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, 2003 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
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, 2003 was approximately
$223,548,000.
The number of shares of the registrant's common stock, $.01 par value,
outstanding as of March 10, 2004 was 17,117,720.
The Index to Exhibits appears on page E-1.
Documents Incorporated by Reference
The registrant's definitive 2004 Proxy Statement, which will be filed pursuant
to Regulation 14A, is incorporated by reference into Items 10, 11, 12 and 14 of
Part III of this Annual Report on Form 10-K.
OSTEOTECH, INC.
2003 Form 10-K Annual Report
TABLE OF CONTENTS
Section Page
- ------- ----
PART I .................................................................... 1
Item 1. Business .................................................... 1
Item 2. Properties .................................................. 24
Item 3. Legal Proceedings ........................................... 25
Item 4. Submissions of Matters to a Vote of Security Holders ........ 29
PART II ................................................................... 29
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters ......................................... 29
Item 6. Selected Financial Data ..................................... 31
Item 7. Management's Discussion And Analysis Of Financial
Condition And Results Of Operations ......................... 32
Item 7A. Quantitative and Qualitative Disclosures About
Market Risk ................................................. 55
Item 8. Financial Statements and Supplementary Data ................. 55
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure ......................... 55
Item 9A. Controls and Procedures ..................................... 55
PART III 57
Item 10. Directors and Executive Officers of the Registrant .......... 57
Item 11. Executive Compensation ...................................... 57
Item 12. Security Ownership of Certain Beneficial Owners
and Management .............................................. 57
Item 13. Certain Relationships and Related Transactions .............. 57
Item 14. Principal Accountant Fees and Services ...................... 57
PART IV ................................................................... 58
Item 15. Exhibits, Financial Statement Schedules and Reports
on Form 8-K ................................................. 58
ii
The following trademarks and service marks appear in this Annual Report:
Plexus(TM), OsteoActive(TM), Ovation(TM) Polyaxial System, Sentinal(TM) Top
Tightening Spinal System, Affirm(TM) Anterior Surgical Plate Systemand Clear
Bone(TM) are trademarks and Osteotech(R), Grafton(R) Demineralized Bone Matrix
(DBM), Grafton Plus(R) DBM Paste, Graftech(R) Bio-Implants, bio-d(R) Threaded
Cortical Bone Dowel, D-Min(R) Aseptic Tissue Demineralization and Allogard(R)
Packaging are registered trademarks 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; Allowash (TM) is a trademark of LifeNet;
VBR(R) Vertebral Body Replacement is a registered trademark of Heinrich C.
Ulrich, K.G.; C3(TM) Anterior Cervical Plate System, PLUS(TM) Pivot Link
Universal System, and Uni-Thread(TM) Versatile Thoraco-Lumbar 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, 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.
Our Board of Directors has adopted a Code of Business Conduct that is
applicable to all of our directors, officers and employees, a copy of which is
attached as an exhibit to this annual report. Any material changes made to our
Code of Business Conduct or any waivers granted to any of our directors and
executive officers will be publicly disclosed by filing a current report on Form
8-K within five business days of such material change or waiver. We intend to
make a copy of the Code of Business Conduct as well as charters for our Audit
Committee and Nominating and Corporate Governance Committee, which comply with
the recently adopted corporate governance rules of Nasdaq, available on our
website at www.osteotech.com. In addition, a copy of such documents will also be
made available to our shareholders upon request by contacting our Investor
Relations Department by calling 732-542-2800 or through an e-mail request from
our website at www.osteotech.com/finrequest.htm.
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.
Cessation of Marketing and Distribution Efforts for Metal Spinal Implant
Products
In January, 2004, we announced that we would terminate the Distribution
Arrangement dated February 1, 2003 with SpineVision, S.A. and SpineVision, Inc.,
in accordance with the provisions of the agreement, effective February 17, 2004.
Also, in September, 2003 we gave notice to Alphatec Manufacturing, Inc., the
manufacturer of the Affirm(TM) Anterior Surgical Plate System and the
Sentinal(TM) Top Tightening Spinal System, that we would not renew the
distribution agreement upon the completion of the current two-year term, which
expires on March 31, 2004. In addition, we announced in March, 2004 that we
would discontinue our marketing and distribution efforts for all remaining metal
spinal implant product lines no later than June 30, 2004. Revenues generated
from metal spinal implants were $4,907,000, $4,166,000 and $2,617,000, in 2003,
2002 and 2001, respectively. As a result of these discussions, we expect to take
a charge of approximately $2.4 million in first quarter 2004 for inventory and
instrument set write-offs and severance related to this decision.
Temporary Suspension of Base Tissue Segment Processing
On September 30, 2002, we voluntarily and temporarily suspended Base
Tissue Segment processing due to a 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 voluntarily retrieved 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 released a portion of the quarantined tissue in 2003 and expect to release
the remainder in 2004. In 2002, we
1
recorded the costs which we estimated we would incur in order to rework the
quarantined issue and allow it to be distributed. In order to successfully
rework the remaining tissue, we will need to continue 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 the remaining tissue for our
estimate.
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 Demineralized Bone Matrix (DBM) Segment, or the DBM Segment
(formerly referred to as the Grafton(R)DBM Segment); and
o Base Allograft Tissue Segment, or Base Tissue Segment.
Our other products are aggregated under the category of "other."
In the DBM Segment we process and market Grafton(R) DBM, which
domestically is primarily distributed by our clients to the end-user.
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 directly to end-users under our own label. The
distribution of Grafton(R) DBM directly by us to end-users under our own label
from allografts bone tissue recovered by TRO's on our behalf represented an
immaterial portion of consolidated revenues in 2003. However, we expect revenue
generated from Grafton(R) DBM distributed directly to end-users by us under our
own label from allografts bone tissue recovered on our behalf to represent a
growing percentage of our consolidated revenues in future years.
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.
The DBM Segment also includes revenues from our processing of a private
label DBM, which is marketed by DePuy Orthopaedics, Inc. and DePuy Acromed,
Inc., or collectively DePuy, and distributed by 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
2
hospital market of a private label DBM. Under the terms of the agreement, we
process the DBM product to specifications determined by LifeNet, from bone
supplied by LifeNet. DePuy markets and promotes the DBM carrier product to
surgeons performing trauma, joint revision and spinal procedures and LifeNet
ships and invoices the private label DBM to hospitals and surgeons.
In the Base Tissue Segment, we process primarily mineralized
weight-bearing allograft bone tissue. Graftech(R) Bio-implant spacers and ramps
for 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 distributed domestically by our clients.
Internationally, these tissue forms are generally marketed and distributed to
the end-user through distributors. To the extent that TRO's recover allograft
bone tissue on our behalf, we process and distribute this tissue either as
bio-implants or other tissue forms primarily to domestic end-users. In 2003, 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 consolidated revenues. We expect revenues generated from
bio-implants and other tissue forms processed from allograft bone tissue
recovered for us and distributed by us to end-users to represent a growing
percentage of consolidated revenues in future years. In this segment, we also
process in 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 $46,000, $1,216,000, and $2,361,000 in 2003, 2002 and
2001, respectively.
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 DBM Segment and Base Tissue Segment, we market and
distribute primarily in the United States, metal spinal implant products. As
previously announced, we expect to discontinue our marketing and distribution
efforts related to metal spinal implant products in the second quarter of 2004.
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 2003 was
approximately $1.5 billion, of which the allograft bone tissue portion, which
includes allograft (the use of processed bone tissue from cadavers) bone tissue,
synthetic graft substitutes and growth factors, in 2003 was approximately $793
million. We estimate that the allograph bone tissue market is growing at a
substantially faster rate than the general bone grafting market,
3
as allograft bone tissue is increasingly becoming accepted as either an augment
to, or a surgical alternative to autograft procedures. Autograft (the use of a
patient's own bone) 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 or quality of their own
harvestable bone for use in a procedure.
We believe that our 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 us and
our clients, has significantly reduced the risk of transmission of infectious
agents.
We operate under a number of different business models in the DBM and Base
Tissue Segments based upon the distribution method used and for whom the tissue
is recovered. In the 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 DBM
Segment is generated from our direct distribution 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 this direct distribution
business model will represent an increasing portion of our revenues in the DBM
Segment in the future. Beginning in 2003, we processed a private label DBM for
LifeNet, which is marketed by DePuy and distributed to end users by LifeNet.
In the Base Tissue Segment, the majority of our revenues are generated
from Graftech(R) Bio-implants, which we processed for our clients, but are
marketed and generally distributed by us to hospitals and surgeons, or in
certain cases distributed by our clients. We also 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(R) 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, our
contract with MTF
4
expires in December, 2008 and our contract with LifeNet expires in December,
2007. 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(R) 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. 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(R) Bio-Implants. The
label for these bio-implants displays both the LifeNet name and the Osteotech
Graftech(R) brand name. These bio-implants are marketed and distributed to
hospitals and surgeons by us on behalf of LifeNet. The LifeNet agreement has
been amended several times to provide for us to process non-proprietary standard
allograft base tissue forms and specialty allograft tissue forms for LifeNet. In
addition, in January, 2003, we entered into a five-year marketing agreement with
LifeNet and DePuy for the processing of LifeNet allograft bone tissue into a
private label DBM, which will be marketed by DePuy and distributed by LifeNet.
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(R) 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 DBM Segment was $46,294,000 in 2003 as compared to
$44,926,000 in 2002, and revenue in our Base Tissue Segment was $41,465,000 in
2003 as compared to 2002 revenue of $32,115,000. We expect that both our DBM and
Base Tissue Segments will be the major contributors to the growth of our
consolidated revenues and profits in 2004, as processed allograft bone tissue
forms continue to gain increased acceptance.
5
Information relating to our revenues for the years ended December 31,
2003, 2002 and 2001 by geographic area is summarized as follows:
(in thousands) United States Europe Consolidated
-------------------------------------------------------------------------------------
Revenues
For the year ended December 31,
2003 $86,070 $8,363 $94,433
2002 $78,576 $4,798 $83,374
2001 71,776 3,939 75,715
For a discussion of (1) our long-lived assets as of December 31, 2003, 2002 and
2001 see Note 18 of "Notes to Consolidated Financial Statements" and (2) our
deferred tax assets for the years ended December 31, 2003 and 2002 see Note 12
of "Notes to Consolidated Financial Statements".
Strategy
Overview
We intend to expand our business as follows:
o We expect to maintain our leading global position as an
orthobiologics company by utilizing our expertise in allograft bone
tissue processing and science to market innovative and
cost-effective proprietary allograft bone tissue forms.
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 leverage our intellectual property to establish private
label and licensing arrangements with other major orthopaedic
companies.
o We intend to utilize our domestic and international marketing and
distribution network to enhance the market share of our allograft
bone tissue forms.
6
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, continue
to contract directly with TRO's to obtain tissue on our behalf and
continue to expand our international tissue bank.
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, distributors 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.
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 DBMs for use beyond spinal surgery.
In addition, we expect to expand sales of Grafton(R) DBM by:
o providing the surgeon an expanded line of Graftech(R) Bio-implants
and other allograft bone tissue forms, which are usable with
Grafton(R) DBM so that we can better meet the needs of the surgeon;
o expanding Grafton(R)DBM's application to additional surgeon
identified new procedures;
o providing surgeon oriented medical education programs;
o providing in-depth sales agent training programs;
o publishing clinical support;
o developing product line extensions; and
o continuing our global expansion of Grafton(R) DBM.
Base Tissue Segment
We expect to achieve continued growth in the Base Tissue Segment by:
o introducing additional Graftech(R) Bio-implants and other
non-proprietary allograft bone tissue grafts with application in
spinal and other surgical procedures, which also have enhanced
performance profiles;
o continuing our global expansion of Graftech(R) Bio-implants and
other non-proprietary allograft bone tissue forms;
o developing proprietary tissue processing technology through internal
research; and
7
o attaining additional domestic and international bone tissue
processing clients and sources of bone tissue, which will allow us
to continue to meet and expand demand.
Spinal Strategy
Our spinal strategy consists of two primary components involving our DBM
and Base Tissue Segments:
o continuing to meet surgeon demand and preference by introducing
additional Graftech(R)Bio-implants; and
o marketing our Graftech(R) Bio-implants together with Grafton(R) DBM
through our network of direct sales representatives and our national
sales agency network.
Our intention is to market and distribute two complementary product lines
to meet surgeons' needs for non weight-bearing tissue grafting products
(Grafton(R) DBM) and weight-bearing bio-implants (Graftech(R) Bio-implants). We
will educate surgeons concerning the benefits of using our product lines either
alone or in conjunction with each other. Allograft bone tissue forms, which we
expect to 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 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 DBM and Base
Tissue Segments. Once processed, the allograft bone tissue is distributed to
surgeons and hospitals by our clients or by 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 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;
8
o augmentation of prosthetic implant procedures; and
o replacement of damaged ligaments and tendons.
We believe our processing methods, tissue recovery techniques utilized by
our clients, TROs and tissue banks and the multiple screening and testing
procedures employed, significantly reduce the risk of transmission of infectious
agents by the allograft bone tissue we process.
We have a validated viral inactivation process utilized to produce
Grafton(R) DBM. 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 2003 there
were approximately 771,000 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 $1.5 billion. Currently, allograft
tissue competes with autograft bone tissue procedures, growth factors 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 2003 was approximately $793 million. Industry data
indicates that the musculoskeletal surgical market is expected to continue to
expand over the next five years. We believe this will expand the potential
market for allograft bone tissue in both our 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
9
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
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) 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 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
10
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.
