UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
or
o 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 001-16757
DJ ORTHOPEDICS, INC.
(Exact name of Registrant as specified in its charter)
Delaware | | 33-0978270 |
(State or other jurisdiction of
Incorporation or organization) | | (I.R.S. Employer
Identification Number) |
| | |
2985 Scott Street | | |
Vista, California | | 92081 |
(Address of principal executive offices) | | (Zip Code) |
| | |
Registrant’s telephone number, including area code: (800) 336-5690 |
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class | | Name of Each Exchange on
Which Registered |
Common Stock, $0.01 Par Value | | New York Stock Exchange |
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No ý
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No ý
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 ý No o
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. o
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No ý
The aggregate market value of all outstanding common equity held by non-affiliates of the Registrant based on the closing price of common stock as reported on the New York Stock Exchange on July 1, 2005 was $494,913,948.
The number of shares of the Registrant’s common stock outstanding at February 10, 2006 was 22,190,085 shares.
Documents Incorporated by Reference
Portions of the Proxy Statement for the Registrant’s 2006 Annual Meeting of Stockholders to be filed with the Commission on or before April 30, 2006 are incorporated by reference in Part III of this Annual Report on Form 10-K. With the exception of those portions that are specifically incorporated by reference in this Annual Report on Form 10-K, such Proxy Statement shall not be deemed filed as part of this Report or incorporated by reference herein.
DJ ORTHOPEDICS, INC.
FORM 10-K
TABLE OF CONTENTS
Explanatory Notes
Unless the context requires otherwise, in this annual report the terms “we,” “us” and “our” refer to dj Orthopedics, Inc., dj Orthopedics, LLC, a wholly-owned subsidiary of dj Orthopedics, Inc., and our other wholly-owned and indirect subsidiaries. When we refer to “we,” “us” and “our” for dates prior to November 20, 2001, the date of our reorganization, the terms are meant to refer to our predecessor, DonJoy, L.L.C. In November 2003, we acquired the bone growth stimulation device business of OrthoLogic Corp. We refer to this business as our “Regeneration” business, formerly known as our Regentek business, the acquisition as the “Regeneration acquisition” and the products we acquired as our bone growth stimulation (BGS) products.
This annual report includes market share and industry data and forecasts that we obtained from industry publications and surveys, primarily by Frost & Sullivan, and internal company surveys. Frost & Sullivan was commissioned by us to provide certain industry and market data. Industry publications, surveys and forecasts generally state that the information contained therein has been obtained from sources believed to be reliable, but there can be no assurance as to the accuracy or completeness of included information. We have not independently verified any of the data from third-party sources nor have we ascertained the underlying economic assumptions relied upon therein. While we are not aware of any misstatements regarding the industry and market data presented herein, such data involve risks and uncertainties and are subject to change based on various factors, including those discussed under the heading “Risk Factors” in this annual report.
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Note on Forward-Looking Information
This annual report on Form 10-K contains, in addition to historical information, statements by us with respect to our expectations regarding future financial results and other aspects of our business that involve risks and uncertainties and may constitute forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. These statements reflect our current views and are based on certain assumptions. Actual results could differ materially from those currently anticipated as a result of a number of factors, including material risks discussed under the heading “Risk Factors” in this annual report. If the expectations or assumptions underlying our forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statement.
Part I
Item 1. Business
Overview
We are a global medical device company specializing in rehabilitation and regeneration products for the non-operative orthopedic and spine markets. We believe that we have a leading market share in the non-operative orthopedic and spine markets that we target. From 2004 to 2005, our consolidated revenues grew 11.8% to $286.2 million.
Marketed under the DonJoy and ProCare brands, our broad range of over 600 rehabilitation products, including rigid knee braces, soft goods and pain management products, are used to prevent injury, to treat chronic conditions and to aid in recovery after surgery or injury. Our regeneration products consist of bone growth stimulation devices that are used to treat nonunion fractures and as an adjunct therapy after spinal fusion surgery.
We sell our products in the United States and in more than 50 other countries through networks of agents, distributors and our direct sales force that market our products to orthopedic and spine surgeons, podiatrists, orthopedic and prosthetic centers, third-party distributors, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals. We believe that we have one of the largest distribution networks for non-operative orthopedic products. We believe that this distribution network, along with our recognized brand names, reputation for quality, innovation and customer service, and our strong relationships with orthopedic professionals have contributed to our leading market position.
We were incorporated in Delaware in August 2001. We are the successor to DonJoy, Inc., a business started in 1978 in Carlsbad, California. In 1987, DonJoy was acquired by Smith & Nephew, Inc. and on June 30, 1999, DonJoy consummated a recapitalization pursuant to which J.P. Morgan DJ Partners, LLC obtained a controlling interest in DonJoy from Smith & Nephew. Concurrently with the completion of our initial public offering on November 20, 2001, DonJoy merged with us through a series of transactions. Our headquarters are located at 2985 Scott Street, Vista, California 92081. Our telephone number is (800) 336-5690. Our website address is www.djortho.com.
We file annual reports, such as this Form 10-K, as well as quarterly reports on Form 10-Q and current reports on Form 8-K, with the United States (U.S.) Securities and Exchange Commission (SEC). We make these reports available free of charge on our website under the investor relations page. These reports can be accessed the same day they are filed with the SEC. All such reports were made available in this fashion during 2005.
4TITUDE®, Defiance®, dj Ortho®, DonJoy®, FourcePoint™, IceMan®, OfficeCare®, ProCare®, SpinaLogic®, UltraSling®, LegendTM, UltraSling ERTM, Knee GuaranteeTM, OL1000TM, OL1000 SCTM, DonJoy Pain Control DeviceTM, VelocityTM and ArcticFlowTM, are certain of our registered trademarks and trademarks for which we have applications pending or common law rights. All other brand names, trademarks and service marks appearing in this annual report are the property of their respective holders.
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Our Strategy
Our strategy is to increase revenue and profitability and enhance cash flow by strengthening our market leadership position. Our key initiatives to implement this strategy include:
• Increase our Lead in the Domestic Rehabilitation Market Segment. We believe we are the market leader in the Domestic Rehabilitation markets in which we compete. We believe we will be able to continue to grow our Domestic Rehabilitation business segment and increase our market share further by focusing on growth initiatives related to maintaining a continuous flow of new product introductions and continuing to enhance the productivity of our sales force and optimize our distribution strategy. Our key Domestic Rehabilitation growth strategies include the following:
- Continue to Introduce New Products and Product Enhancements. We have a history of developing and introducing innovative products into the marketplace, and are committed to continuing that tradition by introducing new products across our product platform. In the year ended December 31, 2005, we launched 30 new products. We believe that product innovation through effective and focused research and development will provide a sustainable competitive advantage. We believe we are currently a technology leader in several product categories and we intend to continue to develop next generation technologies.
- Expand Product Offerings for the Spine and for Foot and Ankle. According to Frost & Sullivan, back pain is the number one cause of healthcare expenditure in the United States. As a result, we believe that expanding our product offerings in this market represents a significant growth opportunity. In 2004, we launched a new compression back brace to address the spine market and we intend to add more products to address this market segment. In addition, according to Frost & Sullivan, the ankle braces and supports segment of the Domestic Rehabilitation market is approximately $226 million in 2005 and offers us an opportunity for future growth as our current level of sales in this market segment is relatively low. In 2005, we launched our Velocity Ankle, a new rigid ankle brace. This product has been one of our most successful new products in recent years. We intend to further expand our foot and ankle product offerings. For example, in early 2006, we launched a new foot orthotic to treat subtle cavus foot.
- Expand Our OfficeCare Channel. Our OfficeCare channel currently includes over 850 physician offices encompassing over 3,400 physicians. We believe that our OfficeCare channel serves a growing need among orthopedic practices to have a number of products readily available for immediate distribution to patients. Expanding our OfficeCare channel also permits us to increase our weighted-average selling prices, as the units sold through this channel are billed to insurance companies and other third-party payors at higher prices than most of our other sales channels. Accordingly, our OfficeCare initiatives represent an opportunity for sales growth based on increases in both unit volume and average selling prices. We intend to expand our OfficeCare channel into more “high-volume” orthopedic offices, thereby increasing the number of potential customers to whom we sell our products. In the year ended December 31, 2005, we added approximately 200 new offices to our OfficeCare channel, net of account terminations, including approximately 45 accounts added through our acquisition of the stock and bill business of Superior Medical Equipment, LLC (SME acquisition).
- Maximize Existing and Secure Additional National Accounts. We plan to capitalize on the growing practice in healthcare in which hospitals and other large healthcare providers seek to consolidate their purchasing activities to national buying groups. Contracts with these national accounts represent a significant opportunity for sales growth. We believe that our broad range of products is well suited to the goals of these buying groups and intend to aggressively pursue these contracts. In the year ended December 31, 2005, we signed four new significant national contracts, including a new three-year, multi-source contract with MedAssets Supply Chain Systems for our soft goods products, and we renewed two other significant national contracts. In addition, in connection with our August 2005 acquisition of the orthopedic soft goods business from Encore Medical L.P. (OSG acquisition), we added one new significant national contract and increased our penetration into several other national account opportunities already within our portfolio.
• Grow Our Regeneration Business. We have integrated the sales force for our OL1000 bone growth stimulator product into our domestic rehabilitation sales organization. We have also increased the number of regeneration sales specialists dedicated to selling our OL1000 product. We believe these specialists will be able to use the established
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relationships of our DonJoy sales representatives to enhance sales of the OL1000 product. Our distribution arrangement with DePuy Spine has also become non-exclusive for 2006, which permits us to sell the SpinaLogic product directly or through other independent sales representatives in all territories where we choose to do so. We intend to add additional selling resources in those geographical parts of the country where sales are not meeting our expectations. We believe that our new selling strategies for our Regeneration segment will drive faster growth for this business.
• Expand International Sales. International sales have historically represented less than 15% of our revenues. Although our presence outside the United States has been limited, we have successfully established direct distribution capabilities in major international markets. We believe that sales to foreign markets continue to represent a significant growth opportunity and we intend to continue to develop direct distribution capabilities in selected additional foreign markets. We also believe we can increase our international revenues by expanding the number of our products we sell in international markets. Historically we have only sold a limited range of our products in our international markets. In 2005, we successfully launched an expanded range of soft goods, our cold therapy products and our bone growth stimulation products in our International segment.
• Pursue Selective Acquisitions. We believe that acquisitions represent an attractive and efficient means to broaden our product lines, expand our geographic reach and increase our revenue. We intend to pursue acquisition opportunities that enhance sales growth, are accretive to earnings, increase customer penetration and/or provide geographic diversity. In the year ended December 31, 2005, we completed the SME and OSG acquisitions that meet these criteria as discussed in Note 3 to the consolidated financial statements included in Item 8 herein. In January 2006, we also completed the acquisition of Newmed SAS (Newmed), as discussed in Note 13 to the consolidated financial statements included in Item 8, herein, which is intended to increase our international revenue in France and other parts of Europe.
Rehabilitation Products
Rigid Knee Bracing
We design, manufacture and market a broad range of rigid knee braces, including ligament braces, which are designed to provide support for knee ligament instabilities, post-operative braces, which are designed to provide both knee immobilization and a protected range of motion, and osteoarthritic braces, which are designed to provide relief of knee pain due to osteoarthritis. These products are generally prescribed to a patient by an orthopedic physician or provided by athletic trainers for use in preventing injury. Our rigid knee braces are either customized braces, utilizing basic frames which are then custom-manufactured to fit a patient’s particular measurements, or are standard braces which are available “off-the-shelf” in various sizes and can be easily adjusted to fit the patient in the orthopedic professional’s office. Sales of rigid knee braces represented approximately 31% of our revenues for 2005.
Ligament Braces. Ligament braces are designed to provide durable support for moderate to severe knee ligament instabilities to help patients regain range of motion capability so they can successfully complete rehabilitation and resume daily activities after knee surgery or injury. Ligament braces are generally prescribed six to eight weeks after knee surgery, often after use of a more restrictive post-operative brace. Our ligament braces can also be used to support the normal functioning of the knee to prevent injury. Our ligament bracing product line includes customized braces generally designed for strenuous athletic activity and off-the-shelf braces generally designed for use in less rigorous activity. We offer a Knee Guarantee program in connection with our Defiance ligament brace. The Knee Guarantee program will, in specified instances, cover a patient’s insurance deductible up to $1,000, or give uninsured patients $1,000 towards surgery, should an ACL re-injury occur while wearing the Defiance ligament brace. We believe that we are the only orthopedic company in the United States that provides such a guarantee. Since we introduced this guarantee, claims under the program have been minimal.
Post-operative Braces. Post-operative braces are designed to limit a patient’s range of motion after knee surgery and protect the repaired ligaments and/or joints from stress and strain that would slow or prevent a healthy healing process. The products within this line provide both immobilization and a protected range of motion, depending on the rehabilitation protocol prescribed by the orthopedic surgeon. Our post-operative bracing product line includes a range of premium to lower priced off-the-shelf braces and accessory products.
Osteoarthritic Braces. Osteoarthritic braces are used to treat patients suffering from osteoarthritis of the knee. Our line of customized and off-the-shelf osteoarthritic braces is designed to redistribute weight through the knee, providing additional stability and reducing pain, and in some cases may serve as a cost-efficient alternative to total knee replacement. Frost & Sullivan estimates that sales of osteoarthritic braces are expected to grow faster than other categories of rigid knee bracing.
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Soft Goods
Our soft goods product line originally consisted of simple neoprene braces for the knee, thigh, elbow and ankle. We now have over 500 soft goods products that offer immobilization and support from head to toe. In addition, in connection with our August 2005 OSG acquisition, we acquired a line of patient safety products and pressure care products. Our soft goods products represented approximately 42% of our revenues for 2005.
Soft Bracing. These products are generally constructed from fabric or neoprene materials and are designed to provide support, immobilization and/or heat retention and compression of the knee, ankle, back and upper extremities, including the shoulder, elbow, neck and wrist. We currently offer products ranging from simple neoprene knee sleeves to more advanced products that incorporate materials and features such as air-inflated cushions and metal alloy hinge components. We recently introduced the Velocity ankle brace. The Velocity represents an evolution in DonJoy ankle brace technology, utilizing several new, proprietary design features. The Velocity is a low profile, lightweight ankle brace that prevents abnormal ankle inversion, eversion, and rotation while allowing natural, unrestricted range of motion. The combination of soft goods with a rigid, hinged foot plate and calf cuff provides enhanced levels of control, fit, and support. The Velocity has been one of our most successful new product introductions in recent years.
Lower Extremity Fracture Boots. These products are boots that fit on a patient’s foot and provide comfort and stability for ankle and foot injuries ranging from ankle sprains, soft tissue injuries and stress fractures in the lower leg to stable fractures of the ankle. Fracture boots are used as an alternative to traditional casts. We also sell a line of fracture boots designed for patients suffering from pre-ulcerative and ulcerative foot conditions, primarily related to complications from diabetes.
Shoulder and Elbow Braces. We offer a line of shoulder and elbow braces and slings, which are designed for immobilization after surgery and allow for controlled motion. For example, the UltraSling is a durable oversized sling, which offers immobilization and support for mild shoulder sprains and strains. We recently introduced the UltraSling ER that externally rotates the injured shoulder for improved healing of certain conditions.
Patient Safety. We offer a variety of patient safety devices to hospitals and healthcare facilities to accommodate ambulatory and non-ambulatory patients, including limb positioning devices and wheelchair and bed safety products.
Pressure Care Products. These products are designed to eliminate the development of ulcers, which form when blood supply to skin tissue is reduced or cut off by pressure. Our pressure care products are constructed with lightweight premium grade material to offer resilience, durability and patient comfort. The products offered within this line are used primarily during or after surgical treatment.
Pain Management Products
Our portfolio of pain management products includes cold therapy products to assist in the reduction of pain and swelling and a system that employs ambulatory infusion pumps for the delivery of local anesthetic to a surgical site. Our pain management products accounted for approximately 8% of our revenues for 2005.
Cold Therapy Products. Cold therapy products are designed to help reduce swelling, minimize the need for post-operative pain medications and generally accelerate the rehabilitation process. We manufacture, market and sell the IceMan and the ArcticFlow devices, as well as other cold therapy products such as ice packs and wraps. The IceMan product is a portable device used after surgery or injury. The product consists of a durable quiet pump and control system used to circulate cold water from a reservoir to a pad designed to fit the injured area, such as the ankle, knee or shoulder. The IceMan product uses a patented circulation system to provide constant fluid flow rates, thereby minimizing temperature fluctuations. The ArcticFlow product is a manual cold therapy product that involves a simple, gravity-based means of applying cold therapy.
Ambulatory Infusion Pumps. Ambulatory infusion pumps are designed to provide a continuous infusion of local anesthetic dispensed by a physician directly into a surgical site following surgical procedures. We are the exclusive North American distributor of a pain management system manufactured by McKinley Medical, LLLP called the DonJoy Pain Control Device. This portable device consists of a range of introducer needles, catheters for easy insertion and connection during surgery and pumps for continuous infusion for up to 72 hours. The pain control systems are intended to provide direct pain relief, reduce hospital stays and allow earlier and greater ambulation. Our exclusive distribution rights for this product continue until 2007 and may be extended thereafter.
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Regeneration Products
BGS devices are designed to promote the healing of musculoskeletal bone and tissue through electromagnetic field technology. The BGS products we offer utilize proprietary combined magnetic field technology to deliver a highly specific, low-energy signal. The OL1000 product is used for the non-invasive treatment of an established nonunion fracture, which are fractures that do not show signs of healing within 90 days. Approximately 3-5% of fractures become nonunion. The SpinaLogic product is used as an adjunct therapy after primary lumbar spinal fusion surgery for at-risk patients. Patients are considered at-risk when the natural healing process of the bone may be compromised by other health conditions of the patient, such as diabetes, smoking habits, weight, age and the severity and location of the fracture. Our BGS products accounted for approximately 19% of our revenues for 2005.
Patients using BGS devices generally receive a prescription for the product from their physician. After insurance approval, the patient receives the device and starts therapy, typically at home. The patient is usually instructed to wear our bone growth stimulators for only 30 minutes each day, a significantly shorter period than most competing products, which may require up to 24 hours of daily therapy. We believe the reduced treatment time leads to increased patient compliance with treatment protocol. The length of therapy with our products varies, but usually is between 25 and 40 weeks.
We offer the Technology You Can Trust program in connection with our BGS products. If a patient has a nonunion fracture that fails to heal while using a BGS product, the Technology You Can Trust program will, if the patient meets the specified requirements of the program, refund the costs for treatment using the BGS product. Since the Technology You Can Trust program was introduced, refunds under this program have been minimal.
OL1000. The OL1000 product is a FDA approved device that comprises two magnetic field treatment transducers, or coils, and a microprocessor-controlled signal generator that delivers a highly specific, low-energy signal to the injured area. This signal is designed to stimulate bone growth and healing. This unique system has a micro-controller that tracks the patient’s daily treatment compliance. The OL1000 is used for the non-invasive treatment of an established nonunion fracture in all major long bones, such as the tibia, femur and humerus.
The OL1000 device is designed to be attached to the patient’s arm, leg or other area where there is a nonunion fracture. The OL1000 is designed to evenly distribute a magnetic field over the patient’s injured area. Because of the even distribution of the fields, specific placement of the device over the nonunion fracture is not as critical for product efficacy as it is for some competing products.
The OL1000 SC product is a FDA approved single coil device, which utilizes the same combined magnetic field as the OL1000. This product is available in three sizes and is designed to be more comfortable for patients with certain types of fractures, such as clavicle and hip fractures, where only a single coil can be applied.
SpinaLogic. The SpinaLogic product is a FDA approved, portable, non-invasive, electromagnetic bone growth stimulator that is designed to enhance the healing process as an adjunct therapy after spinal fusion surgery. With the SpinaLogic product, the patient attaches the device to the lumbar injury location where it is designed to provide localized magnetic field treatment to the fusion site. Similar to the OL1000 product, the SpinaLogic device contains a micro-controller that tracks the patient’s daily treatment compliance and can be checked by the surgeon during follow-up visits. In 2005, we launched our newest design for our SpinaLogic product. The new, more ergonomic design is smaller, lighter and has a gently curved oval shape that conforms to the spine’s anatomy, making it more comfortable than spine bone growth stimulators previously offered by the Company. The new design incorporates the same patented Combined Magnetic Field (CMF) waveform technology that has established SpinaLogic as a convenient-to-use spinal bone growth stimulator, with a daily treatment time of 30 minutes.
Sales, Marketing and Distribution
We distribute our products through four sales channels: DonJoy, ProCare, OfficeCare and International. Our DonJoy, ProCare and OfficeCare channels are managed by regional general managers who are responsible for managing the sale of all of our products across these channels, a general manager who is responsible for managing the sale of our Regeneration products in the U.S. and a vice president who is responsible for managing the sale of our ProCare products in the U.S. Our international channel consists of sales by our wholly-owned foreign subsidiaries and foreign independent distributors. For the year ended December 31, 2005, no single customer represented more than 10% of our revenues.
Our Domestic Rehabilitation segment, which includes sales of our rehabilitation products through the DonJoy, ProCare and OfficeCare sales channels discussed below, accounted for approximately 69% of our revenues for 2005. Our Regeneration segment, which includes sales of our regeneration products through the DonJoy sales channel discussed below, accounted for approximately 19% of our revenues for 2005.
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DonJoy
The DonJoy sales channel is responsible for sales of rigid knee braces, pain management products, Regeneration products (effective August 2004) and certain soft goods. The channel consists of approximately 300 independent commissioned sales representatives who are employed by approximately 45 independent sales agents and a few of our direct sales representatives and approximately 120 sales representatives dedicated to selling our OL1000 product, of which approximately 60 are employed by us. The DonJoy channel is primarily dedicated to the sale of our products to orthopedic surgeons, podiatrists, orthopedic and prosthetic centers, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals. Because the DonJoy product lines generally require customer education on the application and use of the product, our sales representatives are technical specialists who receive extensive training both from us and the agent and use their expertise to help fit the patient with the product and assist the orthopedic professional in choosing the appropriate product to meet the patient’s needs.
The SpinaLogic product was, until the end of 2004, sold by DePuy Spine in the U.S. under an exclusive sales agreement, which can be unilaterally terminated by DePuy Spine with four months notice and expires by its terms in 2010. The agreement required DePuy Spine to meet annual sales minimums in order to maintain exclusivity. In January 2005, we amended the agreement with DePuy Spine to divide the U.S. into territories in which DePuy Spine had exclusive sales rights and non-exclusive territories in which we engaged in our own sales efforts or retained another sales agent. Commencing early in 2006, the agreement with DePuy Spine became a non-exclusive arrangement for the entire U.S. This permits us to sell the SpinaLogic product directly or through other independent sales representatives in all territories where we choose to do so.
After a sales representative receives a product order, we generally ship and bill the product directly to the orthopedic professional, paying a sales commission to the agent. For most BGS products and certain custom rigid braces, we sell directly to the patient and bill a third-party payor, if applicable, on behalf of the patient. We enjoy long-standing relationships with most of our agents and sales representatives. Under the arrangements with the agents, each agent is granted an exclusive geographic territory for sales of our products and is not permitted to market products, or represent competitors who sell or distribute products, that compete with our existing products. The agents receive a commission, which varies based on the type of product being sold. If an agent fails to achieve specified sales quotas, we may terminate the agent.
ProCare
The ProCare channel employs approximately 45 direct and independent representatives that manage over 310 dealers focused on primary and acute facilities. Products in this channel consist primarily of our soft goods, which are generally sold in non-exclusive territories to third-party distributors. These distributors include large, national third-party distributors such as Owens & Minor Inc., McKesson/HBOC, Allegiance Healthcare and Physican Sales and Service Inc., regional medical surgical dealers, and medical products buying groups that consist of a number of dealers who make purchases through the buying group. These distributors generally resell the products to large hospital chains, hospital buying groups, primary care networks and orthopedic physicians for use by the patients. Unlike rigid knee bracing products, our soft goods products generally do not require significant customer education for their use.
In response to the emergence of managed care and the formation of buying groups, national purchasing contracts and various bidding procedures imposed by hospitals and buying groups, we have entered into national contracts primarily for the sale of soft goods products, but often also covering our other product categories, with large healthcare providers and buying groups, such as Broadlane, Premier, HealthTrust Purchasing Group, AmeriNet Inc., Novation and US Government/Military hospitals. Under these contracts, we provide favorable pricing to the buying group and, as a result, are generally designated a preferred purchasing source for the members of the buying group for specified products. Members, however, are not obligated to purchase our products. As part of our strategy, we seek to secure additional national contracts with other healthcare providers and buying groups in the future.
