Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
|X| Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the Period Ended September 30, 2003
or
|_| Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the Transition Period from ____________ to
____________
Commission File Number 0-19278
OSTEOTECH, INC.
(Exact name of registrant as specified in its charter)
Delaware 13-3357370
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
51 James Way, Eatontown, New Jersey 07724
(Address of principal executive offices) (Zip Code)
(732) 542-2800
(Registrant's telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if
changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
Applicable Only to Corporate Issuers
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |X| or No |_|
The number of shares of the registrant's common stock, $.01 par value,
outstanding as of October 31, 2003 was 17,101,120.
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
OSTEOTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(dollars in thousands)
September 30, December 31,
2003 2002
- ---------------------------------------------------------------------------------------------------
ASSETS
- ---------------------------------------------------------------------------------------------------
Current assets:
Cash and cash equivalents $ 12,236 $ 10,040
Short-term investments 3,948
Accounts receivable, net of allowance of
$1,817 in 2003 and $943 in 2002 16,928 11,545
Deferred processing costs 26,287 15,433
Inventories 4,393 4,820
Income tax receivable 1,688 3,357
Deferred tax assets 5,784 5,784
Prepaid expenses and other current assets 1,067 1,023
--------------------------
Total current assets 68,383 55,950
Property, plant and equipment, net 48,881 53,535
Goodwill, net of accumulated amortization of $404 in 2003 and 2002 1,669 1,669
Other assets 4,109 3,931
- ---------------------------------------------------------------------------------------------------
Total assets $123,042 $115,085
===================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
- ---------------------------------------------------------------------------------------------------
Current liabilities:
Accounts payable and accrued liabilities $ 16,249 $ 11,370
Current maturities of long-term debt 2,661 2,661
--------------------------
Total current liabilities 18,910 14,031
Long-term debt 13,927 15,922
Other liabilities 1,333 1,637
- ---------------------------------------------------------------------------------------------------
Total liabilities 34,170 31,590
- ---------------------------------------------------------------------------------------------------
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 17,101,120
shares in 2003 and 17,001,372 shares in 2002 171 170
Additional paid-in capital 63,956 63,368
Accumulated other comprehensive income 266 78
Retained earnings 24,479 19,879
- ---------------------------------------------------------------------------------------------------
Total stockholders' equity 88,872 83,495
- ---------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $123,042 $115,085
===================================================================================================
See accompanying notes to condensed consolidated financial statements.
-2-
OSTEOTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(dollars in thousands, except per share data)
Three Months Nine Months
Ended September 30, Ended September 30,
---------------------------- ----------------------------
2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------
Net revenues:
Service $ 21,209 $ 18,190 $ 65,753 $ 59,878
Product 1,926 1,501 4,653 4,907
---------- ---------- ---------- ----------
23,135 19,691 70,406 64,785
Cost of services 9,647 9,288 26,765 26,601
Cost of products 1,217 3,401 3,422 5,366
---------- ---------- ---------- ----------
10,864 12,689 30,187 31,967
---------- ---------- ---------- ----------
Gross profit 12,271 7,002 40,219 32,818
Marketing, selling, general and administrative 9,806 8,309 28,873 29,849
Research and development 1,095 1,002 3,020 2,990
---------- ---------- ---------- ----------
10,901 9,311 31,893 32,839
Litigation settlement charge (1,785)
---------- ---------- ---------- ----------
Operating income (loss) 1,370 (2,309) 8,326 (1,806)
Interest expense and other, net (126) (162) (590) (782)
Gain on sale of patents 950
---------- ---------- ---------- ----------
Income (loss) from continuing operations
before income taxes 1,244 (2,471) 7,736 (1,638)
Income tax provision (benefit) 525 (3,478) 3,136 (3,258)
---------- ---------- ---------- ----------
Income from continuing operations 719 1,007 4,600 1,620
Income from discontinued operations,
net of loss on disposal of $291 in 2002 93
- ---------------------------------------------------------------------------------------------------------------------
Net income $ 719 $ 1,007 $ 4,600 $ 1,713
=====================================================================================================================
Earnings per share:
Basic:
Income from continuing operations $ .04 $ .06 $ .27 $ .10
Discontinued operations .01
---------- ---------- ---------- ----------
Net income $ .04 $ .06 $ .27 $ .11
========== ========== ========== ==========
Diluted:
Income from continuing operations $ .04 $ .06 $ .26 $ .10
Discontinued operations .01
---------- ---------- ---------- ----------
Net income $ .04 $ .06 $ .26 $ .11
========== ========== ========== ==========
Shares used in computing earnings per share:
Basic 17,093,937 16,916,152 17,049,605 15,542,076
Diluted 17,958,095 17,358,019 17,704,140 15,945,162
See accompanying notes to condensed consolidated financial statements.
-3-
OSTEOTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(dollars in thousands)
Nine Months Ended September 30, 2003 2002
- -----------------------------------------------------------------------------------------------------
Cash Flow From Operating Activities
Net income $ 4,600 $ 1,713
Adjustments to reconcile income to net cash
provided by operating activities:
Depreciation and amortization 6,321 5,789
Litigation settlement charge 1,785
Deferred income taxes (2,273)
Gain on sale of patents (950)
Reversal of tax liability (2,557)
Changes in current assets and liabilities:
Accounts receivable (5,178) 467
Deferred processing costs (10,776) (4,214)
Inventories 555 1,881
Prepaid expenses and other current assets 1,825 (52)
Accounts payable and other liabilities 4,339 (68)
- -----------------------------------------------------------------------------------------------------
Net cash provided by operating activities 1,686 1,521
Cash Flow From Investing Activities
Capital expenditures (1,326) (4,253)
Proceeds from sale of land
Purchases of investments (3,948)
Proceeds from sale of investments 3,948
Proceeds from sale of foreign operation 1,000
Proceeds from sale of patents 1,000
Other, net (507) 81
- -----------------------------------------------------------------------------------------------------
Net cash provided by (used in) investing activities 2,115 (6,120)
Cash Flow From Financing Activities
Proceeds from issuance of common stock 589 16,204
Principal payments on long-term debt (1,995) (1,965)
- -----------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities (1,406) 14,239
Effect of exchange rate changes on cash (199) 158
- -----------------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents 2,196 9,798
Cash and cash equivalents at beginning of period 10,040 5,192
- -----------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 12,236 $ 14,990
=====================================================================================================
Supplementary cash flow data:
Cash paid during the period for interest, excluding amounts capitalized $ 699 $ 996
Cash paid (refunded) during the period for taxes (270) 1,226
Noncash investing activities:
Note receivable from sale of foreign operation $ $ 1,273
See accompanying notes to condensed consolidated financial statements
-4-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
reflect all adjustments (consisting only of normal recurring accruals)
considered necessary by management for a fair presentation of the
consolidated financial position as of September 30, 2003, the consolidated
results of operations for the three months and nine months ended September
30, 2003 and 2002 and the consolidated cash flows for the nine months
ended September 30, 2003 and 2002. The results of operations for the
respective interim periods are not necessarily indicative of the results
to be expected for the full year. The December 31, 2002 financial
information has been derived from the audited financial statements for the
year ended December 31, 2002. The condensed consolidated financial
statements should be read in conjunction with the audited consolidated
financial statements, which were included as part of Osteotech, Inc.'s
(the "Company") Annual Report on Form 10-K for the year ended December 31,
2002.