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, and through our expansion
into European markets and our marketing of Graftech(R) Bio-implants.
Effective January 1, 2003, we entered into a five-year agreement to
process a private label DBM 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, chips,
blocks 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
11
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.
Our Graftech(R) Bio-Implants product line includes the Graftech(R)
Posterior Ramp, Graftech(R) Anterior Ramp, Graftech(R) Cervical Spacer, the
Graftech(R) Cortical Spacer, the Graftech(R) Cervical Dowel and the Graftech(R)
TLIF. In addition to our normal processing techniques, Graftech(R) Bio-Implants
are processed using our OsteoActive(TM) Process which transforms the 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 technology which allows it to
be available in a non-frozen form. 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 domestic and international market demand for Graftech(R) 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 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 three 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(R) Bio-implants and non-proprietary
standard allograft bone tissue forms.
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) Processing 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)
Processing 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.
12
Expansion of Allograft Bone Tissue Business in Europe
We are expanding operations and staff at OST, our subsidiary located in
Clermont-Ferrand, France, as we use it as a base for developing our human
allograft bone tissue graft and tissue processing business internationally. 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 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 throughout the world 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 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 internationally. We will
add facilities and staff to our current operations, as required, to support this
expansion.
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 internationally through OST's
network of distributors and agents. Once sufficient quantities of donated tissue
are obtained from this and other European sources, 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 international 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.
13
OST 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.
Quality Assurance
We have stringent quality assurance programs in place covering all of our
lines of business, including our DBM and Base Tissue Segments. 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 DBM and Base Tissue Segments, our allograft bone tissue
quality assurance program commences at the time allografts bone tissue is
recovered. The allograft bone tissue is recovered 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 for distribution, our quality
assurance team inspects and again tests all processed bone tissue for
microbiological contaminants.
We believe that the serologic screening of donors, the extensive screening
of donor profiles and medical histories performed by our clients, TRO's and
tissue banks, 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 utilized to produce
Grafton(R) DBM 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 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 3.0 million transplanted
grafts we have processed in our 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
14
techniques used by our clients, extensive donor testing, as well as our
demanding quality assurance and processing protocols.
Clients
During 2003, two of our clients, ARC and MTF individually accounted for
approximately 24% and 25% of our consolidated revenue, respectively. We receive
revenues in both our 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, allograft bone
tissue and on a per unit basis for the processing of bio-implants. In the 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 is 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.
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 an increasing 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.
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
15
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, 2003, in the United States, we employed 37 persons
engaged directly in efforts to educate surgeons as to the benefits and
applications of processed allograft bone tissue. We complement our direct sales
organization with a national network of independent sales agents who market
Grafton(R) DBM, Graftech(R) Bio-implants and our other allograft and
non-allograft products. These agents also educate the medical community about
processed allograft bone tissue. At December 31, 2003, we had appointed 34
agencies which employ 167 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 allograft bone tissue forms in
conjunction with a network of independent agents and distributors we have
retained. 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,
16
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 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
the 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 the 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. 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
17
believes that a 510(k) should be submitted for Grafton(R) DBM. The Company has
not submitted a 510(k) and we intend to continue to have a dialog with the FDA
to further present our point of view regarding Grafton(R) DBM. 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 private label DBM we process
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 providing high technology as determined under applicable
French regulations. This authorization was granted
18
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.
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 2003, 2002, and 2001 we spent approximately $3,944,000, $3,927,000,
and $4,372,000, respectively, on research and development activities. The
majority of these expenditures were made in our 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, efficacy 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. In 2004 we expect to substantially increase our
spending on research and development activities in order to accelerate the
development and marketing of certain new products and technologies.
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. Four basic categories of products or alternatives
currently compete in the bone graft market:
19
o autograft bone tissue;
o allograft bone tissue;
o growth factors; and
o synthetic bone void fillers.
We estimate that total domestic allograft bone tissue sales in 2003 was
$793 million, comprising approximately 52% of the U.S. bone graft market. The
number of bone graft procedures is expected to increase during the next five
years as a result of an increase in the number of reconstructive orthopaedic
surgical procedures utilizing bone grafts, particularly in spinal procedures.
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:
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 improved recovery and
processing techniques.
Competitive Overview
In both our DBM and Base Tissue Segments we compete in the bone graft
market with autograft bone tissue, allograft bone tissue processed by others,
growth factors and synthetic bone void fillers. Autograft bone tissue has
traditionally been the primary choice for surgeons and we believe it still
maintains an approximate 48% share of the U.S. bone graft market. Due to factors
such as the increased cost and potential complications associated with an
additional procedure
20
needed to acquire autograft bone tissue, more surgeons are beginning to choose
allograft bone tissue over autograft bone tissue for their bone grafting needs.
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 2003, we introduced 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.
Given its osteoinductive and osteoconductive properties, Grafton(R) DBM
has a distinct advantage over synthetic bone void fillers, all of which are
exclusively osteoconductive.
Grafton(R) DBM'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 IsoTis OrthoBiologics; 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.
21
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; and we have entered into an agreement to
process a private label DBM in order to expand into segments of the orthopaedic
market that are not a focus of our spine focused sales force. We expect to enter
into additional such agreements in 2004. We have also expanded our Graftech(R)
Bio-implant line with which Grafton(R) DBM is used. When taken together, we are
now able to provide the spinal surgeon with the full range of tissue 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 believe that Grafton(R) DBM was used in only a small portion of the
total bone graft procedures performed in the U.S. during 2003. 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.
Base Tissue Segment
For bone grafting procedures which require weight-bearing tissue,
allograft bone tissue is still the only alternative to autograft bone tissue. In
this segment, we process both our non-proprietary allograft bone tissue forms
and Graftech(R) Bio-implants. We market and generally distribute these
bio-implants. 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(R) Bio-implants face
significant competition from bio-implants processed by other tissue banks and
processors such as MTF, Regeneration Technologies, Inc and LifeNet and are
marketed by companies such as Medtronic Sofamor Danek, Synthes Spine and DePuy,
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 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:
22
o leverage our knowledge of allograft bone tissue processing to expand
our proprietary tissue safety claims to our weight-bearing
mineralized allograft bone tissue;
o expand our external scientific presence through publication and
presentation of clinical research and outcome studies;
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 allograft 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(R)
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. Also, several U.S. tissue bank organizations have formed
strategic alliances with orthopaedic device firms to market allograft bone
tissue grafts in European markets.
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 Clermont-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.
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 March 10, 2004, we held an aggregate of 107 United States patents and
patent applications and 214 foreign patents and patent applications. We believe
that our Grafton(R)
23
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 2022.
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 $30
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 currently have one product liability claim asserted
against us. See Item 3. "Legal Proceedings" and Note 13 of "Notes to
Consolidated Financial Statements."
Employees
At December 31, 2003, we had 367 employees, of whom 218 were engaged in
allograft bone tissue processing and the manufacture of products; 24 were
engaged in research and development; 59 were engaged in education, sales and
marketing; and 66 were engaged in 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 a 38,000 square foot
building in Eatontown, New Jersey, which is occupied pursuant to a lease which
expires in December, 2008 and provides for a base annual rental of approximately
$576,000. 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 principal executive offices. We
constructed and validated a 73,000 square foot processing facility, which is
utilized primarily by the DBM and Base Tissue Segments. We fully occupied it in
June, 2002. Our credit facility is
24
collateralized by this tissue processing facility, including all equipments and
improvements therein.
We have a 45,000 square feet processing facility located in Shrewsbury,
New Jersey occupied pursuant to a lease that expires in October, 2008, which
provides for a base annual rental of approximately $309,000 for the remaining
term of the lease. The lease is renewable at our option for an additional
five-year term. We currently 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. 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 human allograft tissue products and bovine bone
graft substitute 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 90,000 Euros (approximately $113,000 at the December 31,
2003 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 30,000 Euros (approximately $38,000 at the December 31, 2003
exchange rate). The lease on this facility expires in February 2010. OST's
Bulgarian subsidiary, Medical Technical Laboratory OsteoCentre Bulgaria EAD,
leases a 3,900 square foot facility in Sofia, Bulgaria utilized for its tissue
banking activities. The annual rental on this facility is 34,000 Euros
(approximately $42,000 at the December 31, 2003 exchange rate) and expires in
February, 2010.
Item 3. Legal Proceedings
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) 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 was 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 did not recognized
any portion of this net award of $14,533,634 in our consolidated 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
25
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, 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, an interest bearing Promissory Note in the amount of $5.0 million and
the $5.0 million letter of credit collateralizing the Promissory Note.
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 agreed to dismiss all
other litigation that was 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 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, dismissing all claims with prejudice.
"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 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
26
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. On
December 18, 2003, the Court extended the stay of all proceedings until March
27, 2004. In the event the parties are unable to consummate a settlement by
March 27, 2004, and no further extension is granted, the Court will lift the
stay of the proceedings and the parties will return to active litigation.
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.
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.
On April 8, 2003, we filed a Motion for Summary Judgment seeking dismissal
of plaintiff's claims with prejudice. On May 9, 2003, the Court granted our
Motion for Summary Judgment dismissing plaintiff's claims as to us with
prejudice.
27
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 denying all allegations 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 commenced and will
continue through May 7, 2004.
We believe that Alphatec's claims are without merit and intends 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).
Anthonsen v. Allosource, Inc.
In January, 2004, we were served with a complaint in an action brought in
the Lake Superior Court of Lake County, State of Indiana against numerous
defendants, including us. The complaint alleges that plaintiff received
defective implants and medical hardware in connection with cervical surgery
performed on plaintiff, and that such implants and hardware were manufactured,
processed or distributed by defendants. Plaintiff alleges personal injuries and
unspecified damages. In February, 2004, the action was removed to the United
States District Court, Northern District of Indiana, Hammond Division. We are
currently reviewing the complaint and a response is due on March 17, 2004.
We maintain a product 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
management is 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 currently unable to
estimate the ultimate liability, if any, that may result from the pending
litigation.
28
Item 4. Submissions of Matters to a Vote of Security Holders
None.
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters
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, 2003
and 2002 based on transaction data as reported by the Nasdaq Stock Market(R).
Year Ended December 31, 2003 High Low
- ---------------------------- ---- ---
First Quarter $ 7.70 $ 6.17
Second Quarter $14.32 $ 6.40
Third Quarter $16.06 $ 8.25
Fourth Quarter $ 8.80 $ 7.25
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
As of March 8, 2004, there were 320 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.
29
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 not available for future option grants under
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 for future issuance
to be issued upon Weighted-average under equity
exercise of exercise price of compensation plans
outstanding options, outstanding options, (excluding securities
Plan Category warrants and rights warrants and rights reflected in column (a))
- ------------- ------------------- ------------------- ------------------------
(a) (b) (c)
- ----------------------------------------------------------------------------------------------------------------------
Equity compensation
plans approved by
security holders 2,499,762 $9.10 1,112,000
- ----------------------------------------------------------------------------------------------------------------------
Equity compensation
plans not approved by
security holders (1)
- ----------------------------------------------------------------------------------------------------------------------
Total 2,499,762 $9.10 1,112,000
- ----------------------------------------------------------------------------------------------------------------------
(1) We do not have any equity compensation plans which have not been approved
by our security holders.
30
Item 6. Selected Financial Data
Set forth below is selected financial data for the five years ended
December 31, 2003. 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."
- -----------------------------------------------------------------------------------------------------------------
Selected Financial Data
(dollars in thousands except per share
data) 2003 2002 2001 2000 1999
For the Year ended December 31,
- -----------------------------------------------------------------------------------------------------------------
Consolidated Results of Operations
- -----------------------------------------------------------------------------------------------------------------
Net revenues $ 94,433 $ 83,374 $ 75,715 $ 74,111 $ 73,642
- -----------------------------------------------------------------------------------------------------------------
Gross profit 52,362 37,103 42,735 47,518 50,690
- -----------------------------------------------------------------------------------------------------------------
Operating expenses 41,730 42,183 48,628 40,199 32,694
- -----------------------------------------------------------------------------------------------------------------
Income (charge) from
litigation settlements 7,500 (1,785) 1,000 2,000
- -----------------------------------------------------------------------------------------------------------------
Operating income (loss) 18,132 (6,865) (5,893) 8,319 19,996
- -----------------------------------------------------------------------------------------------------------------
Other income (loss), net (386) 29 129 1,019 1,133
- -----------------------------------------------------------------------------------------------------------------
Income (loss) from continuing
operations before income taxes 17,746 (6,836) (5,764) 9,338 21,129
- -----------------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations 10,867 (1,248) (3,817) 5,247 12,572
- -----------------------------------------------------------------------------------------------------------------
Income (loss) from continuing
operations per share
- -----------------------------------------------------------------------------------------------------------------
Basic .64 (.08) (.28) .37 .90
- -----------------------------------------------------------------------------------------------------------------
Diluted .62 (.08) (.28) .37 .86
- -----------------------------------------------------------------------------------------------------------------
Dividends per share 0 0 0 0 0
- -----------------------------------------------------------------------------------------------------------------
Year End Financial Position
- -----------------------------------------------------------------------------------------------------------------
Working capital $ 56,384 $ 42,447 $ 24,778 $ 29,239 $ 37,171
- -----------------------------------------------------------------------------------------------------------------
Total assets 127,213 114,732 107,017 104,362 89,671
- -----------------------------------------------------------------------------------------------------------------
Long-term obligations, net of current
portion 13,262 15,922 18,683 19,930 6,359
- -----------------------------------------------------------------------------------------------------------------
Stockholders' equity 96,220 84,023 68,125 71,967 69,495
- -----------------------------------------------------------------------------------------------------------------
In 2003, 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.
