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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
|X| Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the Period Ended September 30, 2004
or
|_| Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the Transition Period from _______ to ________
Commission File Number 0-19278
OSTEOTECH, INC.
(Exact name of registrant as specified in its charter)
Delaware 13-3357370
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
51 James Way, Eatontown, New Jersey 07724
(Address of principal executive offices) (Zip Code)
(732) 542-2800
(Registrant's telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
Applicable Only to Corporate Issuers
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |X| or No |_|
The number of shares of the registrant's common stock, $.01 par value,
outstanding as of October 29, 2004 was 17,164,886.
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
OSTEOTECH, INC. AND Subsidiaries
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(dollars in thousands)
September 30, December 31,
2004 2003
- ------------------------------------------------------------------------------------------------
ASSETS
- ------------------------------------------------------------------------------------------------
Current assets:
Cash and cash equivalents $ 12,476 $ 15,326
Accounts receivable, net of allowance of
$1,405 in 2004 and $1,487 in 2003 18,656 15,187
Deferred processing costs 32,777 29,013
Inventories 1,324 3,581
Prepaid expenses and other current assets 8,573 7,345
----------------------
Total current assets 73,806 70,452
Property, plant and equipment, net 42,845 47,107
Goodwill, net of accumulated amortization of $404 in 2004 and 2003 1,669 1,669
Other assets 6,992 7,985
- ----------------------------------------------------------------------------------------------
Total assets $125,312 $127,213
==============================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
- ----------------------------------------------------------------------------------------------
Current liabilities:
Accounts payable and accrued liabilities $ 12,338 $ 11,407
Current maturities of long-term debt 2,661 2,661
----------------------
Total current liabilities 14,999 14,068
Long-term debt 11,266 13,262
Other liabilities 3,663 3,663
- ----------------------------------------------------------------------------------------------
Total liabilities 29,928 30,993
- ----------------------------------------------------------------------------------------------
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 17,164,886
shares in 2004 and 17,117,720 shares in 2003 172 171
Additional paid-in capital 64,414 64,170
Accumulated other comprehensive income 184 605
Retained earnings 30,614 31,274
- ----------------------------------------------------------------------------------------------
Total stockholders' equity 95,384 96,220
- ----------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $125,312 $127,213
==============================================================================================
See accompanying notes to condensed consolidated financial statements.
-2-
OSTEOTECH, INC. AND Subsidiaries
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(dollars in thousands, except per share data)
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------
Net revenues:
Service $ 21,694 $ 21,209 $ 65,040 $ 65,753
Product 438 1,926 3,094 4,653
------------ ------------ ------------ ------------
22,132 23,135 68,134 70,406
Cost of services 12,129 9,914 34,826 26,959
Cost of products (295) 1,217 3,415 3,422
------------ ------------ ------------ ------------
11,834 11,131 38,241 30,381
------------ ------------ ------------ ------------
Gross profit 10,298 12,004 29,893 40,025
Marketing, selling, general and administrative 7,684 9,806 27,868 28,873
Research and development 1,145 1,095 3,188 3,020
------------ ------------ ------------ ------------
8,829 10,901 31,056 31,893
------------ ------------ ------------ ------------
Operating income (loss) 1,469 1,103 (1,163) 8,132
Interest expense and other, net (4) (126) (349) (590)
------------ ------------ ------------ ------------
Income (loss) before income provision (benefit) 1,465 977 (1,512) 7,542
Income tax provision (benefit) 443 413 (852) 3,055
------------ ------------ ------------ ------------
Net income (loss) $ 1,022 $ 564 $ (660) $ 4,487
==============================================================================================================================
Earnings (loss) per share:
Basic $ .06 $ .03 $ (.04) $ .26
Diluted $ .06 $ .03 $ (.04) $ .25
Shares used in computing earnings (loss) per share:
Basic 17,154,119 17,093,937 17,139,620 17,049,605
Diluted 17,208,069 17,958,095 17,139,620 17,704,140
See accompanying notes to condensed consolidated financial statements.
-3-
OSTEOTECH, INC. AND Subsidiaries
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(dollars in thousands)
Nine Months Ended September 30, 2004 2003
- -----------------------------------------------------------------------------------------------
Cash Flow From Operating Activities
Net income (loss) $ (660) $ 4,487
Adjustments to reconcile income (loss)
to net cash provided by (used in) operating activities:
Depreciation and amortization 5,840 6,321
Provision for metal spinal implant systems 1,998
Changes in current assets and liabilities:
Accounts receivable (3,534) (5,178)
Deferred processing costs (3,776) (10,776)
Inventories 373 555
Prepaid expenses and other current assets (237) 1,825
Accounts payable and other liabilities 144 4,452
- -----------------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities 148 1,686
Cash Flow From Investing Activities
Capital expenditures (1,333) (1,326)
Proceeds from sale of investments 3,948
Other, net (91) (507)
- -----------------------------------------------------------------------------------------------
Net cash provided by (used in) investing activities (1,424) 2,115
Cash Flow From Financing Activities
Proceeds from issuance of common stock 244 589
Principal payments on long-term debt (1,996) (1,995)
- -----------------------------------------------------------------------------------------------
Net cash used in financing activities (1,752) (1,406)
Effect of exchange rate changes on cash 178 (199)
- -----------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents (2,850) 2,196
Cash and cash equivalents at beginning of period 15,326 10,040
- -----------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 12,476 $ 12,236
===============================================================================================
Supplementary cash flow data:
Cash paid during the period for interest $ 410 $ 699
Cash paid (refunded) during the period for taxes 1,434 (270)
See accompanying notes to condensed consolidated financial statements
-4-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
reflect all adjustments (consisting only of normal recurring accruals)
considered necessary by management for a fair presentation of the
consolidated financial position as of September 30, 2004, the consolidated
results of operations for the three months and nine months ended September
30, 2004 and 2003 and the consolidated cash flows for the nine months
ended September 30, 2004 and 2003. The results of operations and cash
flows for the respective interim periods are not necessarily indicative of
the results to be expected for the full year. The December 31, 2003
financial information has been derived from the audited financial
statements for the year ended December 31, 2003. The condensed
consolidated financial statements should be read in conjunction with the
audited consolidated financial statements which were included as part of
Osteotech, Inc.'s (the "Company") Annual Report on Form 10-K for the year
ended December 31, 2003.
