC accounted
for approximately 29% and 30%, respectively, of our revenues. We entered into a
10-year exclusive processing agreement with ARC in December, 1996, which we
amended in 2002, and a non-exclusive processing agreement with MTF in June,
2002, which expires on December 31, 2008. The loss of either MTF or ARC as a
client or a substantial reduction in the amount of allograft bone tissue which
we process for either entity would have a material adverse effect on our
business, financial condition and results of operations.
Our dependence upon a limited supply of human donors may curtail business
expansion.
Our allograft bone tissue processing business primarily depends upon the
availability of bone and related connective tissue from human donors recovered
by our clients and TRO's and tissue banks who recover donated human cadaveric
tissue for us. We rely on the efforts of not-for-profit donor procurement
agencies, including our current clients, to educate the public and foster an
increased willingness to donate bone tissue. These organizations may not be able
to find a sufficient number of persons to donate, or may not be willing to
provide, sufficient amounts of tissue to meet present or future demand for
either allograft bone tissue or any allograft bone tissue-based osteogenic
materials we are developing. Although we have taken steps to address this tissue
supply problem, we cannot assure you that these efforts will be successful in
the future or that we will otherwise be able to secure a sufficient supply of
tissue. Our inability to secure
56
enough donor tissue to meet our demands could have a material adverse effect on
our business, financial condition and results of operations.
We face strong competitive threats from firms with greater financial
resources and lower costs.
The allograft bone tissue we process competes in the bone graft market
with autograft bone tissue, synthetic bone void fillers, growth factors and
allograft bone tissue processed by others, primarily tissue banks. Autograft
bone tissue has traditionally been the primary choice for surgeons and we
believe autograft bone tissue still maintains approximately a 49% share of the
United States bone graft market. In Europe, bone graft substitutes, such as
bovine bone tissue and synthetics, currently comprise most of the bone grafting
market. Many of our competitors have greater financial resources than we do. For
numerous circumstances and procedures for which autograft bone tissue
transplantation is either not feasible or not desirable, there are a number of
competing alternatives available, including allograft bone tissue processed by
others and bone graft substitutes.
In recent years, our Grafton(R) DBM products have faced increasing
competitive pressures as more companies have developed, or have announced they
are developing, products with characteristics similar to Grafton(R) DBM. Certain
of those competitors have, in turn, partnered with large orthopaedic and spine
companies to market the competing products they have developed. We expect that
this competition will continue in the future. Many of these competitors have
research and development, marketing and other resources that are significantly
greater than ours. They also offer a full line of metal implants and other
products used in spinal surgeries. This could give them a competitive advantage
over us since they can offer surgeons a more complete line of products than we
currently can.
We believe that a majority of the cadaveric bone banks operating in the
United States are engaged in processing allograft bone tissue for
transplantation. Many of these bone tissue banks are not-for-profit
organizations, and, as such, they may be able to supply processing services at a
lower cost than we can. Several for-profit companies, certain of which have
substantially greater resources then we do, are processing, marketing and
distributing allograft tissue. We compete with such entities on the basis of our
advanced processing technology and the quality and quantity of the bone tissue
our processing yields. Since we introduced our allograft bone tissue processing
technology in 1987, certain competing processors have claimed to have developed
technology similar to that which we use. We may not be able to compete
successfully in the area of allograft bone tissue processing and distribution.
If we were to lose a patent lawsuit in which another party is asserting
that our products infringe its patents, we would likely be prohibited from
marketing those products and could also be liable for significant damages.
Either or both of these results may have a material adverse effect on our
business, financial condition and results of operations. If we lose a patent
lawsuit in which we are claiming that another party's products are infringing
our patents and thus, are unable to enforce our patents, it may have a material
adverse effect on our business, financial condition and results of operations.
57
Our revenues will depend upon reimbursement from public and private
insurers and national health systems.
The continued ability of our clients to pay our processing charges for the
processing of allograft bone tissue, depends upon our clients' ability to
distribute processed allograft bone tissue and collect fees from their clients,
which are typically hospitals. The ability of hospitals to pay fees to our
clients, or directly to us for allograft bone tissue or non-allograft spinal
implant systems distributed directly by us to the hospitals, depends in part on
the extent to which reimbursement for the costs of such materials and related
treatments will continue to be available from government health administration
authorities, private health coverage insurers and other organizations. We may
have difficulty gaining market acceptance for our products and services if
government and third-party payors do not provide adequate coverage and
reimbursement.
The medical community could choose not to use our allograft bone tissue
products.
We believe the market for allograft bone tissue will continue to be based
primarily upon the use of such products by physicians specializing in the
orthopaedic, neurological and oral/maxillofacial surgical areas. Our future
growth depends in part upon such physicians' wider use of allograft bone tissue
as an alternative to autograft bone tissue and other available materials and
treatments. We have tried to educate physicians through our marketing
activities. Our future efforts in this regard may fail to generate additional
demand for our allograft tissue forms.
Governmental regulation could restrict the use of our products.
In the United States, the procurement and transplantation of allograft
bone tissue is subject to federal law pursuant to NOTA, a criminal statute which
prohibits the purchase and sale of human organs used in human transplantation,
including bone and related tissue, for "valuable consideration." NOTA permits
reasonable payments associated with the removal, transportation, processing,
preservation, quality control, implantation and storage of human bone tissue. We
provide services in all of these areas, with the exception of removal and
implantation and receive payments for all such services. We make payments to
certain of our clients and TRO's and tissue banks for their services related to
recovering allograft bone tissue on our behalf. If NOTA is interpreted or
enforced in a manner which prevents us from receiving payment for services we
render or which prevents us from paying TRO's or certain of our clients for the
services they render for us, our business could be materially, adversely
affected.
We are engaged through our direct sales employees and our independent
sales representatives in ongoing efforts designed to educate the medical
community as to the benefits of processed allograft bone tissue and in
particular our allograft bone tissue forms, and we intend to continue our
educational activities. Although we believe that NOTA permits payments in
connection with these educational efforts as reasonable payments associated with
the processing, transportation and implantation of our allograft bone tissue
forms, payments in connections with such education efforts are not exempt from
NOTA's restrictions and our inability to make such payments in connection with
our education efforts may prevent us from paying our sales representatives for
their education efforts and could adversely affect our business and prospects.
No federal agency or court has determined whether NOTA is, or will be,
applicable to every
58
allograft bone tissue-based material which our processing technologies may
generate. Assuming that NOTA applies to our processing of allograft bone tissue,
we believe that we comply with NOTA, but there can be no assurance that more
restrictive interpretations of, or amendments to, NOTA will not be adopted in
the future which would call into question one or more aspects of our method of
operations.
Our products are extensively regulated by federal and, in certain states,
by state agencies in the United States. Failure to comply with these
requirements may subject us to administrative or judicial sanctions, such as the
FDA's refusal to clear pending applications, warning letters, product recalls,
product seizures, total or partial suspension of production or distribution,
civil penalties, injunctions and/or criminal prosecution.
In the United States, the allograft bone tissues that we process are
regulated by the FDA as human tissue-based products under section 361 of the
Public Health Service Act, and under certain circumstances, may be regulated as
a medical device under the Food, Drug, and Cosmetic Act.
FDA regulations do not require that human tissue-based products be cleared
or approved before they are marketed. We are, however, required to register and
list these products with the FDA and to comply with regulations concerning
tissue donor screening and testing, and related procedures and record keeping.
The FDA periodically inspects tissue processors to determine compliance with
these requirements. The FDA has proposed, but not yet finalized, "Good Tissue
Practice" regulations that would impose requirements on the manufacture of human
tissue-based products, including tissue recovery, donor screening, donor
testing, processing, storage, labeling, packaging, and distribution. The human
tissue-based product category is a relatively new one in FDA regulations, and it
is possible that the FDA will change its approach to human tissue-based products
in general or to particular categories of products to require FDA clearance or
approval or otherwise restrict distribution.
The metal spinal implant products that we distribute in the United States
are regulated by the FDA as medical devices. Medical devices generally require
FDA approval or clearance before they may be marketed. There are two processes
by which medical devices can receive approval or clearance. Some products may
qualify for clearance under the 510(k) process, in which the manufacturer or
processor demonstrates that its product is substantially equivalent to another
lawfully marketed product (i.e., that it has the same intended use and is as
safe and effective as a lawfully marketed product and does not raise different
questions of safety and effectiveness as the lawfully marketed product). 510(k)
submissions usually include safety and performance data, and in some cases, the
submission must include clinical data. Marketing may commence if and when the
FDA issues a letter finding substantial equivalence. All of the metal spinal
implant systems we distribute are being marketed pursuant to 510(k) clearances.
If a medical device does not qualify for the 510(k) process, the product
may not be distributed until a premarket approval application has been approved
by the FDA. Premarket approval applications must demonstrate product safety and
effectiveness. A premarket approval application is typically a complex
submission, usually including the results of preclinical and clinical studies.
The manufacturer must also pass a premarket inspection of its compliance with
59
FDA's Quality Systems regulation. Marketing may commence if and when the FDA
issues a premarket approval.
The FDA has changed the regulatory status of our Grafton(R) DBM products
and the consequences of that decision are uncertain.
In March, 2002, the FDA informed us that the agency is changing the
regulatory status of Grafton(R) DBM and will henceforth regulate it as a medical
device. Medical device regulation is a more stringent category of regulation
and, in particular, medical devices require FDA clearance or approval. We
believe the FDA's change in its position regarding Grafton(R) DBM results from
its decision to regulate all demineralized bone with a carrier, including those
processed and marketed by some of our competitors, as medical devices. We
communicated to the FDA that we believe its initial designation of Grafton(R)
DBM as a human tissue-based product was and still is correct. In this regard, we
have provided information to the FDA that we believe should cause the FDA to
reconsider the position they have expressed in their March, 2002 letter as it
relates to Grafton(R) DBM. On February 26, 2003, we met with representatives of
the FDA to present our facts and views. Communication and interaction with the
FDA on this issue is continuing. If we are unsuccessful in that effort, we will
be required to obtain a medical device approval or clearance, and to comply with
medical device postmarketing obligations. We believe that Grafton(R) DBM will be
eligible for 510(k) clearance, but we cannot be sure that we will not be
required to obtain premarket approval, or that the FDA will issue any clearance
or approval in a timely fashion, or at all. In its March, 2002 letter regarding
Grafton(R) DBM, the FDA stated that it intends to allow us a reasonable period
of time to obtain clearance for Grafton(R) DBM, and we will continue to process
and distribute Grafton(R) DBM during this period. We cannot be sure that the FDA
will clear or approve our submission or will clear or approve any or all claims
that we currently make for Grafton(R) DBM. Failure to obtain FDA clearance or
approval of Grafton(R) DBM, or any limitation on Grafton(R) DBM claims could
materially adversely affect our results of operations and financial position.
We also market Grafton Plus(TM) DBM as a human tissue-based product. The
FDA's determination regarding Grafton(R) DBM is also likely to be applied to
Grafton Plus(TM) DBM. If the FDA maintains its position that all demineralized
bone with a carrier is a medical device, we would also be required to obtain FDA
clearance or approval for Grafton Plus(TM) DBM and any other DBM carrier product
we may process, and to comply with other medical device requirements for that
product. Failure to obtain FDA clearance or approval, if required, or any
limitation on Grafton Plus(TM) DBM could adversely affect us.
Allograft bone tissue and tissue banking activities, such as tissue
donation and recovery and tissue processing, are regulated in virtually all
countries in which we operate outside the United States. The regulatory schemes
and specific requirements for these products and activities vary from
country-to-country. There are no common or harmonized regulatory approvals or
programs for these products and activities, such as there are for medical
devices marketed in the European Union. We believe that we comply with the
national regulations in the countries in which we currently operate or in the
countries we plan to operate in the future, although there can be no assurances
that we will be able to do so in the future.
60
Loss of key persons could limit our success.
Our success depends upon the continued contributions of our executive
officers and scientific and technical personnel. The competition for qualified
personnel is intense, and the loss of services of our key personnel,
particularly members of senior management, could adversely affect our business.
If we are unable to enforce our patents or if it is determined that we
infringe patents held by others it could damage our business.
We consider our allograft bone tissue processing technology and procedures
proprietary and rely primarily on trade secrets and patents to protect our
technology and innovations. Consultants employed by third parties and persons
working in conjunction with medical institutions unaffiliated with us have
conducted significant research and development for our products. Accordingly,
disputes may arise concerning the proprietary rights to information applied to
our projects which have been independently developed by such consultants or
medical institutions. In addition, you should recognize that although we have
attempted to protect our technology with patents, our existing patents may prove
invalid or unenforceable as to products or services marketed by our competitors.
Our pending patent applications may not result in issued patents. Moreover, our
existing or future products and technologies could be found to infringe the
patents of others.
Prosecuting and defending patent lawsuits is very expensive. We are
committed to aggressively asserting and defending our technology and related
intellectual property which we have spent a significant amount of money to
develop. In addition, the industry in which we compete is known for having a
great deal of litigation involving patents. These factors could cause us to
become involved in new patent litigation in the future. The expense of
prosecuting or defending these future lawsuits could also have a material
adverse effect on our business, financial condition and results of operations.
Our products face competitive threats from alternate technologies.
The primary advantage of synthetic bone substitutes and growth factors as
compared to allograft bone tissue is that they do not depend on the availability
of donated human tissue. In addition, members of the medical community and the
general public may perceive synthetic materials and growth factors as safer than
allograft-based bone tissue. The allograft bone tissue we process may be
incapable of competing successfully with synthetic bone substitutes and growth
factors which are developed and commercialized by others, which could have a
material adverse effect on our business, financial condition and results of
operations. Companies are also developing artificial disks which would be used
to replace a patient's own injured, degenerated or diseased spinal disks. If
these disks are successfully developed and commercialized, they could have a
negative impact on our bio-implant business and, therefore, have a material
adverse effect on our financial condition and results of operations.
61
We may incur losses from product liability lawsuits.
The testing and use of human allograft bone tissue, bovine tissue products
and medical devices manufactured by others and which we distribute, entail
inherent risks of medical complications for patients and therefore may result in
product liability claims against us. Further, our agreements with our allograft
bone tissue processing clients provide for indemnification by us for liabilities
arising out of defects in allograft bone tissue they distribute which is caused
by our processing. See Item 3 "Legal Proceedings."