2. Goodwill and Other Intangible Assets
In January, 2002, the Company adopted Statement of Financial Accounting
Standard ("SFAS") No. 142, "Goodwill and Other Intangible Assets", and
accordingly, no longer amortizes goodwill. In accordance with the
provisions of SFAS No. 142, the Company completed an evaluation of the
carrying value of its goodwill as of January 1, 2003 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 represents patents,
patent applications and licenses, have carrying values of $2,472,000 and
$2,105,000 as of September 30, 2003 and December 31, 2002, respectively,
and are being amortized over their estimated useful lives ranging from
five to ten years.
3. Stock Options
The Company has adopted the "disclosure only" provisions of SFAS No. 123,
"Accounting for Stock Based Compensation", as amended by SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure - an
amendment of SFAS No. 123", 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.
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.
-5-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
3. Stock Options (continued)
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------------------------
(in thousands, except per share data) 2003 2002 2003 2002
-------------------------------------------------------------------------------------------------------
Net income
As reported:
Income from continuing operations $ 719 $ 1,007 $ 4,600 $ 1,620
Discontinued operations 93
-----------------------------------------------
Net income $ 719 $ 1,007 $ 4,600 $ 1,713
===============================================
Impact on income from continuing
operations and net income related
to stock-based employee
compensation expense, net of tax $ 273 $ 82 $ 678 $ 218
===============================================
Pro forma:
Income from continuing operations $ 446 $ 925 $ 3,922 $ 1,402
Discontinued operations 93
-----------------------------------------------
Net income $ 446 $ 925 $ 3,922 $ 1,495
===============================================
Net income per share
As reported
Basic:
Income from continuing operations $ .04 $ .06 $ .27 $ .10
Discontinued operations .01
-----------------------------------------------
Net income $ .04 $ .06 $ .27 $ .11
===============================================
Diluted:
Income from continuing operations $ .04 $ .06 $ .26 $ .10
Discontinued operations .01
-----------------------------------------------
Net income $ .04 $ .06 $ .26 $ .11
===============================================
Pro forma
Basic:
Income from continuing operations $ .03 $ .06 $ .23 $ .09
Discontinued operations .01
-----------------------------------------------
Net income $ .03 $ .06 $ .23 $ .10
===============================================
Diluted:
Income from continuing operations $ .03 $ .05 $ .22 $ .09
Discontinued operations .01
-----------------------------------------------
Net income $ .03 $ .05 $ .22 $ .10
=======================================================================================================
-6-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
4. Continuing Operations - Gains/Charges
Reduction in Workforce
On September 24, 2003, the Company implemented a selective reduction in
its workforce, which affected all domestic operational areas of the
Company, except for the sales force, and resulted in the elimination of 22
positions. As a consequence, the Company recorded a pre-tax charge of
$379,000 for the severance costs in the third quarter of 2003.
Provisions for Excess, Obsolescence and Rework
In third quarter 2002, the Company recorded pre-tax charges to costs of
service and products totaling $4,079,000 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 removed from the
market in January, 2003 in connection with the settlement of a patent
lawsuit, and an $840,000 charge for the estimated cost to rework tissue
placed in quarantine in the third quarter of 2002.
Income Tax Benefit
In 1997, the Company recorded liabilities of $2,557,000 relating to
certain tax items which were deducted in that year. In September, 2002,
the Company determined the liabilities were no longer required, and
therefore, recognized an income tax benefit related to releasing such
liabilities.
Sale of Patents
In June, 1997, the Company entered into an exclusive worldwide License and
Option Agreement for its proprietary PolyActive(TM) polymer biomaterials
technology and patents (collectively, the "PolyActive technology") with
IsoTis BV ("IsoTis"), The Netherlands. On April 8, 2002, the Company
amended the License and Option Agreement to reset 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 recognized a pretax gain
of $950,000 upon closing this transaction in the second quarter of 2002.
Medtronic Settlement
In July, 1999, Medtronic Sofamor Danek, Inc., Sofamor Danek L.P. and
Sofamor Danek Holdings, Inc. (collectively, "Medtronic") sued the Company
alleging that certain instruments and instrument sets relating to cortical
bone dowel products, including the bio-d(R) Threaded Cortical Bone Dowel
and Endodowel, manufactured, sold and/or otherwise distributed by the
Company infringe on certain claims of patents owned by Medtronic.
In April, 2002, Medtronic and the Company settled this lawsuit. 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. (See Note 8 - "Debt and Financing
Arrangements"). In accordance with the settlement, the Company ceased the
processing, marketing, distributing, advertising and promoting of the
bio-d(R) Threaded Cortical Bone Dowel on January 31, 2003.
-7-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
4. Continuing Operations - Gains/Charges (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.
5. Discontinued Operations
Effective June 30, 2002, the Company sold 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 received
the first two scheduled payments due under the note. 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, July 10, 2002, the Company has no on-going financial or
operational responsibilities with respect to the acquirer.
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. 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 sold to fair value. Revenues
and net income for these operations were $1,630,000 and $384,000,
respectively, for the six months ended June 30, 2002. The financial
results of these operations prior to the sale are reflected in the
statements of operations as discontinued operations and all prior periods
have been reclassified to conform to this presentation.
6. Deferred Processing Costs
Deferred processing costs consist of the following:
September 30, December 31,
(in thousands) 2003 2002
------------------------------------------------------------------------------------------
Donor tissue to be processed and distributed
by the Company $ 5,529 $ 2,411
Tissue in process 6,537 5,043
Processed implantable donor tissue to be distributed
by the Company 12,354 6,234
Processed implantable donor tissue held for clients 1,867 1,745
------------------------------------------------------------------------------------------
$26,287 $15,433
==========================================================================================
-8-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
7. Inventories
Inventories consist of the following:
September 30, December 31,
(in thousands) 2003 2002
-------------------------------------------------------------
Supplies $ 296 $ 223
Raw materials 771 678
Finished goods 3,326 3,919
-------------------------------------------------------------
$4,393 $4,820
=============================================================
8. Debt and Financing Arrangements
In June, 2002, the Company obtained an automatically declining irrevocable
standby letter of credit to support the $1,900,000 ($554,000 as of
September 30, 2003) due to Medtronic Sofamor Danek, Inc. pursuant to the
settlement agreement. The commitment under the standby letter of credit
was $1,900,000, but such commitment decreases over time based on a
predetermined schedule concurrent with the Company's monthly payments
under the settlement. As of September 30, 2003, the standby letter of
credit has been reduced to $676,000. The amount committed under the
standby letter of credit reduces the Company's availability under its
$5,000,000 revolving line of credit. As of September 30, 2003, no amounts
were outstanding under the revolving line of credit and $4,324,000 was
available.
9. Commitments and Contingencies
Litigation
The following is a description of material developments that occurred in
lawsuits reported in the Company's Annual Report on Form 10-K for the year
ended December 31, 2002 and the Company's Quarterly Reports on Form 10-Q
for the quarters ended March 31, 2003 and June 30, 2003. Additionally, the
Company is party to other litigation incidental to its business, none of
which, individually or in the aggregate, are expected to have a material
adverse effect on the Company.
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. In December
2001, as a result of a trial commenced in the United States District Court
for the Central District of California, 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 1999 and 2000 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.