2. Goodwill and Other Intangible Assets
In accordance with the provisions of Statement of Financial Accounting
Standard ("SFAS") No. 142, "Goodwill and Other Intangible Assets", the
Company completed an evaluation of the carrying value of its goodwill as
of January 1, 2004 and determined that there was no impairment which would
need to be reflected in the Company's consolidated financial statements as
a result of such evaluation.
The Company's other intangibles, which principally represent patents,
patent applications and licenses, are recorded at an original cost of
$4,019,000 and $3,800,000 as of September 30, 2004 and December 31, 2003,
respectively. The carrying values of such intangibles are $2,420,000 and
$2,378,000 as of the same respective dates. 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.
3. 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 (loss) and earnings
(loss) per share is required by SFAS No. 123, and has been determined as
if the Company accounted for its stock options under the Fair Value Method
of that Statement. For purposes of the pro forma disclosures, the
estimated fair value of the options is amortized on a straight-line basis
to expense over the options' vesting period.
-5-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
3. Stock Options (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.
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------------------------
(in thousands, except per share data) 2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------
Net income (loss) - reported $ 1,022 $ 564 $ (660) $ 4,487
Impact on net income (loss) related to
stock-based employee compensation
expense, net of tax $ 190 $ 273 $ 644 $ 678
Net income (loss) - pro forma $ 832 $ 291 $ (1,304) $ 3,809
=============================================================================================================
Earnings (loss) per share
As reported:
Basic $ .06 $ .03 $ (.04) $ .26
Diluted $ .06 $ .03 $ (.04) $ .25
Pro forma:
Basic $ .05 $ .02 $ (.08) $ .22
Diluted $ .05 $ .02 $ (.08) $ .22
=============================================================================================================
4. 2004 Charges
Provision for Metal Spinal Implant Systems
As a result of an assessment of its metal spinal implant business in the
first quarter of 2004, the Company announced that it would cease marketing
and distributing all metal spinal implant product lines by the end of the
second quarter of 2004. The Company recorded a charge to cost of products
in the first quarter of 2004 of $1,998,000 to reduce metal spinal implant
inventory and instrumentation to estimated net realizable value. The
Company ceased distribution of all metal spinal implant product lines in
June, 2004.
Severance - Sales and Marketing Reorganization
In first quarter 2004, the Company reorganized its sales and marketing
departments. As a result, the Company recorded a charge in marketing,
selling, general and administrative expenses of $650,000, principally for
the severance costs associated with the departure of the executive officer
responsible for these areas and two other employees.
-6-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
5. Deferred Processing Costs
Deferred processing costs consist of the following:
September 30, December 31,
(in thousands) 2004 2003
- --------------------------------------------------------------------------------------------------
Donor tissue to be processed $ 8,962 $ 6,758
Tissue in process 11,081 8,350
Processed implantable donor tissue to be distributed
by the Company 10,623 11,962
Processed implantable donor tissue held for clients 2,111 1,943
- ----------------------------------------------------------------------------------------------
$32,777 $29,013
==============================================================================================
6. Inventories
Inventories consist of the following:
September 30, December 31,
(in thousands) 2004 2003
- --------------------------------------------------------------------------------------------------
Supplies $ 251 $ 287
Raw materials 838 765
Finished goods 235 2,529
- ----------------------------------------------------------------------------------------------
$ 1,324 $ 3,581
==============================================================================================
In the first quarter of 2004, the Company recorded a charge to reduce its
metal spinal implant inventory, which was included in finished goods, to
estimated net realizable value. See Note 4, "2004 Charges - Provision for
Metal Spinal Implant Systems".
7. Debt and Financing Arrangements
On April 30, 2004, the Company amended its Credit Facility with its lender
to, among other items, extend the maturity date of its $5.0 million
revolving line of credit to April 30, 2006 from April 30, 2004. In
addition, the amendment revises the restriction on incurring or
maintaining additional indebtedness to allow the Company to incur up to
$1.0 million of capital leases and up to $2.5 million in lines of credit
for its foreign subsidiaries.