31
Item 7. Management's Discussion And Analysis Of Financial Condition And Results
Of Operations
For the Three Years Ended December 31, 2003, 2002, and 2001
Results of Operations
Overview
We provide services and products primarily focused on the repair and
healing of the musculoskeletal system. Our services and technology are
associated with making human tissue safe for transplantation and for use in a
variety of surgical procedures. 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 and tissue banks for us in both
our DBM and Base Tissue Segments.
We perform the medical education to teach surgeons about the uses of these
tissue forms. Prior to 2001, our clients generally distributed these tissue
forms to hospitals and surgeons. Commencing in the first half of 2001, we began
to distribute tissue forms directly to hospitals and surgeons. We expect to
continue to expand our direct distribution efforts in future periods. As a
result, we expect that revenues from direct distribution of tissue will continue
to grow over the next several years. For the years ended December 31, 2003, 2002
and 2001, 54%, 61% and 79%, respectively, of our consolidated revenues were
generated from processing tissue that our clients distributed.
This change in distribution methodology has impacted our liquidity and
cash flow. We have had to make additional investments in deferred processing
costs to support our direct distribution efforts, future programs and
initiatives, which may deplete our available cash balance. 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 investment in accounts receivable will
increase. We believe that available cash, cash equivalents, available lines of
credit and anticipated future cash flow from operations will be sufficient to
meet forecasted cash needs in 2004. 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
32
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 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, 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 numerous
factors, including, but not limited to, the competitive nature of
the market, technological change, expiration 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 we
determine 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.
33
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 we are 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.
Cessation of Marketing and Distribution Efforts for Metal Spinal Implant
Products
In January, 2004, we announced that we would terminate the Distribution
Agreement dated February 1, 2003 with SpineVision, S.A. and SpineVision, Inc. in
accordance with the provisions of the agreement effective February 17, 2004. In
addition, we announced in March, 2004 that we would discontinue our marketing
and distribution efforts for all remaining metal spinal implant product lines.
Revenues generated from metal spinal implants were $4,907,000, $4,166,000 and
$2,617,000 in 2003, 2002 and 2001, respectively. We are currently developing and
implementing the plans to transition our surgeon users from our metal spinal
implant systems and expect to completely cease the marketing and distribution of
metal spinal implant in the second quarter of 2004. In addition, we expect to
take a charge of approximately $2.4 million in the first quarter 2004 for
inventory and instrumentation write-offs and severance related to this decision.
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
34
our Shrewsbury facility. In addition, as a precaution, we voluntarily retrieved
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 released a portion of the quarantined tissue in 2003 and expect to release
the remainder in 2004. We estimated that the total cost to rework this tissue is
$840,000. In order to successfully rework the remaining tissue, we will need to
continue 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 the remaining tissue for our estimated cost.
These events negatively impacted our 2002 operating results. We have
estimated that the 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
Consolidated income from continuing operations was $10,867,000 or $.62
diluted income per share in 2003, compared to a consolidated loss from
continuing operations in 2002 of $1,248,000 or $.08 diluted loss per share and a
consolidated loss from continuing operations of $3,817,000 or $.28 diluted loss
per share in 2001. In 2003 income from continuing operations included an after
tax gain of $4,500,000 related to the settlement with GenSci. In 2002, 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: $1,107,000
related to provisions for excess inventory and instrument sets for metal spinal
implant systems; $1,372,000 for equipment which is no longer utilized in the
processing of allograft bone tissue; and $420,000 primarily for severance costs
associated with the departure of an executive officer.
35
Consolidated income from continuing operations before taxes was
$17,746,000 in 2003 compared to a consolidated loss from continuing operations
before income taxes of $6,836,000 in 2002 and $5,764,000 in 2001.
Discontinued Operations
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 in 2001. The business had net
income of $384,000 in 2002 through the date of sale, compared to a net loss of
$370,000 in 2001.
Net Income (Loss)
Consolidated net income was $10,867,000 or $.62 diluted net income per
share in 2003 compared to net losses in 2002 and 2001 of $1,155,000 or $.07
diluted net loss per share and $4,187,000 or $.30 diluted net loss per share,
respectively.
The following is a discussion of factors affecting results of operations
for the years ended December 31, 2003, 2002, and 2001 after giving effect to the
divestiture of the operations of our subsidiary in The Netherlands in 2002.
Net Revenues
Consolidated net revenues increased 13% in 2003 to $94,433,000 compared to
consolidated revenues of $83,374,000 in 2002. Consolidated net revenues
increased 10% in 2002 to $83,374,000 compared to consolidated revenues of
$75,715,000 in 2001. The increases in 2003 and 2002 were primarily due to
increased revenues in all segments mainly as a result of increased volume, and
to a lesser extent by price increases effective January 1 of each period and the
favorable impact, primarily in 2003, of exchange rates between the U.S. dollar
and the Euro. Consolidated revenues in 2002 were negatively impacted 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 10% to $86,070,000 in 2003 and increased
9% in 2002 to $78,576,000 from $71,776,000 in 2001. The increase in domestic
revenues in 2003 was primarily related to increased base allograft tissue
processing revenues, revenues from the private label DBM processed for LifeNet
and marketed by DePuy, a 13% increase in bio-implant revenues and revenues from
the three metal spinal implant systems we were distributing for SpineVision and
annual price increases, partially offset by a 9% decline in Grafton(R) DBM
revenues and the loss of revenue related to the suspension of sales of
Affirm(TM). The increase in domestic revenues in 2002 was due primarily to
increased unit volume in Grafton(R) DBM, bio-
36
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 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 74% to $8,363,000 in 2003 and increased 22% in 2002 to
$4,798,000 from $3,939,000 in 2001. The increase in foreign-based revenues was
due principally to increased unit sales volume in all product lines and the
favorable impact, primarily in 2003, of exchange rates between the U.S. dollar
and the Euro.
DBM Segment revenues, consisting primarily of Grafton(R) DBM revenues,
increased 3% to $46,294,000 in 2003 from $44,926,000 in 2002. The increase in
2003 principally relates to a 143% increase in international Grafton(R) DBM
revenues as well as revenues from the private label DBM processed for LifeNet
and marketed by DePuy, partially offset by a 9% decline in domestic Grafton(R)
DBM revenues. Domestic DBM Segment revenues declined 4% in 2003 to $41,338,000
from 2002 revenues of $42,883,000. Foreign-based DBM Segment revenues increased
143% in 2003 to $4,956,000 from $2,043,000 in 2002. DBM Segment revenues
increased 3% in 2002 to $44,926,000 from $43,637,000 in 2001 primarily due to
increased worldwide unit volume and the impact of 2002 price increases. Domestic
DBM Segment revenues increased 3% in 2002 to $42,883,000 from 2001 revenues of
$41,683,000. Foreign-based DBM Segment revenues increased 5% in 2002 to
$2,043,000 from $1,954,000 in 2001. In all periods, domestic Grafton(R) DBM
revenues were negatively impacted by increased competition. We expect domestic
Grafton(R) DBM will continue to face increasing competition as more companies
develop and market products with similar characteristics.
Base Tissue Segment revenues increased 29% in 2003 from $41,465,000 from
$32,115,000 in 2002, primarily due to a 56% increase in revenues from the
processing of donor tissue for our clients and a 13% increase in bio-implant
revenues resulting from an increase in unit sales volume and the January 1, 2003
price increase. Base Tissue Segment revenues were negatively impacted in 2002
from the temporary suspension of Base Tissue Segment processing. 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, 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.
Revenues from other product lines, which are mainly metal spinal implant
products and bovine tissue, increased 5% in 2003 to $6,674,000 from 2002
revenues of $6,333,000. The increase in 2003 primarily relates to revenues from
the three metal spinal implant systems we were distributing for SpineVision,
partially offset by a decline in bovine revenues and the suspension of sales of
Affirm(TM). 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 and bovine products.
37
In January, 2004 we announced that we would terminate the Distribution
Agreement dated February 1, 2003 with SpineVision, S.A. and SpineVision, Inc. in
accordance with the provisions of the agreement effective February 17, 2004. In
addition, we announced in March, 2004 that we would discontinue our marketing
and distribution efforts for all remaining metal spinal implant product lines.
Revenues generated from metal spinal implants were $4,907,000, $4,166,000 and
$2,617,000 in 2003, 2002 and 2001, respectively. We are currently developing and
implementing the plans to transition our surgeon users from our metal spinal
implant systems and expect to completely cease the marketing and distribution of
metal spinal implant in the second quarter of 2004.
During 2003, 2002, and 2001, two of our clients, MTF and ARC, in the DBM
and Base Tissue Segments together accounted for 49%, 59%, and 77% 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 55% in 2003, 45% in 2002,
and 56% in 2001. The increase in gross profit as a percentage of revenues in
2003 compared to 2002 is principally due to the increase in revenues, which has
improved the absorption of fixed costs. Gross profit as a percentage of revenues
was negatively impacted in 2002 primarily from the items discussed below. The
decline in gross profit as a percentage of revenues in 2002 compared to 2001 is
primarily due to 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. In addition, the decline in base tissue processing revenues due to
the temporary suspension of base tissue processing, the decline in donors
processed for our clients, and 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.
We expect that gross profit as a percentage of revenues will decline in
2004 from 2003 levels primarily due to the expected charge of approximately $2.4
million for inventory and instrumentation write-offs and severance related to
our decision to discontinue marketing and distribution of metal spinal implant
products, lower margins in the DBM Segment associated with lower margin
international sales volume and private label DBM revenues, increased facility
costs related to terminal sterilization and viral inactivation systems and
increased insurance costs, especially for product liability.
We believe that the continued expansion of our direct distribution efforts
from tissue recovered directly for us will have a positive impact on our future
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
38
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
In 2003, marketing, selling, general and administrative expenses were
$37,786,000 compared to 2002 expenses of $38,256,000. Marketing, selling,
general and administrative expenses decreased 14% in 2002 to $38,256,000 from
$44,256,000 in 2001. Marketing, selling, general and administrative expenses
remained relatively flat in 2003 compared to 2002 primarily due to a reduction
in legal fees and the rescission of our funding of the American Tissue Services
Foundation, partially offset by increased costs for marketing and sales
programs, an increase in the number of direct sales representatives, increased
commissions related to increased revenues, and an approximate 50% increase in
the effective commission rate for domestic Grafton(R) DBM revenues effective
July 1, 2003. The decrease in 2002 relates mainly to decreased legal fees due to
the settlement of a number of our lawsuits in late 2001 and 2002, a reduction in
our funding of the American Tissue Services Foundation, decreased marketing
costs due to the launch in 2001 of new bio-implant tissue forms, which increased
2001 marketing costs, and 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. We expect marketing, selling, general and administrative expenses to
increase slightly in 2004 compared to 2003 as a result of increased commission
costs related to increased revenues and the increase in the effective commission
rate for Grafton(R) DBM and a severance charge of approximately $600,000 related
to the reorganization of our sales and marketing functions in first quarter
2004.
Research and Development Expenses
In 2003, research and development expenses were $3,944,000 compared to
2002 research and development expenses of $3,927,000. Research and development
expenses decreased 10% in 2002 to $3,927,000 from $4,372,000 in 2001. Research
and development expenses were relatively flat in 2003 compared to 2002 as
existing projects continued to be developed and new projects were started after
other projects were completed. The decrease in 2002 from 2001 principally
related to the completion of the development of bio-implant tissue forms, which
were launched in 2001, 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. We expect
research and development costs to increase in 2004 primarily due to decisions to
fund additional projects in 2004 and to contribute additional resources to
previously under-funded projects.
Income (Charge) From Litigation Settlement
In May, 2003, as amended in August, 2003, we entered into a definitive
settlement agreement with GenSci to settle all claims arising out of our patent
litigation with GenSci. The settlement agreement was for an aggregate of
$7,500,000 and was subject to GenSci exiting bankruptcy and completing its
merger with IsoTis B.V. In October, 2003, GenSci emerged from
39
bankruptcy and merged with IsoTis. Pursuant to the settlement agreement, we
received an initial payment of $2,500,000 in cash, an interest bearing
$5,000,000 promissory note and a $5,000,000 letter of credit collateralizing the
promissory note. The promissory note is to be repaid in 20 equal payments of
$250,000 plus interest. As a result, in connection with this settlement we
recognized pre-tax income of $7,500,000 in the fourth quarter of 2003.
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.