OfficeCare
Through OfficeCare, we maintain an inventory of product (mostly soft goods) on hand at orthopedic practices for immediate distribution to the patient. For these products, we arrange billing to the patient or third-party payor after the product is provided to the patient. As of December 31, 2005, the OfficeCare program was located at over 850 physician offices throughout the United States. We have contracts with over 700 third-party payors for our OfficeCare products.
We currently outsource most of the revenue cycle portion of this program, from billing to collecting, to an independent third-party contractor. As a result of the growth of this program, our working capital needs have increased due to higher levels of accounts receivable and inventories necessary to operate the program. The collection period for these receivables as compared to other portions of our business is significantly longer.
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International
We market our products in over 50 countries outside the United States, primarily countries in Europe as well as in Australia, Canada and Japan. International sales are currently made through two distinct channels: independent third-party distributors and through wholly-owned foreign subsidiaries in Germany, the United Kingdom, Canada, France and Denmark. The International sales channel accounted for approximately 12% of our revenues for 2005. In connection with our January 2006 acquisition of Newmed, as discussed in Note 13 to the consolidated financial statements included in Item 8 herein, we have increased the size and scale of our international business. The Newmed acquisition increased our sales and marketing presence in France and through the Newmed subsidiary in Spain, we now have a direct sales presence in Spain. Newmed also adds research and development capabilities in Europe, as well as manufacturing capabilities in Tunisia.
We believe that future opportunities for sales growth within international markets are significant. To this end, we established our direct distributorship subsidiaries in foreign countries. These wholly-owned subsidiaries have enabled us to obtain higher gross margins on our products than we would have obtained on sales through third-party distributors. In addition, we believe that more direct control of the distribution network in these countries will allow us to accelerate the launch of new products and product enhancements.
Manufacturing
Nearly all of our rehabilitation products are manufactured in Tijuana, Mexico. In August 2004, we completed construction of a new 200,000 square foot leased facility in Tijuana, Mexico, to replace three separate facilities we operated in the same area and to further expand our Mexico manufacturing operations. We increased the size of our Mexico facility by another 25,000 square feet in 2005. Our only products that are still manufactured in Vista, California consist of our custom rigid knee bracing products, which remain in the U.S. primarily to facilitate quick turn-around on custom orders, and the assembly and calibration of our Regeneration product lines which was moved to our Vista facility from Tempe, Arizona in the first quarter of 2005 as the final step of integrating the acquired Regeneration operations. Within our Vista and Tijuana facilities, we operate a vertically integrated manufacturing and cleanroom packaging operation and are capable of producing a majority of our subassemblies and components in-house. These include metal stamped parts, injection molding components and fabric-strapping materials. We also have extensive in-house tool and die fabrication capabilities, which provide savings in the development of typically expensive tools and molds as well as flexibility to respond to and capitalize on market opportunities as they are identified. In connection with our January 2006 acquisition of Newmed, as discussed in Note 13 to the consolidated financial statements included in Item 8 herein, we now have manufacturing capabilities in Tunisia, which, although on a smaller scale, are very similar to our manufacturing capabilities in Mexico.
Our Vista, California facility has achieved ISO 9001 certification, EN46001 certification and certification to the Canadian Medical Device Regulation (ISO 13485) and the European Medical Device Directive. Our Tijuana, Mexico facility has achieved ISO 9001 and ISO 13485 certification. These certifications are internationally recognized quality standards for manufacturing and assist us in marketing our products in certain foreign markets.
Most of the raw materials that we use in the manufacture of our products are available from more than one source and are generally readily available on the open market. We source some of our finished products from manufacturers in China as well as other third-party manufacturers.
Research and Development
Our internal research and development program is aimed at developing and enhancing products, processes and technologies. The research and development activities for our rehabilitation products are conducted in our Vista, California facility by a group of product engineers and designers who have substantial experience in developing and designing products using advanced technologies, processes and materials. The research and development team uses computational tools and computer aided design, or CAD, systems during the development process that allow a design to be directly produced on computer-based fabrication equipment, reducing both production time and costs. Our current research and development activities are focused on using new materials, innovative designs and state of the art manufacturing processes to develop new products and to enhance our existing products.
We have developed and maintain close relationships with a number of widely recognized orthopedic surgeons and professionals who assist in product research, development and marketing. These professionals often become product proponents, speaking about our products at medical seminars, assisting in the training of other professionals in the use and fitting of our products and providing us with feedback on the industry’s acceptance of our new products. Some of these surgeons and specialists who participate in the design of products or provide consulting services have contractual relationships with us under which they receive royalty payments or consultant fees in connection with the development of particular products with which they have been
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involved. Our medical advisory board, consisting of five orthopedic surgeons, also assists in our product development by advising us on technological advances in orthopedics, along with competitive and reimbursement updates within the orthopedic industry.
We maintain a clinical education research laboratory in our Vista, California facility, which is used by orthopedic surgeons to evaluate soft tissue repair products in a simulated surgical setting and practice surgical technique. These surgeons often provide us with feedback, which assists us in the development and enhancement of our products. In addition, we utilize our biomechanical laboratory in our Vista, California facility to test the effectiveness of our products. U.S. based and international surgeons and researchers collaborate with our research staff to perform biomechanical testing. The tests are designed to demonstrate the functionality of new products and the effectiveness of new surgical procedures. Mechanical models are used to simulate behavior of normal, injured and osteoarthritic knees and observe the performance of new product designs as well as competitive products. We host numerous orthopedic professionals at our biomechanical and surgical technique laboratories, which allows the professionals to practice procedures and measure the effectiveness of those procedures.
In addition to our internal research and development efforts, we have entered into a number of technology licensing arrangements with third-parties that provide us innovative technologies and processes for the manufacture and development of our products. Finally, we act as the distributor of a number of products that are manufactured by others.
Competition
The non-operative orthopedic and spine markets are highly competitive and fragmented. Our competitors include several large, diversified orthopedic companies and numerous smaller niche companies. Some of our competitors are part of corporate groups that have significantly greater financial, marketing and other resources than we do. Our primary competitors in the rigid knee bracing market include companies such as Orthofix International, N.V., Bledsoe Brace Systems, Ossur hf. and Townsend Industries Inc. In the soft goods products market, our competitors include Aircast Inc., Biomet, Inc., DeRoyal Industries, Ossur hf. and Zimmer Holdings, Inc. In the pain management products market, our competitors include Aircast, I-Flow Corp., Orthofix and Stryker Corporation. In the nonunion bone growth stimulation market, our competitors include Orthofix, Biomet and Smith & Nephew, and in the spinal fusion market we compete with Biomet and Orthofix. Several competitors have initiated stock and bill programs similar to our OfficeCare program.
Competition in the rigid knee brace market is primarily based on product technology, quality and reputation, relationships with customers, service and price. Competition in the soft goods and pain management markets is less dependent on innovation and technology and is primarily based on product range, quality, service and price. Competition in bone growth stimulation devices is more limited as higher regulatory thresholds provide a barrier to market entry. We estimate that Biomet has dominant shares of the U.S. markets for bone growth stimulation products used both to treat nonunion fractures and as adjunct therapy after spinal fusion surgery. International competition is primarily from foreign manufacturers whose costs may be lower due to their ability to manufacture products within their respective countries.
We believe that our extensive product lines, advanced product design, strong distribution networks, reputation with leading orthopedic professionals and customer service provide us with an advantage over our competitors. In particular, we believe that our broad product lines provide us with a competitive advantage over the smaller companies, while our established distribution networks and relationship-based selling efforts provide us with a competitive advantage over larger manufacturers.
Intellectual Property
Our most significant intellectual property rights are our patents and trademarks, including our brand names, and proprietary know-how.
We own or have licensing rights to approximately 289 U.S. and foreign patents and approximately 108 pending patent applications. We anticipate that we will apply for additional patents in the future as we develop new products and product enhancements. One of our most significant patents, which was registered only in the United States, involved the bracing technology and design called the “Four Points of Leverage” system. A majority of our ligament bracing products and certain of our osteoarthritic braces have been designed using the “Four Points of Leverage” system which exerts a force on the upper portion of the tibia, which, in turn, reduces strain on the damaged, reconstructed or torn ligament. Our patent covering the “Four Points of Leverage” system expired in January 2005. Revenues generated from sales of products using our “Four Points of Leverage” system in the U.S. accounted for approximately 14%, 15% and 22% of our historical net revenues for 2005, 2004, and 2003, respectively. We have secured additional patents in recent years that cover several component parts or functions of our line of knee braces, including the FourcePoint™ hinge, anti-migration straps and others.
Our other significant patents include the custom contour measuring instrument, which serves as an integral part of the measurement process for patients using our customized ligament and osteoarthritic braces. In addition, we own patents covering a
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series of hinges for our rigid knee braces, as well as pneumatic pad design and production technologies (which utilize air inflatable cushions that allow the patient to vary the location and degree of support) used in rigid knee braces such as the Defiance ligament brace. We also have patents relating to our osteoarthritic braces and specific mechanisms in a number of our products, and we license patents on an exclusive basis covering the combined magnetic field technology used in our BGS products.
In addition to these patents, we rely on non-patented know-how, trade secrets, processes and other proprietary information, which we protect through a variety of methods, including confidentiality agreements and proprietary information agreements with vendors, employees, consultants and others who have access to our proprietary information. We believe that our patents, trademarks and other proprietary rights are important to the development and conduct of our business and the marketing of our products. As a result, we intend to continue to aggressively protect our intellectual property rights.
Employees
As of December 31, 2005, we had approximately 1,700 employees. Approximately 52% of our employees work in Mexico. Our employees are not unionized. We have not experienced any strikes or work stoppages, and management considers its relationships with our employees to be good.
Government Regulation
Medical Device Regulation
United States. Our products and operations are subject to regulation by the FDA, state authorities and comparable authorities in foreign jurisdictions. Among other things, pursuant to the federal Food, Drug and Cosmetic Act and its implementing regulations, the FDA regulates the research, testing, manufacturing, safety, labeling, storage, recordkeeping, premarket clearance or approval, marketing and promotion, and sales and distribution of medical devices in the United States to ensure that medical products distributed domestically are safe and effective for their intended uses. In addition, the FDA regulates the export of medical devices manufactured in the United States to international markets.
Under the Federal Food, Drug, and Cosmetic Act, or FFDCA, medical devices are classified into one of three classes—Class I, Class II or Class III—depending on the degree of risk associated with each medical device and the extent of control needed to ensure safety and effectiveness. Our currently marketed rehabilitation products are all Class I or Class II medical devices. Our currently marketed bone growth stimulation products are Class III medical devices.
Class I devices are those for which safety and effectiveness can be assured by adherence to a set of regulatory guidelines called General Controls, including compliance with the applicable portions of the FDA’s Quality System Regulation, or QSR, which sets forth the current good manufacturing practices for medical devices, facility registration and product listing, reporting of adverse medical events, and appropriate, truthful and non-misleading labeling, advertising, and promotional materials.
Class II devices also are subject to the General Controls, and most require premarket demonstration of adherence to certain performance standards or other special controls in order to receive marketing clearance from the FDA. Premarket review and clearance by the FDA for these devices may be accomplished through the 510(k) premarket notification procedure. When a 510(k) is required, the manufacturer must submit to the FDA a premarket notification submission demonstrating that the device is “substantially equivalent” to either a device that was legally marketed prior to May 28, 1976 (the date upon which the Medical Device Amendments of 1976 were enacted) or another commercially available, similar device that was subsequently cleared through the 510(k) process. By regulation, the FDA is required to respond to a 510(k) premarket notification within 90 days of submission. As a practical matter, clearances can take significantly longer. If the FDA determines that the device, or its intended use, is not “substantially equivalent” to a previously-cleared device or use, the FDA will place the device, or the particular use of the device, into Class III, and the device sponsor must then fulfill more rigorous premarked review requirements.
A Class III device is a product which has a new intended use or uses advanced technology that is not substantially equivalent to a use or technology with respect to a legally marketed device. The safety and efficacy of Class III devices cannot be assured solely by the General Controls and the other requirements described above. These devices almost always require formal clinical studies to demonstrate safety and effectiveness. Submission and FDA approval of a premarket approval application, or PMA, is required before marketing of a Class III product can proceed. A PMA application, which is intended to demonstrate that the device is safe and effective, must be supported by extensive data, including data from preclinical studies and human clinical trials and information on manufacturing and labeling. The FDA, by statute and regulation, has 180 days to review a PMA that is accepted for filing, but review of a PMA application often occurs over a significantly longer period of time and can take up to several years. In approving a PMA application or clearing a 510(k) application, the FDA may also require some form of post-market surveillance when necessary to protect the public health or to provide additional safety and effectiveness data for the device.
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A clinical trial is generally required to support a PMA application and is sometimes required for a 510(k) premarket notification. These trials generally require submission of an application for an investigational device exemption, or IDE, to the FDA. The IDE application must be supported by appropriate data, such as animal and laboratory testing results, showing that it is safe to test the device in humans and that the testing protocol is scientifically sound. The IDE application must be approved in advance by the FDA for a specified number of patients, unless the product is deemed a non-significant risk device and eligible for more abbreviated IDE requirements. Clinical trials for a significant risk device may begin once the IDE application is approved by the FDA and the appropriate institutional review boards at the clinical trial sites.
Medical devices can be marketed only for the indications for which they are cleared or approved. Modifications to a previously cleared or approved device that could significantly affect its safety or effectiveness or that would constitute a major change in its intended use, design or manufacture require a 510(k) clearance, premarket approval supplement or new premarket approval. The FDA requires each manufacturer to make this determination initially, but the FDA can review any such decision and can disagree with the manufacturers’ determination. We have modified various aspects of our devices in the past and determined that new approvals, clearances or supplements were not required. Nonetheless, the FDA may disagree with our conclusion that clearances or approvals were not required for particular products and may require approval or clearances for such past or any future modifications or to obtain new indications for our existing products. Such submissions may require the submission of additional clinical or preclinical data and may be time consuming and costly, and may not ultimately be cleared or approved by the FDA. Also, in these circumstances, we may be subject to significant regulatory fines and penalties.
Our manufacturing processes and those of our suppliers are required to comply with the applicable portions of the QSR, which covers the methods and documentation of the design, testing, production, processes, controls, quality assurance, labeling, packaging and shipping of our products. Our domestic facility records and manufacturing processes are subject to periodic unscheduled inspections by the FDA. Our Mexican facilities, which export products to the United States, may also be inspected by the FDA. Based on internal audits of our domestic and Mexican facilities, we believe that our facilities are in substantial compliance with the applicable QSR regulations. We also are required to report to the FDA if our products cause or contribute to a death or serious injury or malfunction in a way that would likely cause or contribute to death or serious injury were the malfunction to recur. Although medical device reports have been submitted in the past 5 years, none have resulted in a recall of our products or other regulatory action by the FDA. The FDA and authorities in other countries can require the recall of products in the event of material defects or deficiencies in design or manufacturing. The FDA can also withdraw or limit our product approvals or clearances in the event of serious, unanticipated health or safety concerns.
Even if regulatory approval or clearance of a medical device is granted, the FDA may impose limitations or restrictions on the uses and indications for which the device may be labeled and promoted. Medical devices may be marketed only for the uses and indications for which they are cleared or approved. FDA regulations prohibit a manufacturer from promoting a device for an unapproved, or “off-label” use.
The FDA has broad regulatory and enforcement powers. If the FDA determines that we have failed to comply with applicable regulatory requirements, it can impose a variety of enforcement actions from public warning letters, fines, injunctions, consent decrees and civil penalties to suspension or delayed issuance of approvals, seizure or recall of our products, total or partial shutdown of production, withdrawal of approvals or clearances already granted, and criminal prosecution. The FDA can also require us to repair, replace or refund the cost of devices that we manufactured or distributed. If any of these events were to occur, it could materially adversely affect us.
Legal restrictions on the export from the United States of any medical device that is legally distributed in the United States are limited. However, there are restrictions under U.S. law on the export from the United States of medical devices that cannot be legally distributed in the United States. If a Class I or Class II device does not have 510(k) clearance, and the manufacturer reasonably believes that the device could obtain 510(k) clearance in the United States, then the device can be exported to a foreign country for commercial marketing without the submission of any type of export request or prior FDA approval, if it satisfies certain limited criteria relating primarily to specifications of the foreign purchaser and compliance with the laws of the country to which it is being exported. We believe that all of our current products which are exported to foreign countries currently comply with these restrictions.
International. In many of the foreign countries in which we market our products, we are subject to regulations affecting, among other things, product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. Many of the regulations applicable to our devices and products in such countries are essentially similar to those of the FDA, including those in Germany, our largest foreign market. The regulation of our products in Europe falls primarily within the European Economic Area, which consists of the fifteen member states of the European Union as well as Iceland, Liechtenstein and Norway. The legislative bodies of the European Union have adopted directives in order to harmonize national provisions regulating the design, manufacture, clinical trials, labeling and adverse event reporting for medical devices and the member states of the European Economic Area have implemented the directives into their respective national law. Medical
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devices that comply with the essential requirements of the national provisions and the directives will be entitled to bear a CE marking. Unless an exemption applies, only medical devices which bear a CE marking may be marketed within the European Economic Area. The European Commission has adopted numerous guidelines relating to the medical devices directives to ensure their uniform application. The method of assessing conformity varies depending on the class and type of the medical device and can involve a combination of self-assessment by the manufacturer and a third-party assessment by a Notified Body, which is an independent and neutral institution appointed by the member states to conduct the conformity assessment. This third-party assessment may consist of an audit of the manufacturer’s quality system and specific testing of the manufacturer’s devices. An assessment by a Notified Body in one country within the European Economic Area is generally required in order for a manufacturer to commercially distribute the product throughout the European Economic Area.
The European Standardization Committees have adopted numerous harmonized standards for specific types of medical devices. Compliance with relevant standards establishes the presumption of conformity with the essential requirements for a CE marking. Our quality system relating to the development, production and distribution of rigid and soft orthopedic bracing, cold therapy and regeneration products is certified to international standards through September 28, 2008 for our facilities in Vista, California and Tijuana, Mexico. Our regeneration, sterile cold therapy pads and CCMI (leg contour measuring devices and angle reference bending tools) in our facilities in Vista, California have been certified and the existing certificates have been or are in the process of being extended. The existing certificate remains valid until the issue of a new certificate.
In many countries, the national health or social security organizations require our products to be qualified before they can be marketed with the benefit of reimbursement eligibility. To date, we have not experienced difficulty in complying with these regulations. Due to the movement towards harmonization of standards in the European Union, we expect a changing regulatory environment in Europe characterized by a shift from a country-by-country regulatory system to a European Union-wide single regulatory system. The timing of this harmonization and its effect on us cannot currently be predicted.
Federal Privacy and Transaction Law and Regulations
Other federal legislation requires major changes in the transmission and retention of health information by us. The Health Insurance Portability and Accountability Act of 1996, or HIPAA, mandates, among other things, the adoption of standards for the electronic exchange of health information that has required significant and costly changes to prior practices. Sanctions for failure to comply with HIPAA include civil and criminal penalties. The U.S. Department of Health and Human Services, or HHS, has released three rules to date mandating the use of new standards with respect to certain healthcare transactions and health information. The first rule requires the use of uniform standards for common healthcare transactions, including healthcare claims information, plan eligibility, referral certification and authorization, claims status, plan enrollment and disenrollment, payment and remittance advice, plan premium payments, and coordination of benefits. The second rule released by HHS imposes new standards relating to the privacy of individually identifiable health information. These standards not only require our compliance with rules governing the use and disclosure of protected health information, but they also require us to obtain satisfactory assurances that any business associate of ours to whom such information is disclosed will safeguard the information. The third rule released by HHS establishes minimum standards for the security of electronic health information. We were required to comply with the transaction standards by October 16, 2003 and the privacy standards by April 14, 2003, and were required to comply with the security standards by April 21, 2005.
Third-Party Reimbursement
Our products generally are prescribed by physicians and are eligible for third-party reimbursement. An important consideration for our business is whether third-party payment amounts will be adequate, since this is a factor in our customers’ selection of our products. We believe that third-party payors will continue to focus on measures to contain or reduce their costs through managed care and other efforts. Medicare policies are important to our business because third-party payors often model their policies after the Medicare program’s coverage and reimbursement policies.
Healthcare reform legislation in the Medicare area has focused on containing healthcare spending. For example, the Medicare Prescription Drug, Improvement and Modernization Act of 2003, or the Modernization Act, provides for revisions to payment methodologies and other standards for items of durable medical equipment and orthotic devices under the Medicare program. First, beginning in 2004 through 2008, the payment amounts for orthotic devices (2004 through 2006) and durable medical equipment (2004 through 2008) will no longer be increased on an annual basis. The freeze does not affect Class III devices such as bone growth stimulators, however. Second, a competitive bidding program is scheduled to be phased in to replace the existing fee schedule payment methodology beginning in 2007. Under the Modernization Act, off-the-shelf orthotic devices and other non-Class III devices are subject to the program. The competitive bidding program is scheduled to begin in ten high population metropolitan statistical areas and in 2009 is to be expanded to 80 metropolitan statistical areas (and additional areas thereafter). Payments in regions not subject to competitive bidding may also be adjusted using payment information from regions subject to competitive bidding. Third, supplier quality standards are to be established which will be applied by independent
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accreditation organizations. In September 2005, the Centers for Medicare and Medicaid Services, or CMS, which is the agency that administers the Medicare program, published draft supplier quality standards. The draft standards consist of business-related standards, such as financial and human resources management standards, which would be applicable to all durable medical equipment, orthotics and prosthetics suppliers, and product-specific standards, such as those for customized orthotics products, which focus on product specialization and service standards for such items. CMS has stated that it expects to release the final supplier quality standards in Spring 2006. Fourth, clinical conditions for payment will be established for certain products. Fifth, the Modernization Act mandated that the Government Accountability Office (GAO) make a recommendation to Medicare in 2006 regarding the 2007 fee schedule update for bone growth stimulators. In 2005, the GAO gathered information from bone growth stimulator manufacturers to develop their recommendation.
In recent years, efforts to control Medicare costs have included the heightened scrutiny of reimbursement codes and payment methodologies. Under Medicare, certain devices used by outpatients are classified using reimbursement codes, which in turn form the basis for each device’s Medicare payment levels. Changes to the reimbursement codes describing our products can result in reduced payment levels or a reduction in the breadth of products for which reimbursement can be sought under recognized codes.
On February 11, 2003, the Centers for Medicare and Medicaid Services, or CMS, made effective an interim final regulation implementing ‘‘inherent reasonableness’’ authority, which allows the agency and contractors to adjust payment amounts by up to 15% per year for certain items and services when the existing payment amount is determined to be grossly excessive or grossly deficient. CMS may make a larger adjustment each year if it undertakes prescribed procedures. The Modernization Act, clarified that the use of inherent reasonableness authority is precluded for devices provided under competitive bidding. CMS finalized the inherent reasonableness regulation in December 2005, with an effective date of February 10, 2006, essentially keeping in place the policies in the interim final regulation. We do not know what impact inherent reasonableness and competitive bidding will have on us or the reimbursement of our products.
Beyond changes in reimbursement codes and payment methodologies, the movement, both domestically and in foreign countries, toward healthcare reform and managed care may continue to result in downward pressure on product pricing. Net revenues from third-party reimbursement accounted for approximately 32%, 31% and 19% of our historical net revenues for the years ended December 31, 2005, 2004 and 2003, respectively. Medicare reimbursement consisted of approximately 14% of our historical net revenues from third-party reimbursement or approximately 4% of our total historical net revenues for the year ended December 31, 2005.
Fraud and Abuse
We are subject to various federal and state laws pertaining to healthcare fraud and abuse, including anti-kickback laws and physician self-referral laws. Violations of these laws are punishable by criminal and civil sanctions, including, in some instances, exclusion from participation in federal and state healthcare programs, including Medicare, Medicaid, Veterans Administration health programs and TRICARE. We believe that our operations are in material compliance with such laws. However, because of the far-reaching nature of these laws, there can be no assurance that we would not be required to alter one or more of our practices to be in compliance with these laws. In addition, there can be no assurance that the occurrence of one or more violations of these laws or regulations would not result in a material adverse effect on our financial condition and results of operations.
Anti-kickback and Fraud Laws. Our operations are subject to federal and state anti-kickback laws. Certain provisions of the Social Security Act, which are commonly known collectively as the Medicare Fraud and Abuse Statute, prohibit persons from knowingly and willfully soliciting, receiving, offering or providing remuneration directly or indirectly to induce either the referral of an individual, or the furnishing, recommending, or arranging for a good or service, for which payment may be made under a federal healthcare program such as Medicare and Medicaid. The definition of “remuneration” has been broadly interpreted to include anything of value, including such items as gifts, discounts, waiver of payments, and providing anything at less than its fair market value. HHS has issued regulations, commonly known as safe harbors, that set forth certain provisions which, if fully met, will assure healthcare providers and other parties that they will not be prosecuted under the Medicare Fraud and Abuse Statute. The penalties for violating the Medicare Fraud and Abuse Statute include imprisonment for up to five years, fines of up to $25,000 per violation and possible exclusion from federal healthcare programs such as Medicare and Medicaid. Many states have adopted prohibitions similar to the Medicare Fraud and Abuse Statute, some of which apply to the referral of patients for healthcare services reimbursed by any source, not only by the Medicare and Medicaid programs.