Prior to April 30, 2004, if the Company's cash, cash equivalents and
short-term investments declined below $10.0 million at the end of any
calendar month, the lender, 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. Effective April
30, 2004 in conjunction with the amendment to the Credit Facility, the
$10.0 million limitation noted above was reduced to $5.0 million. In
addition, unless there exists or has existed an event of default prior to
December 31, 2004, the provisions of this covenant will terminate on that
date.
-7-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
7. Debt and Financing Arrangements (continued)
The Company's Credit Facility includes: a $5,000,000 revolving line of
credit, a building mortgage loan, and an equipment term loan. At September
30, 2004, there were no borrowings under the revolving line of credit and
$5,000,000 was available to the Company, $3,808,000 was outstanding under
the building mortgage loan and $10,119,000 was outstanding under the
equipment term loan. The Credit Facility, as amended, imposes certain
operating and financial restrictions and covenants. Based upon a review of
the Company's financial results for the first nine months of 2004, its
current operations and future expected operational activities for the
remainder of 2004, the Company may, in certain circumstances, not comply
with one of these covenants in the fourth quarter of 2004. Should
circumstances indicate that the Company would in fact fail to comply with
any covenant, the Company believes there are options available to it to
achieve compliance, including, but not limited to, obtaining a waiver from
the lender or amending the covenant, or both, or adjusting operational
activities. The Company has begun and is continuing discussions with its
lender concerning the possibility of non-compliance with one of its
covenants, and will continue such discussions throughout the fourth
quarter to explore its options. The Company cannot provide assurance that
it will be able to comply with any or all of the covenants or institute
activities to bring it into compliance, or, in the event of non-compliance
with a covenant, obtain a waiver to, or amendment of, the covenant, in
which case the bank could avail itself of the remedies set forth in the
risk factor entitled "Failure to comply with covenants under our loan and
security agreement could materially adversely impact our business,
financial condition and results of operations" set forth in the Company's
Annual Report on Form 10-K for the year ended December 31, 2003.
8. Commitments and Contingencies
Purchase Commitments
In February, 2001, the Company entered into an exclusive distribution
agreement with Alphatec Manufacturing, Inc. ("Alphatec") to market and
distribute two metal spinal implant products in the United States and
Canada. In September, 2003, the Company provided written notice to
Alphatec terminating the distribution agreement upon the completion of the
then current term, which expired on March 31, 2004.
The agreement included provisions for minimum purchases over the
contractual period, subject to penalty payments if the minimum purchases
were not achieved. The Company settled the provisions of the first year
purchase commitment with Alphatec in the fourth quarter of 2002, and
recorded all appropriate charges at that time. Also, in the fourth quarter
of 2002, the Company recorded an estimated reserve of $1,079,000 for the
penalty that may be due for not achieving the minimum purchase commitment
in year two of the agreement.
-8-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
8. Commitments and Contingencies (continued)
In July, 2003, Alphatec filed an action against the Company arising out of
the distribution agreement between the parties. In August, 2003, the
Company answered Alphatec's complaint and asserted counterclaims. On
September 24, 2004, the Company and Alphatec executed a settlement
agreement resolving all disputes between the parties and dismissing with
prejudice all claims and counterclaims. Pursuant to the settlement
agreement, the Company made a payment to Alphatec in the amount of
$600,000 and returned to Alphatec all remaining inventory held by the
Company that had been manufactured by Alphatec. In September, 2004 the
Company reversed the remaining reserve of $479,000 which had been
established for purchase commitment penalties. Such reversal is recorded
in cost of product in the condensed consolidated statements of operations.
Litigation
The preceding paragraph provides a description of material developments
that occurred during the three months ended September 30, 2004 in lawsuits
reported in the Company's Annual Report on Form 10-K for the year ended
December 31, 2003 and the Company's Quarterly Reports on Form 10-Q for the
quarters ended March 31, 2004 and June 30, 2004.
From time to time the Company is a party to other litigation incidental to
its business, none of which, individually or in the aggregate, are
expected to have a material adverse effect on our results of operations or
financial condition. 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.
9. Comprehensive Income
Comprehensive income for the three months and nine months ended September
30, 2004 and 2003 were as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------------------------
(in thousands) 2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------
Net income $ 1,022 $ 564 $ (660) $4,487
Currency translation adjustments (333) (169) (421) 188
- -------------------------------------------------------------------------------------------------------
Comprehensive income $ 689 $ 395 $(1,081) $4,675
=======================================================================================================
-9-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
10. Earnings Per Share
The following table sets forth the computation of basic and diluted
earnings per share for the three months and nine months ended September
30, 2004 and 2003
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ------------------------------
(dollars in thousands except per share data) 2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------------------
Net income (loss) available to
common shareholders $ 1,022 $ 564 $ (660) $ 4,487
================================================================
- --------------------------------------------------------------------------------------------------------------------------------
Denominator for basic earnings
per share, weighted average common
shares outstanding 17,154,119 17,093,937 17,139,620 17,049,605
Effect of dilutive securities, stock options 53,950 864,158 -- 654,535
----------------------------------------------------------------
Denominator for diluted earnings
per share 17,208,069 17,958,095 17,139,620 17,704,140
================================================================
- --------------------------------------------------------------------------------------------------------------------------------
Earnings (loss) per share:
Basic $ .06 $ .03 $ (.04) $ .26
Diluted $ .06 $ .03 $ (.04) $ .25
- --------------------------------------------------------------------------------------------------------------------------------
Weighted average shares issuable upon the exercise of stock options which
were not included in the calculation of diluted earnings per share were
2,221,038 and 1,931,415, and 418,850 and 478,300 for the three months and
nine months ended September 30, 2004 and 2003, respectively. Such shares
were not included because they were antidilutive.