We presently maintain product liability insurance in the amount of $35
million per occurrence and per year in the aggregate. We may be unable to
maintain such insurance in the future and such insurance may not be sufficient
to cover all claims made against us or all types of liabilities which may be
asserted against us.
We face potential lawsuits or governmental enforcement activities based on
hazardous waste we generate in our operations.
Our allograft bone tissue processing in both the United States and Europe
generates waste materials, which, in the United States, are classified as
medical waste and/or hazardous waste under regulations promulgated by the United
States Environmental Protection Agency and the New Jersey Department of
Environmental Protection. We segregate our waste materials and dispose of them
through a licensed hazardous waste transporter in compliance with applicable
regulations in both the United States and Europe.
Our failure to fully comply with any environmental regulations could
result in the imposition of penalties, sanctions or, in some cases, private
lawsuits, which could have a material adverse effect on our business, financial
condition and results of operations.
We rely on our independent sales agents and sales representatives to
educate surgeons concerning our products and to market our products.
Our success depends largely upon arrangements we have with independent
sales agents and sales representatives whereby they educate surgeons concerning
our products and market our products. These independent sales agents and sales
representatives may terminate their relationship with us, or devote insufficient
sales efforts to our products. We do not control our independent sales agents
and they may not be successful in implementing our marketing plans. Our failure
to attract and retain skilled independent sales agents and sale representatives
could have an adverse effect on our operations.
The issuance of preferred stock may adversely affect rights of common
stockholders or discourage a takeover.
Under our amended and restated certificate of incorporation, our board of
directors has the authority to issue up to 5,000,000 shares of preferred stock
and to determine the price, rights, preferences and privileges of those shares
without any further vote or action by our stockholders. The rights of the
holders of common stock will be subject to, and may be adversely affected by,
the rights of the holders of any shares of preferred stock that may be issued in
the future.
62
In January, 1996, our board of directors authorized shares of Series E
Preferred Stock in connection with its adoption of a stockholder rights plan,
under which we issued rights to purchase Series E Preferred Stock to holders of
our common stock. Upon certain triggering events, such rights become exercisable
to purchase common stock (or, in the discretion of our board of directors,
Series E Preferred Stock) at a price substantially discounted from the then
current market price of the Common Stock. Our stockholder rights plan could
generally discourage a merger or tender offer involving our securities that is
not approved by our board of directors by increasing the cost of effecting any
such transaction and, accordingly, could have an adverse impact on stockholders
who might want to vote in favor of such merger or participate in such tender
offer.
While we have no present intention to authorize any additional series of
preferred stock, such issuance, while providing desirable flexibility in
connection with possible acquisitions and other corporate purposes, could also
have the effect of making it more difficult for a third party to acquire a
majority of our outstanding voting stock. The preferred stock may have other
rights, including economic rights senior to the Common Stock, and, as a result,
the issuance thereof could have a material adverse effect on the market value of
the common stock.
63
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
In the United States, we are exposed to interest rate risk. Changes in
interest rates affect interest income earned on cash, cash equivalents and
short-term investments and interest expense on short-term and long-term debt. We
do not enter into derivative transactions related to our cash, cash equivalents,
short-term investments or debt. Accordingly, we are subject to changes in
interest rates. Based on our December 31, 2002 cash and cash equivalents and
long-term debt, a 1% change in interest rates would impact our results of
operations by approximately $100,000.
The value of the U.S. dollar affects our financial results. Although
currently not significant, changes in exchange rates may positively or
negatively affect revenues, gross margins, operating expenses and net income in
the future. We do not maintain hedging programs to mitigate the potential
exposures of exchange rate risk. Accordingly, our results of operations are
adversely affected by the strengthening of the U.S. dollar against currencies in
which we sell products and services or a weakening exchange rate against
currencies in which we incur costs. Based on the operating results of our
foreign operations for the year ended December 31, 2002, a 10% change in the
exchange rates would impact our results of operations by approximately $100,000.
Because of the foregoing factors, as well as other variables affecting our
operating results, past financial performance should not be considered a
reliable indicator of future performance.
Item 8. Financial Statements and Supplementary Data
The response to this item is submitted as a separate section of this
Annual Report commencing on page F-1.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Not applicable.
64
PART III
Item 10. Directors and Executive Officers of the Registrant
The sections of our 2003 Proxy Statement entitled "Election of Directors"
and "Business Experience of Executive Officers" are incorporated herein by
reference.
Item 11. Executive Compensation
The section of our 2003 Proxy Statement entitled "Executive Compensation"
is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The sections of our 2003 Proxy Statement entitled "Security Ownership of
Certain Beneficial Owners and Management" and "Equity Compensation Plan
Information" are incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
None.
Item 14. 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 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 (or our consolidated subsidiaries) required
to be included in our periodic SEC filings.
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.
65
Item 15. Principal Accountant Fees and Services
The section of our 2003 Proxy Statement entitled "Principal Accountant
Fees and Services" is incorporated herein by reference.
66
PART IV
Item 16. Exhibits, Financial Statement Schedules and Reports on Form 8- K
(a)(1) and (2). The response to this portion of Item 16 is submitted as
a separate section of this report commencing on page F-1.
(a)(3) and (c). Exhibits (numbered in accordance with Item 601 of
Regulation S-K).
Exhibit
Number Description Number
- ------ ----------- ------
3.1 Restated Certificate of Incorporation of Osteotech, as amended #
3.2 Third Amended and Restated Bylaws of Osteotech #
3.3 Form of Stock Certificate **
3.4 Certificate of Retirement and Prohibition or Reissuance of Shares of ++
Osteotech, Inc. dated April 4, 2002
4.1 Rights Agreement dated as of February 1, 1996 between Osteotech, Inc. #
and Registrar and Transfer Co., as amended
10.1 1991 Stock Option Plan, as amended ^ #
10.2 1991 Independent Directors Stock Option Plan, ***
as amended ^
10.3 Processing Agreement between Osteotech and Stichting Eurotransplant
Nederland, dated September 26, 1988 [*] **
10.4 Form of Confidentiality Agreement and Non-Competition Agreement with #
executive officers
10.5 Agreement dated December 10, 1996 between American Red Cross Tissue ********
Services and Osteotech [*]
10.6 Lease for Osteotech's Shrewsbury, New Jersey processing facility, as **
amended through third modification
10.7 Employment Agreement with Michael J. Jeffries dated January 1, 1998 ^ ^^
10.8 Employment Agreement with James L. Russell dated December 18, 1997 ^ ^^
10.9 The Management Performance Bonus Plan ^ ^^^
10.10 Employment Agreement with Richard Russo ^^^
dated April 1, 1997 ^
10.11 Employment Agreement with Richard W. Bauer dated December 4, 1998 ^ ^^^
10.12 Loan and Security Agreement among Summit Bank, Osteotech, Inc., ^^^^
Osteotech Investment Corp., Cam Implants Inc., Cam Implants B.V.,
Osteotech/CAM Services B.V. and OST Developpement dated June 10, 1999.
[Includes Equipment Loan Note, Convertible Revolving Note, and Mortgage
Term Note as exhibits.]
10.13 Amended and Restated Processing Agreement entered into September 11, ^^^^^^
2000 by Osteotech, Inc., Musculoskeletal Transplant Foundation and
Biocon, Inc.[*]
67
10.14 Mortgage Term Note among Summit Bank, Osteotech, Inc., Osteotech ^^^^^^^
Investment Corp., Cam Implants Inc., Osteotech, B.V., H.C. Implants,
B.V., Cam Implants, B.V., Osteotech/CAM Services, B.V. and OST
Developpement dated December 8, 2000
10.15 Allonge to Loan and Security Agreement among Summit Bank, Osteotech, ^^^^^^^
Inc., Osteotech Investment Corp., Cam Implants Inc., Osteotech, B.V.,
H.C. Implants, B.V., Cam Implants, B.V., Osteotech/CAM Services, B.V.
and OST Developpement dated December 8, 2000
10.16 Allonge to Equipment Loan Note among Summit Bank, Osteotech, Inc., ^^^^^^^
Osteotech Investment Corp., Cam Implants Inc., Osteotech, B.V., H.C.
Implants, B.V., Cam Implants, B.V., Osteotech/CAM Services, B.V. and OST
Developpement dated December 8, 2000
10.17 Distribution Agreement entered into February, 2001 by Osteotech, Inc. ^^^^^^^
and Alphatec Manufacturing, Inc. [*]
10.18 Second Allonge to Loan and Security Agreement among Fleet National Bank, ^^^^^^^
Successor in Interest to Summit Bank, Osteotech, Inc., Osteotech
Investment Corp., Cam Implants Inc., Osteotech, B.V., H.C. Implants,
B.V., Cam Implants, B.V., Osteotech/Cam Services, B.V. and OST
Developpement dated March 8, 2001
10.19 Second Allonge to Equipment Loan Note among Fleet National Bank, ^^^^^^^
Successor in Interest to Summit Bank, Osteotech, Inc., Osteotech
Investment Corp., Cam Implants Inc., Osteotech, B.V., H.C. Implants,
B.V., Cam Implants, B.V., Osteotech/Cam Services, B.V. and OST
Developpement dated March 8, 2001
10.20 Allonge to Convertible Revolving Note among Fleet National Bank, ^^^^^^^
Successor in Interest to Summit Bank, Osteotech, Inc., Osteotech
Investment Corp., Cam Implants Inc., Osteotech, B.V., H.C. Implants,
B.V., Cam Implants, B.V., Osteotech/Cam Services, B.V. and OST
Developpement dated March 8, 2001
10.21 Primary Agreement Carrier and Bio-Implant Allografts by and between ###
LifeNet and Osteotech dated January 4, 2002
10.22 2000 Stock Plan dated February 9, 2000 #
10.23 Third Allonge to Loan and Security Agreement among Fleet National Bank, #
Successor in Interest to Summit Bank, Osteotech, Inc., Osteotech
Investment Corp., Cam Implants Inc., Osteotech, B.V., H.C. Implants,
B.V., Cam Implants, B.V., Osteotech/Cam Services, B.V. and OST
Developpement dated September 10, 2001
68
10.24 Third Allonge to Equipment Loan Note among Fleet National Bank, #
Successor in Interest to Summit Bank, Osteotech, Inc., Osteotech
Investment Corp., Cam Implants Inc., Osteotech, B.V., H.C. Implants,
B.V., Cam Implants, B.V., Osteotech/Cam Services, B.V. and OST
Developpement dated September 10, 2001
10.25 Second Allonge to Convertible Revolving Note among Fleet National Bank, #
Successor in Interest to Summit Bank, Osteotech, Inc., Osteotech
Investment Corp., Cam Implants Inc., Osteotech, B.V., H.C. Implants,
B.V., Cam Implants, B.V., Osteotech/Cam Services, B.V. and OST
Developpement dated September 10, 2001
10.26 Agreement of Amendment to Loan and Security Agreement, Mortgage, #
Assignment of Leases and Other Documents by and among Fleet National
Bank, Osteotech, Inc., Osteotech Investment Corporation, CAM Implants,
Inc., Osteotech, B.V., H.C. Implants, B.V., CAM Implants, B.V.,
Osteotech/CAM Services, B.V., Osteotech, S.A., and OST Developpement
S.A. dated March 13, 2002
10.27 Amendment to License and Option Agreement between IsoTis N.V. and H.C. ##
Implants B.V. and Osteotech dated April 8, 2002
10.28 Second Amended and Restated Processing Agreement by and among ++
Musculoskeletal Transplant Foundation, Biocon, Inc., and Osteotech, Inc.
dated as of June 1, 2002[*]
10.29 Settlement Agreement and Release by and among Osteotech, Inc. and ++
Osteotech Investment Corporation, the Musculoskeletal Transplant
Foundation, and Synthes Spine Company, L.P., dated as of June 1, 2002
10.30 License Agreement by and among Osteotech, Inc., Osteotech, Inc., ++
Osteotech Investment Corporation, Musculoskeletal Transplant Foundation,
Biocon, Inc., and Synthes Spine Company, L.P., dated as of June 1, 2002
[*]
10.31 Asset Purchase Agreement between Cam Implants B.V. and Cam Acquisition ++
B.V. dated July 10, 2002 [*]
10.32 Settlement Agreement between Medtronic, Inc. on behalf of itself and as ++
owner, directly or indirectly, of Medtronic Sofamor Danek, Inc.
(formerly known as Sofamor Danek Group, Inc.), Sofamor Danek Holding,
Inc., Medtronic Sofamor Danek USA, Inc., SDGI Holdings, Inc., Sofamor
Danek L.P. and Osteotech, Inc., effective May 15, 2002
10.33 Form of Change in Control Agreement with Executive Officers except Marc +++
Burel
10.34 Employment Agreement, as amended, with Marc Burel dated April 18, 2000 +++
10.35 Change in Control Agreement by and between Osteotech, Inc. and Marc +++
Burel dated April 18, 2002, superceded by the Change in
Control Agreement dated September 8, 2002 included as
Exhibit 10.36)
10.36 Change in Control Agreement by and between Osteotech, Inc. and Marc +++
Burel dated September 8, 2002
69
10.37 Allonge to Agreement of Amendment to the Loan and Security Agreement, E-2
Mortgage, Assignment of Leases and Other Documents by and among Fleet
National Bank, Osteotech, Inc., Osteotech Investment Corporation, CAM
Implants, Inc., Osteotech, B.V., H.C. Implants, B.V., CAM Implants,
B.V., Osteotech/CAM Services, B.V., Osteotech, SA, and OST Developpement
SA. dated March 13, 2002.
10.38 Exclusive Marketing Agreement, by and among Osteotech, Inc., LifeNet, E-13
Depuy Orthopaedics, Inc. and Depuy Acromed, Inc. dated December 13, 2002
[ ]
10.39 Letter Amendment to Agreement dated December 10, 1996, by and between E-77
the American Red Cross and Osteotech, Inc. dated October 27, 2002 [ ]
21.1 Subsidiaries of the Registrant E-88
23.1 Consent of PricewaterhouseCoopers LLP E-89
99.1 Certification pursuant to 18 U.S.C., Section 1350, as Adopted Pursuant E-90
to Section 906 of the Sarbanes Oxley Act of 2002
99.2 Certification Pursuant to 18 U.S.C., Section 1350, as Adopted Pursuant E-91
to Section 906 of the Sarbanes Oxley Act of 2002
** Previously filed as exhibits to Osteotech's Registration Statement on
Form S-1 (File No. 33-40463) and incorporated herein by reference
thereto.