Our OfficeCare program is a stock and bill arrangement through which we make our products and services available in the offices of physicians or other providers. In conjunction with the OfficeCare program, we may pay participating physicians a fee for rental space and support services provided by such physicians to us. In a Special Fraud Alert issued by HHS’ Office of Inspector General, or OIG, in February 2000, the OIG indicated that it may scrutinize stock and bill programs involving excessive
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rental payments or rental space for possible violation of the Medicare Fraud and Abuse Statute, but noted that legitimate arrangements, including fair market value rental arrangements, will not be considered violations of the statute. We believe we have structured the OfficeCare program to comply with the Medicare Fraud and Abuse Statute.
HIPAA created two new federal crimes: healthcare fraud and false statements relating to healthcare matters. The healthcare fraud statute prohibits knowingly and willfully executing or attempting to execute a scheme or artifice to defraud any healthcare benefit program, including private payors. The false statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement or representation in connection with the delivery of or payment for healthcare benefits, items or services. This statute applies to any health benefit plan, not just Medicare and Medicaid. Additionally, HIPAA granted expanded enforcement authority to HHS and the U.S. Department of Justice, or DOJ, and provided enhanced resources to support the activities and responsibilities of the OIG and DOJ by authorizing large increases in funding for investigating fraud and abuse violations relating to healthcare delivery and payment. In addition, HIPAA mandates the adoption of standards for the electronic exchange of health information.
Physician Self-Referral Laws. We are also subject to federal and state physician self-referral laws. Federal physician self-referral legislation (commonly known as the Stark Law) prohibits, subject to certain exceptions, physician referrals of Medicare and Medicaid patients to an entity providing certain “designated health services” if the physician or an immediate family member has any financial relationship with the entity. The Stark Law also prohibits the entity receiving the referral from billing any good or service furnished pursuant to an unlawful referral, and any person collecting any amounts in connection with an unlawful referral is obligated to refund such amounts. A person who engages in a scheme to circumvent the Stark Law’s referral prohibition may be fined up to $100,000 for each such arrangement or scheme. The penalties for violating the Stark Law also include civil monetary penalties of up to $15,000 per referral and possible exclusion from federal healthcare programs such as Medicare and Medicaid. Various states have corollary laws to the Stark Law, including laws that require physicians to disclose any financial interest they may have with a healthcare provider to their patients when referring patients to that provider. Both the scope and exceptions for such laws vary from state to state.
False Claims Laws. Under separate statutes, submission of claims for payment that are “not provided as claimed” may lead to civil money penalties, criminal fines and imprisonment, and/or exclusion from participation in Medicare, Medicaid and other federally funded state health programs. These false claims statutes include the federal False Claims Act, which prohibits the knowing filing of a false claim or the knowing use of false statements to obtain payment from the federal government. When an entity is determined to have violated the False Claims Act, it must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Suits filed under the False Claims Act, known as “qui tam” actions, can be brought by any individual on behalf of the government and such individuals (known as “relators” or, more commonly, as “whistleblowers”) may share in any amounts paid by the entity to the government in fines or settlement. In addition, certain states have enacted laws modeled after the federal False Claims Act. Qui tam actions have increased significantly in recent years, causing greater numbers of healthcare companies to have to defend a false claim action, pay fines or be excluded from the Medicare, Medicaid or other federal or state healthcare programs as a result of an investigation arising out of such action.
Governmental Audits
Because we participate in governmental programs as a supplier of medical devices, our operations are subject to periodic surveys and audits by governmental entities or contractors to assure compliance with Medicare and Medicaid standards and requirements. To maintain our billing privileges, we are required to comply with certain supplier standards, including, by way of example, licensure and documentation requirements for our claims submissions. From time to time in the ordinary course of business, we, like other healthcare companies, are audited by or receive claims documentation requests from governmental entities, which may identify certain deficiencies based on our alleged failure to comply with applicable supplier standards or other requirements. We review and assess such audits or reports and attempt to take appropriate corrective action. We also are subject to surveys of our physical location for compliance with supplier standards. The failure to effect corrective action to address identified deficiencies, or to obtain, renew or maintain any of the required regulatory approvals, certifications or licenses could adversely affect our business, results of operations or financial condition and could result in our inability to offer our products and services to patients insured by the programs.
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Item 1A. Risk Factors
Our ability to achieve our operating and financial goals is subject to a number of risks, including risks relating to our business operations, our debt level and government regulations. If any of the following risks actually occur, our business, operating results, prospects or financial condition could be materially and adversely affected. The risks described below are not the only ones that we face. Additional risks not presently known to us or that we currently deem immaterial may also affect our business operations.
Risks Related to Our Business
Prior to the Regeneration acquisition, we did not have experience operating in the regeneration segment of the non-operative orthopedic and spine markets.
Historically, our principal focus has been the market for orthopedic rehabilitation products. Accordingly, prior to our acquisition of the bone growth stimulation device business from OrthoLogic in November 2003, we did not have any experience operating in the regeneration segment of the non-operative orthopedic and spine markets. The regeneration segment of the non-operative orthopedic and spine markets has different competitive characteristics from those we have experienced in the market for our rehabilitation products and the third-party payor coverage and reimbursement issues are more complex than in our traditional rehabilitation markets. In addition, the products we acquired from OrthoLogic are subject to Class III Food and Drug Administration, or FDA, review. This level of review is more stringent than that required for our rehabilitation products.
In addition, we have made significant changes and additions to the sales force for the BGS products as compared to the sales force in place at the time of the Regeneration acquisition. With respect to the OL1000, we have hired and trained a significant number of new sales specialist and introduced the product to our DonJoy direct distribution sales force. At the time of the Regeneration acquisition, DePuy Spine was acting as the exclusive distributor of the SpinaLogic device in significant portions of the U.S. The agreement with DePuy Spine was amended in 2005 to make certain territories non-exclusive and commencing early in 2006, will become a non-exclusive arrangement for the U.S. We have begun developing alternative selling resources for SpinaLogic and will continue that effort, but prior to the Regeneration acquisition, we did not have any relationships with spine surgeons or with independent distributors who specialize in spine products. The different nature of the Regeneration business from our traditional rehabilitation business and the significant changes we have made and will be required to make to the Regeneration sales force could involve risks to our business such as the following:
• We may have difficulty training and retaining the number of product specialists we will need to grow the OL1000 and SpinaLogic business. To date, we have experienced, and may continue to experience, relatively high turnover among our Regeneration sales specialists and sales managers, which can lead to disruption of customer relations and increased training time and costs;
• In those areas of the country where we will need to supplement the DePuy Spine distributors, we may not be able to develop a network of distributors who can effectively market and sell the SpinaLogic product to spine surgeons;
• Our existing customers may not have a need for bone growth stimulation products or may have existing relationships with our competitors for similar products;
• Our prior experience in billing Medicare is limited, and we may encounter difficulties in processing the higher level of Medicare claims in the Regeneration business as compared to our other businesses; and
• Competitive products or technologies in fracture repair or spinal fusion surgery may undermine our sales and profitability goals.
As a result of these factors, we cannot assure you that we will be successful in operating in the regeneration segment of the non-operative orthopedic and spine markets.
Changes in the regulatory status of our BGS products could adversely affect the operations and financial results of our Regeneration business.
Earlier in 2005 a petition was filed with the US Food and Drug Administration (“FDA”) seeking to reclassify non-invasive bone growth stimulator devices from Class III to Class II. Although our BGS products that utilize combined magnetic field technology were subsequently excluded from the petition, if the petition were to succeed, new market entrants could seek clearance of a BGS device through the 510(k) process (as opposed to the PMA process). This would likely increase competition
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from new products in the electrical bone growth stimulation device business which could result in downward price pressures on our products and business. In addition, the medical committee responsible for providing advice on coverage matters to Medicare held a meeting during 2005 for the purpose of, among other things, considering the effectiveness of products such as our BGS products on healing nonunion fractures among the Medicare patient population. We have actively opposed the granting of the petition to the FDA to reclassify BGS products, and we have provided information to the Medicare advisory committee on the clinical data on effectiveness of our BGS products. Although it has not sought to do so, CMS, which is responsible for Medicare coverage determinations, may decide to re-evaluate current coverage policies in a way that restrict payment for our BGS products. We cannot be certain of the outcome of either regulatory matter, and an adverse outcome on either such matter could impact our ability to grow sales and realize profits in our Regeneration business. Furthermore, we cannot be sure that other regulatory changes will not be proposed or implemented that adversely impact our Regeneration business. See additional risk factors under the heading “Risks Relating to Government Regulation” below.
We intend to pursue, but may not be able to identify, finance or successfully complete, strategic acquisitions.
One element of our growth strategy is to pursue acquisitions, both domestically and, in particular, internationally. We may not be able to identify acceptable opportunities or complete acceptable acquisitions of targets identified in a timely manner. Acquisitions involve a number of risks, including the following:
• Our management’s attention will be diverted from our existing business while evaluating acquisitions and thereafter while integrating the operations and personnel of the new business into our business;
• We may experience adverse short-term effects on our operating results;
• We may be unable to successfully and rapidly integrate the new businesses, personnel and products with our existing business, including financial reporting, management and information technology systems;
• We may experience higher than anticipated costs of integration and unforeseen operating difficulties and expenditures;
• An acquisition may be in a market or geographical area in which we have little experience;
• We may have difficulty in retaining key employees, including employees who may have been instrumental to the success or growth of the acquired business; and
• We may use a substantial amount of our cash and other financial resources to consummate an acquisition.
In addition, we may require additional debt or equity financing for future acquisitions, and such financing may not be available or on favorable terms, if available at all. We may not be able to successfully integrate or operate profitably any new business we acquire, and we cannot assure you that any such acquisition will meet our expectations. Finally, in the event we decide to discontinue pursuit of a potential acquisition, we will be required to immediately expense all costs incurred in pursuit of the possible acquisition that could have an adverse effect on our results of operations in the period in which the expense is recognized.
If we do not effectively manage our growth, our existing infrastructure may become strained, and we may be unable to increase sales of our products or generate revenue growth.
The growth that we have experienced, and in the future may experience, may provide challenges to our organization, requiring us to expand our personnel, manufacturing and distribution operations. Future growth may strain our infrastructure, operations, product development and other managerial and operating resources. If our business resources become strained, we may be unable to increase sales of our products or generate revenue growth.
We have outsourced certain administrative functions relating to our OfficeCare sales channel to a third-party contractor and this arrangement may not prove successful.
Our OfficeCare sales channel maintains an inventory of products (mostly soft goods) on hand at orthopedic practices for immediate distribution to patients. For these products, we arrange billing to a patient or third-party payor after the product is provided to the patient. We outsource the revenue cycle of this program, from billing to collections, to an independent third-party
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contractor. This provider may not remain successful in achieving or maintaining our billing and collections goals and there can be no assurance that we will not have to resume these administrative functions in the future.
We rely on intellectual property to develop and manufacture our products and our business could be adversely affected if and when we lose our intellectual property rights.
We hold or license U.S. and foreign patents relating to a number of our components and products and have patent applications pending with respect to other components and products. We also expect to apply for additional patents as we deem appropriate.
The U.S. patent for our “Four Points of Leverage” system expired in January 2005. Revenues generated from the sale of products in the U.S. using our “Four Points of Leverage” system represented approximately 14%, 15% and 22% of our historical net revenues for 2005, 2004 and 2003, respectively. The majority of our anterior cruciate ligament, or ACL, braces, including Defiance, Legend and 4TITUDE, and certain of our osteoarthritic braces use this system. We believe a number of our competitors may introduce ligament braces that incorporate aspects of our “Four Points of Leverage” system now that the patent has expired. In such event, our competitors may be able to sell products that are similar to ours at lower prices than we currently sell our products, which could adversely affect our revenue and profitability.
We believe that several of our additional existing patents are, and will continue to be, extremely important to our success. These include the patents relating to our:
• knee ligament bracing product lines, including components and features such as frame construction and shape, strap attachment systems, anti-migration padding systems and extreme sport features;
• custom contour measuring system, which serves as an integral part of the measurement process for patients ordering our customized ligament and osteoarthritic braces;
• series of hinges for our rigid braces, including the FourcePoint™ hinge;
• pneumatic pad design and production technologies which utilize air inflatable cushions that allow the patient to vary the location and degree of support provided by braces such as the Defiance knee ligament brace;
• osteoarthritic bracing concepts;
• ankle bracing, both rigid and soft;
• rigid shoulder bracing; and
• combined magnetic field technology, which is used in our bone growth stimulation products.
However, we cannot assure you that:
• our existing or future patents, if any, will afford us adequate protection;
• our patent applications will result in issued patents; or
• our patents will not be circumvented or invalidated.
Our success also depends on non-patented proprietary know-how, trade secrets, processes and other proprietary information. We employ various methods to protect our proprietary information, including confidentiality agreements and proprietary information agreements with vendors, employees, consultants and others who have access to our proprietary information. However, these methods may not provide us with adequate protection. Our proprietary information may become known to, or be independently developed by, competitors, or our proprietary rights in intellectual property may be challenged, any of which could have an adverse effect on our business.
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If we are not able to develop, license or acquire and market new products or product enhancements we may not remain competitive.
Our future success and the ability to grow our revenues and earnings require the continued development, licensing or acquisition of new products and the enhancement of our existing products. We may not be able to:
• continue to develop or license successful new products and enhance existing products;
• obtain required regulatory clearances and approvals for such products;
• market such products in a commercially viable manner; or
• gain market acceptance for such products.
We may be unable to remain competitive if we fail to develop, license or acquire and market new products and product enhancements. In addition, if any of our new or enhanced products contain undetected errors or design defects, especially when first introduced, our ability to market these products could be substantially delayed, resulting in lost revenue, potential damage to our reputation and/or delays in obtaining acceptance of the product by orthopedic and spine surgeons and other healthcare professionals.
We rely heavily on our relationships with orthopedic professionals who prescribe and dispense our products and our failure to maintain these relationships could adversely affect our business.
The sales of our products depend significantly on the prescription or recommendation of such products by orthopedic and spine surgeons and other healthcare professionals. We have developed and maintain close relationships with a number of widely recognized orthopedic surgeons and specialists who support and recommend our products. Failure of our products to retain the support of these surgeons and specialists, or the failure of our products to secure and retain similar support from leading surgeons and specialists, could have an adverse effect on our business.
The majority of our sales force consists of independent agents and distributors who maintain close relationships with our hospital and physician customers.
Our success also depends largely upon arrangements with independent agents and distributors and their relationships with our hospital and physician customers in the marketplace. These agents and distributors are not our employees, and our ability to influence their actions and performance is limited. Our inability to effectively manage these agents and distributors or our failure generally to maintain relationships with these independent agents and distributors could have an adverse effect on our business.
We operate in a very competitive business environment.
The non-operative orthopedic and spine markets are highly competitive and fragmented. Our competitors include several large, diversified general orthopedic products companies and numerous smaller niche companies. Some of our competitors are part of corporate groups that have significantly greater financial, marketing and other resources than we have. Accordingly, we may be at a competitive disadvantage with respect to these competitors.
In the rehabilitation market, our primary competitors in the rigid knee bracing product line include Orthofix International, N.V., Bledsoe Brace Systems, Ossur hf. and Townsend Industries Inc. Our competitors in the soft goods products market include Aircast Inc., Biomet, Inc., DeRoyal Industries, Ossur hf. and Zimmer Holdings, Inc. Our primary competitors in the pain management products market include Aircast, I-Flow Corp., Orthofix and Stryker Corporation.
In the regeneration market, our primary competitors selling bone growth stimulation products approved by the FDA for the treatment of nonunion fractures are Orthofix, Biomet, Inc. and Smith & Nephew. Biomet and Orthofix also sell bone growth stimulation products for use by spinal fusion patients. We estimate that Biomet has dominant shares of the U.S. markets for bone growth stimulation products used both to treat nonunion fractures and as adjunct therapy after spinal fusion surgery.
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Our quarterly operating results are subject to substantial fluctuations and you should not rely on them as an indication of our future results.
Our quarterly operating results may vary significantly due to a combination of factors, many of which are beyond our control. These factors include:
• the number of business days in each quarter;
• demand for our products, which historically has been higher in the fourth quarter when scholastic sports and ski injuries are more frequent;
• our ability to meet the demand for our products;
• the direct distribution of our products in foreign countries;
• the number, timing and significance of new products and product introductions and enhancements by us and our competitors, including delays in obtaining government review and clearance of medical devices;
• our ability to develop, introduce and market new and enhanced versions of our products on a timely basis;
• the impact of any acquisitions that occur in a quarter;
• the impact of any changes in generally accepted accounting principles;
• changes in pricing policies by us and our competitors and reimbursement rates by third-party payors, including government healthcare agencies and private insurers;
• the loss of any of our distributors;
• changes in the treatment practices of orthopedic and spine surgeons and their allied healthcare professionals; and
• the timing of significant orders and shipments.
Accordingly, our quarterly sales and operating results may vary significantly in the future and period-to-period comparisons of our results of operations may not be meaningful and should not be relied upon as indications of future performance. We cannot assure you that our sales will increase or be sustained in future periods or that we will be profitable in any future period.
Our business plan relies on certain assumptions for the market for our products, which, if incorrect, may adversely affect our profitability.
We believe that various demographics and industry specific trends will help drive growth in the rehabilitation and regeneration markets, including:
• a growing elderly population with broad medical coverage, increased disposable income and longer life expectancy;
• a growing emphasis on physical fitness, leisure sports and conditioning, which has led to increased injuries, especially among women; and
• the increasing awareness and use of non-invasive devices for prevention, treatment and rehabilitation purposes.
These demographics and trends are beyond our control. The projected demand for our products could materially differ from actual demand if our assumptions regarding these factors prove to be incorrect or do not materialize or if alternative treatments to those offered by our products gain widespread acceptance.
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Our business, operating results and financial condition could be adversely affected if we become involved in litigation regarding our patents or other intellectual property rights.
The orthopedic products industry has experienced extensive litigation regarding patents and other intellectual property rights. We or our products may become subject to patent infringement claims or litigation or interference proceedings declared by the U.S. Patent and Trademark Office, or USPTO, or the foreign equivalents thereto to determine the priority of inventions. The defense and prosecution of intellectual property suits, USPTO interference proceedings or the foreign equivalents thereto and related legal and administrative proceedings are both costly and time consuming. An adverse determination in litigation or interference proceedings to which we may become a party could:
• subject us to significant liabilities to third-parties;
• require disputed rights to be licensed from a third-party for royalties that may be substantial; or
• require us to cease using such technology.
Any one of these outcomes could have an adverse effect on us. Furthermore, we may not be able to obtain necessary licenses on satisfactory terms, if at all. Accordingly, adverse determinations in a judicial or administrative proceeding or our failure to obtain necessary licenses could prevent us from manufacturing and selling our products, which would have a material adverse effect on our business, operating results and financial condition. Moreover, even if we are successful in such litigation, the expense of defending such claims could be material.
In addition, we have from time to time needed to, and may in the future need to, litigate to enforce our patents, to protect our trade secrets or know-how or to determine the enforceability, scope and validity of the proprietary rights of others. Such enforcement of our intellectual property rights could involve counterclaims against us. Any future litigation or interference proceedings will result in substantial expense to us and significant diversion of effort by our technical and management personnel.
We have limited suppliers for some of our components and products which makes us susceptible to supply shortages and could disrupt our operations.
Some of our important suppliers are in China and other parts of Asia and provide us predominately finished soft goods products. In fiscal year 2005, we obtained approximately 10% of our total purchased materials from suppliers in China and other parts of Asia. Political and economic instability and changes in government regulations in these areas could affect our ability to continue to receive materials from our suppliers there. The loss of our suppliers in China and other parts of Asia, any other interruption or delay in the supply of our required materials or our inability to obtain these materials at acceptable prices and within a reasonable amount of time could impair our ability to meet scheduled product deliveries to our customers and could hurt our reputation and cause customers to cancel orders.
In addition, we purchase the microprocessor used in the OL1000â and SpinaLogic devices from a single manufacturer. Although there are feasible alternate microprocessors that might be used immediately, all are produced by a single supplier. In addition, there are single suppliers for other components used in the OL1000 and SpinaLogic devices and only two suppliers for the magnetic field sensor employed in them. Establishment of additional or replacement suppliers for these components cannot be accomplished quickly.
Our international sales and profitability may be adversely affected by foreign currency exchange fluctuations and other risks.
We sell products in foreign currency through our foreign subsidiaries. The U.S. dollar equivalent of international sales denominated in foreign currencies in fiscal years 2005, 2004 and 2003 were favorably impacted by foreign currency exchange rate fluctuations with the weakening of the U.S. dollar against the foreign currencies of our subsidiaries. The U.S. dollar equivalent of the related costs denominated in these foreign currencies was unfavorably impacted during the same periods. In addition, the costs associated with our Mexico-based manufacturing operations are incurred in Mexican pesos. As we continue to distribute and manufacture our products in selected foreign countries, we expect that future sales and costs associated with our activities in these markets will continue to be denominated in the applicable foreign currencies, which could cause currency fluctuations to materially impact our operating results.
We are also subject to other risks inherent in international operations such as political and economic conditions, foreign regulatory requirements, exposure to different legal requirements and standards, exposure to different approaches to treating injuries, potential difficulties in protecting intellectual property, import and export restrictions, increased costs of transportation or
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shipping, currency fluctuations, difficulties in staffing and managing international operations, labor disputes, difficulties in collecting accounts receivable and longer collection periods and potentially adverse tax consequences. For example, in Germany, our largest foreign market, orthopedic professionals began re-using our bracing devices on multiple patients during 2004, which adversely impacted our sales of these devices in this market in 2004. As we continue to expand our international business, our success will be dependent, in part, on our ability to anticipate and effectively manage these and other risks. If we are unable to do so, these and other factors may have an adverse effect on our international operations.
The direct distribution of our products in selected foreign countries involves financial and operational risks.
We have implemented a strategy to selectively replace our third-party international distributors with wholly-owned distributorships. In 2002, we began to distribute our products in Germany/Austria, the United Kingdom and Canada through wholly-owned subsidiaries. We established a wholly-owned distributorship in France in September 2003 and one in the Nordic countries in August 2004. The creation of direct distribution capabilities in foreign markets requires additional financial and operational controls. We cannot assure you that we will be able to successfully maintain organizational controls in our foreign operations or that our international strategy will result in increased revenues or profitability.
Our concentration on manufacturing operations in North America may cause our products to be less competitive in international markets.
Other than a relatively small manufacturing operation in Tunisia acquired in the recent Newmed acquisition, we have no manufacturing operations in any foreign country other than Mexico. For our international sales to third-party distributors, the cost of transporting our products to foreign countries is currently borne by our third-party distributors who are also often required to pay foreign import duties on our products. As a result, the cost of our products to our third-party distributors is often greater than products manufactured by our competitors in that country. In addition, foreign manufacturers of competitive products may receive various local tax concessions that lower their overall manufacturing costs. In order to compete successfully in international markets, we may be required to open or expand manufacturing operations abroad, which would be costly to implement and would increase our exposure to the risks of doing business in foreign countries. We may not be able to successfully operate offshore manufacturing operations.
Product liability claims may harm our business if our insurance proves inadequate or the number of claims increases significantly.
We face an inherent business risk of exposure to product liability claims in the event that the use of our technology or products is alleged to have resulted in adverse effects. We have, from time to time, been subject to product liability claims. In addition, we have operated a Knee Guarantee program since 2001 in relation to our Defiance knee brace. The Knee Guarantee program will, in specified instances, cover a patient’s insurance deductible up to $1,000, or give uninsured patients $1,000, towards surgery should an ACL re-injury occur while wearing the brace. In 2003, the Technology You Can Trust program was introduced in connection with our BGS products. If a patient has a nonunion fracture that fails to heal while using a BGS product, the Technology You Can Trust program will, if the patient meets the specified requirements of the program, refund the costs for treatment using the BGS product. If there is a significant increase in claims under these programs, our business could be adversely affected.
We maintain product liability insurance with coverage of an annual aggregate maximum of $20 million. The policy is provided on a claims made basis and is subject to annual renewal. There can be no assurance that liability claims will not exceed the coverage limit of such policy or that such insurance will continue to be available on commercially reasonable terms or at all. If we do not or cannot maintain sufficient liability insurance, our ability to market our products may be significantly impaired.
We may be adversely affected if we lose the services of any member of our senior management team.