-9-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
9. Commitments and Contingencies (continued)
On May 30, 2003, the Company entered into a definitive agreement to settle
its claims with GenSci arising out of the patent lawsuit. The settlement
is for an aggregate of $7.5 million. In August, 2003, the parties amended
the definitive settlement agreement to adjust the payment terms of the
settlement. Pursuant to the amended agreement, the Company will receive
$2.5 million from GenSci upon its exit from bankruptcy and GenSci's merger
with IsoTis B.V. ("IsoTis") and the balance of $5.0 million in 20 equal
payments of $250,000 plus interest at the federal judgment rate as
measured at the end of each quarter to a maximum of 3% per annum. To
secure the future amounts to be paid to the Company, GenSci will provide
an irrevocable letter of credit in the amount of $5.0 million. On October
14, 2003, the Bankruptcy Court signed an Order confirming GenSci's Plan of
Reorganization at which time GenSci emerged from bankruptcy. GenSci's
merger with IsoTis was consummated on October 27, 2003. On October 29,
2003 the Company received the initial payment of $2.5 million, a
Promissory Note in the amount of $5.0 million and the $5.0 million letter
of credit collateralizing the Promissory Note. As a result, the Company
will recognize pre-tax income of $7.5 million in the fourth quarter of
2003.
The settlement also provides that the Company covenants not to sue GenSci
for infringing any of the Company's existing patents with respect to
GenSci's products currently marketed under the names Accell(TM),
DynaGraft(R) II and OrthoBlast(TM) II, as long as GenSci does not change
the formulation and composition of the such products. Additionally, the
parties have agreed to dismiss all other litigation that is currently
pending between them.
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 and an attempt to
monopolize the market for demineralized bone matrix ("DBM") and for
entering into agreements in restraint of trade in violation of Sections 1
and 2 of the Sherman Antitrust Act and Section 3 of the Clayton Act; and
for unlawful and unfair business practices in violation of Section 17200
of the California Unfair Competition Law. On December 20, 2001, GenSci
filed a bankruptcy petition with the United States Bankruptcy Court for
the Central District of California. GenSci did not seek relief from the
automatic stay to pursue this action. On May 30, 2003, the Company and
GenSci executed a Joint Settlement Agreement that, inter alia, requires
the dismissal of this action with prejudice within ten days after the
Bankruptcy Court's approval of GenSci's Plan of Reorganization. The
Bankruptcy Court signed an Order on October 14, 2003 confirming GenSci's
Plan of Reorganization. The Consent Judgment and Stipulation of Dismissal
were filed with the Court on November 5, 2003, but have not yet been
signed by the Court.
-10-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
9. 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. 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. The Company successfully moved to dismiss
plaintiffs' claims for negligence and strict liability. Remaining are
claims for breach of warranties, negligent misrepresentation, fraud, and
violation of the New Mexico Unfair Trade Practices Act. Plaintiffs are
seeking monetary damages in an amount to be determined at trial. On
February 13, 2003, the Company filed a motion for summary judgment on the
basis that plaintiffs sued the wrong party. On September 17, 2003, the
court issued a memorandum opinion and order denying Osteotech's motion for
summary judgment. On October 8, 2003, a Rule 16 Settlement Conference was
conducted and the parties reached a tentative settlement agreement, which
does not obligate the Company to pay monetary damages to the plaintiffs,
but assigns certain of the Company's rights under its insurance policies
to the plaintiffs. The parties are now in the process of negotiating and
preparing mutually acceptable definitive agreements. On October 10, 2003,
the Court issued an order staying all proceedings in the action and
vacating case management deadlines. In the event the parties are unable to
consummate a settlement within thirty days from October 8, 2003, and no
further extension is granted, the Court will lift the stay of proceedings
and the parties will return to active litigation. On November 10, 2003,
the parties filed a motion for an extension to continue negotiations on
the settlement documents. If the stay is lifted, further discovery on
matters relating to the merits of plaintiffs' claims and the scope of
plaintiffs' alleged damages would continue.
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 other defendants in several actions
pending in the Superior Court for the State of California, Los Angeles
County. The Regner case sought 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. In addition, the plaintiffs through
the Regner case sought 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.
-11-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
9. Commitments and Contingencies (continued)
In September, 2003, a settlement was entered into by the parties in the
Savitt case, and plaintiffs subsequently dismissed this lawsuit with
prejudice. Also in September, 2003, a global settlement was negotiated in
the Regner, Thacker and Sorrels cases. The settlements in the Savitt,
Regner, Thacker and Sorrels cases had no impact on the Company's financial
position or results of operations. Settlement documents have been
finalized, and on November 6, 2003 the Court issued an order dismissing
the cases, with prejudice.
Alphatec Manufacturing v. Osteotech, Inc.
Alphatec Manufacturing, Inc., the manufacturer of the Affirm(TM) Anterior
Cervical Plate System ("Affirm(TM)"), filed an action on July 3, 2002
against the Company in the United States District Court for the Southern
District of California. The complaint sets forth causes of action for
recovery of contractual penalty, breach of contract, fraud and trade libel
arising out of a distribution agreement between the parties. Alphatec is
seeking $1.4 million plus interest on the contractual penalty claim,
$600,000 on the fraud claim and additional unspecified compensatory
damages.
On August 3, 2003, the Company answered the complaint and asserted
counterclaims setting forth causes of action for breach of contract,
breach of implied covenant of good faith and fair dealing, fraudulent
misrepresentation, fraudulent concealment, unjust enrichment, unfair
competition, cancellation or rescission of the contract and
indemnification. The Company is seeking compensatory and punitive damages
in an amount to be determined at trial as well as reasonable attorney's
fees. Discovery has not yet commenced.
The Company believes that Alphatec's claims are without merit and intends
to vigorously defend against such claims. In the fourth quarter of 2002,
the Company recorded a provision of approximately $2.5 million, which
includes an estimate of the penalty that would be due for the expected
shortfall in the second year purchase commitment and an amount to fully
reserve all implant inventory and instrumentation associated with
Affirm(TM).
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.
-12-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
10. Comprehensive Income
Comprehensive income for the three months and nine months ended September
30, 2003 and 2002 were as follows:
Three months ended Nine months ended
September 30, September 30,
-----------------------------------------------------
(in thousands) 2003 2002 2003 2002
-------------------------------------------------------------------------------------------------------------
Net income $ 719 $ 1,007 $4,600 $1,713
Currency translation adjustments (169) (35) 188 422
-------------------------------------------------------------------------------------------------------------
Comprehensive income $ 550 $ 972 $4,788 $2,135
=============================================================================================================
11. 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 was 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.
12. Foreign Net Operating Loss Carryforwards
In the second quarter of 2002, the Company utilized approximately
$2,000,000 of its historical net operating loss carryforwards relating to
its subsidiary in The Netherlands. Such net operating loss carryforwards
were utilized against the Company's tax gain on the foreign portion of the
gain on the sale of the PolyActive(TM) polymer biomaterial technology and
patents, the tax gain on the sale of the Company's operations in The
Netherlands and earnings from operations in 2002. Utilization of these net
operating loss carryforwards, which were recorded subject to a full
valuation allowance in prior periods, resulted in a reduction of
approximately $680,000 to income tax otherwise payable in The Netherlands,
of which approximately $460,000 is related to discontinued operations.