-10-
OSTEOTECH, INC. AND SUBSIDIARIES
Notes To Condensed Consolidated Financial Statements
(unaudited)
11. Operating Segments
Summarized in the table below is financial information for our reportable
segments for the three months and nine months ended September 30, 2004 and
2003:
Three Months Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------
(dollars in thousands) 2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------
Revenues:
Demineralized Bone Matrix Segment $ 12,021 $ 11,534 $ 34,316 $ 35,166
Base Tissue Segment 9,673 9,675 30,724 30,587
Other 438 1,926 3,094 4,653
- -----------------------------------------------------------------------------------------------------------------
Consolidated $ 22,132 $ 23,135 $ 68,134 $ 70,406
=================================================================================================================
Operating income (loss):
Demineralized Bone Matrix Segment $ 2,008 $ 2,761 $ 3,249 $ 10,418
Base Tissue Segment (929) (216) (1,993) 1,666
Other 390 (1,442) (2,419) (3,952)
- -----------------------------------------------------------------------------------------------------------------
Consolidated $ 1,469 $ 1,103 $ (1,163) $ 8,132
=================================================================================================================
Other principally includes the distribution of metal spinal implants and
bovine tissue. In first quarter 2004, the Company announced that it would
cease marketing and distributing all metal spinal implant product lines by
June 30, 2004. Revenues from metal spinal implant product lines were
$16,000 and $1,597,000 for the three months ended September 30, 2004 and
2003, respectively, and were $1,718,000 and $3,424,000 for the nine months
ended September 30, 2004 and 2003, respectively. Operating income for
Other included a charge in the first quarter of 2004 of $1,998,000 to
reduce metal spinal implant inventory and instrumentation to estimated net
realizable value partially offset by the reversal of the remaining reserve
of $479,000, which had been established for purchase commitment penalties
arising from the Alphatec litigation in the third quarter of 2004.
During the three months ended September 30, 2004, two of our clients,
Musculoskeletal Transplant Foundation ("MTF") and the American Red Cross
Tissue Services ("ARC"), in the Demineralized Bone Matrix and Base Tissue
Segments each accounted for 21% and 20%, respectively, of consolidated net
revenues and accounted for 24% and 25%, respectively, of consolidated net
revenues for the three months ended September 30, 2003. For the nine
months ended September 30, 2004, these same two clients accounted for 22%
and 21%, respectively, of consolidated net revenues, and 25% and 26%,
respectively, of consolidated net revenues for the nine months ended
September 30, 2003.
12. Reclassifications
Certain prior year amounts have been reclassified to conform to the 2004
presentation.
-11-
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Information contained herein contains "forward-looking statements" which can be
identified by the use of forward-looking terminology such as "believes",
"expects", "may", "will", "should", or "anticipates" or the negative thereof or
variations thereon or comparable terminology, or by discussions of strategy. No
assurance can be given that the future results covered by the forward-looking
statements will be achieved. Some of the matters set forth in the "Risk Factors"
section of our Annual Report on Form 10-K for the year ended December 31, 2003
constitute cautionary statements identifying factors with respect to such
forward-looking statements, including certain risks and uncertainties, that
could cause actual results to vary materially from the future results indicated
in such forward-looking statements. Other factors could also cause actual
results to vary materially from the future results indicated in such
forward-looking statements.
FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
Results of Operations
Critical Accounting Policies and Estimates
Critical accounting policies are those that involve subjective or complex
judgments, often as a result of the need to make estimates. The following areas
all require the use of judgments and estimates: product returns, bad debts,
inventories including purchase commitments, deferred processing costs including
rework reserves, property, plant and equipment, intangible assets, current and
deferred income taxes, contingencies and litigation. Estimates in each of these
areas are based on historical experience and various assumptions that we believe
are appropriate. Actual results may differ from these estimates. Our accounting
practices are discussed in more detail in "Management's Discussion and Analysis
of Financial Condition and Results of Operations" and Note 2 of "Notes to
Consolidated Financial Statements" in our Annual Report on Form 10-K for the
year ended December 31, 2003.
Net Income (Loss)
We realized consolidated net income for the three months ended September 30,
2004 of $1,022,000 or $.06 diluted net income per share compared to consolidated
net income of $564,000 or $.03 diluted net income per share for the three months
ended September 30, 2003. We incurred a consolidated net loss for the nine
months ended September 30, 2004 of $660,000 or $.04 diluted net loss per share
compared to consolidated net income of $4,487,000 or $.25 diluted net income per
share for the nine months ended September 30, 2003. Net income for the three
months ended September 30, 2004 includes the after-tax impacts of the reversal
of estimated purchase commitment penalties related to the settlement of a
lawsuit, the reduction in provisions for the Company's Management Bonus Plan and
favorable currency exchange rates for the period and the favorable impact from a
lower effective tax rate. Net income (loss) for the three months and nine months
ended September 30, 2004 is impacted by a decline in gross profit margins
primarily due to lower net revenues, the continued change in revenue mix and
increased per unit processing costs as a result of declining unit production
volumes, which has resulted in the under absorption of fixed costs, partially
offset by lower operating expenses. Additionally, the net loss for the nine
months ended September 30, 2004 is impacted by the reserves recorded in the
first quarter of 2004 for costs associated with our exit from the spinal metal
implant business and the reorganization of our sales and marketing functions.