*** Previously filed as exhibits to Osteotech's Registration Statement on
Form S-8 (File No. 33-44547) and incorporated herein by reference
thereto.
******** Previously filed as exhibits to Osteotech's Annual Report
on Form 10-K for the fiscal year ended December 31, 1996
and incorporated herein by reference thereto.
++ Previously filed as exhibits to Osteotech's Quarterly
Report on Form 10-Q for the quarter ended June 30, 2002
and incorporated herein by reference thereto.
+++ Previously filed as exhibits to Osteotech's Quarterly
Report on Form 10-Q for the quarter ended September 30,
2002 and incorporated herein by reference thereto.
+++++ Previously filed as exhibits to Osteotech's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1996
and incorporated herein by reference thereto.
++++++ Previously filed as exhibits to Osteotech's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1997
and incorporated herein by reference thereto.
+++++++ Previously filed as exhibits to Osteotech's Quarterly
Report on Form 10-Q for the quarter ended September 30,
1997 and incorporated herein by reference thereto.
^ Management contracts or compensatory plans and arrangements required to
be filed pursuant to Item 10(iii)
^^ Previously filed as Exhibits to Osteotech's Annual Report
70
on Form 10-K for the fiscal year ended December 31, 1997
and incorporated herein by reference thereto.
^^^ Previously filed as Exhibits to Osteotech's Annual Report
on Form 10-K for the fiscal year ended December 31, 1998
and incorporated herein by reference thereto.
^^^^ Previously filed as exhibits to Osteotech's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1999
and incorporated herein by reference thereto.
^^^^^ Previously filed as exhibits to Osteotech's Quarterly
Report on Form 10-Q for the quarter ended September 30,
1999 and incorporated herein by reference thereto.
^^^^^^ Previously filed exhibit to Osteotech's Quarterly Report
on Form 10-Q for the quarter ended September 30, 2000 and
incorporated herein by reference thereto.
^^^^^^^ Previously filed exhibit to Osteotech's Annual Report on
Form 10-K for the fiscal year ended December 31, 2000 and
incorporated herein by reference thereto.
# Previously filed exhibit to Osteotech's Annual Report on
Form 10-K for the fiscal year ended December 31, 2001 and
incorporated herein by reference thereto.
## Previously filed exhibit to Osteotech's Quarterly Report
on Form 10-K for the fiscal year ended March 31, 2002 and
incorporated herein by reference thereto
### Previously filed exhibit to Osteotech's Current Report on
Form 8-K filed with the Commission on March 8, 2002 and
incorporated herein by reference thereto.
/ Previously filed exhibit to Osteotech's Quarterly Report
on Form 10-Q for the quarter ended September 30, 1998 and
incorporated herein by reference thereto.
[*] Copy omits information for which confidential treatment has been
granted.
[ ] Copy omits information for which confidential treatment has been
requested.
71
(b) Reports on Form 8-K
On December 20, 2002, we filed with the Commission a Current Report on
Form 8-K to announce that we had entered into an agreement with DePuy
Orthopaedic, Inc., DePuy Acromed, Inc. and LifeNet for the processing and
distribution to the U.S. hospital market of a private label demineralized bone
matrix carrier product.
On October 29, 2002, we filed with the Commission a Current Report on
Form 8-K to announce our third quarter 2002 operating results.
On October 15, 2002, we filed with the Commission a Current Report on
Form 8-K to announce that we had restarted Base Tissue Segment processing in our
Shrewsbury, New Jersey processing facility and to announce the financial impacts
on third quarter 2002 of our voluntary and temporary suspension of Base Tissue
Segment processing in our processing facilities.
On October 7, 2002, we filed with the Commission a Current Report on
Form 8-K to announce that the Food and Drug Administration completed its
inspection on October 4, 2002 related to our voluntary and temporary suspension
of Base Tissue Segment processing and issued two observations in a Form 483.
On October 4, 2002 we filed with the Commission a Current Report on
Form 8-K to report on our October 1, 2002 conference call relating to our
voluntary and temporary suspension of Base Tissue Segment processing.
72
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Dated: March 28, 2003 OSTEOTECH, INC.
By: /s/Richard W. Bauer
----------------------------
Richard W. Bauer
President, Chief Executive Officer
(Principal Executive Officer) and Director
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons in the capacities and
on the dates indicated:
Signature Title Date
- --------------------------------------------------------------------------------
/s/DONALD D. JOHNSTON
- --------------------- Chairman of the March 28, 2003
Donald D. Johnston Board of Directors
/s/RICHARD W. BAUER
- ------------------- President, Chief March 28, 2003
Richard W. Bauer Executive Officer (Principal
Executive Officer) and Director
/s/MICHAEL J. JEFFRIES
- ---------------------- Executive Vice President March 28, 2003
Michael J. Jeffries Chief Financial Officer
(Principal Financial
Accounting Officer),
Secretary and Director
/s/KENNETH P. FALLON III Director March 28, 2003
- ------------------------
Kenneth P. Fallon III
/s/JOHN P. KOSTUIK Director March 28, 2003
- ------------------
John P. Kostuik
/s/STEPHEN J. SOGIN Director March 28, 2003
- -------------------
Stephen J. Sogin
73
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 annual report of Osteotech, Inc.;
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual 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 annual 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 annual report (the "Evaluation Date"); and
c) presented in this annual 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
annual 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.
March 28, 2003 /S/Richard W. Bauer
---------------------------------------------
Richard W. Bauer
President, Chief Executive Officer
(Principal Executive Officer)
74
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 annual report of Osteotech, Inc.;
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual 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 annual 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 annual report (the "Evaluation Date"); and
c) presented in this annual 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
annual 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.
March 28, 2003 /S/Michael J. Jeffries
----------------------------------------
Michael J. Jeffries
Executive Vice President,
Chief Financial Officer
(Principal Financial Officer and
Chief Accounting Officer)
75
OSTEOTECH, INC. AND SUBSIDIARIES
-------------------
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULE
Page
----
1. FINANCIAL STATEMENTS
Report of Independent Accountants..................................................F-2
Consolidated Balance Sheets as of December 31, 2002 and 2001.......................F-3
Consolidated Statements of Operations
for the years ended December 31, 2002, 2001 and 2000............................F-4
Consolidated Statements of Changes in Stockholders' Equity
for the years ended December 31, 2002, 2001, and 2000...........................F-5
Consolidated Statements of Cash Flows
for the years ended December 31, 2002, 2001, and 2000...........................F-6
Notes to Consolidated Financial Statements.........................................F-7
2. SCHEDULE
II. Valuation and Qualifying Accounts
for the years ended December 31, 2002, 2001, and 2000....................S-1
Report of Independent Accountants on Financial Statement Schedule..................S-2
All schedules, except for the one set forth above, have been omitted since the
information required is included in the financial statements or accompanying
notes or have been omitted as not applicable or not required.
F-1
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and
Stockholders of Osteotech, Inc.:
In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, of changes in stockholders'
equity and of cash flows present fairly, in all material respects, the
financial position of Osteotech, Inc. and subsidiaries (the "Company") at
December 31, 2002 and 2001, and the results of their operations and their
cash flows for each of the three years in the period ended December 31,
2002, in conformity with accounting principles generally accepted in the
United States of America. These financial statements are the responsibility
of the Company's management; our responsibility is to express an opinion on
these financial statements based on our audits. We conducted our audits of
these statements in accordance with auditing standards generally accepted
in the United States of America, which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant
estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable
basis for our opinion.
As discussed in Notes 1 and 3, the Company has adopted Statement of
Financial Accounting Standard No. 142, "Goodwill and Other Intangible
Assets", effective January 1, 2002.
PricewaterhouseCoopers LLP
Florham Park, New Jersey
February 21, 2003,
Except for Notes 11 and 13,
for which the date is March 27, 2003.
F-2
OSTEOTECH, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
December 31, 2002 2001
- -----------------------------------------------------------------------------------------------------------------
ASSETS
- -----------------------------------------------------------------------------------------------------------------
Current assets:
Cash and cash equivalents $ 10,040 $ 5,192
Short-term investments 3,948
Accounts receivable, net of allowance of
$943 in 2002 and $303 in 2001 11,545 15,093
Deferred processing costs 15,433 11,165
Inventories 4,820 8,803
Income tax receivable 3,357 896
Deferred tax assets 5,784 2,002
Prepaid expenses and other current assets 1,023 1,129
---------------------------------
Total current assets 55,950 44,280
---------------------------------
Property, plant and equipment, net 53,535 56,736
Goodwill, net of accumulated amortization of $404 in 2002 and
$2,861 in 2001 1,669 2,910
Other assets 3,931 3,318
- -----------------------------------------------------------------------------------------------------------------
Total assets $ 115,085 $ 107,244
=================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
- -----------------------------------------------------------------------------------------------------------------
Current liabilities:
Accounts payable and accrued liabilities $ 11,370 $ 17,311
Current maturities of long-term debt 2,661 2,530
---------------------------------
Total current liabilities 14,031 19,841
Long-term debt 15,922 18,683
Other liabilities 1,637 934
- -----------------------------------------------------------------------------------------------------------------
Total liabilities 31,590 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 17,001,372
shares in 2002 and 14,098,264 shares in 2001 170 140
Additional paid-in capital 63,368 47,076
Accumulated other comprehensive loss 78 (653)
Retained earnings 19,879 21,223
- -----------------------------------------------------------------------------------------------------------------
Total stockholders' equity 83,495 67,786
- -----------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $ 115,085 $ 107,244
=================================================================================================================
The accompanying notes are an integral part of
these consolidated financial statements.
F-3
OSTEOTECH, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share data)
Year ended December 31, 2002 2001 2000
- --------------------------------------------------------------------------------------------------------------
Net revenues:
Service $ 77,041 $71,329 $71,430
Product 6,333 4,386 2,681
----------------------------------------------
83,374 75,715 74,111
Cost of services 37,607 29,905 24,078
Cost of products 8,979 3,400 2,559
----------------------------------------------
46,586 33,305 26,637
----------------------------------------------
Gross profit 36,788 42,410 47,474
Marketing, selling, and general and administrative 38,256 44,305 34,652
Research and development 3,927 4,372 5,547
----------------------------------------------
42,183 48,677 40,199
----------------------------------------------
Income (charge) from litigation settlement (1,785) 1,000
----------------------------------------------
Operating income (loss) (7,180) (6,267) 8,275
----------------------------------------------
Other income (expense):
Interest income 246 506 1,087
Interest expense (1,342) (406) (14)
Gain on sale of patents 950
Other 175 29 (54)
----------------------------------------------
29 129 1,019
----------------------------------------------
Income (loss) from continuing operations before
income taxes (7,151) (6,138) 9,294
Income tax provision (benefit) (5,714) (2,098) 4,074
----------------------------------------------
Income (loss) from continuing operations (1,437) (4,040) 5,220
Income (loss) from discontinued operations, net of loss
on disposal of $291 in 2002 93 (370) (392)
- --------------------------------------------------------------------------------------------------------------
Net income (loss) $ (1,344) $ (4,410) $ 4,828
==============================================================================================================
Net income (loss) per share:
Basic:
Income (loss) from continuing operations $ (.09) $ (.29) $ .37
Discontinued operations .01 (.02) (.03)
----------------------------------------------
Net income (loss) $ (.08) $ (.31) $ .34
==============================================
Diluted
Income (loss) from continuing operations $ (.09) $ (.29) $ .37
Discontinued operations .01 (.02) (.03)
----------------------------------------------
Net income (loss) $ (.08) $ (.31) $ .34
==============================================================================================================
Shares used in computing net income (loss) per share:
Basic 15,904,132 14,030,623 14,057,931
Diluted 15,904,132 14,030,623 14,335,641
- --------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of
these consolidated financial statements.
F-4
OSTEOTECH, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(dollars in thousands)
Years ended December 31, 2002, 2001, and 2000
- ----------------------------------------------------------------------------------------------------------------------------------
Accumulated
Common Stock Additional Other Total
------------------------------ Paid-In Comprehensive Retained Stockholders'
Shares Amount Capital Income (Loss) Earnings Equity
- ----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1999 14,194,126 $ 140 $ 48,837 $ (376) $ 20,805 $ 69,406
Net income 4,828 4,828
Currency translation adjustments (121) (121)
------------------
Total comprehensive income 4,707
Exercise of stock options 74,261 1 304 305
Common stock issued pursuant to
employee stock purchase plan 51,420 418 418
Repurchase of common stock (330,500) (3) (3,121) (3,124)
Tax benefits related to stock options 139 139
- ----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2000 13,989,307 138 46,577 (497) 25,633 71,851
Net loss (4,410) (4,410)
Currency translation adjustments (156) (156)
------------------
Total comprehensive loss (4,566)
Exercise of stock options 10,138 1 41 42
Common stock issued pursuant to
employee stock purchase plan 98,819 1 458 459
- ----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2001 14,098,264 140 47,076 (653) 21,223 67,786
Net loss (1,344) (1,344)
Currency translation adjustments 731 731
------------------
Total comprehensive loss (613)
Sale of common stock 2,800,000 28 15,728 15,756
Exercise of stock options 47,500 1 172 173
Common stock issued pursuant to
employee stock purchase plan 55,608 1 354 355
Tax benefits related to stock options 38 38
- ----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 17,001,372 $ 170 $ 63,368 $ 78 $ 19,879 $ 83,495
==================================================================================================================================
The accompanying notes are an integral part of these consolidated
financial statements.