Operating Income (Loss)
Consolidated operating income in 2003 was $18,132,000 compared to a
consolidated operating loss of $6,865,000 in 2002. DBM Segment operating income
increased 108% in 2003 to $20,646,000 from $9,913,000 in 2002. The increase in
DBM Segment operating income in 2003 results principally from the income of
$7,500,000 from the GenSci settlement, increased revenues and a decline in
operating expenses, primarily due to lower legal fees. Operating income in the
Base Tissue Segment was $2,703,000 in 2003 compared to an operating loss in of
$8,927,000 in 2002. The improvement in operating income in 2003 compared to 2002
results primarily from increased revenues, the impacts in 2002 on revenue and
gross profit related to the temporary suspension of base tissue processing and a
number of reserves and provisions recorded in 2002 related to rework reserves,
excess and obsolete bio-d(R) Threaded Cortical Bone Dowel inventory and the
litigation settlement charge, partially offset by increased operating expenses
in 2003 associated with sales and marketing programs. Operating losses
associated with other revenues were $5,217,000 and $7,851,000 in 2003 and 2002,
respectively. The operating loss in 2003 results primarily from metal spinal
implant revenues for which there is not sufficient unit volume to cover overhead
costs, and increased legal fees.
We incurred a consolidated operating loss in 2002 of $6,865,000 compared
to a consolidated operating loss of $5,893,000 in 2001. DBM Segment operating
income increased 41% in 2002 to $9,913,000 from $7,031,000 in 2001. The increase
in DBM Segment operating income results principally from decreased legal fees
due to the resolution of lawsuits in late 2001 and second quarter 2002,
increased revenue levels, lower research and development costs associated with
the development of Grafton Plus(TM) DBM, which was launched in the first quarter
of 2002, and lower marketing and selling costs. We incurred an operating loss in
the Base Tissue Segment of $8,927,000 in 2002 compared to an operating loss of
$7,877,000 in 2001. The Base Tissue Segment operating loss principally resulted
from 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, 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,
reserves of $840,000 related to the estimated cost to rework tissue from donors
placed in quarantine, 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, increased legal fees, and a decline in donor processing revenue.
Operating losses associated with other revenues were $7,851,000 and $5,047,000
in 2002 and 2001, respectively. The operating
40
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.
Other Income (Expense)
Other expense of $386,000 in 2003 related primarily to interest expense on
our long-term debt of $1,107,000, partially offset by interest income on
available cash balance of $144,000 and foreign currency translation gains
associated with the impact of exchange rates between the U.S. dollar and the
Euro on intercompany debt.
In fourth quarter 2003, as a result of a decision to utilize excess cash
flow, if any, generated by our French subsidiary to repay the remaining
outstanding balance of its intercompany debt, in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 52, "Foreign Currency Translation",
we recognized the impact of foreign currency translation gains and losses on the
outstanding balance of the intercompany debt in our results of operations.
Foreign currency translation gains of $510,000 were recognized in other income
(expense) in the consolidated statement of operations for the year ended
December 31, 2003 related to the impact of exchange rates between the U.S.
dollar and the Euro. Future translation gains and losses may have a material
impact on our results of operations in the event of significant changes in the
exchange rate between the U.S. dollar and the Euro, although the impact of such
gains and losses should not have any impact on consolidated cash flows.
Other income 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 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.
Income Tax Provision
Our effective income tax rate in 2003 was 39%. The effective income tax
rate exceeded the federal statutory income tax rate principally due to the
impact of domestic state income taxes, partially offset by federal and state tax
credits.
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
41
was recorded for foreign losses, principally as a result of the uncertainty of
realization of such future tax benefits.
Liquidity and Capital Resources
At December 31, 2003 we had cash and short-term investments of $15,326,000
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. Working capital increased $13,937,000 to $56,384,000 at December
31, 2003 compared to $42,447,000 at December 31, 2002. The increase resulted
primarily from additional investments in accounts receivable as a result of
increased revenues, and deferred processing fees to continue to expand available
inventories and increase our overall tissue position.
Net cash provided by operating activities was $4,784,000 in 2003 compared
to net cash used in operating activities of $1,633,000 in 2002. The improvement
resulted primarily from the increase in net income and the initial $2,500,000
cash payment received under the GenSci settlement, partially offset by our
additional investments in deferred processing costs.
Net cash provided by investing activities was $2,893,000 in 2003 and is
principally due to proceeds from the sale of investments, partially offset by
capital expenditures. Net cash used in investing activities of $7,242,000 in
2002 primarily resulted from net purchases of short-term investments and capital
expenditures, partially offset by proceeds from the sale of the PolyActive(TM)
polymer biomaterial technology and patents and proceeds from the sale of the
operations of our subsidiary in The Netherlands.
Net cash used in financing activities in 2003 of $1,979,000 relates
primarily to principal payments on long-term debt, partially offset by proceeds
from the exercise of stock options and sales of common stock pursuant to our
employee stock purchase plan. Net cash provided by financing activities in 2002
was $13,654,000, and relates mainly to the sale of 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,
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 December 31, 2003, $3,982,000 was outstanding under the building mortgage
loan and $11,941,000 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. As of December 31, 2003, the standby letter of credit has been
reduced to $428,000. 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 reduced the amounts available under the
revolving line of credit. As of December 31, 2003, no amounts were outstanding
under the revolving line of credit and $4,572,000 was available. The revolving
line of credit expires on April 30, 2004 at which time all amounts outstanding
are due and payable and all remaining commitments are cancelled. We are
currently negotiating an extension
42
of the revolving line of credit with our lender, although there can be no
assurance that we will be successful in such endeavor.
The Credit Facility, as amended, is collateralized by domestic accounts
receivable, domestic inventories, our 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 imposes certain
restrictive operating and financial covenants, including a restriction on the
payment of cash dividends, a restriction on incurring or maintaining additional
indebtedness, a restriction on selling of assets or engaging in mergers or
acquisitions and limitations on cash advances to our foreign operations or
investments. 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 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, our
compliance with our bank covenants in 2003, and our expected compliance with our
bank covenants in 2004, 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.
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, 2003, we had Federal net operating loss carryforwards of
$764,000, which expire in varying amounts beginning in 2007 through 2013, and
state net operating loss carryforwards of $6,889,000, primarily to offset New
Jersey taxable income, which expire in varying amounts beginning in 2007 through
2012. We have provided valuation allowances for all of the 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 state research and development and
manufacturing credits of $690,000, primarily to offset New Jersey income taxes,
which expire in varying amounts beginning in 2008 through 2010. At December 31,
2003, certain of our foreign-based subsidiaries have net operating loss
carryforwards aggregating $6,580,000 expiring in varying amounts beginning 2005
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.
43
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 payment equal to
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
$600,000, $300,000 of which was to settle the first year purchase commitment and
the remaining $300,000 was to apply to purchases made on or after October 1,
2003. 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, 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
recorded a reserve of $1,079,000 in 2002 for the estimated penalty for the
second year commitment. We have reassessed such provision during 2003, and,
based on the Alphatec litigation and other factors, have determined that the
provision is adequate. See Item 3., "Legal Proceedings" and Note 13 to "Notes to
Consolidated Financial Statements" for more information.
The following table summarizes our contractual obligations at December 31,
2003, 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 $ 15,923 $ 2,661 $ 5,322 $ 7,940
Non-cancelable operating lease obligations 5,640 1,234 2,264 2,142
Medtronic litigation settlement payments 317 317
Purchase commitment(1) 1,079 1,079
--------- --------- --------- ---------
$ 22,959 $ 5,291 $ 7,586 $ 10,082
========= ========= ========= =========
(1) Represents the provision for the estimated penalty associated with the
minimum purchase requirements pursuant to the distribution agreement with
Alphatec. Due to the Alphatec litigation, no definitive date, if any, has
been determined for the payment of this provision.
We expect to continue to make investments in our business to support our
direct distribution efforts and future programs and initiatives, which may
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 2004. Our future liquidity and capital requirements
will depend upon numerous factors, including:
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
44
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
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. We adopted this
pronouncement in 2003 and it had no impact on our financial position, results of
operations or cash flows.
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 2003 or 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 did not have any 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,"
and in December, 2003 FASB issued a revised FIN 46(R), "Consolidation of
Variable Interest Entities - an interpretation of ARB No. 51," (collectively
referred to as "FIN 46"), both which address consolidation of variable interest
entities. FIN 46 expanded 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 the adoption of this
portion of FIN 46 had no impact on results of operation, cash flows, or
financial position. FIN 46 applies in the first fiscal year or interim period
ending after March 15, 2004, to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
We do not have any SPE's or other agreements in which the counter party would be
considered a variable
45
interest entity, and therefore, we expect no 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. We are subject to foreign currency
fluctuations for material changes in exchange rates between the U.S. dollar and
the Euro. As our foreign operations continue to grow and represent a larger
percentage of our consolidated revenues and profits, foreign currency
translation adjustments will impact our operating results to a greater extent.
The exchange rate as of December 31, 2003 was $1.26 U.S. dollars to one Euro
compared to an exchange rate of $1.05 U.S. dollars to one Euro as of December
31, 2002. The average exchange rate for the year ended December 31, 2003 was
$1.13 U.S. dollars to one Euro compared to an average exchange rate for the year
ended December 31, 2002 of $.94 U.S. dollars to one Euro.
In fourth quarter 2003, as a result of a decision to utilize excess cash
flow, if any, generated by our French subsidiary to repay the remaining
outstanding balance of its intercompany debt, in accordance with SFAS No. 52,
"Foreign Currency Translation", we recognized the impact of foreign currency
translation gains and losses on the outstanding balance of the intercompany debt
in our results of operations. Foreign currency translation gains of $510,000
were recognized in other income (expense) in the consolidated statement of
operations for the year ended December 31, 2003 related to the impact of
exchange rates between the U.S. dollar and the Euro. Future translation gains
and losses may have a material impact on our results of operations in the event
of significant changes in the exchange rate between the U.S. dollar and the
Euro, although the impact of such gains and losses should not have any impact on
consolidated cash flows.
Foreign currency exchange fluctuations did not have a material impact on
results of operations in 2002 or 2001.
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.
Risk Factors
We may need to secure additional financing to fund our long-term strategic
plan.
We expect to continue to make investments in our business to support our
direct distribution efforts and future programs and initiatives, which may
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
46
meet our forecasted cash needs in 2004. Our future liquidity and capital
requirements will depend upon numerous factors, including
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.
Our credit facility provides for a revolving line of credit, 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 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 line of credit,
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.
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 future periods. 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 may negatively
impact our future
47
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 accounts
receivable balances may increase.
We are dependent upon two primary clients who together provide
approximately half of our revenues.
We are the processor of allograft bone tissue for large national and
international not-for-profit organizations. During 2003, MTF and ARC accounted
for approximately 25% and 24%, respectively, of our consolidated 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, TRO's and tissue banks that 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 willing 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 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. Autograft bone tissue has
traditionally been the primary choice for surgeons and we believe autograft bone
tissue still maintains approximately a 48% 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.
48
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.
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
can.
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
customers, which are typically hospitals. The ability of hospitals to pay fees
to our clients, or directly to us for allograft bone tissue 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
49
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 or our
procurement of tissue.
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, 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 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.
50
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.
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.
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. 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. We have not submitted a 510(k)
and we intend to continue to have a dialog with the FDA to further present our
point of view regarding Grafton(R) DBM. 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. 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. 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 demineralized bone with a carrier is a medical
device, we would also be required to obtain FDA clearance or
51
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.
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.
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.
Our products face competitive threats from alternate technologies.
52
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.
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.
We presently maintain product liability insurance in the amount of $30
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. These independent sales agents and sales representatives may
terminate their relationship with us, or
53
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.
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.
54
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, 2003 cash and cash equivalents and
long-term debt, a 1% change in interest rates would have a negligible impact on
our results of operations.
The value of the U.S. dollar affects our financial results. Changes in
exchange rates may positively or negatively affect revenues, gross margins,
operating expenses and net income. 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, primarily the Euro, 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, 2003, a 10% change in the exchange rates would impact our net income 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 DataThe 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.
Item 9A. 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(e) under the Exchange Act) as of December
31, 2003 (the "Evaluation Date"). Based upon that evaluation, and taking into
consideration the additional procedures discussed below, 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.
55
Changes in Internal Controls
There were no significant changes made in our internal controls over
financial reporting during the period covered by this report, however, in March,
2004, as described below, we made changes in our internal controls over
financial reporting.
On March 2, 2004, we announced that we would restate our consolidated
financial statements as a result of over accruals of certain expenses caused by
a previously undetected flaw in our computer software that is used to maintain
certain accounting records. Executive management and the Audit Committee were
informed by our independent auditors that they considered that there was a
"material weakness" (as defined under standards established by the American
institute of Certified Public Accountants) relating to the timely review and
monitoring of certain account analyses, including the account related to this
portion of our computer software. Other than the matters discussed above related
to the previously undetected flaw in our computer system, no other matters were
identified that required adjustment to or disclosure in our consolidated
financial statements. We have corrected the flaw in our computer software and
have instituted more comprehensive review and monitoring procedures to mitigate
the risk of errors occurring in the future.
56
PART II
Item 10. Directors and Executive Officers of the RegistrantThe sections of our
2004 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 2004 Proxy Statement entitled "Executive Compensation"
is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The sections of our 2004 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. Principal Accountant Fees and Services
The section of our 2004 Proxy Statement entitled "Principal Accountant
Fees and Services" is incorporated herein by reference.