We are dependent on the continued services of our senior management team, who have made significant contributions to our growth and success. Leslie H. Cross, our President and Chief Executive Officer, for example, has worked for us for 16 years and helped lead our 1999 recapitalization and transition from ownership by Smith & Nephew to a stand-alone company. The loss of any one or more members of our senior management team could have a material adverse effect on us.
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Any claims relating to our improper handling, storage or disposal of wastes could be time consuming and costly.
Our facilities and operations are subject to federal, state and local environmental and occupational health and safety requirements of the United States and foreign countries, including those relating to discharges of substances to the air, water, and land, the handling, storage and disposal of wastes and the cleanup of properties affected by pollutants. In the future, federal, state, local or foreign governments could enact new or more stringent laws or issue new or more stringent regulations concerning environmental and worker health and safety matters that could affect our operations. Also, contamination may be found to exist at our current, former or future facilities, including the facility in Tempe, Arizona that we occupied following the Regeneration acquisition, or off-site locations where we have sent wastes. We could be held liable for such contamination, which could have a material adverse effect on our business or financial condition. In addition, changes in environmental and worker health and safety requirements or liabilities from newly discovered contamination could have a material effect on our business or financial condition.
If a natural or man-made disaster strikes our manufacturing facilities, we will be unable to manufacture our products for a substantial amount of time and our sales will decline.
Nearly all of our rehabilitation products are manufactured in our new facility in Tijuana, Mexico, with a number of products for the European market manufactured in our recently-acquired Tunisian facility. The products that are still manufactured in Vista, California consist of our custom rigid bracing products, which remain in the U.S. to facilitate quick turn-around on custom orders and the Regeneration product line. These facilities and the manufacturing equipment we use to produce our products would be difficult to repair or replace. Our facilities may be affected by natural or man-made disasters. If one of our facilities were affected by a disaster, we would be forced to rely on third-party manufacturers or shift production to another manufacturing facility. In addition, our insurance may not be sufficient to cover all of our potential losses and may not continue to be available to us on acceptable terms, or at all.
Because we have various mechanisms in place to discourage takeover attempts, a change in control of our company that a stockholder may consider favorable could be prevented.
Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a change in control of our company that a stockholder may consider favorable. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors and take other corporate actions. These provisions include:
• authorizing the issuance of “blank check” preferred stock by our board of directors to increase the number of outstanding shares and thwart a takeover attempt;
• a classified board of directors with staggered, three-year terms, which may lengthen the time required to gain control of the board of directors;
• prohibiting cumulative voting in the election of directors, which would otherwise allow less than a majority of stockholders to elect director candidates;
• requiring supermajority voting to effect particular amendments to our certificate of incorporation and bylaws;
• limitations on who may call special meetings of stockholders;
• prohibiting stockholder action by written consent, thereby requiring all actions to be taken at a meeting of the stockholders; and
• establishing advance notice requirements for the nomination of candidates for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.
In addition, Section 203 of the Delaware General Corporation Law prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally defined as a person that together with its affiliates owns or within the last three years has owned 15% of the corporation’s voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Section 203 may discourage, delay or prevent a change in control of our company.
As a result, these provisions could limit the price that investors are willing to pay in the future for shares of our common stock.
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Risks Related to Government Regulation
Our failure to comply with regulatory requirements or receive regulatory clearance or approval for our products or operations in the United States or abroad would adversely affect our revenues and potential for future growth.
Our products are medical devices that are subject to extensive regulation in the United States by the Food and Drug Administration, or FDA, and by respective authorities in foreign countries where we do business. The FDA regulates virtually all aspects of a medical device’s design and testing, manufacture, safety, labeling, storage, recordkeeping, reporting, clearance and approval, promotion and distribution. The FDA also regulates the export of medical devices to foreign countries. Failure to comply with the regulatory requirements of the FDA and other applicable U.S. regulatory requirements may subject a company to administrative or judicially imposed sanctions ranging from warning letters to criminal penalties or product withdrawal. Unless an exemption applies, a medical device must receive either clearance or premarket approval from the FDA before it can be marketed in the United States. The FDA’s 510(k) clearance process for Class II devices usually takes from three to twelve months, but may take significantly longer. The premarket approval process for Class III devices generally takes from one to three years from the time the application is filed with the FDA, but also can be significantly longer. Premarket approval typically requires extensive clinical data and can be significantly longer, more expensive and more uncertain than the 510(k) clearance process. Despite the time, effort and expense expended, there can be no assurance that a particular device will be approved or cleared by the FDA through either the 510(k) clearance process or the premarket approval process.
Medical devices may only be marketed for the indications for which they are approved or cleared. We may be required to obtain additional new premarket approvals, premarket approval supplements or 510(k) clearances to market additional products or for new indications for or modifications to our existing products. We cannot be certain that we would obtain additional premarket approvals or 510(k) clearances in a timely manner or at all. We have modified various aspects of our devices in the past and we determined that new approvals, supplements or clearances either were not required. The FDA may not agree with our decisions not to seek approvals, supplements or clearances for particular device modifications. If the FDA requires us to obtain premarket approvals, supplement approvals or 510(k) clearances for any modification to a previously cleared or approved device, we may be required to cease manufacturing and marketing the modified device or to recall such modified device until we obtain FDA clearance or approval and we may be subject to significant regulatory fines or penalties. In addition, there can be no assurance that the FDA will clear or approve such submissions in a timely manner, if at all.
Our failure to obtain FDA clearance or approvals of new products, new indications or product modifications that we develop in the future, any limitations imposed by the FDA on such products’ development or use, or the costs of obtaining FDA clearance or approvals could have a material adverse effect on our business.
In many of the foreign countries in which we market our products, we are subject to extensive regulations essentially the same as those of the FDA, including those in Germany, our largest foreign market. The regulation of our products in Europe falls primarily within the European Economic Area, which consists of the fifteen member states of the European Union, as well as Iceland, Liechtenstein and Norway. The Council of the European Union (formerly the Council of the European Communities) and the Council of the European Parliament have adopted three directives in order to harmonize national provisions regulating the design, manufacture, clinical trials, labeling and adverse event reporting for medical devices to ensure that medical devices marketed are safe and effective for their intended uses. The member states of the European Economic Area have implemented the directives into their respective national law. Medical devices that comply with the conformity requirements of the national provisions and the directives will be entitled to bear a CE marking. Unless an exemption applies, only medical devices which bear a CE marking may be marketed within the European Economic Area. Switzerland also allows the marketing of medical devices that bear a CE marking. Due to the movement towards harmonization of standards in the European Union and the expansion of the European Union, we expect a changing regulatory environment in Europe characterized by a shift from a country-by-country regulatory system to a European Union-wide single regulatory system. Failure to receive, or delays in the receipt of, relevant foreign qualifications, such as the CE marking, could have a material adverse effect on our international operations.
Our products are subject to recalls even after receiving FDA clearance or approval, or after receiving CE-markings, which would harm our reputation and business.
We are subject to medical device reporting regulations that require us to report to the FDA or governmental authorities in other countries if our products cause or contribute to a death or serious injury or malfunction in a way that would be reasonably likely to contribute to death or serious injury if the malfunction were to recur. The FDA and similar governmental authorities in other countries have the authority to require the recall of our products in the event of material deficiencies or defects in design or manufacturing, and we have been subject to product recalls in the past. A government mandated, or voluntary, recall by us could occur as a result of component failures, manufacturing errors or design defects, including defects in labeling. Any recall would
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divert managerial and financial resources and could harm our reputation with customers. There can be no assurance that there will not be product recalls in the future or that such recalls would not have a material adverse effect on our business.
If we fail to comply with the FDA’s Quality System Regulation, our manufacturing could be delayed, and our product sales and profitability could suffer.
Our manufacturing processes are required to comply with the FDA’s Quality System Regulation, which covers the procedures concerning (and documentation of) the design, testing, production processes, controls, quality assurance, labeling, packaging, storage and shipping of our devices. We also are subject to state requirements and licenses applicable to manufacturers of medical devices. In addition, we must engage in extensive recordkeeping and reporting and must make available our manufacturing facilities and records for periodic unscheduled inspections by governmental agencies, including the FDA, state authorities and comparable agencies in other countries. Moreover, failure to pass a Quality System Regulation inspection or to comply with these and other applicable regulatory requirements could result in disruption of our operations and manufacturing delays. Failure to take adequate corrective action could result in, among other things, significant fines, suspension of approvals, seizures or recalls of products, operating restrictions and criminal prosecutions. We have previously received warning letters and untitled letters from the FDA regarding regulatory non-compliance. We cannot assure you that the FDA or other governmental authorities would agree with our interpretation of applicable regulatory requirements or that we have in all instances fully complied with all applicable requirements. Any failure to comply with applicable requirements could adversely affect our product sales and profitability.
Changes in U.S. reimbursement policies for our products by third-party payors or reductions in reimbursement rates for our products could adversely affect our business and results of operations.
Our products are sold to healthcare providers and physicians who may receive reimbursement for the cost of our products from private third-party payors and, to a lesser extent, from Medicare, Medicaid and other governmental programs. In certain circumstances, such as for our Regeneration products and the products sold through our OfficeCare program, we submit claims to third-party payors for reimbursement. Our ability to sell our products successfully will depend in part on the purchasing and practice patterns of healthcare providers and physicians, who are influenced by cost containment measures taken by third-party payors. Limitations or reductions in third-party reimbursement for our products can have a material adverse effect on our sales and profitability.
Congress and state legislatures consider reforms in the healthcare industry that may modify reimbursement methodologies and practices, including controls on healthcare spending of the Medicare and Medicaid programs. It is not clear at this time what proposals, if any, will be adopted or, if adopted, what effect the proposals would have on our business. Many private health insurance plans model their coverage and reimbursement policies after Medicare policies. Congressional or regulatory measures that reduce Medicare reimbursement rates could cause private health insurance plans to reduce their reimbursement rates for our products, which could have an adverse effect on our ability to sell our products or cause our orthopedic professional customers to prescribe less expensive products introduced by us and our competitors.
With the passage of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or Modernization Act, a number of changes have been mandated to the Medicare payment methodology and conditions for coverage for our orthotic devices and durable medical equipment, including our bone growth stimulators. These changes include a freeze in reimbursement levels for certain medical devices from 2004 through 2008, competitive bidding requirements, new clinical conditions for payment and quality standards. The changes affect our products generally, although specific products may be affected by some but not all of the Modernization Act’s provisions. Our Class III bone growth stimulator devices, for example, are not affected by the reimbursement level freeze and are not subject to competitive bidding. Off-the-shelf orthotic devices are subject to competitive bidding. Under competitive bidding, which is scheduled to be phased in beginning in 2007, Medicare will change its approach to reimbursing certain items and services covered by Medicare from the current fee schedule amount to an amount established through a bidding process between the government and suppliers. Competitive bidding may reduce the number of suppliers providing certain items and services to Medicare beneficiaries and the amounts paid for such items and services. Also, Medicare payments in regions not subject to competitive bidding may be reduced using payment information from regions subject to competitive bidding. Any payment reductions or the inclusion of certain of our orthotic devices in competitive bidding, in addition to the other changes to Medicare reimbursement and standards contained in the Modernization Act, could have a material adverse effect on our results of operations.
In addition, on February 11, 2003, CMS made effective an interim final regulation implementing “inherent reasonableness” authority, which allows adjustments to payment amounts for certain items and services covered by Medicare when the existing payment amount is determined to be grossly excessive or grossly deficient. The regulation lists factors that may be used to determine whether an existing reimbursement rate is grossly excessive or grossly deficient and to determine what is a realistic and equitable payment amount. Also, under the regulation, a payment amount will not be considered grossly excessive or
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grossly deficient if an overall payment adjustment of less than fifteen percent would be necessary to produce a realistic and equitable payment amount. The Modernization Act clarified that the use of inherent reasonableness authority is precluded for devices provided under competitive bidding. CMS finalized the inherent reasonableness regulation in December 2005, with an effective date of February 10, 2006, essentially keeping in place the policies in the interim final regulation. When using the inherent reasonableness authority, CMS may reduce reimbursement levels for certain items and services, which could have a material adverse effect on our results of operations.
We cannot assure you that third-party reimbursement for our products will continue to be available or at what rate such products will be reimbursed. Failure by users of our products to obtain sufficient reimbursement from third-party payors for our products or adverse changes in governmental and private payors’ policies toward reimbursement for our products could have a material adverse effect on our results of operations.
Changes in international regulations regarding reimbursement for our products could adversely affect our business and results of operations.
Similar to our domestic business, our success in international markets also depends upon the eligibility of our products for reimbursement through government sponsored healthcare payment systems and third-party payors, the portion of cost subject to reimbursement, and the cost allocation between the patient and government sponsored healthcare payment systems and third-party payors. Reimbursement practices vary significantly by country, with certain countries requiring products to undergo a lengthy regulatory review in order to be eligible for third-party reimbursement. In addition, healthcare cost containment efforts similar to those we face in the United States are prevalent in many of the foreign countries in which our products are sold, and these efforts are expected to continue in the future, possibly resulting in the adoption of more stringent standards. Any developments in our foreign markets that eliminate or reduce reimbursement rates for our products could have an adverse effect on our ability to sell our products or cause our orthopedic professional customers to use less expensive products in these markets.
Medicare laws mandating new supplier quality standards and conditions for coverage could adversely impact our business.
Medicare regulations require entities or individuals submitting claims and receiving payment to obtain a supplier number, which in turn is predicated on compliance with a number of supplier standards. Under the Modernization Act, any entity or individual that bills Medicare for durable medical equipment, such as bone growth stimulators, and orthotics and that has a supplier number for submission of such bills will be subject to new quality standards as a condition of receiving payment from the Medicare program. In September 2005, CMS published draft supplier quality standards. The draft standards consist of business-related standards, such as financial and human resources management standards, which would be applicable to all durable medical equipment, orthotics and prosthetics suppliers, and product-specific standards, such as those for customized orthotics products, which focus on product specialization and service standards for such items. CMS has stated that it expects to release the final supplier quality standards in Spring 2006. The Modernization Act also authorizes CMS to establish clinical conditions for payment for durable medical equipment. These new supplier quality standards and clinical conditions for payment could affect our ability to bill Medicare, limit or reduce the number of individuals who can fit, sell or provide our products and could restrict coverage for our products.
Healthcare reform, managed care and buying groups have put downward pressure on the prices of our products.
The development of managed care programs in which the providers contract to provide comprehensive healthcare to a patient population at a fixed cost per person (referred to as capitation) has put pressure on, and is expected to continue to cause, healthcare providers to lower costs. One result has been, and is expected to continue to be, a shift toward lower priced products, and any such shift in our product mix to lower margin, off-the-shelf products could have an adverse impact on our operating results. For example, in our rigid knee-bracing segment, we and many of our competitors are offering lower priced, off-the-shelf products in response to managed care customers.
A further result of managed care and the related pressure on costs has been the advent of buying groups in the United States. Such buying groups enter into preferred supplier arrangements with one or more manufacturers of orthopedic or other medical products in return for price discounts. The extent to which such buying groups are able to obtain compliance by their members with such preferred supplier agreements varies considerably depending on the particular buying groups. In response to the organization of new buying groups, we have entered into national contracts with selected groups and believe that the high levels of product sales to such groups and the opportunity for increased market share have the potential to offset the financial impact of discounting. We believe that our ability to maintain our existing arrangements will be important to our future success and the growth of our revenues. In addition, we may not be able to obtain new preferred supplier commitments for major buying groups, in which case we could lose significant potential sales, to the extent these groups are able to command a high level of compliance by their members. On the other hand, if we receive preferred supplier commitments from particular groups which do
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not deliver high levels of compliance, we may not be able to offset the negative impact of lower per unit prices or lower margins with any increases in unit sales or in market share.
In international markets, we have experienced downward pressure on product pricing and other effects of healthcare reform similar to that which we have experienced in the United States. We expect healthcare reform and managed care to continue to develop in our primary international markets, which we expect will result in further downward pressure in product pricing. The timing and effects on us of healthcare reform and the development of managed care in international markets cannot currently be predicted.
Proposed laws that would limit the types of orthopedic professionals who can fit, sell or seek reimbursement for our products could, if adopted, adversely affect our business.
In response to pressure from mostly orthopedic practitioners, Congress and state legislatures have from time to time considered proposals that limit the types of orthopedic professionals who can fit or sell our orthotic device products or who can seek reimbursement for them. Several states have adopted legislation which imposes certification or licensing requirements on the measuring, fitting and adjusting of certain orthotic devices. Some of these laws have exemptions for manufacturers’ representatives. Other laws apply to the activities of such representatives. Other states may be considering similar legislation. Such laws could limit our potential customers in those jurisdictions in which such legislation or regulations are enacted by limiting the measuring and fitting of these devices to certain licensed individuals. We may not be successful in opposing their adoption and, therefore, such laws could have a material adverse effect on our business. In addition, efforts have been made to establish such requirements at the federal level for the Medicare program. For example, in 2000 Congress passed the Medicare, Medicaid, and SCHIP Benefits Improvement and Protection Act of 2000 (BIPA). BIPA contained a provision requiring as a condition for payment by the Medicare program that certain certification or licensing requirements be met for individuals and suppliers furnishing certain, but not all, custom-fabricated orthotic devices. CMS has not implemented this requirement. We cannot predict the effect of implementation of BIPA or implementation of other such laws will have on our business.
We may need to change our business practices to comply with healthcare fraud and abuse laws and regulations.
We are subject to various federal and state laws pertaining to healthcare fraud and abuse, including anti-kickback laws and physician self-referral laws. Violations of these laws are punishable by criminal and civil sanctions, including, in some instances, imprisonment and exclusion from participation in federal and state healthcare programs, including Medicare, Medicaid, Veterans Administration health programs and TRICARE. Because of the far-reaching nature of these laws, we may be required to alter one or more of our practices. Healthcare fraud and abuse regulations are complex and even minor, inadvertent irregularities in submissions can potentially give rise to claims that a fraud and abuse law or regulation has been violated. Any violations of these laws or regulations could result in a material adverse effect on our business, financial condition and results of operations. If there is a change in law, regulation or administrative or judicial interpretations, we may have to change our business practices or our existing business practices could be challenged as unlawful.
Audits or denials of our claims by government agencies could reduce our revenue or profits.
As part of our business structure, we submit claims directly to and receive payments directly from the Medicare and Medicaid programs. Therefore, we are subject to extensive government regulation, including requirements for maintaining certain documentation to support our claims. Medicare contractors and Medicaid agencies periodically conduct pre- and post-payment review and other audits of claims, and are under increasing pressure to scrutinize more closely healthcare claims and supporting documentation generally. We periodically receive requests for documentation during the governmental audits of individual claims either on a pre-payment or post-payment basis. We cannot assure you that review and/or other audits of our claims will not result in material delays in payment, as well as material recoupments or denials, which could reduce our revenue or profits.
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Risks Related to our Debt
Our debt agreements contain operating and financial restrictions, which restrict our business and financing activities.
The operating and financial restrictions and covenants in our credit agreement and any future financing agreements may adversely affect our ability to finance future operations, meet our capital needs or engage in our business activities. Currently, our existing credit agreement restricts our ability to:
• incur additional indebtedness;
• issue redeemable equity interests and preferred equity interests;
• pay dividends or make distributions, repurchase equity interests or make other restricted payments;
• redeem subordinated indebtedness;
• create liens;
• enter into certain transactions with affiliates;
• make investments;
• sell assets; or
• enter into mergers or consolidations.
With respect to mergers or acquisitions, our credit agreement limits our ability to finance acquisitions through additional borrowings. In addition, our credit agreement prohibits us from acquiring assets or the equity of another company unless:
• we are not in default under the credit agreement;
• after giving pro forma effect to the transaction, we remain in compliance with the financial covenants contained in the credit agreement;
• if the acquisition price is greater than $10 million, the company we are acquiring has positive EBITDA;
• the acquisition price is less than $50 million individually and less than $75 million in the aggregate with all other permitted acquisitions consummated during the term of the credit agreement; and
• if the acquisition involves assets outside the United States, the acquisition price is less than $25 million in the aggregate with all other permitted acquisitions consummated outside the United States during the term of the agreement.
Restrictions contained in our credit agreement could:
• limit our ability to plan for or react to market conditions or meet capital needs or otherwise restrict our activities or business plans; and
• adversely affect our ability to finance our operations, acquisitions, investments or strategic alliances or other capital needs or to engage in other business activities that would be in our interest.
A breach of any of these covenants, ratios, tests or other restrictions could result in an event of default under the credit agreement. Upon the occurrence of an event of default under the credit agreement, the lenders could elect to declare all amounts outstanding under the credit agreement, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the collateral granted to them to secure such indebtedness. If the lenders under the credit agreement accelerate the payment of the indebtedness, there can be no assurance that our assets would be sufficient to repay in full such indebtedness and our other indebtedness.
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We may not be able to generate sufficient cash to service our indebtedness, which could require us to reduce our expenditures, sell assets, restructure our indebtedness or seek additional equity capital.
We may not have sufficient cash to service our indebtedness. Our ability to satisfy our obligations will depend upon, among other things:
• our future financial and operating performance, which will be affected by prevailing economic conditions and financial, business, regulatory and other factors, many of which are beyond our control; and
• the future availability of borrowings under our revolving credit facility or any successor facility, the availability of which depends or may depend on, among other things, our complying with covenants in the credit agreement.
If we cannot service our indebtedness, we will be forced to take actions such as reducing or delaying acquisitions, investments, strategic alliances and/or capital expenditures, selling assets, restructuring or refinancing our indebtedness, or seeking additional equity capital or bankruptcy protection. We cannot assure you that any of these remedies can be effected on satisfactory terms, if at all. In addition, the terms of existing or future debt agreements may restrict us from adopting any of these alternatives.
Item 1B. Unresolved Staff Comments
We have received no written comments from the Commission staff regarding our periodic or current reports under the Exchange Act of 1934 less than 180 days before the end of our fiscal year ended December 31, 2005 that remain unresolved.
Item 2. Properties
We are headquartered in Vista, California and operate manufacturing locations in Vista, California and Tijuana, Mexico. We are party to a 15-year lease for a 110,000 square foot built-to-suit facility which is under construction in Vista, California, and we intend to consolidate our Vista operations in that facility when completed, which is estimated to be in July 2006. Our manufacturing facilities located in Tijuana, Mexico are less than 100 miles from Vista and consist of a 225,000 square foot built-to-suit factory which we occupied in late 2004. We lease a distribution facility in Indianapolis, Indiana to distribute our products to customers in the Eastern United States. The following table summarizes the largest properties we lease as of December 31, 2005.
Location | | Use (1) | | Owned/Leased | | Lease Termination
Date | | Size (Square Feet) | |
Vista, California | | Corporate Headquarters Research & Development Manufacturing & Distribution | | Leased | | Upon completion of construction of new corporate headquarters (estimated July 2006) | | 266,041 | |
Vista, California | | New Corporate Headquarters Under Construction | | Leased | | 15 years from completion of construction (estimated July 2006) | | 110,000 | |
Tijuana, Mexico | | Manufacturing Facility | | Leased | | September 2014 | | 225,000 | |
Indianapolis, Indiana | | Distribution | | Leased | | April 2010 | | 41,600 | |
Neudrossenfeld, Germany | | Office & Distribution | | Leased | | December 2007 | | 14,300 | |
(1) Our leases in Vista, California serve all of our business segments and our Tijuana, Mexico lease serves our Domestic Rehabilitiation and International segments. The Indianapolis, Indiana distribution center is used only for our Domestic Rehabilitation segment and our German facility is used for our International segment only.
We also lease a total of approximately 20,000 square feet of aggregate warehouse and office space in Tempe, Arizona; Ontario, Canada; Tournes, France; Surrey, United Kingdom; and Horsholm, Denmark. All of our facilities are leased; none are owned.
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In connection with our January 2006 acquisition of Newmed (see Note 13 of the notes to our consolidated financial statements), we also lease additional office, warehouse and manufacturing facilities aggregating 54,000 square feet in France, Spain and Tunisia and we terminated our lease in Tournes, France.
Item 3. Legal Proceedings
From time to time, we are involved in lawsuits arising in the ordinary course of business. This includes patent and other intellectual property disputes between our various competitors and us. With respect to these matters, we believe that we have adequate insurance coverage or have made adequate accruals for related costs, and we may also have effective legal defenses. We are not aware of any pending lawsuits that could have a material adverse effect on our business, financial condition and results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the quarter ended December 31, 2005.