The following is a discussion of factors affecting results of operations for the
three months and nine months ended September 30, 2004 and 2003.
-12-
Net Revenues
Consolidated net revenues declined to $22,132,000 in the third quarter of 2004
compared to consolidated net revenues of $23,135,000 in the corresponding period
in 2003. Domestic net revenues decreased to $19,313,000 for the three months
ended September 30, 2004 from $21,134,000 in the corresponding period in 2003.
Foreign-based net revenues increased 41% to $2,819,000 in the third quarter of
2004 from $2,001,000 for the same period in 2003. Consolidated net revenues
decreased to $68,134,000 for the nine months ended September 30, 2004 compared
to consolidated net revenues of $70,406,000 for the nine months ended September
30, 2003. Domestic net revenues declined for the nine months ended September 30,
2004 to $59,678,000 from $64,317,000 in the corresponding period in 2003.
Foreign-based revenues increased 39% to $8,456,000 for the nine months ended
September 30, 2004 from $6,089,000 in the corresponding period in 2003. The
decline in consolidated revenues in both periods of 2004 is mainly attributable
to lower unit volume in our domestic Grafton(R) DBM and Graftech(R) Bio-implant
product lines due to competitive factors, and from the decline in revenues from
metal spinal implant product lines, which is directly associated with our
announcement in March, 2004 to exit the metal spinal implant business effective
June 30, 2004. The decline in revenues in both periods was partially offset by
increased revenues from private label DBM products, primarily due to the
start-up of our relationship with Smith & Nephew, Inc. and increased
international unit sales volume.
Demineralized Bone Matrix ("DBM") Segment, or DBM Segment, revenues increased to
$12,021,000 in the third quarter of 2004 from revenues of $11,534,000 in the
corresponding period in 2003. DBM Segment revenues for the nine months ended
September 30, 2004 of $34,316,000 decreased from DBM Segment revenues of
$35,166,000 for the nine months ended September 30, 2003. Domestic DBM Segment
revenues increased to $10,574,000 in the third quarter of 2004 from revenues of
$10,335,000 in the third quarter of 2003 and decreased to $29,457,000 for the
nine months ended September 30, 2004 from $31,609,000 for the corresponding
period in the prior year. The increase in domestic DBM Segment revenues for the
three months ended September 30, 2004 is primarily related to increased units
sales volume for private label DBM products, principally as a result of the
start-up of our second private label DBM arrangement with Smith & Nephew which
began shipping product in the third quarter of 2004, partially offset by a 10%
decline in domestic Grafton(R) DBM revenues due to continued strong competition.
The decline in domestic DBM Segment revenues for the nine months ended September
30, 2004 is primarily due to a 12% decline in domestic Grafton(R) DBM revenues,
partially offset by increased revenue from our two private label arrangements.
Foreign-based Grafton(R) DBM revenues increased 21% to $1,447,000 in the third
quarter of 2004 from revenues of $1,199,000 in the corresponding period in the
prior year, and increased 37% to $4,859,000 for the nine months ended September
30, 2004 from $3,557,000 for the nine months ended September 30, 2003. The
increase in foreign-based Grafton(R) DBM revenues is primarily due to increased
penetration in existing markets and the expansion into additional international
markets.
Base Allograft Tissue Segment, or Base Tissue Segment, revenues were relatively
flat at $9,673,000 and $30,724,000 for the three months and nine months ended
September 30, 2004, respectively, compared to $9,675,000 and $30,587,000 in the
corresponding periods in 2003. Graftech(R) Bio-implant revenues in both periods
declined 10% and 9%, respectively. The decline, which was due primarily to
continued strong competition, was offset by increased revenues from the direct
distribution of Osteotech labeled traditional tissue and OsteoPure(TM) Femoral
head processing.
Revenue from other product lines, consisting primarily of metal spinal implants
(through June 30, 2004 the date we discontinued marketing and distributing such
product lines) and bovine tissue, declined in the third quarter of 2004 to
$438,000 from $1,926,000 in the same period in 2003 and declined for the nine
months ended September 30, 2004 to $3,094,000 from $4,653,000 in the
corresponding period in 2003. The decline
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in revenues is directly associated with our exit from the metal spinal implant
business effective June 30, 2004. Revenues related to metal spinal implants were
$16,000 and $1,718,000 for the three months and nine months ended September 30,
2004 and were $1,597,000 and $3,424,000 for the three months and nine months
ended September 30, 2003, respectively. There were principally no revenues from
metal spinal implant products for the third quarter of 2004.
During the three months ended September 30, 2004, two of our clients in the DBM
and Base Tissue Segments, the Musculoskeletal Transplant Foundation, or MTF, and
the American Red Cross Tissue Services, or ARC, accounted for 21% and 20%,
respectively, of consolidated net revenues and accounted for 24% and 25%,
respectively, of consolidated net revenues for the three months ended September
30, 2003. For the nine months ended September 30, 2004, these same two clients
accounted for 22% and 21%, respectively, of consolidated net revenues, and 25%
and 26%, respectively, of consolidated net revenues for the nine months ended
September 30, 2003. We have processing agreements with each of these clients.