57
PART IV
Item 15. 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 Page
Number Description Number
- ------ ----------- ------
3.1 Restated Certificate of Incorporation of Osteotech, as amended *
(incorporated by reference to Exhibit 3.1 to Registrant's
Annual Report on Form 10-K, filed on March 27, 2002)
3.2 Third Amended and Restated Bylaws of Osteotech (incorporated by *
reference to Exhibit 3.2 to Registrant's Annual Report on Form
10-K, filed on March 27, 2002)
3.3 Form of Stock Certificate (incorporated by reference to Exhibit *
3.4 to Registrant's Registration Statement on Form S-1 (File
No. 33-40463), filed on June 14, 1991)
3.4 Certificate of Retirement and Prohibition or Reissuance of *
Shares of Osteotech, Inc. dated April 4, 2002 (incorporated by
reference to Exhibit 3.4 to Registrant's Quarterly Report on
Form 10-Q, filed on August 9, 2002)
4.1 Rights Agreement dated as of February 1, 1996 between *
Osteotech, Inc. and Registrar and Transfer Co., as amended
(incorporated by reference to Exhibit 4.3 to Registrant's
Annual Report on Form 10-K, filed on March 27, 2002)
10.1 1991 Stock Option Plan, as amended (incorporated by reference *
to Exhibit 10.1 to Registrant's Annual Report on Form 10-K,
filed on March 27, 2002) ^
10.2 1991 Independent Directors Stock Option Plan, as amended *
(incorporated by reference to Exhibit 28.2 to Registrant's
Registration Statement on Form S-8 (File No. 33-44547), filed
on December 17, 1991) ^
58
10.3 Processing Agreement between Osteotech and Stichting *
Eurotransplant Nederland, dated September 26, 1988
(incorporated by reference to Exhibit 10.7 to Registrant's
Registration Statement on Form S-1 (File No. 33-40463), filed
on May 9, 1991) #
10.4 Form of Confidentiality Agreement and Non-Competition Agreement *
with executive officers (incorporated by reference to Exhibit
10.10 to Registrant's Annual Report on Form 10-K, filed on
March 27, 2002)
10.5 Agreement dated December 10, 1996 between American Red Cross *
Tissue Services and Osteotech (incorporated by reference to
Exhibit 10.26 to Registrant's Annual Report on Form 10-K, filed
on March 27, 1997) #
10.6 Lease for Osteotech's Shrewsbury, New Jersey processing *
facility (incorporated by reference to Exhibit 10.2 to
Registrant's Registration Statement on Form S-1 (File No.
33-40463), filed on May 9, 1991)
10.7 Sixth Modification of Lease for Osteotech's Shrewsbury, New *
Jersey processing facility (incorporated by reference to
Exhibit 10.22 to Registrant's Quarterly Report on Form 10-Q,
filed on November 13, 1998)
10.8 Employment Agreement with Michael J. Jeffries dated January 1, *
1998 (incorporated by reference to Exhibit 10.35 to
Registrant's Annual Report on Form 10-K, filed on March 31,
1998) ^
10.9 Employment Agreement with James L. Russell dated December 18, *
1997 (incorporated by reference to Exhibit 10.37 to
Registrant's Annual Report on Form 10-K, filed on March 31,
1998) ^
10.10 The Management Performance Bonus Plan (incorporated by *
reference to Exhibit 10.29 to Registrant's Annual Report on
Form 10-K, filed on March 31, 1999) ^
10.11 Employment Agreement with Richard Russo dated April 1, 1997 *
(incorporated by reference to Exhibit 10.30 to Registrant's
Annual Report on Form 10-K, filed on March 31, 1999) ^
59
10.12 Employment Agreement with Richard W. Bauer dated December 4, *
1998 (incorporated by reference to Exhibit 10.32 to
Registrant's Annual Report on Form 10-K, filed on March 31,
1999) ^
10.13 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 (incorporated by reference to Exhibit 10.33 to
Registrant's Quarterly Report on Form 10-Q, filed on August 16,
1999)
10.14 Amended and Restated Processing Agreement entered into *
September 11, 2000 by Osteotech, Inc., Musculoskeletal
Transplant Foundation and Biocon, Inc. (incorporated by
reference to Exhibit 10.36 to Registrant's Quarterly Report on
Form 10-Q, filed on November 14, 2000) #
10.15 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
(incorporated by reference to Exhibit 10.37 to Registrant's
Annual Report on Form 10-K, filed on April 2, 2001)
10.16 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 (incorporated by reference to Exhibit 10.38 to
Registrant's Annual Report on Form 10-K, filed on April 2,
2001)
10.17 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
(incorporated by reference to Exhibit 10.39 to Registrant's
Annual Report on Form 10-K, filed on April 2, 2001)
10.18 Distribution Agreement entered into February, 2001 by *
Osteotech, Inc. and Alphatec Manufacturing, Inc. (incorporated
by reference to Exhibit 10.40 to Registrant's Annual Report on
Form 10-K, filed on April 2, 2001) #
60
10.19 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
(incorporated by reference to Exhibit 10.41 to Registrant's
Annual Report on Form 10-K, filed on April 2, 2001)
10.20 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
(incorporated by reference to Exhibit 10.42 to Registrant's
Annual Report on Form 10-K, filed on April 2, 2001)
10.21 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
(incorporated by reference to Exhibit 10.43 to Registrant's
Annual Report on Form 10-K, filed on April 2, 2001)
10.22 Primary Agreement Carrier and Bio-Implant Allografts by and *
between LifeNet and Osteotech dated January 4, 2002
(incorporated by reference to Exhibit 10.44 to Registrant's
Current Report on Form 8-K, filed on March 8, 2002)
10.23 Amended and Restated 2000 Stock Plan (incorporated by reference *
to Exhibit 10.41 to Registrant's Quarterly Report on Form 10-Q,
filed on August 14, 2003) ^
10.24 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
(incorporated by reference to Exhibit 10.47 to Registrant's
Annual Report on Form 10-K, filed on March 27, 2002)
61
10.25 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
(incorporated by reference to Exhibit 10.48 to Registrant's
Annual Report on Form 10-K, filed on March 27, 2002)
10.26 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
(incorporated by reference to Exhibit 10.49 to Registrant's
Annual Report on Form 10-K, filed on March 27, 2002)
10.27 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 (incorporated by reference to Exhibit 10.51 to
Registrant's Annual Report on Form 10-K, filed on March 27,
2002)
10.28 Amendment to License and Option Agreement between IsoTis N.V. *
and H.C. Implants B.V. and Osteotech dated April 8, 2002
(incorporated by reference to Exhibit 10.55 to Registrant's
Quarterly Report on Form 10-Q, filed on April 19, 2002)
10.29 Second Amended and Restated Processing Agreement by and among *
Musculoskeletal Transplant Foundation, Biocon, Inc., and
Osteotech, Inc. dated as of June 1, 2002 (incorporated by
reference to Exhibit 10.57 to Registrant's Quarterly Report on
Form 10-Q, filed on August 9, 2002) #
10.30 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 (incorporated by reference to Exhibit 10.56
to Registrant's Quarterly Report on Form 10-Q, filed on August
9, 2002)
62
10.31 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 (incorporated by reference to
Exhibit 10.58 to Registrant's Quarterly Report on Form 10-Q,
filed on August 9, 2002) #
10.32 Asset Purchase Agreement between Cam Implants B.V. and Cam *
Acquisition B.V. dated July 10, 2002 (incorporated by reference
to Exhibit 10.59 to Registrant's Quarterly Report on Form 10-Q,
filed on August 9, 2002) #
10.33 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 (incorporated by
reference to Exhibit 10.60 to Registrant's Quarterly Report on
Form 10-Q, filed on August 9, 2002)
10.34 Form of Change in Control Agreement with Executive Officers *
except Marc Burel (incorporated by reference to Exhibit 10.61
to Registrant's Quarterly Report on Form 10-Q, filed on
November 14, 2002) ^
10.35 Employment Agreement, as amended, with Marc Burel dated April *
18, 2000 (incorporated by reference to Exhibit 10.62 to
Registrant's Quarterly Report on Form 10-Q, filed on November
14, 2002) ^
10.36 Change in Control Agreement by and between Osteotech, Inc. and *
Marc Burel dated April 19, 2000, superceded by the Change in
Control Agreement dated September 8, 2002 (included as Exhibit
10.36) (incorporated by reference to Exhibit 10.63 to
Registrant's Quarterly Report on Form 10-Q, filed on November
14, 2002) ^
10.37 Change in Control Agreement by and between Osteotech, Inc. and *
Marc Burel dated September 8, 2002 (incorporated by reference
to Exhibit 10.64 to Registrant's Quarterly Report on Form 10-Q,
filed on November 14, 2002) ^
63
10.38 Allonge to Agreement of Amendment to the 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, SA, and OST Developpement SA. dated
November 13, 2002 (incorporated by reference to Exhibit 10.37
to Registrant's Annual Report on Form 10-K, filed on March 31,
2003)
10.39 Exclusive Marketing Agreement, by and among Osteotech, Inc., *
LifeNet, Depuy Orthopaedics, Inc. and Depuy Acromed, Inc. dated
December 13, 2002 (incorporated by reference to Exhibit 10.38
to Registrant's Annual Report on Form 10-K, filed on March 31,
2003) #
10.40 Letter Amendment to Agreement dated December 10, 1996, by and *
between the American Red Cross and Osteotech, Inc. dated
October 27, 2002 (incorporated by reference to Exhibit 10.39 to
Registrant's Annual Report on Form 10-K, filed on March 31,
2003) #
10.41 Second Allonge to Loan and Security Agreement among Fleet *
National Bank, Successor in Interest to Summit Bank, Osteotech,
Inc., Osteotech, B.V., H.C. Implants, B.V., Cam Implants, B.V.,
Osteotech/Cam Services, B.V., Osteotech Implants, B.V.,
Osteotech S.A. and OST Developpement dated March 27, 2003
(incorporated by reference to Exhibit 10.40 to Registrant's
Quarterly Report on Form 10-Q, filed on May 13, 2003)
10.42 Joint Settlement Agreement and Release by and among Osteotech, *
Inc., GenSci Orthobiologics, Inc. and GenSci Regeneration
Sciences, Inc., dated as of May 29, 2003 (incorporated by
reference to Exhibit 10.42 to Registrant's Quarterly Report on
Form 10-Q, filed on August 14, 2003)
10.43 First Amendment to Joint Settlement Agreement and Release by *
and among Osteotech, Inc., GenSci Orthobiologics, Inc. and
GenSci Regeneration Sciences, Inc., dated as of August 2003
(incorporated by reference to Exhibit 10.43 to Registrant's
Quarterly Report on Form 10-Q, filed on November 13, 2003)
10.44 Lease for Osteotech's Eatontown facility (incorporated by *
reference to Exhibit 10.30 to Registrant's Annual Report on
Form 10-K, filed on March 30, 1995)
10.45 First Modification to Lease for Osteotech's Eatontown +
facility
10.46 Osteotech's Code of Business Conduct +
21.1 Subsidiaries of the Registrant +
64
23.1 Consent of PricewaterhouseCoopers LLP +
31.1 Certification of Chief Executive Officer pursuant to Section +
302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer pursuant to Section +
302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer pursuant to Section +
906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to Section +
906 of the Sarbanes-Oxley Act of 2002
* Previously filed; incorporated herein by reference
+ Filed herewith
^ Management contracts or compensatory plans and arrangements
required to be filed pursuant to Item 10(iii)
# Copy omits information for which confidential treatment has
been granted
(b) Reports on Form 8-K
On November 3, 2003, we filed with the Commission a Current Report on Form 8-K
to announce the completion and closing of the settlement agreement associated
with certain patent litigation between us and GenSci.
On October 21, 2003, we filed with the Commission a Current Report on Form 8-K
to announce our financial results for the quarter ended September 30, 2003.
On October 3, 2003, we filed with the Commission a Current Report on Form 8-K to
announce preliminary financial results for the quarter ended September 30, 2003,
guidance for the remainder of 2003 and initial guidance for 2004.
65
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 15, 2004 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 15, 2004
- ---------------------------- Board of Directors
Donald D. Johnston
/s/ RICHARD W. BAUER President, Chief March 15, 2004
- ---------------------------- Executive Officer (Principal
Richard W. Bauer Executive Officer) and Director
/s/ MICHAEL J. JEFFRIES Executive Vice President March 15, 2004
- ---------------------------- Chief Financial Officer
Michael J. Jeffries (Principal Financial
Accounting Officer),
Secretary and Director
/s/ KENNETH P. FALLON III Director March 15, 2004
- ----------------------------
Kenneth P. Fallon III
/s/ JOHN P. KOSTUIK Director March 15, 2004
- ----------------------------
John P. Kostuik
/s/ STEPHEN J. SOGIN Director March 15, 2004
- ----------------------------
Stephen J. Sogin
66
OSTEOTECH, INC. AND SUBSIDIARIES
-------------------
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULE
Page
----
1. FINANCIAL STATEMENTS
Report of Independent Auditors...........................................F-2
Consolidated Balance Sheets as of December 31, 2003 and 2002.............F-3
Consolidated Statements of Operations
for the years ended December 31, 2003, 2002 and 2001..................F-4
Consolidated Statements of Changes in Stockholders' Equity
for the years ended December 31, 2003, 2002, and 2001.................F-5
Consolidated Statements of Cash Flows
for the years ended December 31, 2003, 2002, and 2001.................F-6
Notes to Consolidated Financial Statements...............................F-7
2. SCHEDULE
II. Valuation and Qualifying Accounts
for the years ended December 31, 2003, 2002, and 2001..........S-1
Report of Independent Auditors 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 AUDITORS
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, 2003 and 2002,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2003, 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 Note 2, the Company has adopted Statement of Financial
Accounting Standards No. 142, "Goodwill and Other Intangible Assets", effective
January 1, 2002.