-13-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
13. Earnings Per Share
The following table sets forth the computation of basic and diluted
earnings per share for the three months and nine months ended September
30, 2003 and 2002:
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------------------------------------------
(dollars in thousands
except per share data) 2003 2002 2003 2002
----------------------------------------------------------------------------------------------------------------------------
Income from continuing operations $ 719 $ 1,007 $ 4,600 $ 1,620
Discontinued operations 93
-------------------------------------------------------------------
Net income available to
common shareholders $ 719 $ 1,007 $ 4,600 $ 1,713
===================================================================
----------------------------------------------------------------------------------------------------------------------------
Denominator for basic earnings
per share, weighted average common
shares outstanding 17,093,937 16,916,152 17,049,605 15,542,076
Effect of dilutive securities, stock options 864,158 441,867 654,535 403,086
-------------------------------------------------------------------
Denominator for diluted earnings
per share 17,958,095 17,358,019 17,704,140 15,945,162
===================================================================
----------------------------------------------------------------------------------------------------------------------------
Basic earnings per share:
Income from continuing operations $ .04 $ .06 $ .27 $ .10
Discontinued operations .01
-------------------------------------------------------------------
Net income $ .04 $ .06 $ .27 $ .11
===================================================================
----------------------------------------------------------------------------------------------------------------------------
Diluted earnings per share:
Income from continuing operations $ .04 $ .06 $ .26 $ .10
Discontinued operations .01
-------------------------------------------------------------------
Net income $ .04 $ .06 $ .26 $ .11
===================================================================
----------------------------------------------------------------------------------------------------------------------------
Weighted average shares issuable upon the exercise of stock options which
were not included in the calculation of diluted earnings per share were
418,850 and 478,300, and 1,144,288 and 1,846,580 for the three months and
nine months ended September 30, 2003 and 2002, respectively. Such shares
were not included because they were antidilutive.
-14-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
14. Operating Segments
Summarized in the table below is financial information for our reportable
segments for the three months and nine months ended September 30, 2003 and
2002 after giving effect to the divestiture of the Company's operations in
The Netherlands in 2002:
Three Months Ended Nine Months Ended
September 30, September 20,
---------------------------------------------------
(dollars in thousands) 2003 2002 2003 2002
--------------------------------------------------------------------------------------------------------------
Revenues:
Demineralized Bone Matrix Segment $ 11,534 $ 10,917 $ 35,166 $ 34,558
Base Tissue Segment 9,675 7,273 30,587 25,320
Other, principally metal spinal implants 1,926 1,501 4,653 4,907
--------------------------------------------------------------------------------------------------------------
Consolidated $ 23,135 $ 19,691 $ 70,406 $ 64,785
==============================================================================================================
Operating income (loss):
Demineralized Bone Matrix Segment $ 2,753 $ 3,647 $ 10,374 $ 8,163
Base Tissue Segment 59 (2,914) 1,904 (5,627)
Other, principally metal spinal implants (1,442) (3,042) (3,952) (4,342)
--------------------------------------------------------------------------------------------------------------
Consolidated $ 1,370 $ (2,309) $ 8,326 $ (1,806)
==============================================================================================================
During the three months ended September 30, 2003, two of our clients,
Musculoskeletal Transplant Foundation ("MTF") and the American Red Cross
Tissue Services ("ARC"), from whom we receive revenues in the
Demineralized Bone Matrix and Base Tissue Segments, each accounted for 24%
and 25%, respectively, of consolidated net revenues and accounted for 29%
and 26%, respectively, of consolidated net revenues for the three months
ended September 30, 2002. For the nine months ended September 30, 2003,
these same two clients accounted for 25% and 26%, respectively, of
consolidated net revenues, and 30% and 30%, respectively, of consolidated
net revenues for the nine months ended September 30, 2002.
15. Reclassifications
Certain prior year amounts have been reclassified to conform to the 2003
presentation.
-15-
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Information contained herein contains "forward-looking statements" which can be
identified by the use of forward-looking terminology such as "believes",
"expects", "may", "will", "should", or "anticipates" or the negative thereof or
variations thereon or comparable terminology, or by discussions of strategy. No
assurance can be given that the future results covered by the forward-looking
statements will be achieved. Some of the matters set forth in the "Risk Factors"
section of our Annual Report on Form 10-K for the year ended December 31, 2002
constitute cautionary statements identifying factors with respect to such
forward-looking statements, including certain risks and uncertainties, that
could cause actual results to vary materially from the future results indicated
in such forward-looking statements. Other factors could also cause actual
results to vary materially from the future results indicated in such
forward-looking statements.
FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
Results of Operations
Critical Accounting Policies and Estimates
Critical accounting policies are those that involve subjective or complex
judgments, often as a result of the need to make estimates. The following areas
all require the use of judgments and estimates: product returns, bad debts,
inventories including purchase commitments, deferred processing costs including
rework reserves, property, plant and equipment, intangible assets, current and
deferred income taxes, contingencies and litigation. Estimates in each of these
areas are based on historical experience and various assumptions that we believe
are appropriate. Actual results may differ from these estimates. Our accounting
practices are discussed in more detail in "Management's Discussion and Analysis
of Financial Condition and Results of Operations" and Note 2 of "Notes to
Consolidated Financial Statements" in our Annual Report on Form 10-K for the
year ended December 31, 2002.
Income from Continuing Operations
Consolidated income from continuing operations was $719,000 or $.04 diluted
earnings per share and $4,600,000 or $.26 diluted earnings per share for the
three and nine months ended September 30, 2003, respectively, compared to
consolidated income from continuing operations of $1,007,000 or $.06 diluted
earnings per share and $1,620,000 or $.10 diluted earning per share in the
respective corresponding periods in 2002. Both the three and nine months ended
September 30, 2003 include an after tax charge of $227,000 related to a
reduction in workforce implemented on September 24, 2003. The three months ended
September 30, 2002 included an after tax charge of $2,447,000 related to
provisions for excess and obsolete metal spinal implant systems and bio-d(R)
Threaded Cortical Bone Dowels, and for the rework of tissue placed in quarantine
in third quarter 2002, offset by the recognition of an income tax benefit of
$2,557,000 related to releasing income tax liabilities which were no longer
required. In addition to the items mentioned directly above, the nine months
ended September 30, 2002 included an after tax provision of $1,071,000
associated with the Medtronic litigation settlement and an after tax gain of
$830,000 related to the sale of the PolyActive(TM) polymer biomaterial
technology and patents to IsoTis BV.
The decline in income from continuing operations in the three months ended
September 30, 2003 from the same period in 2002 is primarily due to the
severance charges related to the reduction in workforce and increased commission
costs associated with programs aimed at stabilizing the domestic Grafton(R) DBM
business. The improvement in income from continuing operations in the nine
months ended September 30, 2003 compared to the corresponding period in 2002 is
due to a combination of increased revenues,
-16-
improved gross margins, continued cost containment and the impact in 2002 of the
charges and income tax benefit mentioned above.
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 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
and net income from these operations were $1,630,000 and $384,000, respectively,
in the nine months ended September 30, 2002.
Net Income
Consolidated net income in the third quarter of 2003 was $719,000 or $.04
diluted net income per share compared to consolidated net income of $1,007,000
or $.06 diluted net income per share in the third quarter of 2002. Consolidated
net income for the nine months ended September 30, 2003 was $4,600,000 or $.26
diluted net income per share compared to consolidated net income of $1,713,000
or $.11 diluted net income per share for the nine months ended September 30,
2002.
The following is a discussion of factors affecting results of continuing
operations for the three months and nine months ended September 30, 2003 and
2002, after giving effect to the divestiture of the operations of our subsidiary
in The Netherlands in 2002.