The MTF agreement expires in December, 2008 and the ARC agreement expires in
December, 2006.
Gross Profit
Consolidated gross profit as a percentage of consolidated net revenues was 47%
in the third quarter of 2004 compared to 52% in the third quarter of 2003.
Consolidated gross profit as a percentage of consolidated net revenues was 44%
for the nine months ended September 30, 2004 compared to 57% for the nine months
ended September 30, 2003. The decline in gross profit as a percentage of
revenues was due primarily to the negative impact of lower net revenues and
higher per unit processing costs as a result of declining unit sales volume,
which has resulted in the under absorption of fixed production costs, and
additionally, for the nine months ended September 30, 2004, by the reserves
recorded in the first quarter of 2004 for costs associated with our exit from
the metal spinal implant business of $1,998,000 to reduce metal spinal implant
inventory and instrumentation to estimated net realizable value. Gross profit as
a percentage of consolidated net revenues was also negatively impacted by the
continuing shift in revenue mix to lower margin products, which include
international Grafton(R) DBM, Osteotech labeled traditional tissue, private
label DBM products and the decline in domestic Grafton(R) DBM revenues, which
represents our highest gross profit margin product category. Gross profit as a
percentage of revenues in both periods of 2004 was favorably impacted by the
reversal of $479,000 of purchase commitment penalties related to the settlement
of a lawsuit.
Marketing, Selling, General and Administrative Expenses
Consolidated marketing, selling, general and administrative expenses decreased
in the third quarter of 2004 to $7,684,000, which includes the reversal of
amounts provided for the Company's Management Bonus Plan of $325,000, from
$9,806,000 in the corresponding period in 2003 and decreased 3% for the nine
months ended September 30, 2004 to $27,868,000 from $28,873,000 for the nine
months ended September 30, 2003. The declines in both periods are primarily due
to the decline in domestic commission costs as a result of the lower domestic
commissionable revenues, lower legal fees due to the resolution of substantially
all outstanding litigation and the reduction in provisions for the Company's
Management Bonus Plan of $130,000 in the third quarter of 2004 compared to the
third quarter of 2003 and $781,000 for the nine months ended September 30, 2004
compared to the nine months ended September 30, 2003 partially offset by
professional fees incurred related to our efforts to comply with Section 404 of
the Sarbanes-Oxley Act of 2002 of $290,000 in third quarter 2004 and $540,000
for the nine months ended September 30, 2004. In addition, consolidated
marketing, selling, general and administrative expenses for the nine months
ended September 30, 2004 included a severance charge of $650,000 related to the
reorganization of the sales and marketing departments in the first quarter of
2004.
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Research and Development Expenses
Consolidated research and development expenses increased 5% in the third quarter
of 2004 to $1,145,000 from $1,095,000 in the corresponding period in 2003, and
increased 6% in the nine months ended September 30, 2004 to $3,188,000 from
$3,020,000 in the nine months ended September 30, 2003. The increase in
consolidated research and development expenses is primarily due to increased
activity on existing and new projects and programs.
Operating Income (Loss)
Consolidated operating income was $1,469,000 in the third quarter of 2004 and we
incurred a consolidated operating loss of $1,163,000 for the nine months ended
September 30, 2004, compared to consolidated operating income of $1,103,000 and
$8,132,000 in the same respective periods in 2003. Consolidated operating income
in the third quarter of 2004 resulted primarily from reduced marketing, selling,
general and administrative expenses discussed above, the reversal of estimated
purchase commitment penalties related to the settlement of a lawsuit, partially
offset by lower gross profit margins. The operating loss for the nine months
ended September 30, 2004 was primarily attributable to the reserves recorded in
the first quarter of 2004 for costs associated with our exit from the spinal
metal implant business and the reorganization of our sales and marketing
functions and the decline in gross profit margins, which were impacted by lower
net revenues and increased per unit processing costs, partially offset by lower
marketing, selling, general and administrative expenses and the reversal of
estimated purchase commitment penalties related to the settlement of a lawsuit.
DBM Segment operating income decreased to $2,008,000 in the three months ended
September 30, 2004 from $2,761,000 in the same period in 2003 and declined to
$3,249,000 for the nine months ended September 30, 2004 from $10,418,000 in the
corresponding period in 2003. These declines are attributable to the decline in
domestic revenue, primarily related to the decline in unit sales volume from
domestic Grafton(R) DBM, a corresponding decline in gross profit margins,
increased operating expenses associated with the shift of sales and marketing
resources from marketing metal spinal implant products to focus on our tissues
businesses, and in the nine months ended September 30, 2004, a portion of the
severance costs related to the reorganization of the sales and marketing
departments.
We incurred operating losses in the Base Tissue Segment of $929,000 and
$1,993,000 in the three months and nine months ended September 30, 2004,
respectively, compared to an operating loss of $216,000 and operating income of
$1,666,000 in the respective corresponding periods in 2003. The operating losses
in 2004 are primarily attributable to the decline in revenues primarily related
to the decline in unit sales volume of domestic Graftech(R) Bio-implants,
associated lower gross profit margins, increased operating expenses associated
with programs to restore revenue growth, including the shift of sales and
marketing resources from marketing metal spinal implant products to focus on our
tissue businesses, and in the nine months ended September 30, 2004, a portion of
the severance costs related to the reorganization of the sales and marketing
departments.