PricewaterhouseCoopers LLP
Florham Park, New Jersey
March 1, 2004
F-2
OSTEOTECH, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
December 31, 2003 2002
- -------------------------------------------------------------------------------------------------
ASSETS
- -------------------------------------------------------------------------------------------------
Current assets:
Cash and cash equivalents $ 15,326 $ 10,040
Short-term investments 3,948
Accounts receivable, net of allowance of
$1,487 in 2003 and $943 in 2002 15,187 11,545
Deferred processing costs 29,013 15,433
Inventories 3,581 4,820
Income tax receivable 135 3,357
Deferred tax assets 5,511 5,431
Prepaid expenses and other current assets 1,699 1,023
-------------------
Total current assets 70,452 55,597
Property, plant and equipment, net 47,107 53,535
Goodwill, net of accumulated amortization of $404 in 2003 and
in 2002 1,669 1,669
Other assets 7,985 3,931
- -------------------------------------------------------------------------------------------------
Total assets $127,213 $114,732
=================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
- -------------------------------------------------------------------------------------------------
Current liabilities:
Accounts payable and accrued liabilities $ 11,407 $ 10,489
Current maturities of long-term debt 2,661 2,661
-------------------
Total current liabilities 14,068 13,150
Long-term debt 13,262 15,922
Other liabilities 3,663 1,637
- -------------------------------------------------------------------------------------------------
Total liabilities 30,993 30,709
- -------------------------------------------------------------------------------------------------
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 17,117,720 shares in 2003
and 17,001,372 shares in 2002 171 170
Additional paid-in capital 64,170 63,368
Accumulated other comprehensive income 605 78
Retained earnings 31,274 20,407
- -------------------------------------------------------------------------------------------------
Total stockholders' equity 96,220 84,023
- -------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $127,213 $114,732
=================================================================================================
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, 2003 2002 2001
- ---------------------------------------------------------------------------------------------------------------
Net revenues:
Service $ 87,759 $ 77,041 $ 71,329
Product 6,674 6,333 4,386
------------------------------------------------
94,433 83,374 75,715
Cost of services 37,034 37,292 29,835
Cost of products 5,037 8,979 3,145
------------------------------------------------
42,071 46,271 32,980
------------------------------------------------
Gross profit 52,362 37,103 42,735
Marketing, selling, and general and administrative 37,786 38,256 44,256
Research and development 3,944 3,927 4,372
------------------------------------------------
41,730 42,183 48,628
------------------------------------------------
Income (charge) from litigation settlements 7,500 (1,785)
------------------------------------------------
Operating income (loss) 18,132 (6,865) (5,893)
Other income (expense):
Interest income 144 246 506
Interest expense (1,107) (1,342) (406)
Gain on sale of patents 950
Other 577 175 29
------------------------------------------------
(386) 29 129
------------------------------------------------
Income (loss) from continuing operations before
income taxes 17,746 (6,836) (5,764)
Income tax provision (benefit) 6,879 (5,588) (1,947)
------------------------------------------------
Income (loss) from continuing operations 10,867 (1,248) (3,817)
Income (loss) from discontinued operations, net of loss
on disposal of $291 in 2002 93 (370)
- ---------------------------------------------------------------------------------------------------------------
Net income (loss) $ 10,867 $ (1,155) $ (4,187)
===============================================================================================================
Net income (loss) per share:
Basic:
Income (loss) from continuing operations $ .64 $ (.08) $ (.28)
Discontinued operations .01 (.02)
------------------------------------------------
Net income (loss) $ .64 $ (.07) $ (.30)
================================================
Diluted
Income (loss) from continuing operations $ .62 $ (.08) $ (.28)
Discontinued operations .01 (.02)
------------------------------------------------
Net income (loss) $ .62 $ (.07) $ (.30)
===============================================================================================================
Shares used in computing net income (loss) per share:
Basic 17,059,495 15,904,132 14,030,623
Diluted 17,520,959 15,904,132 14,030,623
- ---------------------------------------------------------------------------------------------------------------
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, 2003, 2002, and 2001
- ---------------------------------------------------------------------------------------------------------------------------------
Accumulated
Common Stock Additional Other Total
----------------------- Paid-In Comprehensive Retained Stockholders'
Shares Amount Capital Income (Loss) Earnings Equity
- ---------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2000 13,989,307 $ 138 $ 46,577 $ (497) $ 25,749 $ 71,967
Net loss (4,187) (4,187)
Currency translation adjustments (156) (156)
----------
Total comprehensive loss (4,343)
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) 21,562 68,125
Net loss (1,155) (1,155)
Currency translation adjustments 731 731
----------
Total comprehensive loss (424)
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 20,407 84,023
Net income 10,867 10,867
Currency translation adjustments 527 527
----------
Total comprehensive income 11,394
Exercise of stock options 80,437 1 375 376
Common stock issued pursuant to
employee stock purchase plan 35,911 305 305
Tax benefits related to stock options 122 122
- ---------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2003 17,117,720 $ 171 $ 64,170 $ 605 $ 31,274 $ 96,220
=================================================================================================================================
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, 2003 2002 2001
- ----------------------------------------------------------------------------------------------
Cash Flow From Operating Activities
Net income (loss) $ 10,867 $ (1,155) $ (4,187)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization 8,498 8,230 8,598
Deferred income taxes 2,230 (1,840) (2,786)
Gain on sale of patents (950)
Reversal of tax liability (2,557)
Income tax benefit related to stock options 122 38
Changes in assets and liabilities:
Accounts receivable (2,978) 3,934 (2,146)
Deferred processing costs (13,459) (3,938) (5,390)
Inventories 1,392 3,614 (5,073)
Prepaid expenses and other current assets 2,732 (2,445) 2,459
Note receivable from GenSci litigation
settlement (5,000)
Accounts payable and other liabilities 380 (4,564) 6,506
- ----------------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities 4,784 (1,633) (2,019)
Cash Flow From Investing Activities
Capital expenditures (1,571) (4,911) (8,955)
Proceeds from sale of foreign operation 1,000
Proceeds from sale of investments 3,948 5,860
Purchases of investments (3,948) (3,925)
Proceeds from sale of patents 1,000
Proceeds from the sale of land 1,500
Other, net 516 (383) 160
- ----------------------------------------------------------------------------------------------
Net cash provided by (used in) investing activities 2,893 (7,242) (5,360)
Cash Flow From Financing Activities
Proceeds from issuance of common stock 681 16,284 499
Proceeds from issuance of long-term debt 1,468
Principal payments on long-term debt (2,660) (2,630) (340)
- ----------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities (1,979) 13,654 1,627
Effect of exchange rate changes on cash (412) 69 21
- ----------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 5,286 4,848 (5,731)
Cash and cash equivalents at beginning of year 10,040 5,192 10,923
- ----------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 15,326 $ 10,040 $ 5,192
==============================================================================================
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 allograft bone tissue forms processed by the
Company are used in a variety of surgical procedures.
Beginning in 2001, the Company began to distribute tissue forms directly
to hospitals. The Company expects to continue to expand its direct
distribution efforts to hospitals in future years. This change in
distribution methodology has impacted liquidity and cash flow. The Company
has had to make additional investments in deferred processing costs to
support the direct distribution efforts. The Company expects to continue
to make investments in the business to support the direct distribution
efforts and future programs and initiatives, which may deplete available
cash balances. The Company believes that available cash, cash equivalents,
available lines of credit and anticipated future cash flow from operations
will be sufficient to meet forecasted cash needs in 2004. The Company's
future liquidity and capital requirements will depend upon numerous
factors, including:
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 Demineralized Bone
Matrix (DBM) Segment (the "DBM Segment"), formerly referred to as 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.
In January, 2004, the Company notified SpineVision SA that effective
February 17, 2004 it would no longer distribute the three metal spinal
implant systems manufactured by SpineVision. In September, 2003, the
Company provided written notice to Alphatec Manufacturing, Inc.
("Alphatec"), the manufacturer of the Sentinal(TM) Pedicle Screw System
and the Affirm(TM) Anterior Surgical Plate System, that the Company would
not renew the distribution agreement upon the completion of the current
two-year term, which expires on March 31, 2004. In addition, as a result
of an assessment of the remaining metal spinal implant systems in first
quarter 2004, the Company decided to cease the marketing and distribution
of metal spinal implant product during 2004. The Company anticipates
recording an estimated charge of approximately $2.4 million in first
quarter 2004 related to metal spinal implant inventories and
instrumentation and severance. In addition, as a result of the
reorganization of our sales and marketing departments, the Company will
record a provision for severance in first quarter 2004 of approximately
$600,000.
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 for
estimated losses resulting from the inability of its customers
to make required payments. If the financial condition of the
Company's 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, expiration 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 it 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, 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 upon shipment of non-allograft
products to customers, except for consigned inventory, when delivery is
considered to have occurred at the time the product is consumed by the
customer.
F-9
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
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.
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 estimated future cash flows if fair
market value is not readily determinable.
F-10
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Goodwill
Beginning in 2002, pursuant to the provisions of Statement of Financial
Accounting Standards ("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 DBM Segment.
Goodwill related to the Company's subsidiary in The Netherlands was
written off in 2002 when the Company sold the business and substantially
all of the assets, net of certain liabilities of this operation.
Amortization of goodwill included in continuing operations was $132,000 in
2001 and discontinued operations included $252,000 of goodwill
amortization in 2001. Aggregately, the net loss in 2001 would have been
reduced by $384,000 and basic and diluted net loss per share would have
been reduced by $.03 if the non-amortization provisions of SFAS No. 142
had been retroactively applied to 2001.
The Company, pursuant to SFAS No. 142, evaluates goodwill annually for
impairment. 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.
Other Intangible Assets
The Company's other intangibles, which principally represent patents,
patent applications and licenses of $3,800,000 and $3,268,000 as of
December 31, 2003 and 2002 are recorded at cost. The carrying value of
such intangibles are $2,378,000 and $2,105,000 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
$262,000, $245,000 and $227,000 for the years ended December 31, 2003,
2002, and 2001, respectively. Amortization expense for the next five years
is: $210,000 in 2004; $99,000 in 2005; $79,000 in 2006; $51,000 in 2007;
and $20,000 in 2008. 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.
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.
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 on a fair value basis. 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.
F-11
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
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) 2003 2002 2001
-------------------------------------------------------------------------------------------------------
Net income (loss)
As reported:
Income (loss) from continuing operations $ 10,867 $ (1,248) $ (3,817)
Discontinued operations 93 (370)
-------------------------------
Net income (loss) $ 10,867 $ (1,155) $ (4,187)
===============================
Impact on income (loss) from continuing
operations and net income (loss) related
to stock-based employee compensation
expense, net of tax
$ 929 $ 292 $ 1,554
===============================
Pro forma:
Income (loss) from continuing operations $ 9,938 $ (1,540) $ (5,371)
Discontinued operations 93 (370)
-------------------------------
Net income (loss) $ 9,938 $ (1,447) $ (5,741)
===============================
Net income (loss) per share
As reported
Basic:
Income (loss) from continuing operations $ .64 $ (.08) $ (.28)
Discontinued operations .01 (.02)
-------------------------------
Net income (loss) $ .64 $ (.07) $ (.30)
===============================
Diluted:
Income (loss) from continuing operations $ .62 $ (.08) $ (.28)
Discontinued operations .01 (.02)
-------------------------------
Net income (loss) $ .62 $ (.07) $ (.30)
===============================
Pro forma
Basic:
Income (loss) from continuing operations $ .58 $ (.10) $ (.39)
Discontinued operations .01 (.02)
-------------------------------
Net income (loss) $ .58 $ (.09) $ (.41)
===============================
Diluted:
Income (loss) from continuing operations $ .58 $ (.10) $ (.39)
Discontinued operations .01 (.02)
-------------------------------
Net income (loss) $ .58 $ (.09) $ (.41)
=======================================================================================================
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:
2003 2002 2001
----------------------------------------------------------------------
Expected life (years) 5 5 5
Risk free interest rate 2.88% 3.33% 4.62%
Volatility factor 86.00% 80.00% 70.00%
Dividend yield 0.00% 0.00% 0.00%
----------------------------------------------------------------------
F-12
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Translation of Foreign Currency
In general, assets and liabilities of foreign subsidiaries are translated
at rates of exchange in effect at the close of the period, with the
resulting translation gains and losses included in accumulated other
comprehensive income (loss), which is a separate component of
stockholders' equity. Revenues and expenses are translated at the weighted
average exchange rates during the period. Foreign currency transaction
gains and losses are included in other income (expense).
In fourth quarter 2003, as a result of a decision to utilize excess cash
flow, if any, generated by the Company's French subsidiary to repay the
remaining outstanding balance of its intercompany debt, in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 52, "Foreign
Currency Translation", the Company recognized the impact of foreign
currency translation gains and losses on the outstanding balance of the
intercompany debt in the Company's results of operations. Foreign currency
translation gains of $510,000 were recognized in other income (expense) in
the consolidated statement of operations for the year ended December 31,
2003 related to the impact of exchange rates between the U.S. dollar and
the Euro. Future translation gains and losses may have a material impact
on the Company's results of operations in the event of significant changes
in the exchange rate between U.S. dollars and the Euro, although the
impact of such gains and losses should not have any impact on the
Company's consolidated cash flows.