Executive Officers
The following table sets forth information with respect to our executive officers:
Name | | Age | | Position with dj Orthopedics |
| | | | |
Leslie H. Cross | | 55 | | President, Chief Executive Officer and Director |
Vickie L. Capps | | 44 | | Senior Vice President, Finance, Chief Financial Officer and Treasurer |
Luke T. Faulstick | | 42 | | Senior Vice President, Operations |
Louis T. Ruggiero | | 46 | | Senior Vice President, Sales and Marketing |
Donald M. Roberts | | 57 | | Senior Vice President, General Counsel and Secretary |
Leslie H. Cross has been our Chief Executive Officer and President and a member of our board of directors since our incorporation in August 2001. He served as the Chief Executive Officer and a Manager of DonJoy, L.L.C., our predecessor, from June 1999 until November 2001, and has served as President of dj Orthopedics, LLC, our wholly owned operating subsidiary, or its predecessor, the Bracing & Support Systems division of Smith & Nephew, Inc. since June 1995. From 1990 to 1994, Mr. Cross held the position of Senior Vice President of Marketing and Business Development of the Bracing & Support Systems division of Smith & Nephew. He was a Managing Director of two different divisions of Smith & Nephew from 1982 to 1990. Prior to that time, he worked at American Hospital Supply Corporation. Mr. Cross earned a diploma in medical technology from Sydney Technical College in Sydney, Australia and studied business at the University of Cape Town in Cape Town, South Africa.
Vickie L. Capps joined us in July 2002 and serves as our Senior Vice President, Finance, Chief Financial Officer and Treasurer. From September 2001 until July 2002, Ms. Capps was employed by AirFiber, a privately held provider of broadband wireless solutions, where she served as Senior Vice President, Finance and Administration and Chief Financial Officer. From July 1999 to July 2001, Ms. Capps served as Vice President of Finance and Administration and Chief Financial Officer for Maxwell Technologies, Inc., a publicly traded technology company. From 1992 to 1999, Ms. Capps served in various positions, including Chief Financial Officer, with Wavetek Wandel Goltermann, Inc., a multinational communications equipment company. Ms. Capps also served as a senior audit and accounting professional for Ernst & Young LLP from 1982 to 1992. Ms. Capps is a California Certified Public Accountant and received a B.S. degree in business administration/accounting from San Diego State University.
Luke T. Faulstick currently serves as our Senior Vice President, Operations. He joined us as Vice President of Manufacturing in June of 2001. From 1998 to June 2001, Mr. Faulstick served as General Manager for Tyco Healthcare. From 1996 to 1998, Mr. Faulstick served as Plant Manager for Mitsubishi Consumer Electronics. In 1994, he started a contract manufacturing business that supplied products to the medical, electronic and photographic industries. Mr. Faulstick began his career in 1985 working for Eastman Kodak Company in Rochester New York where he held various positions in Engineering, Marketing, and Product Research and Development. He currently serves on the board of directors of Power Partners, Inc., a privately held power transmission manufacturer. Mr. Faulstick received a B.S. in engineering from Michigan State University and an M.S. in engineering from Rochester Institute of Technology.
Louis T. Ruggiero joined us as Senior Vice President, Sales and Marketing in August 2003. Mr. Ruggiero brings more than 20 years of sales experience in medical devices, with more than half of his tenure in management roles. From 2000 to 2003, Mr. Ruggiero served as President and Chief Executive Officer of Titan Scan Technologies, a subsidiary of Titan Corporation, a
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leader in electron beam technology for medical device sterilization, mail sanitization and industrial processes. From 1990 to 2000, Mr. Ruggiero was employed by GE Medical Systems, a global leader in medical diagnostic imaging, healthcare IT, productivity solutions, services and financing. He most recently served as director of corporate alliances. Prior to 1990, Mr. Ruggiero was employed by Davol, Inc., a division of C.R. Bard, Inc., where he served as sales manager in the northeast district. He has also held field sales positions with American V. Mueller, a division of American Hospital Supply, and Proctor & Gamble. Mr. Ruggiero received his undergraduate degree in interpersonal communication/political science from St. John’s University and his M.B.A. from the J.L. Kellogg School of Management, Northwestern University.
Donald M. Roberts joined us in December 2002 and currently serves as Senior Vice President, General Counsel and Secretary. From 1994 to December 2002, Mr. Roberts served as Vice President, Secretary and General Counsel for Maxwell Technologies, Inc., a publicly held technology company. Previous to that, he was with the Los Angeles-based law firm of Parker, Milliken, Clark, O’Hara & Samuelian for 21 years. Mr. Roberts was a shareholder in the firm, having served as partner in a predecessor partnership. Mr. Roberts received his undergraduate degree in political science from Yale University and earned his J.D. at the University of California, Berkeley, Boalt Hall School of Law.
PART II
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock is listed on the New York Stock Exchange under the symbol DJO. The following table sets forth, for the calendar quarters indicated, the high and low sales prices per share of our common stock as reported on the New York Stock Exchange:
| | High | | Low | |
Year ended December 31, 2005: | | | | | |
First Quarter | | $ | 26.50 | | $ | 19.84 | |
Second Quarter | | 29.00 | | 24.14 | |
Third Quarter | | 30.43 | | 23.70 | |
Fourth Quarter | | 32.84 | | 25.79 | |
| | | | | |
Year ended December 31, 2004: | | | | | |
First Quarter | | $ | 27.25 | | $ | 17.35 | |
Second Quarter | | 27.60 | | 20.60 | |
Third Quarter | | 24.90 | | 16.59 | |
Fourth Quarter | | 22.50 | | 16.28 | |
As of February 10, 2006, there were approximately 13 stockholders of record of our common stock.
We have not declared or paid any cash dividends since our inception. We currently intend to retain our future earnings, if any, to finance the further expansion and continued growth of our business. In addition, our ability to pay cash dividends on our common stock is currently restricted under the terms of our credit agreement. Future dividends, if any, will be determined by our board of directors.
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Item 6. Selected Financial Data
The selected financial data set forth below with respect to our consolidated financial statements has been derived from our audited financial statements. The data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited financial statements and Notes thereto appearing elsewhere herein.
| | Years Ended December 31, | |
| | 2005 | | 2004 | | 2003 | | 2002 | | 2001 | |
| | (In thousands, except per share data) | |
Statement of Operations Data: | | | | | | | | | | | |
Net revenues | | $ | 286,167 | | $ | 255,999 | | $ | 197,939 | | $ | 182,636 | | $ | 169,170 | |
Costs of goods sold (a) | | 105,289 | | 95,164 | | 85,927 | | 95,878 | | 83,079 | |
Gross profit | | 180,878 | | 160,835 | | 112,012 | | 86,758 | | 86,091 | |
Operating expenses: | | | | | | | | | | | |
Sales and marketing (b) | | 86,241 | | 78,984 | | 54,067 | | 56,216 | | 36,175 | |
General and administrative | | 29,432 | | 27,727 | | 21,767 | | 26,414 | | 25,042 | |
Research and development | | 6,350 | | 5,627 | | 4,442 | | 2,922 | | 2,285 | |
Amortization of acquired intangibles | | 4,996 | | 4,731 | | 464 | | — | | — | |
Impairment of long-lived assets (c) | | — | | — | | — | | 3,666 | | — | |
Performance improvement, restructuring and other costs (d) | | — | | 4,693 | | (497 | ) | 10,008 | | — | |
Total operating expenses | | 127,019 | | 121,762 | | 80,243 | | 99,226 | | 63,502 | |
Income (loss) from operations | | 53,859 | | 39,073 | | 31,769 | | (12,468 | ) | 22,589 | |
Prepayment premium and other costs related to senior subordinated notes redemption (e) | | — | | (7,760 | ) | — | | — | | (4,669 | ) |
Interest expense and other, net | | (5,398 | ) | (8,276 | ) | (11,718 | ) | (12,088 | ) | (17,388 | ) |
Income (loss) before income taxes | | 48,461 | | 23,037 | | 20,051 | | (24,556 | ) | 532 | |
Benefit (provision) for income taxes (f) | | (19,263 | ) | (9,022 | ) | (7,980 | ) | 9,361 | | 55,958 | |
Net income (loss) | | 29,198 | | 14,015 | | 12,071 | | (15,195 | ) | 56,490 | |
Less: Preferred unit dividends and accretion of preferred unit fees | | — | | — | | — | | — | | (5,667 | ) |
Net income (loss) available to common stockholders | | $ | 29,198 | | $ | 14,015 | | $ | 12,071 | | $ | (15,195 | ) | $ | 50,823 | |
| | | | | | | | | | | |
Net income (loss) per share available to common stockholders: | | | | | | | | | | | |
Basic | | $ | 1.34 | | $ | 0.66 | | $ | 0.67 | | $ | (0.85 | ) | $ | 4.80 | |
Diluted | | $ | 1.29 | | $ | 0.63 | | $ | 0.64 | | $ | (0.85 | ) | $ | 4.68 | |
Weighted average shares outstanding: | | | | | | | | | | | |
Basic | | 21,786 | | 21,221 | | 17,963 | | 17,873 | | 10,593 | |
Diluted | | 22,699 | | 22,209 | | 18,791 | | 17,873 | | 10,858 | |
Balance Sheet Data (at end of period): | | | | | | | | | | | |
Cash | | $ | 1,107 | | $ | 11,182 | | $ | 19,146 | | $ | 32,085 | | $ | 25,814 | |
Total assets | | 304,664 | | 306,850 | | 320,504 | | 237,724 | | 247,922 | |
Long-term obligations | | 47,500 | | 95,000 | | 174,156 | | 109,816 | | 110,934 | |
Total stockholders’ equity | | 226,069 | | 183,038 | | 117,333 | | 100,913 | | 115,240 | |
(a) The year ended December 31, 2002 included aggregate charges of $5.1 million to provide reserves for excess inventories, substantially related to product lines that we discontinued in connection with our 2002 performance improvement program.
(b) The year ended December 31, 2002 included an aggregate increase of $6.7 million in our estimated reserves for contractual allowances and bad debts related to our accounts receivable from third-party payor customers.
(c) The year ended December 31, 2002 included $3.7 million in charges related to impairment of certain of our long-lived assets.
(d) The year ended December 31, 2004 includes $4.7 million in restructuring charges related to the integration of our Regeneration business and the relocation of certain manufacturing operations to Mexico (see Note 4 of the notes to our consolidated financial statements). The year ended December 31, 2002 includes $10.0 million in charges related to our 2002
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performance improvement program, including an accrual for estimated future net rent for vacated facilities. In 2003, we decided to retain the vacant space for future expansion and reversed the remaining accrual of $0.5 million.
(e) The year ended December 31, 2004 includes charges aggregating $7.8 million related to the redemption of all of our outstanding senior subordinated notes in June 2004. The $7.8 million charge includes a prepayment premium and unamortized debt issuance costs and original issue discounts. The year ended December 31, 2001 included a charge of approximately $4.7 million for the write-off of unamortized deferred debt issuance costs, debt discount and a prepayment premium incurred as a result of an early redemption of a portion of our senior subordinated notes.
(f) We recorded a tax benefit (provision) at an effective tax rate of 39.8%, 39.2%, 39.8% and (38.1%) on our income (loss) before income taxes for the years ended December 31, 2005, 2004, 2003 and 2002, respectively, and at an effective tax rate of 40% on our income before income taxes for the period from November 20, 2001, the date of our reorganization, to December 31, 2001. Because DonJoy, L.L.C. operated as a limited liability company from the date of its recapitalization in June 1999 through November 20, 2001, the date on which the reorganization was consummated, in accordance with federal, state and local income tax regulations that provide that no income taxes are levied on U.S. limited liability companies as each member of the LLC is individually responsible for reporting the member’s share of net income or loss, we did not provide for income taxes in our historical consolidated financial statements prior to the reorganization. In connection with the reorganization, we recorded a deferred tax benefit of $54.2 million related to the difference between the book and the tax bases of certain assets and liabilities of DonJoy at November 20, 2001.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
We are a global medical device company specializing in rehabilitation and regeneration products for the non-operative orthopedic and spine markets. Marketed under the DonJoy and ProCare brands, our broad range of over 600 rehabilitation products, including rigid knee braces, soft goods, and pain management products, are used to prevent injury, to treat chronic conditions and to aid in recovery after surgery or injury. Our regeneration products consist of bone growth stimulation devices that are used to treat nonunion fractures and as an adjunct therapy after spinal fusion surgery. We sell our products in the United States and in more than 50 other countries through networks of agents, distributors and our direct sales force that market our products to orthopedic and spine surgeons, podiatrists, orthopedic and prosthetic centers, third-party distributors, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals.
Acquisitions and Other Recent Transactions
On August 8, 2005, we completed the purchase of substantially all of the assets of the orthopedics soft goods (OSG) business of Encore Medical, L.P. (OSG acquisition) for approximately $9.5 million, paid in cash upon closing, plus the assumption of certain liabilities aggregating approximately $0.6 million. The OSG business is comprised of the manufacture and sale of orthopedic soft goods, patient safety products and pressure care products. The OSG acquisition was accounted for using the purchase method of accounting whereby the total purchase price was allocated to tangible and intangible assets acquired based on estimated fair market values with the remainder classified as goodwill. We acquired the OSG business to expand our portfolio of national contracts and increase our related revenues and also to gain access to the patient safety products and pressure care products, which were not previously included in our product portfolio.
On March 10, 2005, we completed the purchase of substantially all of the assets of Superior Medical Equipment, LLC (SME), a Connecticut based distributor of orthopedic products and supplies, for an aggregate purchase price of up to $4.2 million, of which approximately $3.1 million was paid upon closing, $0.1 million was paid as a final purchase price adjustment in April 2005 and $0.5 million will be paid in March 2006. The remaining amount of up to $0.5 million will be paid in March 2006 subject to achievement of certain operating targets. The assets acquired from SME included tangible and intangible assets related to the distribution of orthopedic products and supplies. The SME acquisition was accounted for using the purchase method of accounting whereby the total purchase price was allocated to tangible and intangible assets acquired based on estimated fair market values with the remainder classified as goodwill.
In August 2004, we completed construction of a new 200,000 square foot leased facility in Tijuana, Mexico, to replace three separate facilities we operated in the same area and to provide further opportunities to expand our Mexico manufacturing operations. In late 2004, we moved all of our existing Mexico operations to this new facility and we completed the relocation of the manufacturing of our cold therapy products and machine shop activities from Vista, California to the new Mexico plant. We recorded restructuring charges of $0.9 million ($0.5 million net of tax) in 2004 related to these manufacturing moves, including primarily severance and moving costs.
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On November 26, 2003, we acquired the bone growth stimulation device business from OrthoLogic, which we now call our Regeneration business. Following the Regeneration acquisition in November 2003, we operated the Regeneration business as a stand alone division in Tempe, Arizona with a sales force separate from our domestic rehabilitation product sales force. In August 2004, we began the integration of the former Regeneration sales force into our domestic rehabilitation sales organization, and we took the first steps towards integrating most of the other Regeneration operations into our corporate facility in Vista, California. By the end of 2004, we completed the integration of most of the Regeneration operations except for the assembly and calibration operations which we expect to move to Vista in the first quarter of 2005 following site approval of the U.S. Food and Drug Administration. One of the principal objectives of the integration was to enhance the sales and distribution activities of the Regeneration business to capture more of the growth opportunities in the regeneration market. In addition, we believed the integration would enable us to reduce both costs of goods sold and operating expenses as a percentage of net revenues in future periods, after the related costs of the integration had been incurred. The accompanying consolidated statement of income for the year ended December 31, 2004 includes restructuring charges related to the integration totaling approximately $3.8 million ($2.4 million net of tax). The costs of the integration were primarily severance, recruiting and training.
On January 2, 2006, we completed the acquisition, under an agreement originally signed on December 15, 2005, of the shares of Newmed SAS (Newmed) for cash payments aggregating 13 million Euros (approximately $15.4 million), which included payment of certain debts of Newmed. Certain sellers may also receive up to an additional 1 million Euros (approximately $1.2 million) based on achievement of certain revenue targets for 2006. We also incurred certain transaction costs and other expenses in connection with the acquisition that are estimated to be approximately $0.4 million. Newmed, through wholly-owned subsidiaries in France and Spain, operating under the trade name Axmed, is engaged in the design, manufacture and sale of orthopedic rehabilitation devices including rigid knee braces and soft goods. Newmed also owns 70% of a manufacturing subsidiary in Tunisia, which provides low cost manufacturing capabilities to the Axmed group. The Newmed acquisition will be accounted for in the first quarter of 2006 using the purchase method of accounting whereby the total purchase price, including transaction expenses, will be allocated to tangible and intangible assets acquired based on estimated fair market values, with the remainder classified as goodwill. We acquired Newmed to increase our revenue and improve our market share in France and Spain. We funded the cash paid on January 2, 2006 and our transaction expenses, with the proceeds of a $16.0 million draw on our revolving line of credit.
Segments
Prior to 2005, we disclosed the following reportable segments, which, except for Regeneration, were based on our sales channels: DonJoy, ProCare, OfficeCare, Regeneration and International. Effective 2005, we have aggregated the DonJoy, ProCare and OfficeCare segments into one new segment, Domestic Rehabilitation. In accordance with the aggregation criteria in SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, the historical segments have been aggregated due to changes in our management and compensation structure that focus on the results of Domestic Rehabilitation, taken as a whole, rather than on its separate components. The segment data for all prior periods have been restated (aggregated) to conform to the new segmentation. The following are our current reportable segments.
• Domestic Rehabilitation consists of the sale of our rehabilitation products (rigid knee braces, soft goods and pain management products) in the United States through three sales channels, DonJoy, ProCare and OfficeCare.
Through the DonJoy sales channel, we sell our rehabilitation products utilizing a few of our direct sales representatives and a network of approximately 300 independent commissioned sales representatives who are employed by approximately 45 independent sales agents. These sales representatives are primarily dedicated to the sale of our products to orthopedic surgeons, podiatrists, orthopedic and prosthetic centers, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals. Because certain of the DonJoy product lines require customer education on the application and use of the product, our sales representatives are technical specialists who receive extensive training both from us and the agent and use their expertise to help fit the patient with the product and assist the orthopedic professional in choosing the appropriate product to meet the patient’s needs. After a product order is received by a sales representative, we generally ship the product directly to the orthopedic professional and pay a sales commission to the agent. These commissions are reflected in sales and marketing expense in our consolidated statements of income.
Through the ProCare sales channel, which is comprised of approximately 45 direct and independent representatives that manage over 310 dealers focused on primary and acute facilities, we sell our rehabilitation products to national third-party distributors, other regional medical supply dealers and medical product buying groups, generally at a discount from list prices. The majority of these products are soft goods which require little or no patient education. The distributors and dealers generally resell these products to large hospital chains, hospital buying groups, primary care networks and orthopedic physicians for use by the patients.
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Through the OfficeCare sales channel, we maintain an inventory of rehabilitation products (mostly soft goods) on hand at orthopedic practices for immediate distribution to the patient. For these products, we arrange billing to the patient or third-party payor after the product is provided to the patient. As of December 31, 2005, the OfficeCare program was located at over 850 physician offices throughout the United States. We have contracts with over 700 third-party payors.
• Regeneration consists of the sale of our bone growth stimulation products in the United States. Our OL1000 product is sold through a combination of the DonJoy channel direct sales representatives and approximately 120 additional sales representatives dedicated to selling our OL1000 product, of which approximately 60 are employed by us. The SpinaLogic product is also included in this segment and was, until the end of 2004, sold by DePuy Spine in the U.S. under an exclusive sales agreement. In January 2005, we amended the agreement with DePuy to divide the U.S. into territories in which DePuy Spine has exclusive sales rights and non-exclusive territories in which we are permitted to engage in our own sales efforts or retain another sales agent. In early 2006, the agreement was further modified to be non-exclusive in all territories. These products are sold either directly to the patient or to independent distributors. We arrange billing to the third-party payors or patients, for products sold directly to the patient.
• International consists of the sale of our products in foreign countries through wholly-owned subsidiaries or independent distributors. We sell our products in over 50 foreign countries, primarily in Europe, Canada, Australia and Japan.
Set forth below is net revenues, gross profit and operating income information for our reporting segments for the years ended December 31 (in thousands). This information excludes the impact of other expenses not allocated to segments, which are comprised of (i) general corporate expenses for all periods presented and (ii) the restructuring costs associated with the manufacturing moves in 2004. Information for the Regeneration segment includes operations for the period subsequent to the Regeneration acquisition on November 26, 2003 and includes the impact of purchase accounting and related amortization of acquired intangible assets. For the years ended December 31, 2005, 2004 and 2003, Regeneration income from operations was reduced by amortization of acquired intangible assets amounting to $4.6 million, $4.7 million and $0.5 million, respectively. For the year ended December 31, 2005, Domestic Rehabilitation income from operations was reduced by amortization of acquired intangible assets amounting to $0.3 million for 2005 acquisitions. For the year ended December 31, 2004, Regeneration income from operations was also reduced by restructuring charges of $3.8 million related to the integration of the business operations of the segment.
| | 2005 | | 2004 | | 2003 | |
Domestic Rehabilitation: | | | | | | | |
Net revenues | | $ | 197,279 | | $ | 177,481 | | $ | 168,842 | |
Gross profit | | 109,752 | | 100,200 | | 93,791 | |
Gross profit margin | | 55.6 | % | 56.5 | % | 55.5 | % |
Operating income | | 41,878 | | 36,341 | | 35,462 | |
Operating income as a percent of net revenues | | 21.2 | % | 20.5 | % | 21.0 | % |
Regeneration: | | | | | | | |
Net revenues | | $ | 55,474 | | $ | 49,658 | | $ | 3,989 | |
Gross profit | | 49,710 | | 43,032 | | 3,145 | |
Gross profit margin | | 89.6 | % | 86.7 | % | 78.8 | % |
Operating income | | 14,623 | | 7,836 | | 537 | |
Operating income as a percent of net revenues | | 26.4 | % | 15.8 | % | 13.5 | % |
International: | | | | | | | |
Net revenues | | $ | 33,414 | | $ | 28,860 | | $ | 25,108 | |
Gross profit | | 21,416 | | 17,603 | | 15,076 | |
Gross profit margin | | 64.1 | % | 61.0 | % | 60.0 | % |
Operating income | | 8,430 | | 5,398 | | 6,255 | |
Operating income as a percent of net revenues | | 25.2 | % | 18.7 | % | 24.9 | % |
Domestic Sales
Domestic sales, including all sales of our Domestic Rehabilitation and Regeneration segments, accounted for approximately 88%, 89% and 87% of our net revenues in 2005, 2004 and 2003, respectively.
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International
International sales accounted for approximately 12%, 11% and 13% of our net revenues in 2005, 2004 and 2003, respectively. The following table sets forth our international net revenues as a percentage of our total net revenues, by country for the years ended December 31:
| | 2005 | | 2004 | | 2003 | |
| | | | | | | |
Germany | | 3.9 | % | 4.3 | % | 5.2 | % |
Canada | | 2.0 | | 1.9 | | 2.1 | |
United Kingdom | | 1.2 | | 1.0 | | 0.9 | |
Japan | | 0.7 | | 0.7 | | 1.1 | |
Other countries | | 3.9 | | 3.4 | | 3.4 | |
Total international sales | | 11.7 | % | 11.3 | % | 12.7 | % |
The “Other countries” category consists primarily of sales in France, Denmark, Belgium, Italy, Australia and the Czech Republic.
International sales are made primarily through two distinct channels: independent third-party distributors and through our wholly-owned foreign subsidiaries. Through our wholly-owned international subsidiaries, we sell products in Euros, Pounds Sterling, Canadian Dollars and Danish Krones. The U.S. dollar equivalent of our international sales denominated in foreign currencies in 2005, 2004 and 2003 were favorably impacted by foreign currency exchange rate fluctuations with the weakening of the U.S. dollar against the foreign currencies of our subsidiaries. The U.S. dollar equivalent of the related costs denominated in these foreign currencies were unfavorably impacted during the same periods. In addition, the costs associated with our Mexico-based manufacturing operations are incurred in Mexican pesos. As we continue to distribute and manufacture our products in selected foreign countries, we expect that future sales and costs associated with our activities in these markets will continue to be denominated in the applicable foreign currencies, which could cause currency fluctuations to materially impact our operating results. Occasionally we seek to reduce the potential impact of currency fluctuations on our business through hedging transactions. At December 31, 2005, we had no hedging transactions in place.
Our Strategy
Our strategy is to increase revenue and profitability and enhance cash flow by strengthening our market leadership position. Our key initiatives to implement this strategy include:
• Increase our Lead in the Domestic Rehabilitation Market Segment. We believe we are the market leader in the Domestic Rehabilitation markets in which we compete. We believe we will be able to continue to grow our Domestic Rehabilitation business segment and increase our market share further by focusing on growth initiatives related to maintaining a continuous flow of new product introductions and continuing to enhance the productivity of our sales force and optimize our distribution strategy. Our key Domestic Rehabilitation growth strategies include the following:
- Continue to Introduce New Products and Product Enhancements. We have a history of developing and introducing innovative products into the marketplace, and are committed to continuing that tradition by introducing new products across our product platform. In the year ended December 31, 2005, we launched 30 new products. We believe that product innovation through effective and focused research and development will provide a sustainable competitive advantage. We believe we are currently a technology leader in several product categories and we intend to continue to develop next generation technologies.