Operating income associated with other revenues was $390,000 for the third
quarter of 2004 compared to an operating loss of $1,442,000 in the third quarter
of 2003. We incurred operating losses of $2,419,000 and $3,952,000 for the nine
months ended September 30, 2004 and 2003, respectively. The operating income in
the third quarter of 2004 includes the reversal of estimated purchase commitment
penalties of $479,000 related to the settlement of a lawsuit. The operating loss
for the nine months ended September 30, 2004 includes a charge of $1,998,000 to
reduce metal spinal implant inventory and instrumentation to estimated net
realizable value, partially offset by the reversal of purchase commitment
penalties discussed above.
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Interest Expense and Other, Net
Interest expense and other, net, which primarily represents interest expense,
net of interest income, was $4,000 and $349,000 for the three months and nine
months ended September 30, 2004, respectively, compared to interest expense, net
of interest income, of $126,000 and $590,000 in the corresponding periods in
2003, respectively. In all periods in 2004 and 2003, interest expense on
long-term debt is partially offset by interest income. Our financial results for
the three months ended September 30, 2004 was favorably impacted by $105,000 for
exchange rates on foreign intercompany indebtedness while there was no
meaningful impact on our financial results from exchange rates on foreign
intercompany indebtedness for the nine months ended September 30, 2004.
Income Tax Provision (Benefit)
The effective tax rate for the three months ended September 30, 2004 was 30%,
which was less than the statutory rate primarily due to our ability to utilize
previously unrecognized net operating loss carryforwards, which carried a full
valuation allowance, to offset foreign income. We recognized an income tax
benefit for the nine months ended September 30, 2004 primarily due to losses in
our domestic operations and our ability to utilize previously unrecognized net
operating loss carryforwards, which carried a full valuation allowance, to
offset foreign income. We anticipate that we will consume substantially all of
utilizable net operating loss carryforwards by the end of 2004.
The effective income tax rate for the three months and nine months ended
September 30, 2003 were 42% and 41%, respectively.
Liquidity and Capital Resources
At September 30, 2004 we had cash and cash equivalents of $12,476,000 compared
to $15,326,000 at December 31, 2003. We invest excess cash in U.S.
Government-backed securities and investment grade commercial paper of major U.S.
corporations. Working capital increased $2,423,000 to $58,807,000 at September
30, 2004 compared to $56,384,000 at December 31, 2003, principally due to
continued investment in processed and unprocessed tissue inventories.
Net cash provided by operating activities was $148,000 and $1,686,000 for the
nine months ended September 30, 2004 and 2003, respectively. The decline in net
cash provided by operating activities is primarily due to the net loss incurred
in 2004, partially offset by the reserve recorded to reduce metal spinal implant
inventory and instrumentation to net realizable value.
Cash used in investing activities was $1,424,000 for the nine months ended
September 30, 2004 compared to cash provided by investing activities of
$2,115,000 for the nine months ended September 30, 2003. Cash used in investing
activities in 2004 primarily results from capital expenditures of $1,333,000.
Cash provided by investing activities in 2003 was primarily generated from the
sale of short-term investments of $3,948,000, partially offset by capital
expenditures of $1,326,000.
Net cash used in financing activities was $1,752,000 and $1,406,000 for the nine
months ended September 30, 2004 and 2003, respectively. Net cash used in
financing activities in both periods principally results from payments on
long-term debt, partially offset by proceeds from the sale of common stock
associated with employee stock option exercises and our employee stock purchase
plan.
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We have a Credit Facility with a U.S. bank that includes: a $5,000,000 revolving
line of credit, a building mortgage loan, and an equipment term loan. At
September 30, 2004, there were no borrowings under the revolving line of credit
and $5,000,000 was available to us, $3,808,000 was outstanding under the
building mortgage loan and $10,119,000 was outstanding under the equipment term
loan. The Credit Facility, as amended, imposes certain operating and financial
restrictions and covenants. Based upon a review of our financial results for the
first nine months of 2004, our current operations and our future expected
operational activities for the remainder of 2004, we may, in certain
circumstances, not comply with one of these covenants in the fourth quarter of
2004. Should circumstances indicate that we would in fact fail to comply with
any covenant, we believe there are options available to us to achieve
compliance, including, but not limited to, obtaining a waiver from our lender or
amending the covenant, or both, or adjusting our operational activities. We have
begun and are continuing discussions with our lender concerning the possibility
of our non-compliance with one of its covenants, and will continue such
discussions throughout the fourth quarter to explore our options. We cannot
provide assurance that we will be able to comply with any or all of the
covenants or institute activities to bring us into compliance, or, in the event
of non-compliance with a covenant, obtain a waiver to, or amendment of, the
covenant, in which case the bank could avail itself of the remedies set forth in
the risk factor entitled "Failure to comply with covenants under our loan and
security agreement could materially adversely impact our business, financial
condition and results of operations" set forth in our Annual Report on Form 10-K
for the year ended December 31, 2003.