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 49%, 59% and 77% of consolidated revenues in 2003,
2002, and 2001, respectively. As of December 31, 2003 and 2002, these two
customers together accounted for 32% and 46%, respectively, of
consolidated 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 2003 presentation.
F-13
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. RECENT ACCOUNTING PRONOUNCEMENTS
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 adopted this pronouncement in 2003 and it had no
impact on the Company's financial position, results of operations or cash
flows.
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 2003 or 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 did not have
any 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," and in December, 2003 FASB issued a revised FIN 46(R),
"Consolidation of Variable Interest Entities - an interpretation of ARB
No. 51," (collectively referred to as "FIN 46"), both of which address
consolidation of variable interest entities. FIN 46 expanded 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 the adoption of this
portion of FIN 46 had no impact on the Company's results of operation,
cash flows, or financial position. FIN 46 applies in the first fiscal year
or interim period ending after March 15, 2004, to variable interest
entities in which an enterprise holds a variable interest that it acquired
before February 1, 2003. The Company does not have any SPE's or other
agreements in which the counter party would be considered a variable
interest entity, and therefore, the Company expects no impact on its
results of operations, cash flows or financial position.
4. CONTINUING OPERATIONS - GAINS AND CHARGES
2003 Gains and Charges
GenSci Settlement
In fourth quarter 2003, the Company received the initial $2.5 million
payment, a $5.0 million interest bearing promissory note and a $5.0
million letter of credit collateralizing the promissory note from GenSci
pursuant to the definitive $7.5 million settlement agreement entered into
in May, 2003. (See Note 13, "Commitments and Contingencies - Litigation".)
Accordingly, the Company recognized a pretax gain of $7.5 million from
this settlement. Such gain is related to the Company's DBM Segment and is
reflected as income from litigation settlement in the consolidated
statements of operations.
F-14
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. CONTINUING OPERATIONS - GAINS/CHARGES (continued)
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 immediate
elimination of 22 positions. As a consequence, the Company recorded a
pre-tax charge of $379,000 for severance costs in the third quarter of
2003.
2002 Gains and Charges
Affirm(TM) Cervical Plating System
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)"). 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").
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 $2,509,000 to reserve all Affirm(TM) implant inventory
and instrumentation and to record a provision for the penalty associated
with the expected shortfall under the purchase commitment.
Provision 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 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 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 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.
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.
F-15
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. CONTINUING OPERATIONS - GAINS/CHARGES (continued)
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, supported by an irrevocable
standby letter of credit. (See Note 11 - "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.
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 statement of operations.
2001 Charges
Provision for Production Equipment
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 bone tissue.
Severance - Executive Officer
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.
Provision for Metal Spinal Implant System
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 metal spinal
implant systems.
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
all of the 2003 scheduled payments 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, in 2002 up to the effective date of sale. Revenues and net
loss for these operations were $2,131,000 and $370,000, respectively, in
2001. 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.
F-16
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. DEFERRED PROCESSING COSTS
Deferred processing costs consist of the following at December 31:
(in thousands) 2003 2002
--------------------------------------------------------------------------
Donor tissue to be processed and distributed by the
Company $ 6,758 $ 2,411
Tissue in process 8,350 5,043
Processed implantable donor tissue to be distributed
by the Company 11,962 6,234
Processed implantable donor tissue held for clients 1,943 1,745
--------------------------------------------------------------------------
$ 29,013 $ 15,433
==========================================================================
7. INVENTORIES
Inventories consist of the following at December 31:
(in thousands) 2003 2002
--------------------------------------------------------------------------
Supplies $ 287 $ 223
Raw materials 765 678
Finished goods 2,529 3,919
--------------------------------------------------------------------------
$ 3,581 $ 4,820
==========================================================================
Metal spinal implant inventory is included in finished goods, and as a
result of the Company's decision in the first quarter of 2004 to cease
marketing and distribution of such products, the Company will record an
estimated reserve of approximately $2.4 million in first quarter 2004.
8. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following at December 31:
(in thousands) 2003 2002
--------------------------------------------------------------------------
Land $ 811 $ 811
Building and improvements 14,918 14,763
Machinery and equipment 47,000 45,772
Computer hardware and software 4,966 4,475
Office equipment, furniture and fixtures 6,192 6,135
Spinal instruments 2,214 3,935
Leasehold improvements 8,325 8,107
Construction in progress 620 648
-------- --------
85,046 84,646
Less accumulated depreciation
and amortization 37,939 31,111
--------------------------------------------------------------------------
$ 47,107 $ 53,535
==========================================================================
F-17
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. ACCOUNTS PAYABLE AND accrued LIABILITIES
Accounts payable and accrued liabilities consist of the following at
December 31:
(in thousands) 2003 2002
--------------------------------------------------------------------------
Trade accounts payable $ 3,343 $ 2,774
Accrued compensation 609 890
Accrued professional fees 430 1,035
Accrued commissions payable to non-employees 1,079 668
Accrued taxes payable 1,769 458
Accrued purchase commitment penalty 1,079 1,079
Litigation settlement payable 313 901
Other accrued liabilities 2,785 2,684
--------------------------------------------------------------------------
$ 11,407 $ 10,489
==========================================================================
10. LEASING TRANSACTIONS
The Company leases office and production facilities and equipment under
various operating lease agreements which have non-cancelable terms through
February, 2010. 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, 2003 are as follows:
Year Operating Leases
-----------------------------------------------------------
(in thousands)
2004 $1,234
2005 1,165
2006 1,099
2007 1,041
2008 and thereafter 1,101
-------
Total minimum lease payments $5,640
=======
Rental expense was $1,000,000, $971,000, and $936,000 for the years ended
December 31, 2003, 2002, and 2001, 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, amounts outstanding for each loan under the
Credit Facility bears interests at a variable rate ranging from prime
(4.00% as of December 31, 2003) 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. 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 5.20% in 2003 and 6.20% in
2002.
F-18
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. DEBT AND FINANCING ARRANGEMENTS (continued)
In June, 2002, the Company obtained an irrevocable standby letter of
credit to support the $1,900,000 ($317,000 as of December 31, 2003) due to
Medtronic Sofamor Danek, Inc. pursuant to the settlement of certain patent
litigation. The commitment under the standby letter of credit decreases
over time based on a predetermined schedule concurrent with the Company's
monthly payments under the settlement. As of December 31, 2003, the
standby letter of credit has been reduced to $428,000. The amount
committed under the standby letter of credit reduces the Company's
availability under its revolving line of credit. As of December 31, 2003,
no amounts were outstanding under the revolving line of credit and
$4,572,000 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 Company is currently negotiating an
extension of the revolving line of credit with its lender, although there
can be no assurance that the Company will be successful in such endeavor.
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.
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 Company's 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. In addition, if available cash, cash equivalents and
short-term investments decline below $10.0 million at the end of any
calendar month, the bank, at its option, has 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. 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.
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
complied with these covenants in 2003.
F-19
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. DEBT AND FINANCING ARRANGEMENTS (continued)
Long-term debt consists of the following at December 31:
2003 2002
(in thousands)
-------------------------------------------------------------------------------------------
Domestic bank equipment term loan, repayable in monthly
principal payments of $202 plus interest through November, 2008 $ 11,941 $ 14,369
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 $2,320 due December, 2010 3,982 4,214
-------------------------------------------------------------------------------------------
15,923 18,583
Less current portion 2,661 2,661
-------------------------------------------------------------------------------------------
$ 13,262 $ 15,922
===========================================================================================
Aggregate maturities of long-term debt for the next five years are as
follows: 2004, $2,661,000; 2005, $2,661,000; 2006, $2,661,000; 2007,
$2,661,000; 2008, $2,458,000; thereafter, $2,821,000.
12. INCOME TAXES
The income tax provision (benefit) at December 31 is summarized as
follows:
(in thousands) 2003 2002 2001
-----------------------------------------------------------------------
Current:
Federal $ 4,005 $ (3,938) $ 265
State 644 190 574
-----------------------------------------------------------------------
4,649 (3,748) 839
--------------------------------
Deferred:
Federal 1,690 (577) (1,793)
State 540 (1,263) (993)
-----------------------------------------------------------------------
2,230 (1,840) (2,786)
--------------------------------
Income tax provision (benefit) $ 6,879 $ (5,588) $ (1,947)
=======================================================================
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.
F-20
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. INCOME TAXES (continued)
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) 2003 2002 2001
-----------------------------------------------------------------------------
Computed tax at statutory Federal rate $ 6,034 $ (2,324) $ (2,085)
Release of prior year tax liability (2,557)
State income taxes, net of Federal benefit 781 (702) (269)
Foreign income/losses for which no tax
(expense) benefit is recognized (14) (55) 606
Other 78 50 (199)
-----------------------------------------------------------------------------
Income tax provision (benefit) $ 6,879 $ (5,588) $ (1,947)
=============================================================================
Income before income taxes from foreign operations, including discontinued
operations and intercompany charges, was $41,000 and $161,000 in 2003 and
2002, respectively, 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 and intercompany charges, was $1,669,000
in 2001. The loss 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.
The components of the deferred tax assets and deferred tax liabilities are
as follows at December 31:
(in thousands) 2003 2002
--------------------------------------------------------------------
Deferred Tax Assets:
Net operating loss carryforwards:
Federal $ 260 $ 460
Foreign 2,404 2,474
State 715 748
Tax credits:
Federal 288
State 690 908
Inventory reserves 3,674 3,082
Other 1,918 1,973
--------------------------------------------------------------------
9,661 9,933
Less valuation allowance 2,759 2,803
--------------------------------------------------------------------
Deferred tax assets 6,902 7,130
--------------------------------------------------------------------
Deferred Tax Liabilities:
Depreciation 3,376 1,518
Other 1,593 1,434
--------------------------------------------------------------------
Deferred tax liabilities 4,969 2,952
--------------------------------------------------------------------
Net deferred tax asset (liability) $1,933 $4,178
====================================================================
F-21
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. INCOME TAXES (continued)
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 $6,580,000 expiring in varying amounts beginning 2005 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, 2003, the Company has Federal and state net operating loss
carryforwards of $764,000 and $6,889,000, respectively. The Federal net
operating loss carryforwards expire in varying amounts beginning in 2007
through 2013. The state net operating loss carryforwards, which will
primarily offset New Jersey taxable income, expire in varying amounts
beginning in 2007 through 2012. The Company has provided valuation
allowances for $764,000 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 state research and development and manufacturing credits of
$690,000, primarily to offset New Jersey income taxes, which expire in
varying amounts beginning in 2008 through 2010.
13. COMMITMENTS AND CONTINGENCIES
Service Agreements
The Company is the processor of allograft bone tissue for domestic and
international clients and 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.
On January 1, 1997, 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"). In
October, 2002, the processing agreement was amended. The amendment, among
other items, removed the requirements that ARC exclusively provide all
tissue recovered by ARC to the Company for processing. In its place, the
amendment requires ARC to provide a monthly minimum number of donors to
the Company for processing.
F-22
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
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(R) 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(R)
Bio-implant tissue forms, all of which will be distributed to hospital
end-users by the Company under its own label.
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. Under the terms of the
agreement, the Company will process a private label DBM to specifications
determined by LifeNet, from bone tissue supplied by LifeNet. DePuy will
market and promote the private label DBM to domestic 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
April 1, 2002 and automatically renews for additional two-year terms
unless terminated in writing by either party six months prior to the
expiration of the then current two-year term. In September, 2003, the
Company provided written notice to Alphatec terminating the distribution
agreement upon the completion of the then current two-year term, which
expires on March 31, 2004.
The Company has agreed to purchase $6,000,000 of inventory during the
first two years of the agreement. If the Company fails to make the minimum
purchases, the Company is contractually required to 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 $600,000, $300,000 of which was to settle the first
year purchase commitment and the remaining $300,000 was to apply to
purchases made on or after October 1, 2003. Therefore in the third quarter
of 2002, the Company recorded a charge of $300,000 for the settlement of
the purchase commitment and a deposit for future purchases of $300,000.
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 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"). The Company has re-assessed such
provision during 2003, and based upon the Alphatec litigation and other
factors have determined that the provision is adequate.
F-23
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
In July, 2003, Alphatec filed an action against the Company for recovery
of contractual penalty, breach of contract, fraud and trade libel arising
out of the distribution agreement between the parties. In August, 2003,
the Company answered Alphatec's 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. (See Note
13, "Commitments and Contingencies - Litigation").
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) 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 was 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 did not
recognized any portion of this net award of $14,533,634 in its
consolidated financial statements. On December 21, 2001, GenSci filed for
bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code.
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, an
interest bearing 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 recognized 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 such products. Additionally, the
parties agreed to dismiss all other litigation that was currently pending
between them.
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 and an attempt to
monopolize the market for demineralized bone matrix 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, dismissing all claims with
prejudice.
"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
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. On December 18, 2003, the Court extended the stay of all
proceedings until March 27, 2004. In the event the parties are unable to
consummate a settlement by March 27, 2004, and no further extension is
granted, the Court will lift the stay of the proceedings and the parties
will return to active litigation.
F-25
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
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.
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.
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.