Net Revenues
Consolidated net revenues increased 17% to $23,135,000 in the third quarter of
2003 compared to consolidated net revenues of $19,691,000 in the corresponding
period in 2002. Domestic net revenues increased 14% to $21,134,000 in the third
quarter of 2003 from third quarter 2002 domestic net revenues of $18,489,000.
The increase in domestic revenues was due primarily to increased base tissue
processing fees as a result of a 112% increase in donors processed, shipments of
the Optium(TM) DBM carrier product, a 64% increase in metal spinal implant
revenues and the impact of our 2003 price increases; partially offset by a 6%
decline in domestic Grafton(R) DBM revenue principally as a result of a decline
in unit sales volume. Foreign-based revenues increased 66% to $2,001,000 in the
third quarter of 2003 from $1,202,000 in the same period in 2002. The increase
in foreign-based revenues was primarily a result of increased unit sales volume
in Grafton(R) DBM and OsteoPure(TM)Allogeneic Cancellous Tissue, increased base
tissue processing fees and 2003 price increases; partially offset by a decline
in bovine tissue unit sales volume.
Consolidated net revenues increased 9% to $70,406,000 for the nine months ended
September 30, 2003 compared to consolidated revenues of $64,785,000 in the
corresponding period in 2002. Domestic net revenues increased 5% in the nine
months ended September 30, 2003 to $64,317,000 from $61,212,000 in the
corresponding period in 2002. The increase in domestic revenues was due
primarily to increased base tissue processing fees as a result of a 33% increase
in donors processed, including the release of a portion of the donors that were
subject to our 2002 tissue quarantine, increased bio-implant units shipped,
shipments of the Optium(TM) DBM carrier product, increased sales of metal spinal
implants and the impact of our 2003 price increases; partially offset by a
decline in unit sales volume in Grafton(R) DBM. Foreign-based revenues increased
70% to $6,089,000 for the nine months ended September 30, 2003 from $3,573,000
for the nine months ended September 30, 2002. The increase in foreign-based
revenues was primarily a result of increased unit sales volume in Grafton(R) DBM
and OsteoPure(TM) Allogeneic Cancellous Tissue, increased
-17-
base tissue processing fees and 2003 price increases; partially offset by a
decline in bovine tissue unit sales volume.
Demineralized Bone Matrix ("DBM") Segment (formerly the Grafton(R) DBM Segment),
or DBM Segment, revenues increased 6% to $11,534,000 in the third quarter of
2003 from revenues of $10,917,000 in the corresponding period in 2002. DBM
Segment revenues of $35,166,000 for the nine months ended September 30, 2003
increased 2% from DBM Segment revenues of $34,558,000 for the nine months ended
September 30, 2002. Domestic DBM Segment revenues were relatively flat in third
quarter 2003 at $10,335,000 compared to revenues of $10,343,000 in third quarter
2002 primarily due to a 6% decline in Grafton(R) DBM revenues as a result of a
decline in unit sales volume, offset by shipments of the Optium(TM) DBM carrier
product and the effects of the 2003 price increases. Domestic Grafton(R) DBM
revenues decreased 4% to $31,609,000 for the nine months ended September 30,
2003 from $33,003,000 for the corresponding period in the prior year. The
decrease resulted primarily from a decline in Grafton(R) DBM unit sales volume
due to continuing strong competition resulting in a 9% decline in domestic
Grafton(R) DBM revenues in the nine months ended September 30, 2003, partially
offset by shipments of the Optium(TM) DBM carrier product and the effects of the
2003 price increases. To address the continued decline in domestic Grafton(R)
DBM unit volume and revenues, in third quarter 2003, we have provided additional
commission incentives to our sales force and have initiated sales and marketing
programs, which include aggressively priced contracts for fixed contractual
periods with Osteotech branded Grafton Plus(TM) DBM Paste for competitive
accounts. Foreign-based Grafton(R) DBM revenues increased 109% to $1,199,000 in
the third quarter of 2003 from revenues of $573,000 in the corresponding period
in the prior year and increased 129% to $3,557,000 for the nine months ended
September 30, 2003 from $1,554,000 for the nine months ended September 30, 2002.
These increases were primarily the result of increased unit sales volume and the
effects of the 2003 price increases.
Base Allograft Tissue Segment, or Base Tissue Segment, revenues increased 33% to
$9,675,000 in the third quarter of 2003 from $7,273,000 in the corresponding
period in 2002. The increase is principally the result of a 106% increase in
base tissue processing fees as a result of a 112% increase in the number of
donors processed for our clients, including the release of a portion of the
donors that were subject to our 2002 tissue quarantine, and the direct
distribution of Osteotech labeled base allograft tissue, a 27% increase in
OsteoPure(TM) Allogeneic Cancellous Tissue revenues and the impact of our 2003
price increases. Base Tissue Segment revenues increased 21% to $30,587,000 for
the nine months ended September 30, 2003 from $25,320,000 in the corresponding
period in 2002. The increase is principally the result of a 39% increase in base
tissue processing fees as a result of a 33% increase in the number of donors
processed for our clients, including the release of a portion of the donors that
were subject to our 2002 tissue quarantine, and the direct distribution of
Osteotech labeled base allograft tissue, an 8% increase in bio-implant revenues
as a result of increased unit sales volume, a 78% increase in OsteoPure(TM)
Allogeneic Cancellous Tissue revenues and the impact of our 2003 price
increases. As part of the settlement of a lawsuit in the second quarter of 2002,
we removed our bio-d(R) Threaded Cortical Bone Dowel, or bio-d(R) Dowel, from
the market in January, 2003. Revenues for the bio-d(R) Dowel were $192,000 in
the third quarter of 2002, and $40,000 and $1,189,000 for the nine months ended
September 30, 2003 and 2002, respectively. Base tissue processing revenues in
third quarter 2002 were negatively impacted by the effects of the temporary
suspension of Base Tissue Segment processing from which the Company placed
tissue processed in third quarter 2002 from 693 donors in quarantine.
Revenue from other product lines increased 28% in the third quarter of 2003 to
$1,926,000 from $1,501,000 in the same period in 2002 and declined 5% for the
nine months ended September 30, 2003 to $4,653,000 from $4,907,000 in the
corresponding period in 2002. Metal spinal implant system revenues increased 64%
in the third quarter of 2003 and 5% for the nine months ended September 30, 2003
compared to the corresponding periods in 2002, principally as a result of sales
from three product lines manufactured by
-18-
SpineVision, partially offset by a decline in revenues associated with the
suspension of the sale and distribution of the Affirm(TM) Anterior Cervical
Plate System in October, 2002 due to a higher than normal level of complaints.
Revenues from the Affirm(TM) Anterior Cervical Plating System were $404,000 and
$1,133,000 for the three and nine months ended September 30, 2002, respectively.
Bovine tissue product revenues declined 44% in the three months ended September
30, 2003 and 29% for the nine months ended September 30, 2003 compared to the
corresponding periods in 2002, primarily as a result of lower unit sales volume.
In February, 2003, we entered into a three-year distribution agreement with
SpineVision SA, which allows us to distribute SpineVision's C3(TM) Anterior
Cervical Plate System, the Plus(TM) Pivot Link Universal System and the
Uni-Thread(TM) Versatile Thoraco-Lumbar Spinal System in the United States. The
initial phase of the agreement is a Trial Period, as defined in the agreement,
which expired in October, 2003. Since the Uni-Thread(TM) System was not
introduced to the market until September, 2003, in October, 2003, the parties
agreed to extend the Trial Period until January 31, 2004 in order to allow for a
sufficient period of time to complete the evaluation of the Uni-Thread(TM)
System.