- Expand Product Offerings for the Spine and for Foot and Ankle. According to Frost & Sullivan, back pain is the number one cause of healthcare expenditure in the United States. As a result, we believe that expanding our product offerings in this market represents a significant growth opportunity. In 2004, we launched a new compression back brace to address the spine market and we intend to add more products to address this market segment. In addition, according to Frost & Sullivan, the ankle braces and supports segment of the Domestic Rehabilitation market is approximately $226 million in 2005 and offers us an opportunity for future growth as our current level of sales in this market segment is relatively low. In 2005, we launched our Velocity Ankle, a new rigid ankle brace. This product has been one of our most successful new products in recent years. We intend to further expand our foot and ankle product offerings. For example, in early 2006, we launched a new foot orthotic to treat subtle cavus foot.
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- Expand Our OfficeCare Channel. Our OfficeCare channel currently includes over 850 physician offices encompassing over 3,400 physicians. We believe that our OfficeCare channel serves a growing need among orthopedic practices to have a number of products readily available for immediate distribution to patients. Expanding our OfficeCare channel also permits us to increase our weighted-average selling prices, as the units sold through this channel are billed to insurance companies and other third-party payors at higher prices than most of our other sales channels. Accordingly, our OfficeCare initiatives represent an opportunity for sales growth based on increases in both unit volume and average selling prices. We intend to expand our OfficeCare channel into more “high-volume” orthopedic offices, thereby increasing the number of potential customers to whom we sell our products. In the year ended December 31, 2005, we added approximately 200 new offices to our OfficeCare channel, net of account terminations, including approximately 45 accounts added through the SME acquisition.
- Maximize Existing and Secure Additional National Accounts. We plan to capitalize on the growing practice in healthcare in which hospitals and other large healthcare providers seek to consolidate their purchasing activities to national buying groups. Contracts with these national accounts represent a significant opportunity for sales growth. We believe that our broad range of products is well suited to the goals of these buying groups and intend to aggressively pursue these contracts. In the year ended December 31, 2005, we signed four new significant national contracts, including a new three-year, multi-source contract with MedAssets Supply Chain Systems for our soft goods products, and we renewed two other significant national contracts. In addition, in connection with the OSG acquisition, we added one new significant national contract and increased our penetration into several other national account opportunities already within our portfolio.
• Grow Our Regeneration Business. We have integrated the sales force for our OL1000 bone growth stimulator product into our domestic rehabilitation sales organization. We have also increased the number of regeneration sales specialists dedicated to selling our OL1000 product. We believe these specialists will be able to use the established relationships of our DonJoy sales representatives to enhance sales of the OL1000 product. Our distribution arrangement with DePuy Spine has also become non-exclusive for 2006, which permits us to sell the SpinaLogic product directly or through other independent sales representatives in all territories where we choose to do so. We intend to add additional selling resources in those geographical parts of the country where sales are not meeting our expectations. We believe that our new selling strategies for our Regeneration segment will drive faster growth for this business.
• Expand International Sales. International sales have historically represented less than 15% of our revenues. Although our presence outside the United States has been limited, we have successfully established direct distribution capabilities in major international markets. We believe that sales to foreign markets continue to represent a significant growth opportunity and we intend to continue to develop direct distribution capabilities in selected additional foreign markets. We also believe we can increase our international revenues by expanding the number of our products we sell in international markets. Historically we have only sold a limited range of our products in our international markets. In 2005, we successfully launched an expanded range of soft goods, our cold therapy products and our bone growth stimulation products in our International segment.
• Pursue Selective Acquisitions. We believe that acquisitions represent an attractive and efficient means to broaden our product lines, expand our geographic reach and increase our revenue. We intend to pursue acquisition opportunities that enhance sales growth, are accretive to earnings, increase customer penetration and/or provide geographic diversity. In the year ended December 31, 2005, we completed the SME and OSG acquisitions that meet these criteria as discussed in Note 3 to the consolidated financial statements included in Item 8 herein. In January 2006, we also completed the acquisition of Newmed SAS (Newmed), as discussed in Note 13 to the consolidated financial statements included in Item 8, herein, which is intended to increase our international revenue in France and other parts of Europe.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates including those related to contractual allowances, doubtful accounts, inventories, rebates, product returns, warranty
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obligations, income taxes, intangibles and investments. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements and this discussion and analysis of our financial condition and results of operations:
Provision for Contractual Allowances and Doubtful Accounts. We maintain provisions for contractual allowances for reimbursement amounts from our third-party payor customers based on negotiated contracts and historical experience for non-contracted payors. We also maintain provisions for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We have contracts with certain third-party payors for our third-party reimbursement billings, which call for specified reductions in reimbursement of billed amounts based upon contractual reimbursement rates. For 2005 and 2004, we reserved for and reduced gross revenues from third-party payors by between 29% and 39% for allowances related to these contractual reductions. For our Regeneration business, we record revenue net of actual contractual allowances and discounts from our gross prices, which are determined on a specific identification basis and amount to approximately 29% to 34% of our gross prices for bone growth stimulation products.
Our reserve for doubtful accounts is based upon estimated losses from customers who are billed directly and the portion of third-party reimbursement billings that ultimately become the financial responsibility of the end user patients. Direct-billed customers represent approximately 51% of our net accounts receivable at December 31, 2005, and we have historically experienced write-offs of less than 2% of these accounts receivable. Our third-party reimbursement customers including insurance companies, managed care companies and certain governmental payors such as Medicare include all of our OfficeCare customers and certain other customers of our Domestic Rehabilitation business segment and the majority of our Regeneration customers. Our third-party payor customers represented approximately 32% of our net revenue for the year ended December 31, 2005 and 49% of our net accounts receivable at December 31, 2005, and we estimate bad debt expense to be approximately 4% to 8% of gross revenues from these third-party reimbursement customers. If the financial condition of our customers were to deteriorate resulting in an impairment of their ability to make payments or if third-party payors were to deny claims for late filings, incomplete information or other reasons, additional provisions may be required.
Historically, we relied heavily on third-party billing service providers to provide information about the accounts receivable of certain of our third-party payor customers, including the data utilized to determine reserves for contractual allowances and doubtful accounts. In March 2003, we completed the transition to a new third-party insurance billing service provider. Based on information currently available to us, we believe we have provided adequate reserves for our third-party payor accounts receivable. If claims are denied, or amounts are otherwise not paid, in excess of our estimates, the recoverability of our net accounts receivable could be reduced by a material amount. In addition, if our third-party insurance billing service provider does not perform to our expectations we may be required to increase our reserve estimates.
Reserve for Excess and Obsolete Inventories. We provide reserves for estimated excess or obsolete inventories equal to the difference between the cost of inventories on hand plus future purchase commitments and the estimated market value based upon assumptions about future demand. If future demand is less favorable than currently projected by management, additional inventory write-downs may be required. In addition, reserves for inventories on hand in our OfficeCare locations are provided based on historical shrinkage rates of approximately 16%. If actual shrinkage rates differ from our estimated shrinkage rates, revisions to the reserve may be required. We also provide reserves for newer product inventories, as appropriate, based on any minimum purchase commitments and our level of sales of the new products.
Rebates. We offer certain of our distributors rebates based on sales volume, sales growth and to reimburse the distributor for certain discounts. We record estimated reductions to revenue for customer rebate programs based upon historical experience and estimated revenue levels.
Returns and Warranties. We provide for the estimated cost of returns and product warranties at the time revenue is recognized based on historical trends. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our suppliers, our actual returns and warranty costs could differ from our estimates. If actual product returns, failure rates, material usage or service costs differ from our estimates, revisions to the estimated return and/or warranty liabilities may be required.
Valuation Allowance for Deferred Tax Asset. As of December 31, 2005, we have approximately $39.5 million of net deferred tax assets on our balance sheet related primarily to tax deductible goodwill arising at the date of our reorganization in 2001 and not recognized for book purposes and net operating loss carryforwards. Realization of our deferred tax assets is
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dependent on our ability to generate future taxable income prior to the expiration of our net operating loss carryforwards. Our management believes that it is more likely than not that the deferred tax assets will be realized based on forecasted future taxable income. However, there can be no assurance that we will meet our expectations of future taxable income. Management will evaluate the realizability of the deferred tax assets on a quarterly basis to assess any need for valuation allowances.
Goodwill and Other Intangibles. In accordance with Statement of Financial Accounting Standards No. 142, or SFAS No. 142, Goodwill and Other Intangible Assets, we do not amortize goodwill. In lieu of amortization, we are required to perform an annual review for impairment. Goodwill is considered to be impaired if we determine that the carrying value of the segment or reporting unit exceeds its fair value. At October 1, 2005, our goodwill was evaluated for impairment and we determined that no impairment existed at that date. With the exception of goodwill related to our Regeneration acquisition of $39 million, we believe that the goodwill acquired through December 31, 2005 benefits the entire enterprise and since our reporting units share the majority of our assets, we compared the total carrying value of our consolidated net assets (including goodwill) to the fair value of the Company. With respect to goodwill related to our Regeneration acquisition, we compared the carrying value of the goodwill related to the Regeneration segment to the fair value of the Regeneration segment.
At December 31, 2005, other intangibles were evaluated for impairment as required by SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets. The determination of the fair value of certain acquired assets and liabilities is subjective in nature and often involves the use of significant estimates and assumptions. Determining the fair values and useful lives of intangible assets requires the exercise of judgment. Upon initially recording certain of our other intangible assets, including the intangible assets that were acquired in connection with the Regeneration acquisition, we used independent valuation firms to assist us in determining the appropriate values for these assets. Subsequently, we have used the same methodology and updated our assumptions. While there are a number of different generally accepted valuation methods to estimate the value of intangible assets acquired, we primarily used the undiscounted cash flows expected to result from the use of the assets. This method requires significant management judgment to forecast the future operating results used in the analysis. In addition, other significant estimates are required such as residual growth rates and discount factors. The estimates we have used are consistent with the plans and estimates that we use to manage our business and are based on available historical information and industry averages.
We recorded an impairment charge for certain long-lived assets in 2002 as a result of certain new products not achieving anticipated revenues and estimated recovery values of assets being disposed of being less than anticipated. The value of our goodwill and other intangible assets is exposed to future impairments if we experience future declines in operating results, if negative industry or economic trends occur or if our future performance is below our projections or estimates.
Results of Operations
We operate our business on a manufacturing calendar, with our fiscal year always ending on December 31. Each quarter is 13 weeks, consisting of one five-week and two four-week periods. The first and fourth quarters may have more or less working days from year to year based on the days of the week on which holidays and December 31 fall.
Year Ended December 31, 2005 Compared To Year Ended December 31, 2004
Net Revenues. Set forth below are net revenues for our reporting segments (in thousands):
| | Years Ended | | | | | |
| | December 31,
2005 | | % of Net Revenues | | December 31, 2004 | | % of Net
Revenues | | Increase | | %
Increase | |
Domestic Rehabilitation | | $ | 197,279 | | 68.9 | | $ | 177,481 | | 69.3 | | $ | 19,798 | | 11.2 | |
Regeneration | | 55,474 | | 19.4 | | 49,658 | | 19.4 | | 5,816 | | 11.7 | |
International | | 33,414 | | 11.7 | | 28,860 | | 11.3 | | 4,554 | | 15.8 | |
Consolidated net revenues | | $ | 286,167 | | 100.0 | | $ | 255,999 | | 100.0 | | $ | 30,168 | | 11.8 | |
Net revenues in our Domestic Rehabilitation segment increased due to normal market growth in existing product lines, sales of new products, sales attributed to the OSG acquisition, an increase in the number of units billed to third-party payors, which are sold at higher average selling prices, and growth in sales related to national contracts in our ProCare sales channel. We have also gained incremental revenue from the addition of approximately 200 new OfficeCare locations in 2005, net of account terminations, including approximately 45 accounts added in connection with our March 2005 SME acquisition. Net revenues in our Regeneration segment increased, in part, from our sales force integration and an increased number of sales specialists selling our OL1000 product. Sales of our SpinaLogic product also increased due to selling resources added in territories that became non-exclusive in 2005. International net revenues increased partly due to favorable changes in exchange rates compared to the rates in
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effect in 2004, an increase in the number of products we sell in international markets, incremental revenues from the OSG acquisition, and the addition of our new direct sales subsidiary in the Nordic countries, effective September 1, 2004. Excluding the impact of exchange rates, local currency international revenues increased 14.6% in the year ended December 31, 2005 compared to the year ended December 31, 2004.
Gross Profit. Set forth below is gross profit information for our reporting segments (in thousands):
| | Years Ended | | | | | |
| | December 31,
2005 | | % of Net
Revenues | | December 31,
2004 | | % of Net
Revenues | | Increase | | %
Increase | |
Domestic Rehabilitation | | $ | 109,752 | | 55.6 | | $ | 100,200 | | 56.5 | | $ | 9,552 | | 9.5 | |
Regeneration | | 49,710 | | 89.6 | | 43,032 | | 86.7 | | 6,678 | | 15.5 | |
International | | 21,416 | | 64.1 | | 17,603 | | 61.0 | | 3,813 | | 21.7 | |
Consolidated gross profit | | $ | 180,878 | | 63.2 | | $ | 160,835 | | 62.8 | | $ | 20,043 | | 12.5 | |
The improvement in consolidated gross profit and gross profit margin is related partly to increased revenues from the higher gross margin products sold in our Regeneration segment and partly due to certain manufacturing cost reductions, offset by increased freight costs and increased expenses related to employee bonuses. Gross profit decreased as a percentage of net revenues in our Domestic Rehabilitation segment primarily due to increased freight costs and a change in product mix including incremental sales from the OSG acquisition, which are primarily sold to third-party distributors at a reduced gross margin. The Regeneration segment gross profit increased as a percentage of revenues due to increased sales volume, an increase in the proportion of unit sales sold to third-party payors, which are sold at higher average selling prices, and certain cost benefits realized upon the consolidation of the Regeneration product manufacturing into our facility in Vista, California. The increase in the International segment gross profit is primarily related to the favorable impact of changes in exchange rates and the addition of the incremental in-market gross margin from our direct sales in the Nordic countries since September 1, 2004.
Operating Expenses. Set forth below is operating expense information (in thousands):
| | Years Ended | | | | % | |
| | December 31,
2005 | | % of Net
Revenues | | December 31,
2004 | | % of Net
Revenues | | Increase
(Decrease) | | Increase
(Decrease) | |
Sales and marketing | | $ | 86,241 | | 30.1 | | $ | 78,984 | | 30.9 | | $ | 7,257 | | 9.2 | |
General and administrative | | 29,432 | | 10.3 | | 27,727 | | 10.8 | | 1,705 | | 6.1 | |
Research and development | | 6,350 | | 2.2 | | 5,627 | | 2.2 | | 723 | | 12.8 | |
Amortization of acquired intangibles | | 4,996 | | 1.7 | | 4,731 | | 1.9 | | 265 | | 5.6 | |
Restructuring costs | | — | | — | | 4,693 | | 1.8 | | (4,693 | ) | (100.0 | ) |
Consolidated operating expenses | | $ | 127,019 | | 44.3 | | $ | 121,762 | | 47.6 | | $ | 5,257 | | 4.3 | |
Sales and Marketing Expenses. The increase in sales and marketing expenses is due to costs associated with additional sales personnel in our Regeneration segment and increases in commissions on increased sales, advertising and marketing programs, employee bonus expenses and costs related to the businesses we acquired in 2005.
General and Administrative Expenses. The increase in general and administrative expenses is primarily due to increases in legal costs, employee bonus expenses and costs associated with the businesses we acquired in 2005, partially offset by savings related to the integration of the Regeneration business.
Research and Development Expenses. The increase in research and development expenses is primarily due to an increase in costs associated with prototyping new products, increased employee bonus expenses and certain severance costs incurred in 2005.
Amortization of Acquired Intangibles. The increase in amortization of acquired intangibles relates to intangible assets acquired in 2005 in connection with the SME acquisition, which are being amortized over lives ranging from five to ten years, and intangible assets acquired in 2005 in connection with the OSG acquisition, which are being amortized over lives ranging from three to eight years. For 2004, all amortization of acquired intangibles related to intangible assets acquired in connection with the Regeneration acquisition, which are being amortized over lives ranging from four months to ten years.
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Restructuring costs. In 2004, we incurred restructuring charges related to our Regeneration integration and certain manufacturing moves, including charges for severance, recruiting, training and other related exit costs.
Income from Operations. Set forth below is income from operations information for our reporting segments (in thousands):
| | Years Ended | | | | | |
| | December 31,
2005 | | % of Net
Revenues | | December 31,
2004 | | % of Net
Revenues | | Increase | | %
Increase | |
Domestic Rehabilitation | | $ | 41,878 | | 21.2 | | $ | 36,341 | | 20.5 | | $ | 5,537 | | 15.2 | |
Regeneration | | 14,623 | | 26.4 | | 7,836 | | 15.8 | | 6,787 | | 86.6 | |
International | | 8,430 | | 25.2 | | 5,398 | | 18.7 | | 3,032 | | 56.2 | |
Income from operations of reportable segments | | 64,931 | | 22.7 | | 49,575 | | 19.4 | | 15,356 | | 31.0 | |
Expenses not allocated to segments | | (11,072 | ) | (3.9 | ) | (10,502 | ) | (4.1 | ) | 570 | | 5.4 | |
Consolidated income from operations | | $ | 53,859 | | 18.8 | | $ | 39,073 | | 15.3 | | $ | 14,786 | | 37.8 | |
The increase in income from operations for each of our segments is due to increased net revenues and gross profit, which exceed increased operating expenses for each respective segment.
Interest Expense, Net of Interest Income and Prepayment premium and other costs related to Senior Subordinated Notes redemption. Interest expense, net of interest income, was $4.4 million in the year ended December 31, 2005 compared to $9.0 million in the year ended December 31, 2004. The decrease is due to reduced debt levels following the June 2004 redemption of our senior subordinated notes and other debt repayments made after the third quarter of 2004. We incurred pre-tax charges aggregating $7.8 million in the second quarter of 2004 related to the redemption of our senior subordinated notes.
Other Income (Expense). Other income (expense) for the year ended December 31, 2005 reflects a write-off of costs related to potential acquisitions that were abandoned in 2005 and net foreign exchange transaction losses. Other income (expense) for the year ended December 31, 2004 includes a net foreign exchange transaction gain and a gain on the sale of an investment, partially offset by a write-off of costs related to a potential acquisition.
Provision for Income Taxes. Our estimated worldwide effective tax rate was 39.8% for the year ended December 31, 2005 and 39.2% for the year ended December 31, 2004. Our tax rate for 2005 increased compared to 2004 primarily due to a higher average effective state tax rate in 2004.
Net Income. Net income was $29.2 million for the year ended December 31, 2005 compared to net income of $14.0 million for the year ended December 31, 2004 as a result of the changes discussed above.
Year Ended December 31, 2004 Compared To Year Ended December 31, 2003
Regeneration segment amounts in the tables below include operations for the period subsequent to the Regeneration acquisition on November 26, 2003 and include the impact of the Regeneration purchase accounting and related amortization of acquired intangible assets. For the years ended December 31, 2004 and 2003, Regeneration income from operations was reduced by amortization of acquired intangible assets amounting to $4.7 million and $0.5 million, respectively. For the year ended December 31, 2004, Regeneration income from operations was also reduced by restructuring charges of $3.8 million related to the integration of the business operations of the segment. The proforma amounts in the tables below show the impact of the Regeneration acquisition as if it had occurred on January 1, 2003.
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Net Revenues. Set forth below are net revenues for our reporting segments (in thousands):
| | Years Ended | | | | | | Pro Forma
Year ended | |
| | December 31,
2004 | | % of Net
Revenues | | December 31,
2003 | | % of Net
Revenues | | Increase | | %
Increase | | December 31,
2003 | | % of Net
Revenues | |
Domestic Rehabilitation | | $ | 177,481 | | 69.3 | | $ | 168,842 | | 85.3 | | $ | 8,639 | | 5.1 | | $ | 168,842 | | 70.3 | |
Regeneration | | 49,658 | | 19.4 | | 3,989 | | 2.0 | | 45,669 | | 1,144.9 | | 46,428 | | 19.3 | |
International | | 28,860 | | 11.3 | | 25,108 | | 12.7 | | 3,752 | | 14.9 | | 25,108 | | 10.4 | |
Consolidated net revenues | | $ | 255,999 | | 100.0 | | $ | 197,939 | | 100.0 | | $ | 58,060 | | 29.3 | | $ | 240,378 | | 100.0 | |
Net revenues in our Domestic Rehabilitation segment increased primarily due to the implementation of sales productivity initiatives, increased sales of rigid knee braces into school athletic programs and sales of new products. These increases were partially offset by a negative impact from changes in 2004 in the California workers compensation system and reduced sales of certain of our pain management products. Net revenues in our Domestic Rehabilitation segment also increased due to growth in sales related to national contracts, the addition of approximately 100 net new OfficeCare locations and price increases implemented in mid-2003, offset by price reductions in our fracture boot products due to a change in the Medicare reimbursement code. On a pro forma basis, net revenue in our Regeneration segment increased due to increased sales volumes, offset by a negative impact in the third quarter of 2004 caused by disruption from the commencement of the integration of our Regeneration sales organization into our DonJoy sales organization. Revenues in our Regeneration segment were also impacted during the third quarter of 2004 by a decline in sales of our SpinaLogic product, which we believe was due partly to slow market conditions and partly to weak sales performance in certain territories. International revenues increased due partly to favorable changes in exchange rates compared to the rates in effect in 2003. Excluding the impact of exchange rates, local currency international revenue increased 8.6% in the year ended December 31, 2004 compared to the year ended December 31, 2003, due to an increase in the number of our products we sell in our international markets and the addition of our new direct sales subsidiary in the Nordic countries, effective September 1, 2004.
Gross Profit. Set forth below is gross profit information for our reporting segments (in thousands):
| | Years Ended | | | | | | Pro Forma
Year ended | |
| | December 31,
2004 | | % of Net
Revenues | | December 31,
2003 | | % of Net
Revenues | | Increase | | %
Increase | | December 31,
2003 | | % of Net
Revenues | |
Domestic Rehabilitation | | $ | 100,200 | | 56.5 | | $ | 93,791 | | 55.5 | | $ | 6,409 | | 6.8 | | $ | 93,791 | | 55.5 | |
Regeneration | | 43,032 | | 86.7 | | 3,145 | | 78.8 | | 39,887 | | 1,268.3 | | 38,949 | | 83.9 | |
International | | 17,603 | | 61.0 | | 15,076 | | 60.0 | | 2,527 | | 16.8 | | 15,076 | | 60.0 | |
Consolidated gross profit | | $ | 160,835 | | 62.8 | | $ | 112,012 | | 56.6 | | $ | 48,823 | | 43.6 | | $ | 147,816 | | 61.5 | |
The improvement in consolidated gross profit and gross profit margin is primarily related to the favorable impact of higher gross margins associated with the products sold in our Regeneration segment, continued manufacturing cost reduction initiatives and a reduction in expenses associated with employee bonuses, partially offset by increased freight costs. Gross profit increased in the Domestic Rehabilitation segment primarily due to a favorable product mix, including increased sales to our third-party payor customers which carry a higher gross margin than other Domestic Rehabilitation sales, and certain price increases implemented in mid-2003, partially offset by price reductions due to a change in the Medicare reimbursement code for certain fracture boot products and by increased sales through our national contracts, which carry lower gross margins. On a pro forma basis and excluding the impact of one-time purchase accounting adjustments, Regeneration gross profit increased as a percentage of revenues due to reduced cost of goods sold for these products and a higher mix of insurance sales, which have higher average selling prices and therefore generate higher gross margins than sales to wholesale customers. The increase in the International gross profit is primarily related to the favorable impact of changes in exchange rates and the addition of the incremental in-market gross margin on our direct sales in the Nordic countries since September 1, 2004.