On April 8, 2003, the Company filed a Motion for Summary Judgment seeking
dismissal of plaintiff's claims with prejudice. On May 9, 2003, the Court
granted the Company's Motion for Summary Judgment dismissing plaintiff's
claims as to the Company 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.
F-26
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. COMMITMENTS AND CONTINGENCIES (continued)
On August 3, 2003, the Company answered the complaint denying all
allegations 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 commenced and will continue through May 7,
2004.
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).
Anthonsen v. Allosource, Inc.
In January, 2004, the Company was served with a complaint in an action
brought in the Lake Superior Court of Lake County, State of Indiana
against numerous defendants, including the Company. The complaint alleges
that plaintiff received defective implants and medical hardware in
connection with cervical surgery performed on plaintiff, and that such
implants and hardware were manufactured, processed or distributed by
defendants. Plaintiff alleges personal injuries and unspecified damages.
In February, 2004, the action was removed to the United States District
Court, Northern District of Indiana, Hammond Division. The Company is
currently reviewing the complaint and a response is due on March 17, 2004.
The Company maintains a product general liability insurance policy and has
notified the insurance company of this action. The insurance company has
agreed to defend this action.
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.
F-27
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. STOCKHOLDERS' EQUITY (continued)
Preferred Stock
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 any time during
2003, 2002 or 2001.
Stock Options
The Company's 2000 Stock Plan (the "2000 Plan"), as amended pursuant to a
shareholders' vote at the Company's annual meeting in 2003, authorizes the
grant of up to 2,250,000 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. Prior to the
shareholder vote in June, 2003, the 2000 Plan authorized the grant of up
to 1,000,000 shares of common stock in the form of stock-based awards.
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, authorized the
grant 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, authorized the grant of options to purchase 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. In September, 2001, the Directors Plan was
replaced by the 2000 Plan and, therefore, options will no longer be issued
under the Directors Plan.
F-28
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. STOCKHOLDERS' EQUITY (continued)
Stock option activity for the years 2003, 2002, and 2001 is as follows:
2003 2002 2001
--------------------- ---------------------- -----------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
-----------------------------------------------------------------------------------------------------------------
Outstanding at January 1, 2,405,312 $ 9.26 2,510,699 $ 9.50 2,319,325 $ 9.98
Granted 374,450 9.06 373,800 7.71 238,000 5.37
Exercised 80,437 4.74 47,500 3.68 10,138 4.10
Cancelled or expired 199,563 12.75 431,687 9.94 36,488 14.29
-----------------------------------------------------------------------------------------------------------------
Outstanding at December 31, 2,499,762 $ 9.10 2,405,312 $ 9.26 2,510,699 $ 9.50
----------------------------------------------------------------------
Exercisable at December 31, 1,758,957 $ 9.56 1,655,821 $ 10.35 1,544,076 $ 10.48
-----------------------------------------------------------------------------------------------------------------
Available for grant at
December 31, 1,112,000 150,105 494,500
-----------------------------------------------------------------------------------------------------------------
Weighted average fair value per share
of options granted during the period $ 7.67 $ 5.08 $ 3.30
-----------------------------------------------------------------------------------------------------------------
The following table summarizes the information about stock options
outstanding at December 31, 2003:
Options Outstanding Options Exercisable
----------------------------------------- ----------------------------
Weighted
Number Average Weighted Number Weighted
Outstanding at Remaining Average Exercisable at Average
Range of December 31, Contractual Exercise December 31, Exercise
Exercise Prices 2003 Life (Years) Price 2003 Price
------------------------------------------------------------------------------------------------------
$2.33 To $3.78 207,575 6.2 $3.46 170,135 $3.45
3.79 To 7.57 903,612 5.5 5.87 685,447 5.75
7.58 To 11.36 943,700 6.5 8.57 530,250 8.75
11.37 To 15.15 119,000 7.5 13.02 47,250 12.22
15.16 To 18.93 115,375 5.3 16.20 115,375 16.20
18.94 To 22.73 160,500 4.9 20.67 160,500 20.67
34.09 To 37.88 50,000 5.4 37.85 50,000 37.85
------------------------------------------------------------------------------------------------------
$2.33 To $ 37.88 2,499,762 6.0 $ 9.10 1,758,957 $ 9.56
======================================================================================================
F-29
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. STOCKHOLDERS' EQUITY (continued)
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, 2003, 202,802
shares were available for future offerings under this plan.
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, 2003, 2002, and 2001 was $2,669,000, $2,480,000, and
$2,415,000, respectively. Depreciation and amortization expense from
continuing operations related to property, plant and equipment for the
years ended December 31, 2003, 2002, and 2001 was $8,236,000, $7,739,000,
and $7,856,000, respectively.
16. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
(in thousands) 2003 2002 2001
---------------------------------------------------------------------------
Cash paid (refunded) during the year for taxes $ (79) $1,576 $1,170
Cash paid during the year for interest, excluding
amounts capitalized 874 1,227 379
Noncash investing activities:
Note receivable from sale of foreign operation 1,273
---------------------------------------------------------------------------
F-30
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) 2003 2002 2001
-----------------------------------------------
Income (loss) from continuing operations $ 10,867 $ (1,248) $ (3,817)
Discontinued operations 93 (370)
-----------------------------------------------
Net income (loss) 10,867 (1,155) (4,187)
======================================================================================================
Denominator for basic earnings (loss) per share:
Weighted average common shares outstanding 17,059,495 15,904,132 14,030,623
Effect of dilutive securities - stock options 461,464
-----------------------------------------------
Denominator for diluted earnings (loss) per share 17,520,959 15,904,132 14,030,623
======================================================================================================
Basic earnings (loss) per share:
Income (loss) from continuing operations $ .64 $ (.08) $ (.28)
Discontinued operations .01 (.02)
-----------------------------------------------
Net income (loss) $ .64 $ (.07) $ (.30)
======================================================================================================
Diluted earnings (loss) per share:
Income (loss) from continuing operations $ .62 $ (.08) $ (.28)
Discontinued operations .01 (.02)
-----------------------------------------------
Net income (loss) $ .62 $ (.07) $ (.30)
======================================================================================================
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 468,505 in 2003, 1,536,790 in 2002 and 1,744,518 in 2001. Such
shares were not included because they were antidilutive.
18. OPERATING SEGMENTS
The Company has two primary business segments: the DBM Segment, formerly
referred to as the Grafton(R) DBM Segment, and Base Tissue Segment. The
DBM Segment engages in the processing and marketing of Grafton(R) and
private label DBMs. 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, marketing and
distributing bovine tissue products.
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.
F-31
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
18. OPERATING SEGMENTS (continued)
Summarized financial information concerning the Company's segments after
giving effect to the divestiture of the Company's operations in The
Netherlands in 2002 is shown in the following table.
Base Tissue
(in thousands) DBM Segment Segment Other Consolidated
------------------------------------------------------------------------------------------
Revenues:
2003 $46,294 $41,465 $ 6,674 $94,433
2002 44,926 32,115 6,333 83,374
2001 43,637 27,692 4,386 75,715
------------------------------------------------------------------------------------------
Operating income (loss):
2003 $20,646 $ 2,703 $ (5,217) $18,132
2002 9,913 (8,927) (7,851) (6,865)
2001 7,031 (7,877) (5,047) (5,893)
------------------------------------------------------------------------------------------
Depreciation and amortization:
2003 $ 2,206 $ 5,104 $ 1,188 $ 8,498
2002 2,411 4,488 1,331 8,230
2001 1,962 5,413 1,223 8,598
------------------------------------------------------------------------------------------
Financial information by geographic area after giving effect to the
divestiture of the Company's operations in The Netherlands in 2002 is
summarized as follows:
(in thousands) United States Europe Consolidated
---------------------------------------------------------------------
Revenues
2003 $86,070 $ 8,363 $94,433
2002 78,576 4,798 83,374
2001 71,776 3,939 75,715
Long-lived Assets
2003 $45,911 $ 1,196 $47,107
2002 52,408 1,127 53,535
2001 55,261 1,475 56,736
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 DBM and Base Tissue Segments, are as
follows:
(in thousands) 2003 2002 2001
------------------------------------------------------------
Revenues
MTF $23,424 $24,202 $28,967
ARC 23,037 24,960 29,097
------------------------------------------------------------
$46,461 $49,162 $58,064
============================================================
F-32
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 contributes 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, 2003, 2002, and 2001 were $414,000, $433,000, and
$393,000, respectively.
The Company does not maintain any other pension or post retirement plans.
F-33
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, 2003 and 2002 as restated and as originally
reported. During 2003 year-end closing procedures, the Company identified
a previously undetected flaw in its computer software used to maintain
certain accounting records resulting in over accruals of certain expenses
in the Company's accounting records over a period of years. As such, the
Company has restated its consolidated financial statements to reflect the
reversal of such over accruals.
Quarter Ended
------------------------------------------------------------
March 31 June 30 September 30 December 31
(in thousands except per share data) (Restated) (Restated) (Restated) (As Reported)
----------------------------------------------------------------------------------------------------
2003
----------------------------------------------------------------------------------------------------
Net revenues $ 22,479 $ 24,792 $ 23,135 $ 24,027
Gross profit 12,693 15,328 12,004 12,337
Income (loss) from continuing
operations 1,181 2,742 564 6,380
Discontinued operations
Net income (loss) 1,181 2,742 564 6,380
Net income (loss) per share:
Basic:
Income (loss) from continuing
operations $ .07 $ .16 $ .03 $ .37
Discontinued operations
------------------------------------------------------------
Net income (loss) $ .07 $ .16 $ .03 $ .37
============================================================
Diluted:
Income (loss) from continuing
operations $ .07 $ .15 $ .03 $ .37
Discontinued operations
------------------------------------------------------------
Net income (loss) $ .07 $ .15 $ .03 $ .37
============================================================
Quarter Ended
-------------------------------------------------------------
March 31 June 30 September 30 December 31
(As reported) (As reported) (As reported) (As reported)
-----------------------------------------------------------------------------------------------------
2003
-----------------------------------------------------------------------------------------------------
Net revenues $ 22,479 $ 24,792 $ 23,135 $ 24,027
Gross profit 12,672 15,276 12,271 12,337
Income (loss) from continuing
operations 1,169 2,712 719 6,380
Discontinued operations
Net income (loss) 1,169 2,712 719 6,380
Net income (loss) per share:
Basic:
Income (loss) from continuing
operations $ .07 $ .16 $ .04 $ .37
Discontinued operations
-----------------------------------------------------------
Net income (loss) $ .07 $ .16 $ .04 $ .37
===========================================================
Diluted:
Income (loss) from continuing
operations $ .07 $ .15 $ .04 $ .37
Discontinued operations
-----------------------------------------------------------
Net income (loss) $ .07 $ .15 $ .04 $ .37
===========================================================
F-34
OSTEOTECH, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
20. QUARTERLY FINANCIAL DATA (unaudited)
Quarter Ended
-------------------------------------------------------------
March 31 June 30 September 30 December 31
(in thousands except per share data) (Restated) (Restated) (Restated) (Restated)
--------------------------------------------------------------------------------------------------------
2002
--------------------------------------------------------------------------------------------------------
Net revenues $ 22,085 $ 23,009 $ 19,691 $ 18,589
Gross profit 13,136 12,938 7,035 3,994
Income (loss) from continuing
operations 422 346 1,027 (3,043)
Discontinued operations 7 86
Net income (loss) 429 432 1,027 (3,043)
Net income (loss) per share:
Basic:
Income (loss) from continuing
operations $ .03 $ .02 $ .06 $ (.18)
Discontinued operations .01
------------------------------------------------------------
Net income (loss) $ .03 $ .03 $ .06 $ (.18)
============================================================
Diluted:
Income (loss) from continuing
operations $ .03 $ .02 $ .06 $ (.18)
Discontinued operations .01
------------------------------------------------------------
Net income (loss) $ .03 $ .03 $ .06 $ (.18)
============================================================
Quarter Ended
-------------------------------------------------------------
March 31 June 30 September 30 December 31
(As reported) (As reported) (As reported) (As reported)
------------------------------------------------------------------------------------------------------
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)
============================================================
See Note 4, "Continuing Operations - Gains and Charges" and Note 5,
"Discontinued Operations" for discussion of significant gains and charges
recorded in 2003 and 2002.
F-35
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, 2003:
Allowance for doubtful accounts $ 943 $ 561 $ 34(a) $ (51)(b) $1,487
Valuation allowance for deferred
tax asset 2,803 474(a) (518)(d) 2,759
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
(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 Auditors 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 March 1, 2004, appearing on page F-2 of this Form 10-K also included an
audit of the Financial Statement Schedule listed in Item 15(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
March 1, 2004
S-2
EXHIBIT INDEX
Exhibit Page
Number Description Number
- ------ ----------- ------
10.45 First Modification to Lease for Osteotech's Eatontown facility *
10.46 Osteotech's Code of Business Conduct *
21.1 Subsidiaries of Registrant *
23.1 Consent of PricewaterhouseCoopers LLP *
31.1 Certification of Chief Executive Officer pursuant to Section *
302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer pursuant to Section *
302 of the Sarbanes-Oxley Act of 2002
32.1 Certificate of Chief Executive Officer pursuant to Section 906 *
of the Sarbanes-Oxley Act of 2002
32.2 Certificate of Chief Financial Officer pursuant to Section 906 *
of the Sarbanes-Oxley Act of 2002
*Filed herewith.