During the three months ended September 30, 2003, two of our clients in the DBM
and Base Tissue Segments, the Musculoskeletal Transplant Foundation, or MTF, and
the American Red Cross, or ARC, each accounted for 24% and 25%, respectively, of
consolidated net revenues. In the three months ended September 30, 2002, MTF and
ARC accounted for 29% and 26%, respectively, of consolidated net revenues. In
the nine months ended September 30, 2003, these same clients accounted for 25%
and 26%, respectively, of consolidated revenues, and accounted for 30% and 30%,
respectively, of consolidated revenues for the nine months ended September 30,
2002. We have processing agreements with each of these clients. The MTF
agreement expires in December, 2008 and the ARC agreement expires in December,
2006.
We market Grafton(R) DBM as a human tissue-based product pursuant to an August,
1995 designation from the Food and Drug Administration, or FDA. In March, 2002,
the FDA informed us that they were changing the regulatory status of Grafton(R)
DBM and will henceforth regulate it as a medical device. 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. On October 30, 2003, we received further correspondence from
the FDA indicating that after considering the information we provided them in
the February, 2003 meeting, the FDA still believes that a 510(k) should be
submitted for Grafton(R) DBM. The Company has not submitted a 510(k) and we
continue to disagree with the FDA's opinion and we intend to continue to have a
dialog with the FDA to further present our point of view.
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 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. In its
October 30, 2003 letter, the FDA indicated that its determination regarding
Grafton(R) DBM is also 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 the Optium(TM) DBM carrier product we
process for LifeNet(R) and which is marketed by DePuy Spine and DePuy
Orthopaedics, and to comply with other medical device requirements for those
products.
-19-
Gross Profit
Consolidated gross profit as a percentage of consolidated net revenues was 53%
in the third quarter of 2003 compared to 36% in the third quarter of 2002.
Consolidated gross profit as a percentage of consolidated net revenues was 57%
for the nine months ended September 30, 2003 compared to 51% for the nine months
ended September 30, 2002. The improvement in gross profit margin in both periods
of 2003 was primarily the result of increased revenues, which generated higher
production levels and greater absorption of the fixed costs associated with
tissue processing. The corresponding periods of 2002 were negatively impacted by
the temporary suspension of Base Tissue Segment processing operations and
provisions for excess and obsolete inventories and the estimated cost to rework
tissue placed in quarantine in third quarter 2002. We expect that consolidated
gross profit margins will decline slightly in future periods primarily as a
result of expected revenue growth in our lower gross profit margin product
lines, which will only be partially offset by revenue growth in our higher gross
profit margin product lines.
Marketing, Selling, General and Administrative Expenses
Consolidated marketing, selling, general and administrative expenses increased
18% in third quarter 2003 to $9,806,000 from $8,309,000 in the corresponding
period in 2002, and declined 3% for the nine months ended September 30, 2003 to
$28,873,000 from $29,849,000 for the nine months ended September 30, 2002. The
increase in marketing, selling, general and administrative expenses in the third
quarter of 2003 as compared to the third quarter of 2002 is primarily due to
increased commission costs associated with higher revenues and programs aimed at
stabilizing the domestic Grafton(R) DBM business, increased selling costs
associated with a shift in our domestic sales force towards more direct sales
representation from agency representation and severance costs associated with
the reduction in workforce. The decreases in marketing, selling, general and
administrative expenses in the nine months ended September 30, 2003 compared to
the corresponding period in 2002 relates mainly to decreased legal fees as a
result of the settlement of a number of our lawsuits in the first half of 2002
and the cessation of our funding of the American Tissue Services Foundation;
partially offset by increased costs for insurance coverage as a result of the
tightening of the insurance markets, increased commission costs associated with
higher revenues and programs aimed at stabilizing the domestic Grafton(R) DBM
business, increased selling costs associated with a shift in our domestic sales
force to direct sales representative from agency representation and severance
costs associated with the reduction in workforce.
Research and Development Expenses
Consolidated research and development expenses increased 9% in the third quarter
of 2003 to $1,095,000 from $1,002,000 in the corresponding period in 2002, and
increased 1% in the nine months ended September 30, 2003 to $3,020,000 from
$2,990,000 in the nine months ended September 30, 2002. The increases primarily
related to spending on certain on-going research and development projects,
including efforts for the continued development of new Grafton(R) DBM and
bio-implant tissue forms and our Plexus(TM) Technology.
-20-
Litigation Settlement Charge
In April, 2002, we settled a patent lawsuit and agreed to pay an aggregate of
$1,900,000 in 24 equal monthly installments, without interest. We recorded a
charge of $1,785,000 related to this settlement representing the present value
of the amounts due in the second quarter of 2002.
Operating Income
Consolidated operating income increased $3,679,000 to $1,370,000 in the third
quarter of 2003 from an operating loss of $2,309,000 in the third quarter of
2002. Consolidated operating income increased $10,132,000 for the nine months
ended September 30, 2003 to $8,326,000 from an operating loss of $1,806,000 for
the nine months ended September 30, 2002. Included in the nine months ended
September 30, 2002 is the aforementioned litigation settlement charge of
$1,785,000.
DBM Segment operating income declined to $2,753,000 in the three months ended
September 30, 2003 from $3,647,000 in the same period in 2002. The decrease
results principally from a decline in gross profit margins as a result of
increased revenues in international DBM revenues, which generate a significantly
lower gross profit margin than domestic DBM revenues, increased commission costs
associated with programs aimed at stabilizing the domestic Grafton(R) DBM
business and increased selling costs associated with a shift in our domestic
sales force to direct sales representative from agency representation. DBM
Segment operating income increased to $10,374,000 for the nine months ended
September 30, 2003 from $8,163,000 in the corresponding period in 2002. The
improvement in operating income in the nine months ended September 30, 2003
compared to the same period in 2002 is due primarily to lower operating
expenses, principally from a $2,365,000 reduction in legal fees, partially
offset by a decline in gross profit margins.
Base Tissue Segment operating income improved $2,973,000 in the third quarter of
2003 to $59,000 from an operating loss of $2,914,000 in the corresponding period
in 2002, and improved $7,531,000 for the nine months ended September 30, 2003 to
$1,904,000 from an operating loss of $5,627,000 for the nine months ended
September 30, 2002. The improvements in both periods resulted primarily from the
increase in revenues and improved gross profit margins. The 2002 periods were
negatively impacted by the temporary suspension of Base Tissue Segment
processing operations, the provisions for excess and obsolete bio-d(R) Dowels,
the estimated cost to rework tissue placed in quarantine in third quarter 2002
and, in the nine months ended September 20, 2002, by the litigation settlement
charge of $1,785,000.
Operating losses associated with other revenues were $1,442,000 and $3,952,000
for the three months and nine months ended September 30, 2003, respectively, and
were $3,042,000 and $4,342,000 for the same respective periods in 2002. The
operating loss is generated primarily from our metal spinal implant product line
due to the costs associated with the infrastructure established to support these
product lines which were not offset by sufficient unit volume, increased costs
associated with marketing, selling and promotional activities and increased
legal fees. The operating losses in 2002 were primarily due to our metal spinal
implant product line resulting from the costs associated with the infrastructure
established to support these product lines which were not offset by sufficient
unit volume and the provisions of $2,145,000, which were recorded for excess and
obsolete metal spinal implant products.