F-5
OSTEOTECH, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
Year ended December 31, 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flow From Operating Activities
Net income (loss) $ (1,344) $ (4,410) $ 4,828
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:
Depreciation and amortization 8,230 8,598 4,597
Litigation settlement charge 1,785
Deferred income taxes (1,966) (2,937) 775
Gain on sale of patents (950)
Reversal of tax liability (2,557)
Income tax benefit related to stock options 38 139
Changes in assets and liabilities:
Accounts receivable 3,934 (2,146) 1,629
Inventories 3,614 (5,073) (218)
Deferred processing costs (3,938) (5,390) (604)
Prepaid expenses and other current assets (2,445) 2,459 764
Accounts payable and other liabilities (6,034) 6,880 (1,735)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities (1,633) (2,019) 10,175
Cash Flow From Investing Activities
Capital expenditures (4,911) (8,955) (28,343)
Proceeds from sale of foreign operation 1,000
Proceeds from sale of investments 5,860 5,888
Purchases of investments (3,948) (3,925) (3,877)
Proceeds from sale of patents 1,000
Proceeds from the sale of land 1,500
Other, net (383) 160 (796)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (7,242) (5,360) (27,128)
Cash Flow From Financing Activities
Proceeds from issuance of common stock 16,284 499 723
Repurchase of common stock (3,124)
Proceeds from issuance of long-term debt 1,468 13,672
Principal payments on long-term debt (2,630) (340)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 13,654 1,627 11,271
Effect of exchange rate changes on cash 69 21 (165)
- ------------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 4,848 (5,731) (5,847)
Cash and cash equivalents at beginning of year 5,192 10,923 16,770
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 10,040 $ 5,192 $ 10,923
====================================================================================================================================
The accompanying notes are an integral part of these consolidated
financial statements.
F-6
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS
Osteotech, Inc. (the "Company") provides services and develops, markets and
sells products to the orthopaedic, neurological, oral/maxillofacial, dental
and general surgery markets in the United States and Europe. The Company's
current technology, products and services, and those under development, are
focused primarily on the repair and healing of the musculoskeletal system.
The Company is engaged in the processing of human bone and bone connective
tissue (collectively, "allograft bone tissue") used for transplantation.
The Company also develops and processes new forms of tissue for use in a
variety of surgical procedures.
Commencing in the first half of 2001, and expanding in the second half of
2001 and throughout 2002, the Company began to distribute tissue forms
directly to hospitals. The Company expects to continue to expand the direct
distribution efforts to hospitals in 2003 and beyond. This change in
distribution methodology has impacted liquidity and cash flow. The Company
has had to make additional investments in inventories and deferred
processing costs to support the direct distribution efforts, and expects to
make additional investments in inventory and deferred processing costs, as
necessary, to support the efforts to expand direct distribution. Exclusive
of the funds the Company raised in the sale of 2.8 million shares of common
stock in the second quarter of 2002, which generated net proceeds of
$15,756,000, in 2002 and 2001, the Company experienced a decrease in
available cash, cash equivalents and short-term investments due to
continued investments in the business and from operating losses incurred in
2002 and 2001. The Company expects to continue to make investments in the
business to support the direct distribution efforts and future programs and
initiatives, which may further deplete available cash balances. The Company
believes that available cash, cash equivalents and short-term investments,
available lines of credit and anticipated future cash flow from operations
will be sufficient to meet forecasted cash needs in 2003. The Company's
future liquidity and capital requirements will depend upon numerous
factors, including:
o additional investments in inventories and deferred processing costs,
if any, to support direct distribution efforts;
o the progress of product development programs and the need and
associated costs relating to regulatory approvals, if any, which may
be needed to commercialize some of the products under development, or
those commercialized whose regulatory status may change; and
o the resources to be devoted to the development, manufacture and
marketing of services and products.
The Company has two primary operating segments: the Grafton(R)
Demineralized Bone Matrix (DBM) Segment (the "Grafton(R) DBM Segment") and
Base Allograft Bone Tissue Segment (the "Base Tissue Segment"). In addition
to these two primary segments, the Company markets and distributes metal
spinal implant products domestically, and processes, markets and
distributes bovine bone tissue products outside of the United States.
F-7
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Critical Accounting Policies and Estimates
The preparation of these financial statements requires the Company to make
estimates and judgments that effect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. On an on-going basis, the Company evaluates the
estimates and may adjust them based upon the latest information available.
These estimates generally include those related to product returns, bad
debts, inventories including purchase commitments, deferred processing
costs including rework reserves, intangible assets, income taxes and
contingencies and litigation. The Company bases the estimates on historical
experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying value of assets and liabilities that
are not readily apparent from other sources. Actual results may differ from
these estimates.
The Company believes the following critical accounting policies affect the
more significant judgments and estimates used in the preparation of the
consolidated financial statements.
o The Company maintains allowances for doubtful accounts primarily for
its direct distribution accounts for estimated losses resulting from
the inability of these customers to make required payments. If the
financial condition of these customers were to deteriorate, resulting
in an impairment of their ability to make payments, additional
allowances may be required.
o The Company records reductions to revenue for estimated product and
allograft bone tissue form returns based upon historical experience.
If future returns are less than historical experience, reduction in
estimated reserves would increase revenue. Alternatively, should
returns exceed historical experience, additional allowances would be
required, which would reduce revenue.
o The Company writes down inventory and deferred processing costs for
estimated excess, obsolescence, or unmarketable products and allograft
bone tissue forms equal to the difference between cost and the
estimated market value based upon assumptions about future demand and
market conditions. Excess and obsolescence could occur from numerous
factors, including, but not limited to, the competitive nature of the
market, technological change and changes in surgeon preference. If
actual market conditions are less favorable than those projected by
management, additional write-downs may be required. In addition, the
Company provides reserves, if any, for the difference between its
contractual purchase commitments and its projected purchasing patterns
based upon maintenance of adequate inventory levels and forecasted
revenues. If actual revenue is less favorable than those forecasted by
management, additional reserves may be required; alternatively, if
revenue is stronger than forecasted by management, such reserves would
be reduced.
o The Company depreciates/amortizes its property, plant and equipment
based upon the Company's estimate of the respective asset's useful
life. In addition, the Company evaluates impairments of its property,
plant and equipment based upon an analysis of estimated undiscounted
future cash flows. If the Company determines that a change is required
in the useful life of an asset, future depreciation/amortization is
adjusted accordingly. Alternatively, should the Company determine that
an asset has been impaired, an adjustment would be charged to income
based on its fair market value, or expected discounted cash flows if
the fair market value is not readily determinable, reducing income in
that period.
F-8
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
o The Company records a valuation allowance to reduce deferred tax
assets to the amount that is more likely than not to be realized.
While the Company has considered future taxable income, in the event
that the Company would be able to realize deferred tax assets in the
future in excess of the net recorded amount, an adjustment to the
deferred tax asset would increase income in the period such
determination was made. Likewise, should the Company determine that
the Company would not be able to realize all or part of the net
deferred tax asset in the future, an adjustment to the deferred tax
asset would be charged to income in the period such determination was
made.
o The Company accrues current and future tax liabilities based upon
levels of taxable income, tax planning strategies and assessments of
the timing of taxability of the tax attributes. While the Company has
considered current tax laws in establishing tax liabilities, in the
event the Company was to settle the tax liabilities for less than
amounts accrued the Company would increase income in the period such
determination was made. Should the Company determine it would cost
more to settle the tax liabilities, an adjustment would be charged to
income thus reducing income in that period.
o Litigation is subject to many uncertainties and management is unable
to predict the outcome of the pending suits or claims. 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,
and if appropriate, will reduce such liability to the extent covered
by insurance. If the outcome or resolution of the pending suit or
claim is for amounts greater than accrued, an adjustment will be
charged to income in the period the determination is made.
Alternatively, should the suit or claim be for less than accrued, the
Company would increase income in the period the determination is made.
Consolidated Financial Statements
The consolidated financial statements include the accounts of the Company
and its majority-owned subsidiaries. All intercompany transactions and
balances are eliminated.
Revenue Recognition
The Company principally derives revenue from allograft bone tissue
processing services and other non-allograft tissue products and services.
Revenues for products and services, net of trade discounts and allowances,
are recognized once delivery has occurred provided that persuasive evidence
of an arrangement exists, the price is fixed or determinable, and
collectibility is reasonably assured. For allograft tissue, delivery is
considered to have occurred when risk of loss has transferred to the
Company's clients or customers, primarily upon shipment of such allograft
tissue to customers or clients, except for consigned inventory, when
delivery is considered to have occurred at the time that the allograft
tissue is consumed by the customer. For non-allograft tissue products and
services, delivery is considered to have occurred when title and risk of
loss have transferred to the Company's customers primarily upon shipment of
non-allograft products to customers or clients.
Cash Equivalents and Short-Term Investments
The Company considers all highly liquid investments with original
maturities of three months or less, when purchased, to be cash equivalents.
Investments with maturities in excess of three months but less than one
year are classified as short-term investments and are stated at cost, net
of any unamortized premiums or discounts, which approximates fair value.
F-9
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Deferred Processing Costs
Deferred processing costs are stated at the lower of cost or market, with
cost determined under the first-in, first-out method. Costs related to
allograft bone tissue processing are deferred until the processed allograft
bone tissue is released from final quality assurance testing and shipped to
clients or customers, except for consigned inventory, whose costs are
deferred until the allograft bone tissue is consumed by the customer.
Inventories
Inventories are stated at the lower of cost or market, with cost determined
under the first-in, first-out method. Inventories consist of supplies,
which principally support the Company's two primary operating segments, and
raw materials and finished goods, which principally support the Company's
other product lines.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Major renewals and
betterments are capitalized while maintenance and repairs are expensed as
incurred. Interest, if any, is capitalized in connection with the
construction of major facilities. The capitalized interest is recorded as
part of the underlying asset and is amortized over the asset's estimated
useful life. The cost of leasehold improvements is amortized on the
straight-line method over the shorter of the lease term or the estimated
useful life of the asset. Depreciation is computed on the straight-line
method over the following estimated useful lives of the assets:
Building and improvements 10 to 20 years
Machinery and equipment 5 to 10 years
Computer hardware and software 5 years
Office equipment, furniture and fixtures 5 years
Spinal Instruments 3 years
When depreciable assets are retired or sold, the cost and related
accumulated depreciation are removed from the accounts and any resulting
gain or loss is reflected in other income (expense) in the consolidated
statement of operations.
Whenever events and circumstances indicate that the carrying value of an
asset may not be recoverable, the Company reviews the asset's carrying
value for impairment on an analysis of undiscounted cash flows. If an
impairment is determined, the assets carrying value is written down to fair
market value, or discounted cash flows if fair market value is not readily
determinable.
Goodwill
Beginning in 2002, pursuant to the provisions of Statement of Financial
Accounting Standard ("SFAS") No. 142, "Goodwill and Other Intangible
Assets", the Company is no longer amortizing goodwill. Prior to 2002, the
Company amortized goodwill on a straight-line basis over 15 years. The
Company's goodwill arose in the acquisition of its French subsidiary in
1999 and relates mainly to the Company's activities in the Grafton(R) DBM
Segment. The Company, pursuant to SFAS No. 142, will evaluate goodwill
annually for impairment. See Note 3, "Recent Accounting Pronouncements."
Research and Development
Research and development costs, which principally relate to internal costs
for the development of new technologies, processes and products, are
expensed as incurred.
F-10
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Stock Options
The Company has adopted the "disclosure only" provisions of SFAS No. 123,
"Accounting for Stock Based Compensation", and accordingly, no compensation
cost has been recognized in the consolidated statements of operations. Pro
forma information regarding net income and net income per share is required
by SFAS No. 123, and has been determined as if the Company accounted for
its stock options under the Fair Value Method of that Statement. For
purposes of the pro forma disclosures, the estimated fair value of the
options is amortized on a straight-line basis to expense over the options'
vesting period.
As required by SFAS No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure - an amendment of SFAS No. 123", the following
table shows the estimated effect on earnings and per share data as if the
Company had applied the fair value recognition provisions of SFAS No. 123
to stock-based employee compensation.
(in thousands except per share data) 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Net income (loss)
As reported:
Income (loss) from continuing operations $ (1,437) $ (4,040) $ 5,220
Discontinued operations 93 (370) (392)
--------------------------------------------
Net income (loss) $ (1,344) $ (4,410) $ 4,828
============================================
Impact on income (loss) from continuing operations and net income
(loss) related to stock-based employee compensation expense,
net of tax $ 292 $ 1,554 $ 1,129
============================================
Pro forma:
Income (loss) from continuing operations $ (1,729) $ (5,594) $ 4,091
Discontinued operations 93 (370) (392)
--------------------------------------------
Net income (loss) $ (1,636) $ (5,964) $ 3,699
============================================
Net income (loss) per share
As reported
Basic:
Income (loss) from continuing operations $ (.09) $ (.29) $ .37
Discontinued operations .01 (.02) (.03)
--------------------------------------------
Net income (loss) $ (.08) $ (.31) $ .34
============================================
Diluted:
Income (loss) from continuing operations $ (.09) $ (.29) $ .37
Discontinued operations .01 (.02) (.03)
--------------------------------------------
Net income (loss) $ (.08) $ (.31) $ .34
============================================
Pro forma
Basic:
Income (loss) from continuing operations $ (.11) $ (.41) $ .29
Discontinued operations .01 (.02) (.03)
--------------------------------------------
Net income (loss) $ (.10) $ (.43) $ .26
============================================
Diluted:
Income (loss) from continuing operations $ (.11) $ (.41) $ .29
Discontinued operations .01 (.02) (.03)
--------------------------------------------
Net income (loss) $ (.10) $ (.43) $ .26
====================================================================================================================================
F-11
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
The fair value for the option grants was estimated at the date of grant
using the Black-Scholes Option-Pricing Model with the following
weighted-average assumptions:
2002 2001 2000
--------------------------------------------------------------------------
Expected life (years) 5 5 5
Risk free interest rate 3.33% 4.62% 5.70%
Volatility factor 80.00% 70.00% 60.00%
Dividend yield 0.00% 0.00% 0.00%
--------------------------------------------------------------------------
Translation of Foreign Currency
Assets and liabilities of foreign subsidiaries are translated at rates of
exchange in effect at the close of the period. Revenues and expenses are
translated at the weighted average exchange rates during the period.
Translation gains and losses are included in accumulated other
comprehensive income (loss), which is a separate component of stockholders'
equity. Foreign currency transaction gains and losses are included in other
income (expense).
Concentrations of Credit Risk
The Company invests the majority of its excess cash in U.S.
Government-backed securities and investment grade commercial paper of major
U.S. corporations. The Company does not believe it is exposed to any
significant credit risk on its cash equivalents and short-term investments.