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Operating Expenses. Set forth below is operating expense information (in thousands):
| | Years Ended | | | | | | Pro Forma
Year ended | |
| | December 31,
2004 | | % of Net
Revenues | | December 31,
2003 | | % of Net
Revenues | | Increase | | %
Increase | | December 31,
2003 | | % of Net
Revenues | |
Sales and marketing | | $ | 78,984 | | 30.9 | | $ | 54,067 | | 27.3 | | $ | 24,917 | | 46.1 | | $ | 72,924 | | 30.3 | |
General and administrative | | 27,727 | | 10.8 | | 21,767 | | 11.0 | | 5,960 | | 27.4 | | 25,870 | | 10.8 | |
Research and development | | 5,627 | | 2.2 | | 4,442 | | 2.2 | | 1,185 | | 26.7 | | 5,211 | | 2.2 | |
Amortization of acquired intangibles | | 4,731 | | 1.9 | | 464 | | 0.2 | | 4,267 | | 919.6 | | 4,808 | | 2.0 | |
Restructuring costs | | 4,693 | | 1.8 | | (497 | ) | (0.2 | ) | 5,190 | | 1,044.3 | | (497 | ) | (0.2 | ) |
Consolidated operating expenses | | $ | 121,762 | | 47.6 | | $ | 80,243 | | 40.5 | | $ | 41,519 | | 51.7 | | $ | 108,316 | | 45.1 | |
Sales and Marketing Expenses. The increase in sales and marketing expenses is primarily attributed to $21.4 million of expenses related to the Regeneration segment. In addition, selling and marketing expenses increased due to costs associated with increased commissions on increased sales, additional sales personnel, increased advertising and marketing programs and the impact of unfavorable foreign exchange rate changes. These increases were offset by a reduction in expenses associated with employee bonuses. Our international segment also incurred increased expenses in 2004 related to our new subsidiaries in France and Denmark, added in September 2003 and September 2004, respectively, and a bi-annual trade exhibition in Europe.
General and Administrative Expenses. The increase in general and administrative expenses is primarily attributed to $4.3 million of expenses related to the Regeneration segment, increased professional fees related to compliance with section 404 of the Sarbanes-Oxley Act, and legal costs, including the settlement of a contract dispute, offset by a reduction in expenses associated with employee bonuses. General and administrative expenses also increased in 2004 related to increased efforts to maximize cash collections from our third-party payor customers.
Research and Development Expenses. The increase in research and development expense is attributed to $0.9 million of expenses related to the Regeneration segment and an increase in professional fees related to various patents and technology offset by a reduction in expenses associated with employee bonuses.
Amortization of Acquired Intangibles. Amortization of acquired intangibles relates to intangible assets acquired in connection with the Regeneration acquisition, which are being amortized over lives ranging from four months to ten years. On a pro forma basis the amortization expense in the year ended December 31, 2004 is consistent with the year ended December 31, 2003.
Restructuring costs. In 2004, we recorded charges of $4.7 million related to our Regeneration integration and manufacturing moves, including charges for severance, recruiting, training and other related exit costs. In the year ended December 31, 2003, we recorded a credit to restructuring costs of approximately $0.5 million as a reversal of an accrual recorded in 2002 related to future rent to be paid for vacated facilities, as we decided to retain the vacant space for future expansion.
Income from Operations. Set forth below is income from operations information for our reporting segments (in thousands):
| | Years Ended | | | | | | Pro Forma
Year ended | |
| | December
31, 2004 | | % of Net
Revenues | | December 31,
2003 | | % of Net
Revenues | | Increase
(Decrease) | | % Increase
(Decrease) | | December 31,
2003 | | % of Net
Revenues | |
Domestic Rehabilitation | | $ | 36,341 | | 20.5 | | $ | 35,462 | | 21.0 | | $ | 879 | | 2.5 | | $ | 35,462 | | 21.0 | |
Regeneration | | 7,836 | | 15.8 | | 537 | | 13.5 | | 7,299 | | 1,359.2 | | 8,268 | | 17.8 | |
International | | 5,398 | | 18.7 | | 6,255 | | 24.9 | | (857 | ) | (13.7 | ) | 6,255 | | 24.9 | |
Income from operations of reportable segments | | 49,575 | | 19.4 | | 42,254 | | 21.3 | | 7,321 | | 17.3 | | 49,985 | | 20.8 | |
Expenses not allocated to segments | | (10,502 | ) | (4.1 | ) | (10,485 | ) | (5.3 | ) | 17 | | 0.2 | | (10,485 | ) | (4.4 | ) |
Consolidated income from operations | | $ | 39,073 | | 15.3 | | $ | 31,769 | | 16.0 | | $ | 7,304 | | 23.0 | | $ | 39,500 | | 16.4 | |
The decrease in income from operations as a percentage of net revenue for the Domestic Rehabilitation segment is primarily due to an increased investment in sales and marketing expense for personnel and programs and lower gross profit margins associated with increased revenue from national contracts, partially offset by increased margins from higher OfficeCare
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sales. The decrease in income from operations, on a pro forma basis, for the Regeneration segment is primarily the result of restructuring charges of $3.8 million in 2004, partially offset by increased revenues and higher gross margins. Income from operations in the International segment was reduced from the prior year due primarily to the investment we made in the start up activities of our new direct sales subsidiaries in France and Denmark, as well as the expenses associated with a bi-annual European exhibition which occurred in the second quarter of 2004.
Interest Expense, Net of Interest Income and Prepayment premium and other costs related to Senior Subordinated Notes redemption. Interest expense, net of interest income, was $9.0 million in the year ended December 31, 2004 compared to $12.2 million in the year ended December 31, 2003. The decrease is due to the retirement of our former credit facility and the June 2004 redemption of our senior subordinated notes, offset by interest related to the incremental outstanding debt we incurred in connection with the Regeneration acquisition. We incurred costs of $7.8 million in connection with the redemption of the notes, comprised of a $4.7 million redemption premium and write-offs of $2.3 million and $0.8 million for debt issuance costs and unamortized discounts, respectively.
Other Income (Expense). Other income (expense) for the year ended December 31, 2004 includes a net foreign exchange transaction gain and a gain on the sale of an investment, partially offset by a write-off of costs related to a potential acquisition. For the year ended December 31, 2003, other income (expense) includes a net foreign exchange transaction gain.
Provision for Income Taxes. Our estimated worldwide effective tax rate was 39.2% for the year ended December 31, 2004 and 39.8% for the year ended December 31, 2003. The tax rate in 2004 was reduced compared to 2003 primarily due to a lower average effective state tax rate in 2004.
Net Income. Net income was $14.0 million for the year ended December 31, 2004 compared to net income of $12.1 million for the year ended December 31, 2003 as a result of the changes discussed above.
Liquidity and Capital Resources
Our principal liquidity requirements are to service our debt and meet our working capital and capital expenditure needs. Total indebtedness was $47.5 million at December 31, 2005. Total cash and cash equivalents were $1.1 million at December 31, 2005.
Net cash provided by operating activities was $47.1 million and $39.5 million for the years ended December 31, 2005 and 2004, respectively. The net cash provided by operations in both 2005 and 2004 reflected positive operating results, partially offset by an increase in net working capital. In connection with the move of the billing and collections activities of our Regeneration segment from Tempe, Arizona to Vista, California in 2004, we were required to amend certain registrations and contracts with certain of our third-party payor customers of this business. As a result of this transition, certain payments owed to us by these payors were delayed, contributing to an increase in accounts receivable in this segment. We continue to work with these third-party payors to expedite the delayed payments. The percentage of our revenues that is derived from third-party payor customers also increased in 2005, contributing to higher levels of accounts receivable as these customers typically pay slower than our other customers. In addition, in 2005 approximately $1.9 million was used to pay for restructuring costs accrued in 2004.
Cash flows used in investing activities were $19.3 million and $10.2 million for the years ended December 31, 2005 and 2004, respectively. Cash used in investing activities in 2005 included $3.1 million used for the SME acquisition, $9.5 million used for the OSG acquisition, $0.1 million additional consideration to KD Innovation A/S (KDI) for meeting operating income targets, $5.1 million used for capital expenditures and $1.5 million used for purchasing rights to distributor territories, net of amounts repaid to us by the new distributors. We may be required to pay up to an additional $0.4 million to KDI through 2009, if certain net operating income targets are met.
Cash used in investing activities in 2004 includes $6.0 million used for capital expenditures and $1.8 million related to the final payment for the acquisition of certain patent licenses in 2003 and the initial payment for the acquisition of a patent license in 2004. In addition, as part of our 2004 sales initiatives, we proactively reorganized certain territories within our DonJoy sales channel by changing distributor partners or adding direct sales representatives. We paid $1.2 million in 2004 to acquire distribution rights to facilitate this reorganization. We also paid $0.7 million in 2004 to acquire the outstanding stock of KDI, our independent distributor in Denmark.
Cash flows used in financing activities were $37.7 million and $37.5 million for the years ended December 31, 2005 and 2004, respectively. Cash used in financing activities in 2005 included $55.5 million of repayments on long-term debt and $0.7 million of debt issuance costs, offset by proceeds of $8.7 million received from the issuance of common stock through our Employee Stock
44
Purchase Plan and the exercise of stock options, $1.8 million received from collection of stockholder notes receivable and $8.0 million received from borrowing.
Cash used in financing activities in 2004 included $79.7 million used to redeem our senior subordinated notes and $5.0 million used to repay our term loan, partially offset by the net proceeds, amounting to $56.3 million, from the sale of shares by us in stock offerings completed in 2004. Also in 2004, proceeds of $5.9 million were received from the issuance of common stock through our Employee Stock Purchase Plan and the exercise of stock options and $0.3 million was received from collection of a note receivable. On September 27, 2004, our board of directors authorized a program to repurchase up to $20 million of our common stock. Through December 31, 2004 we had repurchased 837,300 shares of our common stock at an average price of $17.62 per share, for an aggregate total cost of approximately $14.8 million. There were no repurchases of our common stock during the year ended December 31, 2005. The stock repurchase program expired in September 2005.
Contractual Obligations and Commercial Commitments
On May 5, 2005, we completed an amendment to our credit agreement. Previously, the credit agreement consisted of a $100.0 million term loan, of which approximately $93.8 million was owed as of the date of the amendment, and a $30.0 million revolving line of credit on which no amounts had been drawn. The amended credit agreement provides for total borrowings of $125.0 million, consisting of a term loan of $50.0 million, which was fully drawn at closing and $75.0 million available under a revolving line of credit, of which approximately $43.8 million was drawn at closing. Prior to December 31, 2005, we repaid all of the amounts outstanding under the revolving line of credit. We were contingently liable for outstanding letters of credit aggregating approximately $4.0 million at December 31, 2005. Under the amended agreement, up to $25.0 million of outstanding borrowings may be denominated in British Pounds or Euros. As of December 31, 2005, all borrowings under the credit agreement were denominated in U.S. dollars. Borrowings under the term loan and on the revolving credit facility bear interest at variable rates (either a LIBOR rate or the lenders’ base rate, as elected by us) plus an applicable margin, which varies based on our leverage ratio. The amended agreement reduced our interest rate to LIBOR plus an applicable margin of 1.25% to 2.00%, or the lenders’ base rate plus an applicable margin of 0.25% to 1.00%. At our current leverage ratio, the applicable interest rate is either LIBOR plus 1.25% or base rate plus 0.25%. The weighted average interest rate applicable to our borrowings as of December 31, 2005 was 5.35%.
Repayment. We are required to make quarterly principal payments on the term loan of $1.25 million, beginning in September 2005 and increasing to $1.875 million in September 2007, $3.125 million in September 2008 and $5 million in September 2009. The balance of the term loan, if any, and any borrowings under the revolving credit facility are due in full on May 5, 2010. Prior to December 31, 2005, we repaid $2.5 million of the amounts outstanding under the term loan and $47.5 million remained outstanding as of December 31, 2005. In addition to scheduled principal payments, we are required to make annual mandatory payments of the term loan in an amount equal to 50% of our excess cash flow if our ratio of total debt to consolidated EBITDA (earnings before interest, taxes, depreciation and amortization) exceeds 2.25 to 1.00. Excess cash flow represents our net income adjusted for extraordinary gains or losses, depreciation, amortization and other non-cash charges, changes in working capital, changes in deferred revenues, payments for capital expenditures, repayment of certain indebtedness and payments for certain common stock repurchases. In addition, the term loan is subject to mandatory prepayments in an amount equal to (a) 50% of the net cash proceeds of certain equity issuances by us if our ratio of total debt to consolidated EBITDA exceeds 2.25 to 1.00, (b) 100% of certain debt issuances by us and (c) 100% of the net cash proceeds of certain asset sales or other dispositions of property by us, in each case subject to certain exceptions.
Security; Guarantees. The obligations of dj Ortho under the credit agreement are irrevocably guaranteed, jointly and severally, by us, dj Development, DJ Capital and future U.S. subsidiaries. In addition, the credit agreement and the guarantees thereunder are secured by substantially all of our assets.
Covenants. The credit facility contains a number of covenants that, among other things, restrict our ability to (i) incur additional indebtedness; (ii) incur or guarantee obligations; (iii) pay dividends or make other distributions (except for certain tax distributions); (iv) redeem or repurchase equity, make investments, loans or advances, make acquisitions; (v) engage in mergers or consolidations; (vi) change the business we conduct; (vii) grant liens on or sell our assets; (viii) or engage in certain other activities. The amended agreement provides less restriction than our previous agreement in most of these areas. The credit agreement also requires us to maintain a ratio of total debt to consolidated EBITDA of no more than 2.75 to 1.00 and a ratio of consolidated EBITDA to fixed charges of at least 1.50 to 1.00. At December 31, 2005, our ratio of total debt to consolidated EBITDA was approximately 0.72 to 1.00 and our ratio of consolidated EBITDA to fixed charges was approximately 4.18 to 1.00. We were in compliance with all covenants as of December 31, 2005.
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Debt issuance costs. In connection with the amendment, we incurred costs of approximately $0.7 million, which were capitalized. These costs, along with the unamortized balance of the costs incurred in connection with the original agreement and a previous amendment, are being amortized over the term of the amended credit agreement.
As part of our strategy, we may pursue additional acquisitions, investments and strategic alliances. We may require new sources of financing to consummate any such transactions, including additional debt or equity financing. We cannot assure you that such additional sources of financing will be available on acceptable terms, if at all. In addition, we may not be able to consummate any such transactions due to the operating and financial restrictions and covenants in our credit agreement.
The following table lists our contractual obligations as of December 31, 2005 (in thousands):
| | Payments Due by Period | |
| | | | 2006 | | 2007-2009 | | 2010-2011 | | 2012+ | |
Contractual Obligations | | Total | | Less than 1
Year | | 1-3 Years | | 4-5 Years | | After 5 years | |
Long-Term Debt (1) | | $ | 47,500 | | $ | 5,000 | | $ | 32,500 | | $ | 10,000 | | $ | — | |
Operating Leases | | 52,728 | | 6,950 | | 11,856 | | 7,231 | | 26,691 | |
Total Contractual Cash Obligations | | $ | 100,228 | | $ | 11,950 | | $ | 44,356 | | $ | 17,231 | | $ | 26,691 | |
(1) Represents scheduled principal payments for 2006 through 2010 under the term loan portion of our credit facility.
In October 2004, we entered into a lease agreement with Professional Real Estate Services, Inc. (PRES) under which PRES has undertaken to build a new 110,000 square foot corporate headquarters facility for us on vacant land currently leased to us in Vista, California. Construction of the new facility is underway and once completed, we will occupy the facility under a 15-year lease with two five-year options to extend the term and will move out of our existing facilities in Vista. Rent for the new facility will be based on an agreed percentage of the total project cost for the construction of the facility and is not expected to exceed the rent currently paid by us for our existing Vista facilities.
The new lease with PRES was contingent on PRES closing a transaction to purchase the existing facilities in Vista, California leased by us, as well as the real property underlying the new lease. The purchase transaction closed in February 2005. Effective on the closing date, our lease for the vacant land was terminated, and when the new headquarters facility is completed and occupied, our leases for our existing Vista facilities will be terminated. Those leases would otherwise have continued until February 2008. Upon occupancy of the new facility, expected to occur in mid-2006, we will make a lump sum rent payment to PRES equal to 40% of the rent that would have been due under the existing facilities leases from the termination date of the existing leases through the original expiration date, estimated at $1.6 million. If PRES is able to lease our former facilities during what would have remained of the term of our existing leases, a portion of that sum may be refunded to us. This lump sum rent payment, net of the remaining $0.4 million accrual related to lease termination costs and other exit costs originally accrued in 2002 (see Note 4 to the consolidated financial statements included in Item 8 herein), will be accounted for as additional rent expense over the term of the new lease. The contractual obligations table above assumes a July 2006 occupancy date for our new corporate headquarters and includes both estimated rent for our new facility beginning in July 2006 and the estimated lump sum rent payment of approximately $1.6 million for termination of our existing facilities in July 2006.
Our ability to pay principal and interest on our indebtedness, fund working capital requirements and make anticipated capital expenditures will depend on our future performance, which is subject to general economic, financial and other factors, some of which are beyond our control. We believe that based on current levels of operations and anticipated growth, cash flow from operations, together with other available sources of funds including the availability of borrowings under our revolving credit facility, will be adequate for at least the next twelve months to make required payments of principal and interest on our indebtedness, to fund anticipated capital expenditures and for working capital requirements. There can be no assurance, however, that our business will generate sufficient cash flow from operations or that future borrowings will be available under the revolving credit facility in an amount sufficient to enable us to service our indebtedness or to fund our other liquidity needs. In such event, we may need to raise additional funds through public or private equity or debt financings. We cannot assure you that any such funds will be available to us on favorable terms or at all.
We do not currently have and have never had any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in these relationships.
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On January 2, 2006, as discussed in Note 13 to the consolidated financial statements included in Item 8 herein, we completed the acquisition, under an agreement originally signed on December 15, 2005, of the shares of Newmed for cash payments aggregating 13 million Euros (approximately $15.4 million), which included payment of certain debts of Newmed. Certain sellers may also receive up to an additional 1 million Euros (approximately $1.2 million) based on achievement of certain revenue targets for 2006. We also incurred certain transaction costs and other expenses in connection with the acquisition that are estimated to be approximately $0.4 million. We funded the cash paid on January 2, 2006 and our transaction expenses, with the proceeds of a $16.0 million draw on our revolving line of credit. We repaid $3.0 million of this borrowing on January 31, 2006.
As of December 31, 2005, we had available liquidity of approximately $1.1 million in cash and cash equivalents and $71.0 million available under our revolving credit facility, net of $4.0 million of outstanding letters of credit. For 2006, we have already spent or expect to spend total cash of approximately $39.0 million for the following requirements:
• approximately $15.8 million for the Newmed acquisition in January 2006, including transaction expenses;
• approximately $5.0 million scheduled principal and interest payments on our credit facility;
• approximately $7.0 million scheduled payments for noncancellable operating leases;
• up to approximately $1.2 million for additional purchase price that could be paid to certain of the Newmed sellers if certain revenue targets are attained; and
• up to approximately $10.0 million for capital expenditures.
In addition, we expect to make other general corporate payments in 2006, including the $3.0 million repayment we made on our revolving line of credit in January 2006.
Seasonality
We generally record our highest net revenues per day in the fourth quarter due to a greater number of orthopedic surgeries and injuries resulting from increased sports activity, particularly football and skiing. In addition, during the fourth quarter, a patient has a greater likelihood of having satisfied his or her annual insurance deductible than in the first three quarters of the year, and thus there is an increase in the number of elective orthopedic surgeries. We follow a manufacturing calendar that has a varied number of shipping days in each quarter. Although on a per day basis net revenues may be higher in a certain quarter, total net revenues may be higher or lower based upon the number of shipping days in such quarter. Conversely, we generally have lower net revenues per day during our second quarter as a result of decreased sports activity.
Recent Accounting Pronouncements
For information on the recent accounting pronouncements impacting our business, see Note 1 of the notes to our consolidated financial statements included in Item 8.
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Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to certain market risks as part of our ongoing business operations. Our primary exposures include changes in interest rates and foreign exchange rates.
We are exposed to interest rate risk in connection with the term loan and borrowings under our revolving credit facility, which bear interest at floating rates based on the London Inter-Bank Offered Rate (LIBOR) or the prime rate plus an applicable borrowing margin. For variable rate debt, interest rate changes generally do not affect the fair market value of the underlying debt, but do impact future earnings and cash flows, assuming other factors are held constant.
As of December 31, 2005, we had $47.5 million of variable rate debt represented by borrowings under our credit facility (at a weighted-average interest rate of 5.35% at December 31, 2005). Based on the balance outstanding under the credit facility as of December 31, 2005, an immediate change of one percentage point in the applicable interest rate would have caused an increase or decrease in interest expense of approximately $0.5 million on an annual basis. At December 31, 2005, up to $71.0 million of variable rate borrowings were available under our $75.0 million revolving credit facility. We may use derivative financial instruments, where appropriate, to manage our interest rate risks. However, as a matter of policy, we do not enter into derivative or other financial investments for trading or speculative purposes. At December 31, 2005, we had no such derivative financial instruments outstanding.
Through our wholly-owned international subsidiaries, we sell products in Euros, Pounds Sterling, Canadian Dollars and Danish Krones. The U.S. dollar equivalent of our international sales denominated in foreign currencies in 2005, 2004 and 2003 were favorably impacted by foreign currency exchange rate fluctuations with the weakening of the U.S. dollar against the foreign currencies of our subsidiaries. The U.S. dollar equivalent of the related costs denominated in these foreign currencies were unfavorably impacted during the same period. In addition, the costs associated with our Mexico-based manufacturing operations are incurred in Mexican pesos. As we continue to distribute and manufacture our products in selected foreign countries, we expect that future sales and costs associated with our activities in these markets will continue to be denominated in the applicable foreign currencies, which could cause currency fluctuations to materially impact our operating results. Occasionally we seek to reduce the potential impact of currency fluctuations on our business through hedging transactions. At December 31, 2005, we had no hedging transactions in place.
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Item 8. Financial Statements and Supplementary Data
The following documents are filed as part of this report:
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
dj Orthopedics, Inc.
We have audited the accompanying consolidated balance sheets of dj Orthopedics, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of dj Orthopedics, Inc. at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of dj Orthopedics, Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 3, 2006 expressed an unqualified opinion thereon.
| /s/ ERNST & YOUNG LLP | |
|
|
San Diego, California |
February 3, 2006 |
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dj Orthopedics, Inc.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and par value data)
| | December 31, | |
| | 2005 | | 2004 | |
Assets | | | | | |
Current assets: | | | | | |
Cash and cash equivalents | | $ | 1,107 | | $ | 11,182 | |
Accounts receivable, net of provisions for contractual allowances and doubtful accounts of $26,792 and $26,628 at December 31, 2005 and 2004, respectively | | 62,068 | | 46,981 | |
Inventories, net | | 24,228 | | 19,071 | |
Deferred tax asset, current portion | | 7,066 | | 7,902 | |
Prepaid expenses and other current assets | | 4,387 | | 5,359 | |
Total current assets | | 98,856 | | 90,495 | |
Property, plant and equipment, net | | 15,396 | | 15,463 | |
Goodwill | | 101,235 | | 96,639 | |
Intangible assets, net | | 51,242 | | 54,717 | |
Debt issuance costs, net | | 2,479 | | 2,374 | |
Deferred tax asset | | 32,437 | | 46,100 | |
Other assets | | 3,019 | | 1,062 | |
Total assets | | $ | 304,664 | | $ | 306,850 | |
| | | | | |
Liabilities and stockholders’ equity | | | | | |
Current liabilities: | | | | | |
Accounts payable | | $ | 10,270 | | $ | 7,300 | |
Accrued compensation | | 6,310 | | 5,484 | |
Accrued commissions | | 3,483 | | 4,425 | |
Long-term debt, current portion | | 5,000 | | 5,000 | |
Accrued restructuring costs | | 417 | | 2,288 | |
Other accrued liabilities | | 10,615 | | 9,315 | |
Total current liabilities | | 36,095 | | 33,812 | |
| | | | | |
Long-term debt, less current portion | | 42,500 | | 90,000 | |
| | | | | |
Commitments and contingencies | | | | | |
| | | | | |
Stockholders’ equity: | | | | | |
Preferred stock, $0.01 par value; 1,000,000 shares authorized, none issued and outstanding at December 31, 2005 and 2004 | | — | | — | |
Common stock, $0.01 par value; 39,000,000 shares authorized, 22,137,860 shares and 21,459,428 shares issued and outstanding at December 31, 2005 and 2004, respectively | | 221 | | 215 | |
Additional paid-in-capital | | 133,656 | | 121,139 | |
Notes receivable from stockholders and officers for stock purchases | | — | | (1,749 | ) |
Accumulated other comprehensive income | | 492 | | 931 | |
Retained earnings | | 91,700 | | 62,502 | |
Total stockholders’ equity | | 226,069 | | 183,038 | |
Total liabilities and stockholders’ equity | | $ | 304,664 | | $ | 306,850 | |
See accompanying Notes.
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dj Orthopedics, Inc.