Other Income (Expense)
Other income (expense), which primarily represents interest expense, net of
interest income, was $126,000 and $590,000 for the three months and nine months
ended September 30, 2003, respectively, compared to
-21-
interest expense, net of interest income, of $162,000 and $782,000 in the
corresponding periods in 2002, respectively.
In May, 2002, we completed the sale of the PolyActive(TM) polymer biomaterial
technology and patents to IsoTis BV for $1,000,000 in cash. We recognized a
$950,000 gain on this transaction after deducting costs and expenses.
Income Tax Provision
The effective income tax rate for the three months and nine months ended
September 30, 2003 was 42% and 41%, respectively, which exceeded the United
States federal statutory rate principally due to domestic state income taxes.
For the three months and nine months ended September 30, 2002, we recognized an
income tax benefit from continuing operations primarily due to losses incurred
in our domestic operation and our ability to utilize previously unrecognized net
operating loss carryforwards, which carried a full valuation allowance, to
offset foreign income and the reversal of liabilities for previously deferred
income tax benefits of $2,557,000 that are no longer required. In addition, we
did not record an income tax provision for discontinued operations due to our
ability to utilize additional foreign net operating loss carryforwards to offset
taxable income.
In the nine month period ended September 30, 2002, we utilized approximately
$2,000,000 (tax effect of approximately $680,000) of our historical net
operating loss carryforwards relating to our subsidiary in The Netherlands.
Liquidity and Capital Resources
At September 30, 2003 we had cash, cash equivalents and short-term investments
of $12,236,000 compared to $13,988,000 at December 31, 2002. We invest excess
cash in U.S. Government-backed securities and investment grade commercial paper
of major U.S. corporations. The decline in cash, cash equivalents and short-term
investments was primarily due to continued investments in deferred processing
costs as we expand our allograft tissue inventories, partially offset by
improvements in operating results and the receipt of a Federal income tax
refund. Working capital increased $7,554,000 to $49,473,000 at September 30,
2003 compared to $41,919,000 at December 31, 2002. The increase in working
capital resulted primarily from an increase in accounts receivables from clients
and customers as a result of the increase in revenues in 2003 as compared to
fourth quarter 2002 and additional investments in deferred processing costs,
partially offset by an increase in accounts payable and accrued expenses.
Net cash provided by operating activities was $1,686,000 and $1,521,000 in the
nine months ended September 30, 2003 and 2002, respectively. The increase
resulted primarily from improved profitability compared to the prior year, an
increase in accounts payable and accrued expenses and the receipt of a Federal
income tax refund; partially offset by an increase in accounts receivables from
clients and customers as a result of the increase in revenues in 2003 as
compared to fourth quarter 2002 and additional investments in deferred
processing costs.
Cash provided by investing activities was $2,115,000 for the nine months ended
September 30, 2003 compared to cash used in investing activities of $6,120,000
for the nine months ended September 30, 2002. Cash provided by investing
activities in 2003 was primarily generated from the sale of short-term
investments of $3,948,000, partially offset by capital expenditures of
$1,326,000. Cash used in investing activities in 2002 was principally the result
of capital expenditures of $4,253,000, the purchase of short-term
-22-
investments of $3,948,000, partially offset by the proceeds received from the
sale of our subsidiary in The Netherlands and the sale of the PolyActive(TM)
polymer biomaterial technology and patents to IsoTis BV.
Net cash used in financing activities was $1,406,000 for the nine months ended
September 30, 2003 and cash provided by financing activities was $14,239,000 for
the nine months ended September 30, 2002. Net cash used in financing activities
in 2003 was principally the result of payments on long-term debt, partially
offset by proceeds from the sale of common stock associated with employee stock
option exercises and our employee stock purchase plan. Cash provided by
financing activities in 2002 primarily resulted from the sale of 2.8 million
shares of common stock in May, 2002 at a price of $6.25 generating net proceeds
of $15,756,000, sales of common stock associated with employee stock option
exercises and our employee stock purchase plan, partially offset by principal
payments on 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
September 30, 2003, there were no borrowings under the revolving line of credit,
$4,040,000 was outstanding under the building mortgage loan and $12,548,000 was
outstanding under the equipment term loan. In support of the amounts due under
the settlement of certain patent litigation, we provided an automatically
declining irrevocable standby letter of credit in an original amount of
$1,900,000. As of September 30, 2003, the standby letter of credit has been
reduced to $676,000. Amounts committed under this standby letter of credit
decrease over time based on a predetermined schedule concurrent with our monthly
payments under the settlement and reduce the amounts available under the
revolving line of credit. As of September 30, 2003, no amounts were outstanding
under the revolving line of credit and $4,324,000 was available.
As of September 30, 2003, there were no material changes in our contractual
obligations or long-term debt from that disclosed in Item 7, "Management's
Discussion and Analysis of Financial Condition and Results of Operations,
Liquidity and Capital Resources" in our Annual Report on Form 10-K for the year
ended December 31, 2002.
We believe that our cash and cash equivalents and available lines of credit,
together with anticipated future cash flows from operations, will be sufficient
to meet our forecasted cash needs for the next twelve months. From time to time
we may seek additional funds through equity or debt financing. However, there
can be no assurance that such additional funds will be available, or if
available, that such funds will be available on favorable terms.
Impact of Inflation and Foreign Currency Exchange Fluctuations
Results of operations for the periods discussed above have not been materially
affected by inflation or foreign currency fluctuations.
Litigation
Osteotech, Inc. is involved in various legal proceedings. For a discussion of
these matters see, Note 9 of "Notes to Condensed Consolidated Financial
Statements" included elsewhere herein and PART II. ITEM 1. LEGAL PROCEEDINGS,
and our Annual Report on Form 10-K for the year ended December 31, 2002. It is
possible that our results of operations or liquidity and capital resources could
be adversely affected by the ultimate outcome of pending litigation or as a
result of the costs of contesting such lawsuits.
-23-
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For information regarding our exposure to certain market risks, see Item 7A,
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK, in our Annual Report
on Form 10-K for the year ended December 31, 2002. There have been no
significant changes in our market risk exposures from the fiscal 2002 year-end.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures
Under the supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, we evaluated the
effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rule 13a-15 under the Exchange Act) as of September
30, 2003 (the "Evaluation Date"). Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that, as of the
Evaluation Date, our disclosure controls and procedures were effective in timely
alerting them to the material information relating to us required to be included
in our periodic SEC filings.
Changes in internal controls
There were no significant changes made in our internal controls during the
period covered by this report or, to our knowledge, in other factors that could
significantly affect these controls subsequent to the date of their last
evaluation.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The following is a description of material developments that occurred in
lawsuits reported in our Annual Report on Form 10-K for the year ended December
31, 2002 and our Quarterly Reports on Form 10-Q for the quarters ended March 31,
2003 and June 30, 2003. Additionally, we are a party to other litigation
incidental to our business, none of which, individually or in the aggregate, are
expected to have a material adverse effect.
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 the patents involving our Grafton(R) Demineralized
Bone Matrix (DBM) process. In December 2001, as a result of a trial commenced in
the United States District Court for the Central District of California, 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 1999 and 2000 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.