The Company provides credit, in the normal course of business, to its
clients and customers. In addition, the Company performs on-going credit
evaluations of its clients' and customers' financial condition, but
generally does not require collateral in support of available credit. The
Company maintains an allowance for doubtful accounts and charges actual
losses to the allowance when incurred. The Company has two customers who
together account for 59%, 77% and 92% of revenues in 2002, 2001, and 2000,
respectively. As of December 31, 2002 and 2001, these two customers
together accounted for 46% and 66%, respectively, of outstanding accounts
receivable. For one of these customers the Company has a contractual right
of offset.
Fair Value of Financial Instruments
The carrying value of financial instruments, including short-term
investments, accounts receivable, notes receivable, accounts payable and
other accrued expenses, approximate their fair values. Short-term
investments are designated as available-for-sale, are of investment grade
quality securities and are not subject to significant market risk. The
carrying value of amounts outstanding under the credit facility
approximates fair value because the debt is subject to short-term variable
interest rates that were reflective of market rates of interest.
Reclassifications
Certain prior year amounts within the financial statements have been
reclassified to conform to the 2002 presentation.
F-12
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. 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 $132,000 and $136,000 for the years ended
December 31, 2001 and 2000, respectively. Discontinued operations included
$252,000 of goodwill amortization for each of the years ended December 31,
2001 and 2000. (See Note 5, "Discontinued Operations"). 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 principally represent patents,
patent applications and licenses, are recorded at cost of $3,268,000 and
$2,792,000 as of December 31, 2002 and 2001 and carrying values of
$2,105,000 and $1,873,000 for the same respective periods. Patents and
licenses are amortized over their estimated useful lives ranging from five
to ten years. Patent application costs are amortized upon grant of the
patent or expensed if the application is rejected or withdrawn.
Amortization expense for these intangibles was $245,000, $227,000 and
$216,000 for the years ended December 31, 2002, 2001, and 2000,
respectively. Amortization expense for the next five years is: $242,000 in
2003; $151,000 in 2004; $59,000 in 2005; $39,000 in 2006; and $11,000 in
2007. The Company reviews other intangibles to assess recoverability from
future operations using undiscounted cash flows derived from the lowest
appropriate asset groupings. Impairments are recognized in operating
results to the extent that carrying value exceeds fair value determined
based on the net present value of estimated future cash flows.
The following table presents comparative data for the years ended December
31, 2002, 2001 and 2000 to reflect the adoption of SFAS No. 142 as of
January 1, 2002:
Year Ended
December 31,
------------------------------------------------------------
(in thousands) 2002 2001 2000
----------------------------------------------------------------------------------------------------------------
Net income (loss) - as reported $ (1,344) $ (4,410) $ 4,828
Add back goodwill amortization 384 388
------------------------------------------------------------
Net income (loss) - as adjusted $ (1,344) $ (4,026) $ 5,216
================================================================================================================
Basic earnings per share:
Net income (loss) - as reported $ (.08) $ (.31) $ .34
Goodwill amortization .03 .03
------------------------------------------------------------
Net income (loss) - as adjusted $ (.08) $ (.28) $ .37
================================================================================================================
Diluted earnings per share:
Net income (loss) - as reported $ (.08) $ (.31) $ .34
Goodwill amortization .03 .03
------------------------------------------------------------
Net income (loss) - as adjusted $ (.08) $ (.28) $ .37
================================================================================================================
In June, 2002, the Financial Accounting Standards Board 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 flows.
F-13
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. RECENT ACCOUNTING PRONOUNCEMENTS (continued)
In November, 2002, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness
of Others, an interpretation of SFAS Nos. 5, 57, and 107 and Rescission of
FASB Interpretation No. 34" ("FIN 45"). FIN 45 clarifies the requirements
of SFAS No. 5, "Accounting for Contingencies," relating to the guarantor's
accounting for, and disclosure of, the issuance of certain types of
guarantees. The disclosure requirements of FIN 45 are effective for
financial statements of interim or annual periods after December 15, 2002.
The disclosure provisions have been implemented and no disclosures were
required in 2002. The provisions for initial recognition and measurement
are effective on a prospective basis for guarantees that are issued or
modified after December 31, 2002, irrespective of the guarantor's year-end.
FIN 45 requires that upon issuance of a guarantee, the entity must
recognize a liability for the fair value of the obligation it assumes under
that guarantee. Adoption of FIN 45 in 2003 has not and is not expected to
have a material effect on the Company's results of operations, cash flows
or financial position.
In January, 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities - an interpretation of ARB No.
51," ("FIN 46"), which addresses consolidation of variable interest
entities. FIN 46 expands the criteria for consideration in determining
whether a variable interest entity should be consolidated by a business
entity, and requires existing unconsolidated variable interest entities
(which include, but are not limited to, Special Purpose Entities, or SPE's)
to be consolidated by their primary beneficiaries if the entities do not
effectively disperse risks among parties involved. This interpretation
applies immediately to variable interest entities created after January 31,
2003, and to variable interest entities in which an enterprise obtains an
interest after that date. It applies in the first fiscal year or interim
period beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that it acquired before
February 1, 2003. We do not currently have any SPE's or variable interest
entities, therefore, the adoption of FIN 46 is not expected to have any
impact on the Company's results of operations, cash flows or financial
position.
4. CONTINUING OPERATIONS - GAINS AND CHARGES
2002 Gains and Charges
In October, 2002, because of a higher than normal level of complaints, the
Company temporarily suspended the sale and distribution of the Affirm(TM)
Cervical Plating System ("Affirm(TM)"). In fourth quarter 2002, due to the
continuing uncertainty surrounding the re-introduction of Affirm(TM) into
the market, the Company recorded a pre-tax charge of $1,430,000 to fully
reserve all implant inventory and instrumentation for Affirm(TM).
Affirm(TM), along with the Sentinal(TM) Pedicle Screw System, products
manufactured by Alphatec Manufacturing, Inc., are subject to a firm
purchase commitment. (See Note 13, "Commitments and Contingencies"). As a
result of the uncertainty surrounding the re-introduction of Affirm(TM)
into the market, the Company expects that it will be unable to meet the
purchase commitment, and accordingly recorded a provision of $1,079,000 for
the penalty associated with the expected shortfall under the purchase
commitment.
F-14
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. CONTINUING OPERATIONS - GAINS/CHARGES (continued)
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 implant systems 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 13,
"Commitments and Contingencies - Litigation"), and an $840,000 charge for
the estimated cost to rework tissue placed in quarantine.
In September, 2002, the Company determined liabilities of $2,557,000 that
had been established in 1997 related to certain items, which were deducted
in that year's income tax return, 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 B.V. for $1,000,000. The Company
recognized a pretax gain of $950,000 on this transaction. (See Note 13,
"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 13, "Commitments and Contingencies - Litigation").
2001 Charges
In December, 2001, the Company recorded a charge to cost of sales of
$2,287,000 related to equipment which will no longer be utilized in the
processing of allograft tissue.
In November, 2001, the Company recorded a charge in marketing, selling,
general and administrative expenses primarily for the severance costs
associated with the departure of an executive officer in the amount of
$700,000.
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.
5. 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 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.
F-15
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. DISCONTINUED OPERATIONS (continued)
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) of the operations sold, up through June 30,
2002, the effective date of sale, were as follows:
Year Ended
December 31,
----------------------------------
(in thousands) 2002 2001 2000
------------------------------------------------------------------------
Revenues $ 1,630 $ 2,131 $ 1,572
==================================
Net income (loss) from operations $ 384 $ (370) $ (392)
Loss on disposal (291)
----------------------------------
Net income (loss) $ 93 $ (370) $ (392)
==================================
6. DEFERRED PROCESSING COSTS
Deferred processing costs consist of the following at December 31:
(in thousands) 2002 2001
-------------------------------------------------------------------------
Donor tissue to be processed and distributed by the
Company $ 2,411 $ 492
Tissue in process 5,043 2,936
Processed implantable donor tissue to be distributed
by the Company 6,234 5,359
Processed implantable donor tissue held for clients 1,745 2,378
-------------------------------------------------------------------------
$15,433 $11,165
=========================================================================
7. INVENTORIES
Inventories consist of the following at December 31:
(in thousands) 2002 2001
-------------------------------------------------------------------------
Supplies $ 223 $ 245
Raw materials 678 784
Finished goods 3,919 7,774
-------------------------------------------------------------------------
$ 4,820 $ 8,803
=========================================================================
F-16
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following at December 31:
(in thousands) 2002 2001
---------------------------------------------------------------------------
Land $ 811 $ 811
Building and improvements 14,763 13,821
Machinery and equipment 45,772 24,695
Computer hardware and software 4,475 4,264
Office equipment, furniture and fixtures 6,135 5,839
Spinal instruments 3,935 3,563
Leasehold improvements 8,107 7,850
Construction in progress 648 20,957
---------------------------------
84,646 81,800
Less accumulated depreciation
and amortization 31,111 25,064
---------------------------------------------------------------------------
$ 53,535 $ 56,736
===========================================================================
In the fourth quarter of 1998, the Company commenced construction of a new
tissue processing facility in Eatontown, New Jersey. At December 31, 2002
and 2001, approximately $41,383,000 and $37,922,000, respectively, had been
incurred, primarily for construction of the facility, production equipment
and furniture and fixtures, of which approximately $1,769,000 represents
capitalized interest in 2002 and 2001. In late 2001, the Company began to
occupy the administrative and warehouse portions of the facility. In the
second quarter of 2002, the Company commenced production in the facility.
The Company began to depreciate the administrative and warehouse portions
of the facility in the fourth quarter of 2001, and depreciate the remainder
of the costs in the second quarter of 2002.
In 2001, the Company recorded additional provisions of $2,287,000 for
machinery and equipment that will no longer be utilized in the processing
of allograft tissue and $1,190,000 primarily for excess spinal instruments.
(See Note 4, "Continuing Operations - Gains and Charges").
9. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable and accrued liabilities consist of the following at
December 31:
(in thousands) 2002 2001
------------------------------------------------------------------------
Trade accounts payable $ 3,655 $ 8,802
Accrued compensation 890 878
Accrued professional fees 1,035 1,333
Accrued taxes payable 458 3,100
Accrued purchase commitment penalty 1,079
Litigation settlement payable 901
Other accrued liabilities 3,352 3,198
------------------------------------------------------------------------
$ 11,370 $17,311
========================================================================
F-17
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. LEASING TRANSACTIONS
The Company leases office and production facilities and equipment under
various operating lease agreements which have non-cancelable terms through
October, 2008. The leases for office and production facilities include
renewal provisions at the Company's option. Additionally, certain of the
leases contain fair value purchase options.
Future minimum lease commitments as of December 31, 2002 are as follows:
Year Operating Leases
----------------------------------------------------------
(in thousands)
2003 $ 797
2004 787
2005 464
2006 403
2007 and thereafter 671
--------
Total minimum lease payments $ 3,122
========
Rental expense was $971,000, $936,000, and $914,000 for the years ended
December 31, 2002, 2001, and 2000, respectively.
11. DEBT AND FINANCING ARRANGEMENTS
The Company has a Credit Facility, as amended, which includes a $5,000,000
revolving line of credit, a mortgage loan and an equipment term loan.
Beginning January 1, 2002, each tranche of the Credit Facility bears
interests at a variable rate ranging from prime (4.25% as of December 31,
2002) minus .25% to prime plus 1.50%, or from the London Interbank Offered
Rate ("LIBOR") plus 2.25% to LIBOR plus 4.0%, based upon a leverage ratio
as defined in the Credit Facility. Throughout 2002, interest on each
tranche of the Credit Facility bore interest at either prime plus 1.50% or
LIBOR plus 4.0%. Prior to January 1, 2002, the mortgage bore interest at
7.38%, the equipment term loan bore interest at prime minus .50% or at
LIBOR plus 1.75% or 2.25%, and the revolving line of credit bore interest
at prime minus .75% or LIBOR plus 1.75%. The Company's effective weighted
average interest rate for borrowings under the Credit Facility was 6.20% in
2002 and 6.60% in 2001.
In June, 2002, the Company obtained an irrevocable standby letter of credit
to support the $1,900,000 ($1,267,000 as of December 31, 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 13,
"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 December 31, 2002, the standby
letter of credit has been reduced to $1,386,000. The amount committed under
the standby letter of credit reduces the Company's availability under its
revolving line of credit. As of December 31, 2002, no amounts were
outstanding under the revolving line of credit and $3,614,000 was
available.
The revolving line of credit is committed through April 30, 2004 at which
time all amounts outstanding are due and payable and all remaining
commitments are cancelled. The mortgage loan is repayable in 120 equal
monthly installments of principal, based on a twenty-year amortization
schedule, plus interest. Upon the 120th payment, the remaining amount of
the unpaid principal will be due and payable. The equipment term loan is
repayable in equal monthly installments of principal, based on a seven-year
amortization schedule, plus interest.
F-18
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. DEBT AND FINANCING ARRANGEMENTS (continued)
Payments under the mortgage loan commenced in February, 2001 and payments
under the equipment term loan commenced in December, 2001.
The Credit Facility, as amended, is collateralized by domestic accounts
receivable, domestic inventories, the new allograft tissue processing
facility, including all equipment and improvements therein and a pledge of
65% of the Company's ownership in its foreign subsidiaries. The Credit
Facility imposes certain restrictive operating and financial covenants on
the Company. The Credit Facility established additional covenants including
a restriction on the payment of cash dividends, a restriction on incurring
or maintaining additional indebtedness, a restriction on selling assets or
engaging in mergers or acquisitions and limitations on cash advances to the
Company's foreign operations and investments. The Credit Facility also
includes subjective acceleration provisions. Such provisions are based
upon, in the reasonable opinion of the bank, the occurrence of any adverse
or material change in the condition or affairs, financial or otherwise, of
the Company which impairs the interests of the bank. The bank also has the
right to approve, in advance, the form and substance of any equity capital
transaction, except for a common stock transaction resulting in the
issuance of less than 20% of the total issued and outstanding capital stock
of the company as of the date of such transaction.
In March, 2003, the Credit Facility was amended to permanently waive the
Company's non-compliance with the interest coverage ratio for the quarter
ended December 31, 2002. In addition, if available cash, cash equivalents
and short-term investments decline below $10.0 million at the end of any
calendar month, the amendment gives the bank, at its option, the right to
obtain a security interest in the Company's general intangibles, including,
but not limited to, the Company's patents and patent applications.