We believe that our cash and cash equivalents and available lines of credit,
together with anticipated future cash flows from operations, will be sufficient
to meet our forecasted cash needs for the next twelve months. From time to time
we may seek additional funds through equity or debt financing. However, there
can be no assurance that such additional funds will be available, or if
available, that such funds will be available on favorable terms.
As of September 30, 2004, there were no material changes in our contractual
obligations or long-term debt from that disclosed in Item 7, "Management's
Discussion and Analysis of Financial Condition and Results of Operations,
Liquidity and Capital Resources" in our Annual Report on Form 10-K for the year
ended December 31, 2003.
Impact of Inflation and Foreign Currency Exchange Fluctuations
Results of operations for the periods discussed above have not been materially
affected by inflation or foreign currency fluctuations.
Off-Balance Sheet Arrangements
As part of our ongoing business, we do not participate in transactions that
generate relationships with unconsolidated entities or financial partnerships,
such as entities often referred to as structured finance or special purpose
entities ("SPE"), which would have been established for the purpose of
facilitating off-balance sheet arrangements or other contractually narrow
limited purposes.
Litigation
Osteotech, Inc. is not currently involved in any material legal proceedings. For
a discussion of material legal proceedings that we have been involved in, see
Note 8 of "Notes to Condensed Consolidated Financial Statements" included
elsewhere herein and PART II. ITEM 1. LEGAL PROCEEDINGS, and our Annual Report
on Form 10-K for the year ended December 31, 2003 and our Quarterly Reports on
Form 10-Q for the quarters ended March 31, 2004 and June 30, 2004.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For information regarding our exposure to certain market risks, see Item 7A,
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK, in our Annual Report
on Form 10-K for the year ended December 31, 2003. There have been no
significant changes in our market risk exposures from the fiscal 2003 year-end.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures
Under the supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, we evaluated the
effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rule 13a - 15(e) under the Exchange Act) as of
September 30, 2004 (the "Evaluation Date"). Based upon that evaluation the Chief
Executive Officer and Chief Financial Officer concluded that, as of the
Evaluation Date, our disclosure controls and procedures were effective in timely
alerting them to the material information relating to us required to be included
in our periodic SEC filings.
Changes in Internal Controls
There were no changes made in our internal controls during the period covered by
this report or, to our knowledge, in other factors that could affect these
controls subsequent to the date of their last evaluation, except for the
procedures instituted in the first quarter of 2004, which has been previously
disclosed, related to the timely review and monitoring of certain account
analyses, including the account impacted by the flaw in our computer software
detected during year-end 2003 closing procedures. We have evaluated the
additional procedures instituted in the first quarter of 2004 discussed above
and have found that such procedures are operating effectively.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The following is a description of material developments that occurred during the
three months ended September 30, 2004 in lawsuits reported in our Annual Report
on Form 10-K for the year ended December 31, 2003 and our Quarterly Reports on
Form 10-Q for the quarters ended March 31, 2004 and June 30, 2004. Additionally,
from time to time we are a party to other litigation incidental to our business,
none of which, individually or in the aggregate, are expected to have a material
adverse effect on our results of operations or financial condition.
Alphatec Manufacturing v. Osteotech, Inc.
In February, 2001, we entered into an exclusive distribution agreement with
Alphatec Manufacturing, Inc. ("Alphatec") to market and distribute two metal
spinal implant products in the United States and Canada. In September, 2003, we
provided written notice to Alphatec terminating the distribution agreement upon
the completion of the then current term, which expired on March 31, 2004.
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The agreement included provisions for minimum purchases over the contractual
period, subject to penalty payments if the minimum purchases were not achieved.
We settled the provisions of the first year purchase commitment with Alphatec in
the fourth quarter of 2002, and recorded all appropriate charges at that time.
Also, in the fourth quarter of 2002, we recorded an estimated reserve of
$1,079,000 for the penalty that may be due for not achieving the minimum
purchase commitment in year two of the agreement.
In July, 2003, Alphatec filed an action against us arising out of the
distribution agreement between the parties. In August, 2003, we answered
Alphatec's complaint and asserted counterclaims. On September 24, 2004, we
executed a settlement agreement with Alphatec resolving all disputes between the
parties and dismissing with prejudice all claims and counterclaims. Pursuant to
the settlement agreement, we made a payment to Alphatec in the amount of
$600,000 and returned to Alphatec all remaining inventory held by us that had
been manufactured by Alphatec.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibits (required by Item 601 of Regulation S-K)
Exhibit Page
Number Description Number
------ ----------- ------
10.48 Employment Agreement with Sam Owusu-Akyaw dated July 2, 2004 *
10.49 Employee Non-Competition, Non-Solicitation, Confidential Information and *
Inventions Agreement with Sam Owusu-Akyaw dated July 2, 2004
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 *
* Filed herewith.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: November 5, 2004 Osteotech, Inc.
(Registrant)
Date: November 5, 2004 By: /S/ Richard W. Bauer
--------------------------------
Richard W. Bauer
Chief Executive Officer
(Principal Executive Officer)
Date: November 5, 2004 By: /S/ Michael J. Jeffries
--------------------------------
Michael J. Jeffries
Executive Vice President,
Chief Financial Officer
(Principal Financial Officer and
Chief Accounting Officer)
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