On May 30, 2003, we entered into a definitive agreement to settle our claims
with GenSci arising out of the patent lawsuit. The settlement is for an
aggregate of $7.5 million. In August, 2003, the parties amended the definitive
settlement agreement to adjust the payment terms of the settlement. Pursuant to
the amended agreement, we will receive $2.5 million from GenSci upon its exit
from bankruptcy and GenSci's merger with IsoTis B.V. ("IsoTis") and the balance
of $5.0 million in 20 equal payments of $250,000 plus interest at the federal
judgment rate as measured at the end of each quarter to a maximum of 3% per
annum. To secure the future amounts to be paid to us, GenSci will provide an
irrevocable letter of credit in the amount of $5.0 million. On October 14, 2003,
the Bankruptcy Court signed an Order confirming GenSci's Plan of Reorganization
at which time GenSci emerged from bankruptcy. GenSci's merger with IsoTis was
consummated on October 27, 2003. On October 29, 2003 we received the initial
payment of $2.5 million, a Promissory Note in the amount of $5.0 million and the
$5.0 million letter of credit collateralizing the Promissory Note. As a result,
we will recognize pre-tax income of $7.5 million in the fourth quarter of 2003.
The settlement also provides that we covenant not to sue GenSci for infringing
any of our existing patents with respect to GenSci's products currently marketed
under the names Accell(TM), DynaGraft(R) II and OrthoBlast(TM) II, as long as
GenSci does not change the formulation and composition of such products.
Additionally, the parties have agreed to dismiss all other litigation that is
currently pending between them.
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 and an attempt to monopolize the market for
demineralized bone matrix ("DBM") and for entering into agreements in restraint
of trade in violation of Sections 1 and 2 of the Sherman Antitrust Act and
Section 3 of the Clayton Act; and for unlawful and unfair business practices in
violation of Section 17200 of the California Unfair Competition Law. On December
20, 2001, GenSci filed a bankruptcy petition with the United States Bankruptcy
Court for the Central District of California. GenSci did not seek relief from
the automatic stay to pursue this action. On May 30, 2003, the parties executed
a Joint Settlement Agreement that, inter alia, requires the dismissal of this
action with prejudice within ten days after the Bankruptcy Court's approval of
GenSci's Plan of Reorganization. The Bankruptcy Court signed an Order on October
14, 2003 confirming GenSci's Plan of Reorganization. The Consent Judgment and
Stipulation of Dismissal were filed with the Court on November 5, 2003, but have
not yet been signed by the Court.
-24-
"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. In
August, 1998, we removed this action to the United States District Court for the
District of New Mexico and filed and served our answer, denying any and all
liability in this action and moved to dismiss five of the seven claims alleged
against us. We successfully moved to dismiss plaintiffs' claims for negligence
and strict liability. Remaining are claims for breach of warranties, negligent
misrepresentation, fraud, and violation of the New Mexico Unfair Trade Practices
Act. Plaintiffs are seeking monetary damages in an amount to be determined at
trial. On February 13, 2003, we filed a motion for summary judgment on the basis
that plaintiffs sued the wrong party. On September 17, 2003, the court issued a
memorandum opinion and order denying our motion for summary judgment. On October
8, 2003, a Rule 16 Settlement Conference was conducted and the parties reached a
tentative settlement agreement, which does not obligate us to pay monetary
damages to the plaintiffs, but assigns certain of our rights under our insurance
policies to the plaintiffs. The parties are now in the process of negotiating
and preparing mutually acceptable definitive agreements. On October 10, 2003,
the Court issued an order staying all proceedings in the action and vacating
case management deadlines. In the event the parties are unable to consummate a
settlement within thirty days from October 8, 2003, and no further extension is
granted, the Court will lift the stay of proceedings and the parties will return
to active litigation. On November 10, 2003, the parties filed a motion for an
extension to continue negotiations on the settlement documents. If the stay is
lifted, further discovery on matters relating to the merits of plaintiffs'
claims and the scope of plaintiffs' alleged damages would continue.
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 other defendants in several actions pending in the
Superior Court for the State of California, Los Angeles County. The Regner case
sought 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. In addition, the plaintiffs through
the Regner case sought 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.
In September, 2003, a settlement was entered into by the parties in the Savitt
case, and plaintiffs subsequently dismissed this lawsuit with prejudice. Also in
September, 2003, a global settlement was negotiated in the Regner, Thacker and
Sorrels cases. The settlements in the Savitt, Regner, Thacker and Sorrels cases
had no impact on our financial position or results of operations. Settlement
documents have been finalized, and on November 6, 2003 the Court issued an order
dismissing the cases, with prejudice.
Alphatec Manufacturing v. Osteotech, Inc.
Alphatec Manufacturing, Inc., the manufacturer of the Affirm(TM) Anterior
Cervical Plate System ("Affirm(TM)"), filed an action on July 3, 2002 against us
in the United States District Court for the Southern District of California. The
complaint sets forth causes of action for recovery of contractual penalty,
breach of contract, fraud and trade libel arising out of a distribution
agreement between the parties. Alphatec is seeking $1.4 million plus interest on
the contractual penalty claim, $600,000 on the fraud claim and additional
unspecified compensatory damages.
On August 3, 2003, we answered the complaint and asserted counterclaims setting
forth causes of action for breach of contract, breach of implied covenant of
good faith and fair dealing, fraudulent misrepresentation, fraudulent
concealment, unjust enrichment, unfair competition, cancellation or rescission
of the contract and indemnification. We are seeking compensatory and punitive
damages in an amount to be determined at trial as well as reasonable attorney's
fees. Discovery has not yet commenced.
We believe that Alphatec's claims are without merit and intend to vigorously
defend against such claims. In the fourth quarter of 2002, we recorded a
provision of approximately $2.5 million, which includes an estimate of the
penalty that would be due for the expected shortfall in the second year purchase
commitment and an amount to fully reserve all implant inventory and
instrumentation associated with Affirm(TM).
-25-
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits (numbered in accordance with Item 601 of Regulation S-K)
Exhibit Page
Number Description Number
------ ----------- ------
3.1 Restated Certificate of Incorporation of Osteotech, as amended ^
3.2 Third Amended and Restated Bylaws of Osteotech ^
3.3 Certificate of Retirement and Prohibition of 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 ^
10.43 First Amendment dated August 21, 2003, to the Joint Settlement
Agreement and Agreements for Release of Claims and Amendment of
Plan of Reorganization dated May 30, 2003 among Osteotech, Inc.,
GenSci Orthobiologics, Inc. and GenSci Regeneration Sciences, Inc. *
31.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 *
31.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 *
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 *
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 *
* Filed herewith.
^ Previously filed as an exhibit to the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 2001 and incorporated herein by
reference thereto.
^^ Previously filed as an exhibit to the Company's Quarterly Report on Form
10-Q for the quarter ended September 30, 2002 and incorporated herein by
reference thereto.
(b) Reports on Form 8-K
On September 26, 2003, we filed with the Commission a Current Report on
Form 8-K to announce a reduction in our workforce effective September 24,
2003.
On July 25, 2003, we filed with the Commission a Current Report on Form
8-K to announce our financial results for the quarter ended June 30, 2003.
-26-
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: November 12, 2003 Osteotech, Inc.
----------------------------------
(Registrant)
Date: November 12, 2003 By: /S/ Richard W. Bauer
----------------------------------
Richard W. Bauer
President, Chief Executive Officer
(Principal Executive Officer)
Date: November 12, 2003 By: /S/ Michael J. Jeffries
----------------------------------
Michael J. Jeffries
Executive Vice President,
Chief Financial Officer
(Principal Financial Officer and
Chief Accounting Officer)
-27-