Failure to comply with any of these restrictions could result in a default
under this loan facility. Following a default, the bank may determine not
to make any additional financing available under the revolving line of
credit, could accelerate the indebtedness under the revolving credit
facility, the equipment loan and/or the mortgage, and could foreclose on
the real and personal property collateralizing the loans. The Company
either complied with or obtained the necessary waivers from its lenders
regarding these covenants.
Long-term debt consists of the following at December 31:
2002 2001
(in thousands)
-------------------------------------------------------------------------------------------------
Domestic bank equipment term loan, repayable in monthly
principal payments of $202 plus interest through November, 2008 $14,369 $16,798
Domestic revolving line of credit
Domestic building mortgage loan, repayable in monthly installments of
$19 plus interest through December, 2010 with a balloon
payment of $3,087 due December, 2010. 4,214 4,415
-------------------------------------------------------------------------------------------------
18,583 21,213
Less current portion 2,661 2,530
-------------------------------------------------------------------------------------------------
$15,922 $18,683
=================================================================================================
Aggregate maturities of long-term debt for the next five years are as
follows: 2003, $2,661,000; 2004, $2,661,000; 2005, $2,661,000; 2006,
$2,661,000; 2007, $2,661,000; thereafter, $5,278,000.
F-19
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. INCOME TAXES
The income tax provision (benefit) at December 31 is summarized as follows:
(in thousands) 2002 2001 2000
-----------------------------------------------------------------------
Current:
Federal $ (3,938) $ 265 $ 2,897
State 190 574 402
-----------------------------------------------------------------------
(3,748) 839 3,299
-----------------------------------------------------------------------
Deferred:
Federal (684) (1,921) 551
State (1,282) (1,016) 224
-----------------------------------------------------------------------
(1,966) (2,937) 775
-----------------------------------------------------------------------
Income tax provision (benefit) $ (5,714) $ (2,098) $ 4,074
=======================================================================
In 2002, the Company determined liabilities of $2,557,000 that had been
established in 1997 related to certain items, which were deducted in that
year's income tax return, were no longer required, and therefore,
recognized a current income tax benefit relating to releasing such
liabilities.
The difference between income tax provision (benefit) and the expected tax
which would result from the use of the Federal statutory income tax rate is
as follows:
(in thousands) 2002 2001 2000
---------------------------------------------------------------------------
Computed tax at statutory Federal rate $ (2,431) $ (2,213) $ 3,027
Release of prior year tax liability (2,557)
State income taxes, net of Federal benefit (721) (292) 413
Foreign income/losses for which no tax
(expense) benefit is recognized (55) 606 660
Other 50 (199) (26)
---------------------------------------------------------------------------
Income tax provision (benefit) $ (5,714) $ (2,098) $ 4,074
===========================================================================
Income before income taxes from foreign operations, including discontinued
operations, was $917,000 in 2002, which impacted the Company's effective
income tax rate due to the utilization of historical net operating loss
carryforwards that were subject to full valuation allowances in prior years
to offset income taxes otherwise payable. Loss before income taxes from
foreign operations, including discontinued operations, was $882,000 in 2001
and $1,151,000 in 2000. The losses before income taxes from foreign
operations negatively impact the Company's effective income tax rate due to
the non-recognition of such losses for tax purposes and the need for a
valuation allowance in the foreign jurisdictions.
F-20
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. INCOME TAXES (continued)
The components of the deferred tax assets and deferred tax liabilities are as
follows at December 31:
(in thousands) 2002 2001
-----------------------------------------------------------------------
Deferred Tax Assets:
Net operating loss carryforwards:
Federal $ 460 $ 281
Foreign 2,474 2,286
State 748 235
Tax credits:
Federal 288 425
State 908 634
Inventory reserves 3,082 68
Other 2,326 2,139
-----------------------------------------------------------------------
10,286 6,068
Less valuation allowance 2,803 2,614
-----------------------------------------------------------------------
Deferred tax assets 7,483 3,454
-----------------------------------------------------------------------
Deferred Tax Liabilities:
Depreciation 1,518 8
Other 1,434 670
-----------------------------------------------------------------------
Deferred tax liabilities 2,952 678
-----------------------------------------------------------------------
Net deferred tax asset (liability) $ 4,531 $ 2,776
=======================================================================
The Company's valuation allowance results principally from foreign losses
and related net operating loss carryforwards for which the realization of
future tax benefits is uncertain. Foreign net operating loss carryforwards
aggregate $6,606,000 expiring in varying amounts beginning 2004 through
2010). Although realization is not assured, the Company has concluded that
it is more likely than not that the remaining deferred tax assets, which
arise principally from domestic operations, will be realized based on the
reversal of deferred tax liabilities and projected taxable income.
In 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, of which approximately $460,000
is related to discontinued operations.
At December 31, 2002, the Company has Federal and state net operating loss
carryforwards of $1,293,000 and $8,801,000, respectively. The Federal net
operating loss carryforwards expire in varying amounts beginning in 2007
through 2021. The state net operating loss carryforwards, which will
primarily offset New Jersey taxable income, expire in varying amounts
beginning in 2007 through 2016. The Company has provided valuation
allowances for $768,000 in Federal, and a corresponding amount of state,
net operating loss carryforwards due to the uncertainty of realizing future
tax benefits from these net operating loss carryforwards. The Company has
Federal research and development credits of $288,000, which expire in
varying amounts beginning in 2021 through 2022. The Company also has state
research and development and manufacturing credits of $748,000, primarily
to offset New Jersey income taxes, which expire in varying amounts
beginning in 2005 through 2009.
F-21
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES
Service Agreements
The Company is the processor of allograft bone tissue for domestic and
international clients. The Company provides these processing services
pursuant to long-term service agreements. The Company's agreements with its
clients generally provide for cross-indemnification against liability
arising out of performance of the agreements.
The Company entered into an exclusive ten-year processing agreement with
one of its major allograft bone tissue processing clients, the American Red
Cross Tissue Services ("ARC"). The agreement was effective January 1, 1997.
In October, 2002, the processing agreement was amended. The amendment,
among other items, removes the requirements that ARC exclusively provide
all tissue recovered by ARC to the Company for processing and, in its
place, provides that ARC provide a monthly minimum number of donors to the
Company for processing.
Effective June 1, 2002, the Company entered into a new Processing Agreement
with the Musculoskeletal Transplant Foundation ("MTF"), which will continue
through December 31, 2008. Under the terms of the Processing Agreement, MTF
will supply a certain increasing minimum annual amount of donor tissue to
the Company for processing into standard base tissue forms, Grafton(R) DBM
and Graftech(TM) Bio-implants, all of which will be distributed to hospital
end-users by MTF, under the MTF label, and provide a certain increasing
minimum annual amount of tissue for the Company to process into standard
base tissue forms, Grafton(R) DBM and Graftech(TM)Bio-implant tissue forms,
all of which will be distributed to hospital end-users by the Company under
its own label. This new Processing Agreement was entered into as part of
the settlement of the Company's litigation with MTF. (See Note 13,
"Litigation - Musculoskeletal Transplant Foundation v. Osteotech, Inc.").
Effective January 4, 2002, the Company entered into a five-year agreement
with LifeNet. Under the terms of the agreement, the Company will process
allograft bone tissue provided by LifeNet into the Company's broad line of
Graftech(R) Bio-implants. Effective January 1, 2003, the Company entered
into a five-year agreement with DePuy Orthopaedics, Inc. and DePuy Acromed,
Inc. (collectively, "DePuy") and LifeNet for the processing and
distribution to the domestic hospital market of a private label DBM carrier
product. Under the terms of the agreement, the Company will process the DBM
carrier product to specifications determined by LifeNet, from bone tissue
supplied by LifeNet. DePuy will market and promote the DBM carrier product
to surgeons performing trauma, joint revision and spinal procedures and
LifeNet will ship and bill the product to end-users
Purchase Commitments
In February, 2001, the Company entered into an exclusive distribution
agreement with Alphatec Manufacturing, Inc. ("Alphatec") to market and
distribute the Sentinal(TM) Pedicle Screw System and Affirm(TM) in the
United States and Canada. The term of the agreement is two years from the
beginning of the first quarterly period after completion of the initial
order. The agreement automatically renews for additional two-year terms
unless terminated in writing by either party six months prior to expiration
of the then current two-year term. The Company has agreed to purchase
$6,000,000 of inventory during the first two years of the agreement, and
$8,000,000 during the second two-year term, if the agreement renews.
F-22
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
Purchase commitments for each successive renewal period would be negotiated
prior to those renewals. If the Company fails to make the minimum purchases
in any period, the Company will pay Alphatec a penalty payment equal to 50%
of the shortfall. 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 is $2,800,000 for the second year (April 1, 2003 to
March 31, 2004) of the commitment period.
In October, 2002, because of a higher than normal level of complaints, the
Company temporarily suspended the sale and distribution of Affirm(TM). Due
to the continuing uncertainty surrounding the re-introduction of Affirm(TM)
into the market, the Company does not expect to purchase sufficient
inventory to meet the purchase commitment. Accordingly, the Company
recorded a provision of $1,079,000 for the penalty that will be due for the
expected shortfall under the purchase commitment. (See Note 4, "Continuing
Operations - Gains and Charges").
Loan Receivable
In November, 2000, the Company entered into a Loan Agreement with the
American Tissue Services Foundation ("ATSF"), a not-for-profit tissue
recovery organization. The Loan Agreement expires on December 31, 2010.
Through June, 2002, the Company had loaned ATSF an aggregate of $2,458,000
at an average interest rate of 5.59%. The Company has fully reserved all
amounts outstanding under the loans, of which $457,000 was reserved in 2002
and the balance was reserved in 2001. All charges related to these reserves
are included in marketing, selling, general and administrative expenses in
the statements of operations.
Through June 15, 2002, Michael J. Jeffries, the Company's Executive Vice
President and Chief Financial Officer, was one of the three members of
ATSF's Board of Directors. ATSF is a not-for-profit corporation, and
neither Mr. Jeffries nor the Company owns any equity or any other interest
in ATSF. Mr. Jeffries received no compensation from ATSF. On June 15, 2002,
the existing ATSF management and ATSF's Board of Directors, including Mr.
Jeffries resigned and were replaced by a new management group and a new
Board of Directors. Concurrent with this change, the Company and ATSF
re-negotiated the existing Loan Agreement to convert it to a non-interest
bearing note and to provide for the forgiveness of approximately 50% of the
loan balance, which remains fully reserved. The note requires minimum
annual repayments of $150,000 beginning January 1, 2003.
In December, 2000, the Company entered into an exclusive fifteen-year
processing and distribution agreement with ATSF. Pursuant to the agreement,
the Company has the right to process and distribute all ATSF recovered
musculoskeletal tissue. In June, 2002, in conjunction with the change in
ATSF's management and Board of Directors, the Company waived the
exclusivity provisions of the agreement where ATSF's management believes
other processors have technology desired by surgeons in ATSF's service
areas.
F-23
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. 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 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. (See Note 4, "Continuing Operations
- Gains and Charges").
Litigation
GenSci Regeneration Laboratories, Inc. v. Osteotech, Inc.; Osteotech, Inc.
v. GenSci Regeneration Sciences, Inc.
In January, 1998, the Company filed a patent infringement action against
GenSci Regeneration Laboratories, Inc. ("GenSci Labs") and GenSci
Regeneration Sciences, Inc. ("GenSci Sciences", collectively, "GenSci")
alleging that GenSci violated claims of one of the patents involving the
Company's Grafton(R) Demineralized Bone Matrix (DBM) process. Approximately
two weeks after the Company's filing, GenSci Labs filed a suit against the
Company alleging that the Company's Grafton(R) DBM Flex tissue form
infringes two patents assigned to GenSci Labs in addition to allegations
against us for tortious interference with a business expectancy, negligent
interference with a prospective economic advantage and inducing breach of
contract and seeking a declaratory judgment of the invalidity of the
Company's patents U.S. Patent Nos. 5,284,655 (the "655 Patent") and
5,290,558 (the "558 Patent") covering Grafton(R) DBM. In February, 1998,
GenSci Labs amended its complaint alleging essentially the same causes of
action but adding a third patent to the allegation of patent infringement.
In August, 1998, the actions were consolidated into one case before the
United States District Court for the Central District of California. In
April, 2000, GenSci Labs and GenSci Sciences agreed to dismiss with
prejudice all of GenSci's patent infringement claims against the Company.
Between September, 1998 and September, 2001, there were numerous amendments
to the complaints of both parties and both parties filed numerous motions
with the Court.
On October 31, 2001, the trial commenced in the United States District
Court for the Central District of California. In November, 2001, the jury
returned a verdict that the 558 Patent and the 655 Patent are valid and
that GenSci infringed on both patents through their sales of the
DynaGraft(TM) Gel and Putty products. In arriving at its verdict, the jury
rejected all of GenSci's defenses.
In December 2001, the Company was awarded damages in the amount of
$17,533,634 for GenSci's infringement of its patents. This damage award
will be reduced by the $3.0 million previously paid by DePuy in 2000 and
1999 in settlement of the Company's claims against DePuy in this lawsuit.
The Company has not recognized any portion of the net award of $14,533,634
in its financial statements. On December 21, 2001, GenSci filed for
bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code.
F-24
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
GenSci Orthobiologics, Inc. v. Osteotech, Inc.
On March 6, 2000, GenSci Orthobiologics, Inc. ("GenSci") filed a complaint
in the United States District Court for the Central District of California
against the Company, alleging unlawful monopolization, attempt to
monopolize the market for demineralized bone matrix and for entering
agreements in restraint of trade, in violation of Sections 1 and 2 of the
Sherman Antitrust Act and Section 3 of the Clayton Act; and that the
Company engaged in unlawful and unfair business practices in violation of
Section 17200 of the California Unfair Competition Law. GenSci has alleged
that the Company has monopoly power in the market for demineralized bone
matrix products in the United States, and has engaged in anticompetitive
conduct by improperly asserting its patents through patent infringement
actions, seeking to have the Food and Drug Administration remove certain of
GenSci's products from the market, restricting competitors' access to raw
materials, interfering with GenSci's arrangements to manufacture
demineralized bone matrix implants, interfering with GenSci's marketing and
distribution arrangements, and disparaging GenSci's products.
GenSci seeks compensatory, incidental, consequential, and punitive damages
in an unspecified amount, and injunctive relief to stop the Company from
restricting the tissue banks for which it processes tissue from supplying
processed demineralized bone matrix to the Company's competitors and
distributing the demineralized bone matrix implant products of the
Company's competitors. Certain of these allegations had previously been
asserted by GenSci in its patent litigation with the Company in the Central
District of California federal court.
In April, 2000, the Company reached an agreement with GenSci whereby tort
claims that were dismissed from the patent litigation would be transferred
to this action and this action was stayed pending completion of the
Company's patent infringement case against GenSci. On December 20, 2001,
GenSci filed a bankruptcy petition with the United States Bankruptcy Court
for the Central District of California. GenSci has not sought relief from
the automatic stay to pursue this action.
The Company believes the claims made in this lawsuit are without merit and
intends to vigorously defend against these claims.
Osteotech, Inc. v. GenSci Orthobiologics, Inc.
On October 25, 2000, the Company filed suit against GenSci Orthobiologics,
Inc. ("GenSci"), in the United States District Court for the Central
District of California, alleging that GenSci's demineralized bone matrix
materials sold under the name Orthoblast, infringe the Company's U.S.
Patent No. 5,290,558 and infringe the re-examined claims of the Company's
U.S. Patent No. 5,676,146. The Company's complaint seeks injunctive relief,
treble damages, costs and attorneys' fees.
In its Second Amended Answer and Counterclaim filed in March, 2001, GenSci
denies infringement, asserts a number of affirmative defenses, and asserts
a counterclaim seeking a declaratory judgement that the patents-in-suit are
invalid, not infringed and/or unenforceable, together with costs and
attorneys' fees.
The Company intends to pursue its claims against GenSci and vigorously
defend against the counterclaims. On December 20, 2001, GenSci filed a
bankruptcy petition with the United States Bankruptcy Court for the Central
District of California. As a result, this suit is currently stayed.
F-25
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
"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
misrepresentation, fraud, and violation of the New Mexico Unfair Trade
Practices Act arising from allegedly defective dental implant coating and
coating services provided to plaintiffs by the Company's subsidiary,
Osteotech Implants BV, formerly known as Cam Implants BV. Plaintiffs have
demanded unspecified monetary damages. In August, 1998, the Company removed
this action to the United States District Court for the District of New
Mexico and filed and served its answer, denying any and all liability in
this action, and moved to dismiss five of the seven claims alleged against
it. In March, 1999, the court dismissed with prejudice the plaintiff's
negligence and strict liability claims. As to the remaining claims, the
Company, in addition to denying any and all liability, has moved for
summary judgement on the basis that all of the remaining claims are barred
by their applicable 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. On February 13,
2003, the Company filed another motion for summary judgment on the basis
that plaintiffs sued the wrong party. The motion has not yet been fully
briefed and submitted to the court. Discovery on matters relating to the
merits of the plaintiffs' claims and scope of alleged damages, is in
progress.
The Company believes that the claims made against it in this action are
without merit and will continue to vigorously defend against such claims.
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, "Danek") 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
("bio-d(R)"), 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 Danek.
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,
and supported by an irrevocable standby letter of credit, and to cease
processing, marketing, distributing, advertising and promoting of the
bio-d(R) by January 31, 2003. In accordance with the Medtronic Settlement,
we completed the removal of the bio-d(R) from the market on January 31,
2003. In addition, Medtronic agreed to discontinue its participation in the
lawsuit brought by the University of Florida Tissue Bank, Inc.,
Regeneration Technologies, Inc., Sofamor Danek Group, Inc. and Sofamor
Danek L.P. (see "University of Florida Tissue Bank, Inc. v. Osteotech,
Inc."), to neither fund nor voluntarily assist RTI or any other party to
continue to pursue this suit against the Company, and to contact RTI,
inform it of the terms of this settlement and recommend to RTI to accept
the terms of this settlement in complete resolution of its suit against the
Company.
F-26
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
The Company recorded a charge of $1,785,000 in the second quarter of 2002
representing the present value of the amounts due to Medtronic under this
settlement. This charge is reflected as a litigation settlement charge in
the consolidated statements of operations. (See Note 4, "Continuing
Operations - Gains and Charges").
University of Florida Tissue Bank, Inc. v. Osteotech, Inc.
In February, 1999, Southeast Tissue Alliance, formerly known as the
University of Florida Tissue Bank, Inc. ("Southeast"), Regeneration
Technologies, Inc. ("RTI"), Sofamor Danek Group, Inc. and Sofamor Danek
L.P. filed a complaint against the Company in the United States District
Court for the Northern District of Florida alleging that the Company's
bio-d(R)infringed on the claims of U.S. Patent Nos. 5,814,084, 4,950,296
and 6,096,081.
In April, 2002 Medtronic settled its portion of this lawsuit with the
Company pursuant to the Medtronic Settlement discussed above. In June,
2002, Southeast and RTI settled their portions of this lawsuit with the
Company under the same terms as the Medtronic Settlement without any
additional monetary payments.
Regner v. Inland Eye & Tissue Bank of Redlands; Thacker v. Inland Eye &
Tissue Bank of Redlands; Savitt v. Doheny Eye and Tissue Bank; Sorrels,
Decker and Blake v. Inland Eye & Tissue Bank, et al.
The Company is a defendant with several other defendants in three actions
pending in the Superior Court for the State of California, Los Angeles
County. One of the suits seeks class action status and initially alleged
causes of action based on a violation of the California Business and
Professional Code Section 17200, as well as a number of common law causes
of action, including negligence, deceit, and intentional and negligent
infliction of emotional distress. Through dismissals, either by the Court
or voluntarily by plaintiffs, only the California Business and Professional
Code claims, which are based on the allegation that defendants are engaging
in the activity of buying or selling organs or tissue for valuable
consideration or profit, and certain negligence claims remain with respect
to the actions. It appears that plaintiffs are seeking class action status
and injunctive relief and "restitution" with respect to their California
Business and Professional Code claims. To the extent any of the other
causes of action lie against the Company, plaintiffs are seeking damages in
an unspecified amount. Although this litigation has been pending for some
time, significant discovery has only recently commenced. Plaintiffs filed a
motion for leave to file a Fourth Amended Complaint to allow the adding of
two additional class representatives and to make other changes to the
complaint, which motion was denied without prejudice on February 3, 2003.
Plaintiffs' counsel have recently indicated that, rather than seek to amend
the Regner complaint, they plan to file three new actions on behalf of
three plaintiffs alleging claims similar to those asserted in the Regner
case. We also expect the court to set a schedule for a class certification
motion in the near future.
On March 24, 2003, the Company was served with a new similar action,
Sorrels, Decker and Blake v. Inland Eye & Tissue Bank, et al. This action
purports to be a class action and alleges violations of Section 17200 and
negligence against the Company.
The Company believes that the claims made against it in this action are
without merit and will continue to vigorously defend against such claims.
F-27
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
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. 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 the case was formally dismissed on December 30, 2002. 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 operation or financial condition.
Musculoskeletal Transplant Foundation v. Osteotech, Inc.
In October, 2000, the Musculoskeletal Transplant Foundation ("MTF") and
Synthes Spine Company, L.P. ("Synthes") commenced an action against the
Company in the United States District Court for the District of New Jersey.
Plaintiffs sought a declaratory judgment that their manufacture, use, sale
and/or offer for sale of their demineralized bone matrix products, known as
DBX(R), do not infringe on the claims of the Company's U.S. Patent Nos.
5,290,558 and 5,284,655, and that the Patents are invalid and
unenforceable.
By agreement dated June 1, 2002, the parties have settled this action. The
settlement included the execution of a new processing agreement between MTF
and the Company (see Note 13, "Service Agreement"), an agreement by MTF and
Synthes not to challenge the validity and enforceability of any claims
related to the aforementioned patents, and the Company granted MTF and
Synthes a non-exclusive, worldwide license under the aforementioned patents
to sell, distribute, import and/or export certain bone filler products,
including MTF's DBX(R) product, that are comprised of demineralized and/or
partially demineralized bone powder in carriers.
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 alleged 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 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.
Younger v. Hayes Medical Center, Inc.
In April, 2001, the Company was served in an action brought in the
Twentieth Judicial District Court in Ellis County, Kansas against Hayes
Medical Center, Inc., MTF, Metropath, Inc. and the Company. With respect to
the Company, the suit alleged a cause of action for negligence in
connection with allegedly defective allograft bone tissue provided by
defendants and allegedly implanted in plaintiff during a surgical
procedure. In May, 2002, plaintiff voluntarily dismissed this action
without prejudice.
F-28
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
Wright Medical Technology, Inc. v. Osteotech, Inc.
In June, 2001, Wright Medical Technology, Inc. ("Wright") filed a complaint
against the Company in the United States District Court for New Jersey,
which alleged claims for false advertising, and related causes of action
concerning certain statements allegedly made by the Company regarding a FDA
Warning Letter received by Wright with respect to a tissue product marketed
by Wright.
On June 14, 2002, the parties settled this action. The settlement of this
action did not have a material impact on the Company's results of
operations or financial condition.
Hardman v. Nussbaum
ARC notified the Company in the first quarter of 2002 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. On December 2, 2002, ARC moved for summary
judgment dismissing all of plaintiff's claims. After ARC filed its summary
judgment papers, the plaintiff voluntarily dismissed ARC from the case.
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 other than the
Company. 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. On November 14, 2002, the Court entered a scheduling order
setting forth the pertinent deadlines to which the parties must adhere.
Plaintiff missed a February 7, 2003 deadline for submitting expert reports.
The Company moved to strike all expert testimony on behalf of plaintiff due
to plaintiff's failure to provide the expert reports within the time
specified in the Court's scheduling order. On February 19, 2003,
plaintiff's attorney moved to withdraw as counsel of record. On February
20, 2003, the Court ordered that plaintiff's attorney be permitted to
withdraw as counsel of record.
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.
F-29
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
Other than the foregoing matters, the Company is not a party to any
material pending legal proceeding. 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.
14. 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.
The authorized capital of the Company includes 5,000,000 shares of
Preferred Stock, the rights and provisions of which will be determined by
the Board of Directors at the time any such shares are issued, if at all.
No shares of Preferred Stock were issued or outstanding at December 31,
2002 or 2001.
Stock Repurchase Program
In May, 2000, the Board of Directors of the Company authorized the
repurchase and retirement of up to 1,000,000 shares of the Company's common
stock through open market purchases, or block purchases. As of December 31,
2000, the Company had repurchased and retired 330,500 shares of common
stock at a cost of approximately $3,124,000. No shares were repurchased in
2002 or 2001.
F-30
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. STOCKHOLDERS' EQUITY (continued)
Stock Options
The Company's 2000 Stock Plan (the "2000 Plan") authorizes the grant of up
to 1,000,000 shares of the Company's common stock in the form of incentive
stock options, non-qualified stock options or other stock-based awards to
employees, directors and consultants. Incentive stock options may be
granted at prices not less than 100% of the fair market value on the date
of grant. Non-qualified stock options and other stock-based awards may be
granted at the discretion of the Compensation Committee of the Board of
Directors under terms and conditions as determined by the Compensation
Committee. Options will expire ten years from the date of grant and vesting
will be determined by the Compensation Committee. Options issued pursuant
to the 2000 Plan typically have terms requiring vesting ratably over four
years.
The 1991 Stock Option Plan (the "1991 Plan"), as amended, authorizes the
grant of up to 4,220,648 shares of the Company's common stock in the form
of incentive stock options or non-qualified stock options to employees and
consultants. In June, 2000, the 1991 Plan was replaced by the 2000 Plan,
and therefore, options will no longer be issued under the 1991 Plan.
The 1991 Independent Directors Stock Option Plan (the "Directors Plan"), as
amended, authorizes the grant of options to purchase up to 750,000 shares
of the Company's common stock to members of the Board of Directors who are
not officers or employees of the Company. Option exercise prices equal 100%
of the fair market value on the date of grant. Options issued prior to July
1, 1997 become exercisable in ratable installments over four years with
unexercised options expiring five years from the vesting date. Effective
July 1, 1997, the Directors Plan was amended to provide for options issued
to become 100% exercisable on the first anniversary of the date of grant,
provided that the holder of such option is on the Company's Board of
Directors during such year, with unexercised options expiring ten years
from the date of grant. The Directors Plan does not have any available
securities for issuance pursuant to options and all shares pursuant to
outstanding options that expire or are forfeited are cancelled upon return
to the Plan.
Stock option activity for the years 2002, 2001, and 2000 is as follows:
2002 2001 2000
--------------------------- ------------------------- -------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
--------------------------------------------------------------------------------------------------------------------------
Outstanding at January 1, 2,510,699 $ 9.50 2,319,325 $ 9.98 1,866,522 $ 11.93
Granted 373,800 7.71 238,000 5.37 686,000 5.76
Exercised 47,500 3.68 10,138 4.10 74,261 4.14
Cancelled or expired 431,687 9.94 36,488 14.29 158,936 17.45
--------------------------------------------------------------------------------------------------------------------------
Outstanding at December 31, 2,405,312 $ 9.26 2,510,699 $ 9.50 2,319,325 $ 9.98
--------------------------------------------------------------------------------------------------------------------------
Exercisable at December 31, 1,655,821 $ 10.35 1,544,076 $ 10.48 1,236,336 $ 10.36
--------------------------------------------------------------------------------------------------------------------------
Available for grant at
December 31, 150,105 494,500 714,750
--------------------------------------------------------------------------------------------------------------------------
Weighted average fair value per share
of options granted during the period $ 5.08 $ 3.30 $ 3.28
--------------------------------------------------------------------------------------------------------------------------
F-31
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. STOCKHOLDERS' EQUITY (continued)
The following table summarizes the information about stock options
outstanding at December 31, 2002:
Options Outstanding Options Exercisable
------------------------------------------------------ ------------------------------------
Weighted Average
Number Remaining Weighted Number Weighted
Range of Outstanding at Contractual Life Average Exercisable at Average
Exercise Prices December 31, 2002 (Years) Exercise Price December 31, 2002 Exercise Price
----------------------------------------------------------------------------------------------------------------------
$ 2.33 To $ 3.78 244,450 7.3 $ 3.46 110,825 $ 3.42
3.79 To 7.57 986,799 6.5 5.81 594,121 5.50
7.58 To 11.36 690,250 6.2 8.81 493,250 8.75
11.37 To 15.15 66,000 4.9 12.47 63,000 12.42
15.16 To 18.93 164,375 5.8 16.24 142,812 16.30
18.94 To 22.73 201,938 5.6 20.67 201,938 20.67
34.09 To 37.88 51,500 6.4 37.76 49,875 37.78
----------------------------------------------------------------------------------------------------------------------
$ 2.33 To $ 37.88 2,405,312 6.3 $ 9.26 1,655,821 $ 10.35
======================================================================================================================
Stock Warrants
As part of financing and contract arrangements, the Company has, at certain
times, issued warrants to purchase its Convertible Preferred Stock. As of
January 1, 2000 there were Convertible Preferred Stock warrants to purchase
458 shares of Common Stock at an exercise price of $3.72. During 2000, all
outstanding Convertible Preferred Stock warrants expired.
Stock Purchase Plan
Prior to June, 2002, the 1994 Employee Stock Purchase Plan (the "1994
Purchase Plan") provided for the issuance of up to 375,000 shares of Common
Stock. At the Company's annual meeting in June, 2002, the shareholders
approved to increase the number of shares of Common Stock issuable under
the 1994 Purchase Plan by 200,000 share to 575,000 shares. Eligible
employees may purchase shares of the Company's Common Stock through payroll
deductions of 1% to 7 1/2% of annual compensation. The purchase price for
the stock is 85% of the fair market value of the stock on the last day of
each calendar quarter. At December 31, 2002, 238,713 shares were available
for future offerings under this plan.
F-32
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. STOCKHOLDERS' EQUITY (continued)
Stockholder Rights Agreement
In January, 1996, the Board of Directors of the Company unanimously adopted
a stockholder rights agreement (the "Rights Agreement") declaring a
dividend of one preferred stock purchase right (the "Right") for each
outstanding share of common stock. Upon the occurrence of certain events,
each Right entitles the stockholder to purchase from the Company one
one-hundredth of a preferred share at a price of $170.00 per one
one-hundredth of a preferred share, subject to adjustment. The Rights will
not be exercisable or separable from the common shares until ten business
days after a person or group acquires or tenders for 20% or more of the
Company's outstanding common shares ("triggering event"). The Rights
Agreement also provides that, after a triggering event occurs, the Rights
convert into a Right to buy common stock and entitle its holder to receive
upon exercise that number of common shares having a market value of two
times the exercise price of the Right. In the event the Company is acquired
in a merger or other business combination transaction, each Right will
entitle its holder to receive upon exercise of the Right, at the Right's
then current exercise price, that number of the acquiring company's common
shares having a market value of two times the exercise price of the Right.
The Company is entitled to redeem the Rights at a price of $.01 per Right
at any time prior to their becoming exercisable, and the Rights expire on
March 31, 2009. The Rights Agreement was adopted to maximize the value of
all stockholders' ownership interest in the Company by establishing a
deterrent to abusive takeover tactics sometimes used in challenges for
corporate control.
15. SUPPLEMENTAL STATEMENT OF OPERATIONS INFORMATION
Maintenance and repairs expense from continuing operations for the years
ended December 31, 2002, 2001, and 2000 was $2,480,000, $2,415,000, and
$2,525,000, respectively. Depreciation and amortization expense from
continuing operations related to property, plant and equipment for the
years ended December 31, 2002, 2001, and 2000 was $7,739,000, $7,856,000,
and $3,842,000, respectively.
16. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
(in thousands) 2002 2001 2000
---------------------------------------------------------------------------------
Cash paid during the year for taxes $ 1,576 $ 1,170 $ 1,895
Cash paid during the year for interest, excluding
amounts capitalized 1,227 379 11
Noncash investing activities:
Note receivable from sale of foreign operation 1,273
F-33
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
17. NET INCOME (LOSS) PER SHARE
The following table sets forth the computation of basic and diluted net
income (loss) per share:
Year Ended
------------------------------------------------
(dollars in thousands except per share data) 2002 2001 2000
------------------------------------------------
Income (loss) from continuing operations $ (1,437) $ (4,040) $ 5,220
Discontinued operations 93 (370) (392)
------------------------------------------------
Net income (loss) (1,344) (4,410) 4,828
===================================================================================================================
Denominator for basic earnings (loss) per share:
Weighted average common shares outstanding 15,904,132 14,030,623 14,057,931
Effect of dilutive securities:
Stock options 277,601
Warrants 109
------------------------------------------------
Denominator for diluted earnings (loss) per share 15,904,132 14,030,623 14,335,641
===================================================================================================================
Basic earnings (loss) per share:
Income (loss) from continuing operations $ (.09) $ (.29) $ .37
Discontinued operations .01 (.02) (.03)
------------------------------------------------
Net income (loss) $ (.08) $ (.31) $ .34
===================================================================================================================
Diluted earnings (loss) per share:
Income (loss) from continuing operations $ (.09) $ (.29) $ .37
Discontinued operations .01 (.02) (.03)
------------------------------------------------
Net income (loss) $ (.08) $ (.31) $ .34
===================================================================================================================
For the year ended 2002 and 2001, common equivalent shares, consisting
solely of stock options, are excluded from the calculation of diluted net
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 net income (loss) per share
were 1,536,790 in 2002, 1,744,518 in 2001, and 771,498 in 2000. Such shares
were not included because they were antidilutive.
18. OPERATING SEGMENTS
The Company has two primary business segments: the Grafton(R) DBM Segment
and Base Tissue Segment. The Grafton(R) DBM Segment engages in the
processing and marketing of Grafton(R) DBM. Grafton(R) DBM is processed
using the Company's advanced proprietary demineralization process. The Base
Tissue Segment primarily engages in the processing of mineralized
weight-bearing allograft bone tissue. The Company's other business units
engage in marketing and distributing metal spinal implant products and
processing, and marketing and distributing bovine tissue products.
F-34
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
18. OPERATING SEGMENTS (continued)
The accounting policies of the reportable segments are the same as those
described in the Summary of Significant Accounting Policies. The Company
evaluates the performance of its operating segments based on revenue
performance and operating results. The Company does not generate
information about assets for its operating segments, and accordingly no
asset information is presented in the table below. All corporate related
expenses are allocated to operating segments and geographic areas in
determining operating income (loss) of the respective segments. These
expenses are allocated to the segments and geographic areas based on
allocations that the Company considers to be a reasonable reflection of the
utilization of services provided or the benefits received.
Summarized financial information concerning the Company's segments after
giving effect to the divestiture of the Company's operations in The
Netherlands is shown in the following table.
Grafton(R)DBM Base Tissue
(in thousands) Segment Segment Other Consolidated
-------------------------------------------------------------------------------------------------------------
Revenues:
2002 $ 44,926 $ 32,115 $ 6,333 $ 83,374
2001 43,637 27,692 4,386 75,715
2000 45,226 26,204 2,681 74,111
-------------------------------------------------------------------------------------------------------------
Operating income (loss):
2002 $ 9,836 $ (9,165) $ (7,851) $ (7,180)
2001 7,014 (7,979) (5,302) (6,267)
2000 11,389 694 (3,808) 8,275
-------------------------------------------------------------------------------------------------------------
Depreciation and amortization:
2002 $ 2,411 $ 4,488 $ 1,331 $ 8,230
2001 1,962 5,413 1,223 8,598
2000 2,198 1,376 1,023 4,597
-------------------------------------------------------------------------------------------------------------
Financial information by geographic area after giving effect to the
divestiture of the Company's operations in The Netherlands is summarized as
follows:
(in thousands) United States Europe Consolidated
-------------------------------------------------------------------------------------------------------------
Revenues
2002 $78,576 $ 4,798 $83,374
2001 71,776 3,939 75,715
2000 71,468 2,643 74,111
Long-lived Assets
2002 $52,408 $ 1,127 $53,535
2001 55,261 1,475 56,736
2000 56,618 1,672 58,290
F-35
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
18. OPERATING SEGMENTS (continued)
Two of the Company's customers individually comprise 10% or more of the
Company's consolidated net revenues. Revenues by these customers, which are
reported as part of the Company's Grafton(R) DBM and Base Tissue Segments,
are as follows:
(in thousands) 2002 2001 2000
-----------------------------------------------------
Revenues
MTF $24,202 $28,967 $37,743
ARC 24,960 29,097 30,469
-----------------------------------------------------
$49,162 $58,064 $68,212
=====================================================
19. RETIREMENT BENEFITS
The Company has a 401(k) plan which covers substantially all full time U.S.
employees. Effective January 1, 2002, the Company has agreed to contribute
an amount equal to 35% of each participant's contribution. Previously, the
Company contributed 25% of each participant's contributions. A
participant's contribution may not exceed 15% of annual compensation, or
the maximum allowed by the Internal Revenue Code, if less than 15% of
compensation. Provisions of the plan include graduated vesting over five
years from date of employment. Total Company contributions for the years
ended December 31, 2002, 2001, and 2000 were $433,000, $393,000, and
$285,000, respectively.
The Company does not maintain any other pension or post retirement plans.
F-36
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
20. QUARTERLY FINANCIAL DATA (unaudited)
The following is a summary of the unaudited quarterly results for the years
ended December 31, 2002 and 2001:
Quarter Ended
--------------------------------------------------------------------
(in thousands except per share data) March 31 June 30 September 30 December 31
- --------------------------------------------------------------------------------------------------------------------
2002
- --------------------------------------------------------------------------------------------------------------------
Net revenues $ 22,085 $23,009 $ 19,691 $ 18,589
Gross profit 13,065 12,751 7,002 3,970
Income (loss) from continuing
operations 379 234 1,007 (3,057)
Discontinued operations 7 86
Net income (loss) 386 320 1,007 (3,057)
Net income (loss) per share:
Basic:
Income (loss) from continuing
operations $ .03 $ .01 $ .06 $ (.18)
Discontinued operations .01
-------------------------------------------------------------------
Net income (loss) $ .03 $ .02 $ .06 $ (.18)
===================================================================
Diluted:
Income (loss) from continuing
operations $ .03 $ .01 $ .06 $ (.18)
Discontinued operations .01
-------------------------------------------------------------------
Net income (loss) $ .03 $ .02 $ .06 $ (.18)
===================================================================
2001
- --------------------------------------------------------------------------------------------------------------------
Net revenues $ 17,443 $18,972 $ 19,118 $ 20,182
Gross profit 10,297 10,445 11,345 10,323
Income (loss) from continuing
operations (288) (2,124) 281 (1,909)
Discontinued operations (19) (6) (49) (296)
Net income (loss) (307) (2,130) 232 (2,205)
Net income (loss) per share:
Basic:
Income (loss) from continuing
operations $ (.02) $ (.15) $ .02 $ (.14)
Discontinued operations (.02)
-------------------------------------------------------------------
Net income (loss) $ (.02) $ (.15) $ .02 $ (.16)
===================================================================
Diluted:
Income (loss) from continuing
operations $ (.02) $ (.15) $ .02 $ (.14)
Discontinued operations (.02)
-------------------------------------------------------------------
Net income (loss) $ (.02) $ (.15) $ .02 $ (.16)
===================================================================
See Note 4, "Continuing Operations - Gains and Charges" and Note 5,
"Discontinued Operations" for discussion of significant gains and charges
recorded in 2002 and 2001.
F-37
SCHEDULE II
OSTEOTECH, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
Additions
Balance At ------------------------------ Balance At
Beginning Charged To Charged End
Of Period Expenses To Other Deductions Of Period
--------------------------------------------------------------------------------
For the year ended December 31, 2002:
Allowance for doubtful accounts $ 303 $ 638 $ 15(a) $ (13)(b) $ 943
Valuation allowance for deferred
tax asset 2,614 455(c) 466(a) (732)(d) 2,803
For the year ended December 31, 2001:
Allowance for doubtful accounts 123 296 (10)(a) (106)(b) 303
Valuation allowance for deferred
tax asset 2,058 607(c) (58)(a) 7(d) 2,614
For the year ended December 31, 2000:
Allowance for doubtful accounts 129 1 (3)(a) (4)(b) 123
Valuation allowance for deferred
tax asset 1,749 440(c) (122)(a) (9)(d) 2,058
(a) Represents foreign currency translation adjustments.
(b) Represents the write-off of accounts receivable.
(c) Represents the tax effect of temporary differences.
(d) Represents recognition of a deferred tax asset.
S-1
Report of Independent Accountants on
Financial Statement Schedule
To the Board of Directors of Osteotech, Inc.
Our audits of the consolidated financial statements referred to in our report
dated February 21, 2003, except for Notes 11 and 13, for which the date is March
27, 2003, appearing on page F-2 of this Form 10-K also included an audit of the
Financial Statement dated November 13, 2002 Schedule listed in Item 16(a)(2) of
this Form 10-K. In our opinion, this Financial Statement Schedule presents
fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements.
PricewaterhouseCoopers LLP
Florham Park, New Jersey
February 21, 2003,
except for Notes 11 and 13,
for which the date is March 27, 2003.
S-2
EXHIBIT INDEX
Exhibit Page
Number Description Number
10.37 Allonge to Agreement of Amendment to the Loan and Security Agreement, Mortgage, E-2
Assignment of Leases and Other Documents by and among Fleet National Bank, Osteotech,
Inc., Osteotech Investment Corporation, CAM Implants, Inc., Osteotech, B.V., H.C.
Implants, B.V., CAM Implants, B.V., Osteotech/Cam Services, B.V., Osteotech, SA and
OST Developpement, SA dated November 13, 2002
10.38 Exclusive Marketing Agreement, by and among Osteotech, Inc., LifeNet, DePuy E-13
Orthopaedics, Inc. and DePuy Acromed, Inc. dated December 13, 2002
10.39 Letter Amendment to Agreement dated December 10, 1996, by and between the American E-77
Red Cross and Osteotech, Inc. dated October 27, 2002
21.1 Subsidiaries of Registrant E-88
23.1 Consent of PricewaterhouseCoopers LLP E-89
99.1 Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of E-90
the Sarbanes-Oxley Act of 2002
99.2 Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of E-91
the Sarbanes-Oxley Act of 2002
E-1