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
| | Years Ended December 31, | |
| | 2005 | | 2004 | | 2003 | |
Net revenues | | $ | 286,167 | | $ | 255,999 | | $ | 197,939 | |
Costs of goods sold | | 105,289 | | 95,164 | | 85,927 | |
Gross profit | | 180,878 | | 160,835 | | 112,012 | |
Operating expenses: | | | | | | | |
Sales and marketing | | 86,241 | | 78,984 | | 54,067 | |
General and administrative | | 29,432 | | 27,727 | | 21,767 | |
Research and development | | 6,350 | | 5,627 | | 4,442 | |
Amortization of acquired intangibles | | 4,996 | | 4,731 | | 464 | |
Restructuring costs (credit) | | — | | 4,693 | | (497 | ) |
Total operating expenses | | 127,019 | | 121,762 | | 80,243 | |
Income from operations | | 53,859 | | 39,073 | | 31,769 | |
Other income (expense): | | | | | | | |
Interest expense | | (4,667 | ) | (9,431 | ) | (12,582 | ) |
Interest income | | 249 | | 472 | | 398 | |
Prepayment premium and other costs related to senior subordinated notes redemption | | — | | (7,760 | ) | — | |
Other income (expense) | | (980 | ) | 683 | | 466 | |
Other expense, net | | (5,398 | ) | (16,036 | ) | (11,718 | ) |
Income before income taxes | | 48,461 | | 23,037 | | 20,051 | |
Provision for income taxes | | (19,263 | ) | (9,022 | ) | (7,980 | ) |
Net income | | $ | 29,198 | | $ | 14,015 | | $ | 12,071 | |
Net income per share: | | | | | | | |
Basic | | $ | 1.34 | | $ | 0.66 | | $ | 0.67 | |
Diluted | | $ | 1.29 | | $ | 0.63 | | $ | 0.64 | |
| | | | | | | |
Weighted average shares outstanding used to calculate per share information: | | | | | | | |
Basic | | 21,786 | | 21,221 | | 17,963 | |
Diluted | | 22,699 | | 22,209 | | 18,791 | |
See accompanying Notes.
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dj Orthopedics, Inc.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(In thousands, except share data)
| | | | | | | | Notes | | | | | | | |
| | | | | | | | Receivable | | | | | | | |
| | | | | | | | from | | Accumulated | | | | | |
| | | | | | Additional | | Stockholders | | Other | | | | Total | |
| | Common Stock | | Paid-in | | and Officers for | | Comprehensive | | Retained | | Stockholders’ | |
| | Shares | | Amount | | Capital | | Stock Purchases | | Income | | Earnings | | Equity | |
Balance at December 31, 2002 | | 17,872,956 | | $ | 179 | | $ | 65,478 | | $ | (2,197 | ) | $ | 1,037 | | $ | 36,416 | | $ | 100,913 | |
Transfer of interest receivable to notes receivable from management | | — | | — | | — | | (123 | ) | — | | — | | (123 | ) |
Proceeds from payment of notes receivable | | — | | — | | — | | 332 | | — | | — | | 332 | |
Stock options granted for services | | — | | — | | 178 | | — | | — | | — | | 178 | |
Net proceeds from issuance of common stock under Employee Stock Purchase Plan | | 73,172 | | 1 | | 227 | | — | | — | | — | | 228 | |
Net proceeds from exercise of stock options | | 358,141 | | 3 | | 3,662 | | — | | — | | — | | 3,665 | |
Comprehensive income: | | | | | | | | | | | | | | | |
Foreign currency translation adjustment | | — | | — | | — | | — | | 69 | | — | | 69 | |
Net income | | — | | — | | — | | — | | — | | 12,071 | | 12,071 | |
Total comprehensive income | | | | | | | | | | | | | | 12,140 | |
Balance at December 31, 2003 | | 18,304,269 | | 183 | | 69,545 | | (1,988 | ) | 1,106 | | 48,487 | | 117,333 | |
Transfer of interest receivable to notes receivable from management | | — | | — | | — | | (92 | ) | — | | — | | (92 | ) |
Proceeds from payment of notes receivable | | — | | — | | — | | 331 | | — | | — | | 331 | |
Stock options granted for services | | — | | — | | 63 | | — | | — | | — | | 63 | |
Net proceeds from issuance of common stock under Employee Stock Purchase Plan | | 346,919 | | 3 | | 1,614 | | — | | — | | — | | 1,617 | |
Net proceeds from exercise of stock options | | 483,040 | | 5 | | 4,128 | | — | | — | | — | | 4,133 | |
Tax benefit of stock option exercises | | — | | — | | 4,315 | | — | | — | | — | | 4,315 | |
Proceeds from sale of common stock, net of expenses of $1,077 | | 3,162,500 | | 32 | | 56,499 | | — | | — | | — | | 56,531 | |
Expenses of sale of common stock by stockholders | | — | | — | | (245 | ) | — | | — | | — | | (245 | ) |
Repurchases of common stock | | (837,300 | ) | (8 | ) | (14,780 | ) | — | | — | | — | | (14,788 | ) |
Comprehensive income: | | | | | | | | | | | | | | | |
Foreign currency translation adjustment | | — | | — | | — | | — | | (175 | ) | — | | (175 | ) |
Net income | | — | | — | | — | | — | | — | | 14,015 | | 14,015 | |
Total comprehensive income | | | | | | | | | | | | | | 13,840 | |
Balance at December 31, 2004 | | 21,459,428 | | 215 | | 121,139 | | (1,749 | ) | 931 | | 62,502 | | 183,038 | |
Proceeds from payment of notes receivable | | — | | — | | — | | 1,749 | | — | | — | | 1,749 | |
Stock options granted for services | | — | | — | | 219 | | — | | — | | — | | 219 | |
Net proceeds from issuance of common stock under Employee Stock Purchase Plan | | 59,767 | | — | | 1,028 | | — | | — | | — | | 1,028 | |
Net proceeds from exercise of stock options | | 618,665 | | 6 | | 7,715 | | — | | — | | — | | 7,721 | |
Tax benefit of stock option exercises | | — | | — | | 3,455 | | — | | — | | — | | 3,455 | |
Reversal of expenses from 2004 sale of common stock | | — | | — | | 100 | | — | | — | | — | | 100 | |
Comprehensive income: | | | | | | | | | | | | | | | |
Foreign currency translation adjustment | | — | | — | | — | | — | | (439 | ) | — | | (439 | ) |
Net income | | — | | — | | — | | — | | — | | 29,198 | | 29,198 | |
Total comprehensive income | | | | | | | | | | | | | | 28,759 | |
Balance at December 31, 2005 | | 22,137,860 | | $ | 221 | | $ | 133,656 | | $ | — | | $ | 492 | | $ | 91,700 | | $ | 226,069 | |
See accompanying Notes.
53
dj Orthopedics, Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
| | Years Ended December 31, | |
| | 2005 | | 2004 | | 2003 | |
Operating activities | | | | | | | |
Net income | | $ | 29,198 | | $ | 14,015 | | $ | 12,071 | |
Adjustments to reconcile net income to net cash provided by operating activities: | | | | | | | |
Provision for contractual allowances and doubtful accounts | | 34,594 | | 30,556 | | 22,641 | |
Provision for excess and obsolete inventories | | 983 | | (113 | ) | 2,087 | |
Restructuring costs | | — | | 4,693 | | (497 | ) |
Depreciation and amortization | | 13,320 | | 13,070 | | 8,186 | |
Step-up to fair value of inventory charged to costs of goods sold | | 404 | | 438 | | — | |
Amortization of debt issuance costs and discount on senior subordinated notes | | 560 | | 808 | | 1,499 | |
Write-off of debt issuance costs and discount on senior subordinated notes | | — | | 3,025 | | — | |
Liquidation preference on redemption of senior subordinated notes | | — | | 4,735 | | — | |
Other | | 219 | | 63 | | 178 | |
Changes in operating assets and liabilities: | | | | | | | |
Accounts receivable | | (49,681 | ) | (33,353 | ) | (24,708 | ) |
Inventories | | (2,599 | ) | (3,635 | ) | 58 | |
Other current assets | | 912 | | 856 | | (1,991 | ) |
Accounts payable | | 2,970 | | (1,403 | ) | (501 | ) |
Accrued compensation | | 826 | | (1,065 | ) | 1,494 | |
Accrued commissions | | (942 | ) | (214 | ) | 2,847 | |
Deferred income taxes | | 17,580 | | 9,044 | | 6,944 | |
Accrued restructuring costs | | (1,871 | ) | (3,171 | ) | (4,631 | ) |
Other accrued liabilities | | 591 | | 1,121 | | 850 | |
Net cash provided by operating activities | | 47,064 | | 39,470 | | 26,527 | |
| | | | | | | |
Investing activities | | | | | | | |
Purchases of property, plant and equipment | | (5,144 | ) | (5,959 | ) | (5,334 | ) |
Purchases of intangible assets | | (76 | ) | (3,277 | ) | (3,000 | ) |
Purchase of Superior Medical Equipment business | | (3,045 | ) | — | | — | |
Purchase of Encore Medical OSG business | | (9,491 | ) | — | | — | |
Purchase of Regeneration business | | — | | — | | (93,939 | ) |
Purchase of DuraKold business | | — | | — | | (2,899 | ) |
Purchase of dj Nordic business and related earn-out payments, net of cash acquired | | (125 | ) | (578 | ) | — | |
Change in other assets, net | | (1,454 | ) | (360 | ) | (280 | ) |
Net cash used in investing activities | | (19,335 | ) | (10,174 | ) | (105,452 | ) |
| | | | | | | |
Financing activities | | | | | | | |
Proceeds from long-term debt | | 8,000 | | — | | 100,000 | |
Repayment of long-term debt | | (55,500 | ) | (5,000 | ) | (35,815 | ) |
Net proceeds from exercise of stock options | | 7,721 | | 4,133 | | 3,665 | |
Net proceeds from issuance of common stock under Employee Stock Purchase Plan | | 1,028 | | 1,617 | | 228 | |
Debt issuance costs | | (665 | ) | (313 | ) | (2,600 | ) |
Proceeds from payment of notes receivable | | 1,749 | | 331 | | 332 | |
Net proceeds from issuance of common stock | | — | | 56,286 | | — | |
Repurchases of common stock | | — | | (14,788 | ) | — | |
Repayment of senior subordinated notes | | — | | (75,000 | ) | — | |
Prepayment premium on redemption of senior subordinated notes | | — | | (4,735 | ) | — | |
Net cash (used in) provided by financing activities | | (37,667 | ) | (37,469 | ) | 65,810 | |
Effect of exchange rate changes on cash and cash equivalents | | (137 | ) | 209 | | 176 | |
Net decrease in cash and cash equivalents | | (10,075 | ) | (7,964 | ) | (12,939 | ) |
Cash and cash equivalents at beginning of year | | 11,182 | | 19,146 | | 32,085 | |
Cash and cash equivalents at end of year | | $ | 1,107 | | $ | 11,182 | | $ | 19,146 | |
| | | | | | | |
Supplemental disclosure of cash flow information: | | | | | | | |
Interest paid | | $ | 4,436 | | $ | 3,844 | | $ | 10,513 | |
Income taxes paid (refunded), net | | $ | 1,263 | | $ | 618 | | $ | (43 | ) |
Supplemental disclosure of non-cash transactions: | | | | | | | |
Transfer of interest receivable to notes receivable | | $ | — | | $ | 92 | | $ | 123 | |
See accompanying Notes.
54
dj Orthopedics, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands)
1. Organization and Summary of Significant Accounting Policies
dj Orthopedics, Inc. (the Company), is a global medical device company specializing in rehabilitation and regeneration products for the non-operative orthopedic and spine markets.
Basis of Presentation and Principles of Consolidation
The accompanying consolidated financial statements present the historical financial position and results of operations of the Company and include the accounts of its operating subsidiary, dj Orthopedics, LLC (dj Ortho), dj Orthopedics Development Corporation (dj Development), DJ Orthopedics Capital Corporation (DJ Capital), dj Ortho’s wholly owned Mexican subsidiary that manufactures a majority of dj Ortho’s products under Mexico’s maquiladora program, and dj Ortho’s wholly-owned subsidiaries in Canada, Germany, France, the United Kingdom and Denmark. All intercompany accounts and transactions have been eliminated in consolidation.
In August 2004, the Company commenced direct distribution of its products in Denmark, Finland, Norway and Sweden through a new wholly-owned subsidiary, dj Nordic. In October 2003, the Company commenced direct distribution of its products in France through a new wholly-owned subsidiary, dj Orthopedics France S.A.S. (dj France). In each of these countries the Company had previously sold its products through third-party distributors. In connection with the Company’s January 2006 acquisition of Newmed SAS (Newmed), as discussed in Note 13, the Company has increased the size and scale of its international business. The Newmed acquisition increases the Company’s sales and marketing presence in France and the business activities of dj France will be combined with Newmed. Through the Newmed subsidiary in Spain, the Company also now has a direct sales presence in Spain (dj Spain). Newmed also owns 70% of a manufacturing subsidiary in Tunisia.
Use of Estimates in the Preparation of Financial Statements
The preparation of these financial statements requires that the Company make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to contractual allowances, doubtful accounts, inventories, rebates, product returns, warranty obligations, income taxes and intangibles. The Company bases its 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 values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
Cash Equivalents
Cash equivalents are short-term, highly liquid investments and consist of investments in money market funds and commercial paper with maturities of three months or less at the time of purchase.
Fair Value of Financial Instruments
In accordance with Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 107, Disclosures about Fair Value of Financial Instruments, the following methods and assumptions were used in estimating fair value disclosures:
• Cash and Cash Equivalents and Accounts Receivable. The carrying amounts approximate fair values because of the short maturities of these instruments and the reserves for contractual allowances and doubtful accounts which, in the opinion of management, are adequate to state accounts receivable at their fair value.
• Long-Term Debt. Based on the borrowing rates currently available to the Company for loans with similar terms and average maturities, management of the Company believes the fair value of long-term debt approximates its carrying value at December 31, 2005.
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Discounts and Allowances
Accounts receivable in the accompanying consolidated balance sheets are presented net of reserves for estimated payment discounts, contractual allowances related to third-party payors, and allowances for doubtful accounts.
Long-Lived Assets
Property, plant and equipment and intangible assets are recorded at cost. The Company provides for depreciation of property, plant and equipment (three to seven years) and amortization of intangible assets (four months to 20 years) using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the lesser of their estimated useful lives or the terms of the related leases.
Computer Software Costs
The Company applies the American Institute of Certified Public Accountants Statement of Position 98-1, Accounting for Costs of Computer Software Developed or Obtained for Internal Use. This standard requires companies to capitalize qualifying computer software costs, incurred during the application development stage and then amortizes the costs over the estimated useful life of the software. The Company is amortizing computer software costs over lives of three to seven years. The Company has unamortized capitalized computer software costs aggregating $2.2 million and $2.6 million at December 31, 2005 and 2004, respectively. Capitalized computer software amortization expense was approximately $1.1 million, $1.3 million and $1.0 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Debt Issuance Costs
Debt issuance costs are capitalized. The Company amortizes these costs over the lives of the related debt instruments (currently, five years) and classifies the amortization expense with interest expense in the accompanying consolidated statements of income.
Inventories
Inventories are stated at the lower of cost or market, with cost determined on a first-in, first-out (FIFO) basis.
Revenue Recognition
The Company distributes its products in the United States and international markets primarily through networks of agents, distributors and the Company’s direct sales force that market its products to orthopedic and spine surgeons, podiatrists, orthopedic and prosthetic centers, third-party distributors, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals.
The Company recognizes revenue pursuant to Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. Accordingly, revenue is recognized when all four of the following criteria are met: (i) persuasive evidence that an arrangement exists; (ii) shipment of goods and passage of title; (iii) the selling price is fixed or determinable; and (iv) collectibility is reasonably assured. Revenues from third-party insurance payors are recorded net of estimated contractual allowances, which are accrued as a percent of revenues based on actual historical experience. Revenues are also reduced by allowances for estimated returns and rebates related to sales transacted through distribution agreements that provide the distributors with a right to return excess and obsolete inventory. Estimated returns, based on historical actual returns, are accrued in accordance with the provisions of SFAS No. 48, Revenue Recognition When Right of Return Exists, in the period sales are recognized. In addition, rebates are accrued at the time of sale based upon historical experience and estimated revenue levels in accordance with agreed upon terms with customers. The Company includes amounts billed to customers for freight in revenue.
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Warranty Costs
Some products have a limited warranty and estimated warranty costs are accrued based on historical experience in the period sales are recognized. Warranty costs are included in costs of goods sold and were $0.9 million, $1.3 million and $0.5 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Advertising Expense
Advertising costs are expensed as incurred. The Company incurred $0.7 million, $0.5 million and $0.2 million in advertising expenses for the years ended December 31, 2005, 2004 and 2003, respectively.
Foreign Currency Translation
The financial statements of the Company’s international operations where the local currency is the functional currency are translated into United States (U.S.) dollars using period-end exchange rates for assets and liabilities and average exchange rates during the period for revenues and expenses. Cumulative translation gains and losses are excluded from results of operations and recorded as a separate component of consolidated stockholders’ equity. Gains and losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity’s local currency) are included in the consolidated statements of operations as either a component of costs of goods sold or other income or expense, depending on the nature of the transaction. The aggregate exchange rate gain or (loss) included in determining net income for the years ended December 31, 2005, 2004 and 2003 was ($0.6) million, $0.6 million and $0.4 million, respectively.
Concentration of Credit Risk
The Company sells the majority of its products in the United States to orthopedic professionals, distributors, specialty dealers, buying groups, insurance companies, managed care companies and certain governmental payors such as Medicare. International sales comprised 12%, 11% and 13% of the Company’s net revenues for the years ended December 31, 2005, 2004 and 2003, respectively, and are sold through its wholly-owned subsidiaries and certain independent distributors. Credit is extended based on an evaluation of the customer’s financial condition and generally collateral is not required. The Company also provides a reserve for estimated bad debts. In addition, approximately 49% and 48% of the Company’s net receivables at December 31, 2005 and 2004, respectively, are from third-party payors. Management reviews and revises its estimates for credit losses from time to time and such credit losses have been within management’s estimates.
During the three years ended December 31, 2005, the Company had no individual customer or distributor that accounted for 10% or more of total annual revenues.
Per Share Information
Earnings per share are computed in accordance with SFAS No. 128, Earnings Per Share. Basic earnings per share are computed using the weighted average number of common shares outstanding during each period. Diluted earnings per share include the dilutive effect of weighted average common share equivalents potentially issuable upon the exercise of stock options. For purposes of computing diluted earnings per share, weighted average common share equivalents (computed using the treasury stock method) do not include stock options with an exercise price that exceeds the average fair market value of the Company’s common stock during the periods presented. For the years ended December 31, the weighted average shares outstanding used to calculate basic and diluted share information consist of the following (in thousands):
| | 2005 | | 2004 | | 2003 | |
Shares used in basic net income per share – weighted average shares outstanding | | 21,786 | | 21,221 | | 17,963 | |
Net effect of dilutive common share equivalents based on treasury stock method | | 913 | | 988 | | 828 | |
Shares used in computations of diluted net income per share | | 22,699 | | 22,209 | | 18,791 | |
Stock-Based Compensation
Through December 31, 2005, the Company accounted for its employee stock option plans and employee stock purchase plan under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25,
57
Accounting for Stock Issued to Employees and its related interpretations, and has adopted the disclosure only provisions of SFAS No. 123, Accounting for Stock-Based Compensation and its related interpretations. Accordingly, no compensation cost has been recognized for the Company’s fixed stock option plans or stock purchase plan. In accordance with EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, stock options and warrants issued to consultants and other non-employees as compensation for services provided to the Company are accounted for based upon the fair value of the services provided or the estimated fair market value of the option or warrant, whichever can be more clearly determined. The Company recognizes this expense over the period the services are provided; however, the amount of expense related to these types of arrangements has never been significant.
Pro forma information regarding net income is required by SFAS No. 123 and has been determined as if the Company had accounted for its employee stock options and employee stock purchase plan purchases under the fair value method of SFAS No. 123. The fair value of the options was estimated at the date of grant using the Black-Scholes valuation model for option pricing with the following assumptions for 2005, 2004 and 2003: a risk-free interest rate of 3.81%, 3.18% and 2.68%, respectively; a dividend yield of zero; expected volatility of the market price of the Company’s common stock of 59.6%, 71.5% and 74.2%, respectively, and a weighted average life of an option of 3.7, 4.0 and 4.0 years, respectively. The fair value of the employee stock purchase plan purchases was estimated using the Black-Scholes valuation model with the following assumptions for 2005, 2004 and 2003: a risk-free interest rate of 2.71%, 1.51% and 1.30%, respectively; a dividend yield of zero; expected volatility of the market price of the Company’s common stock of 61.7%, 61.7% and 59.0%, respectively, and a weighted average life of 0.7 years, 1.3 years and 0.8 years, respectively.
For the years ended December 31, the following table illustrates the effect on net income and net income per share had the Company applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (in thousands, except per share amounts):
| | 2005 | | 2004 | | 2003 | |
Net income as reported | | $ | 29,198 | | $ | 14,015 | | $ | 12,071 | |
Total stock-based employee compensation expense determined under fair value method for all option plans and stock purchase plan, net of related tax effects | | (6,993 | ) | (6,356 | ) | (2,026 | ) |
Pro forma net income | | $ | 22,205 | | $ | 7,659 | | $ | 10,045 | |
Basic net income per share: | | | | | | | |
As reported | | $ | 1.34 | | $ | 0.66 | | $ | 0.67 | |
Pro forma | | $ | 1.02 | | $ | 0.36 | | $ | 0.56 | |
| | | | | | | |
Diluted net income per share: | | | | | | | |
As reported | | $ | 1.29 | | $ | 0.63 | | $ | 0.64 | |
Pro forma | | $ | 0.98 | | $ | 0.34 | | $ | 0.53 | |
The pro forma effect on net income as shown above is not necessarily indicative of potential effects on results for future years. The weighted average fair value of options granted during 2005, 2004 and 2003 was $12.54, $12.09 and $11.30 per share, respectively.
On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), or SFAS No. 123(R), Share-Based Payment, which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes APB Opinion No. 25, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values and pro forma disclosure will no longer be an alternative. SFAS No. 123(R) is required to be implemented no later than the first interim period beginning after December 15, 2005. The Company plans to adopt SFAS No. 123(R) effective in its fiscal quarter beginning January 1, 2006. The Company estimates that the adoption of SFAS No. 123(R) will reduce its operating income for 2006 by an amount that will not exceed the pro forma amount shown in the table above for 2005. This estimate assumes that the number of employee stock options granted in 2006 will be similar to the number granted in 2005 and is subject to change based on the actual number of stock options granted in 2006, the dates on which the grants are made and the share price on the date of grant. In an effort to reduce stock based compensation expense for 2006, the Company postponed its year-end option grants from December 2005 to an estimated future grant date of April 2006 and also has added a three-year vesting schedule to future annual director grants.
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Income Taxes
The Company utilizes the liability method of accounting for income taxes as set forth in SFAS No. 109, Accounting for Income Taxes. Under the liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized.
Comprehensive Income (Loss)
The Company has adopted SFAS No. 130, Reporting Comprehensive Income, which requires that all components of comprehensive income (loss), including net income (loss), be reported in the financial statements in the period in which they are recognized. Comprehensive income (loss) is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. Net income (loss) and other comprehensive income (loss), including foreign currency translation adjustments, and unrealized gains and losses on investments, are reported, net of related tax, to arrive at comprehensive income (loss).
Recently Issued Accounting Standards
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which is a replacement of APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. Among other changes, SFAS No. 154 requires that a voluntary change in accounting principle be applied retrospectively such that all prior period financial statements are presented in accordance with the new accounting principle, unless impracticable to do so. SFAS No. 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a “restatement”. SFAS No. 154 is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005.
In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, which is the result of its efforts to converge U.S. accounting standards for inventories with International Accounting Standards. SFAS No. 151 requires idle facility expenses, freight, handling costs, and wasted material (spoilage) costs to be recognized as current-period charges. It also requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not expect the adoption of SFAS No. 151 to have a material impact on its consolidated financial statements.
Purchase of Rights to Distributor Territories
From time to time the Company purchases rights to certain distributor territories in the U.S. and then sells the distribution rights to another party for similar amounts. These distribution reorganizations are intended to achieve several objectives, including improvement of sales results within the affected territories. The Company generally receives promissory notes for the resale amounts, which are recorded as notes receivable and included in other current and long-term assets in the accompanying consolidated balance sheets. For the years ended December 31, 2005 and December 31, 2004, the Company purchased and resold territory rights for amounts aggregating $2.1 million and $1.9 million, respectively, and did not record any gains or losses from the transfer of these distribution rights. For the years ended December 31, 2005 and 2004, purchase price aggregating $2.0 million and $0.7 million, respectively, was recorded as notes receivable and is included in other current or long-term assets, depending on maturity, and will be repaid over periods ranging from three years to five years. For the years ended December 31, 2005 and 2004, purchase price aggregating $0.1 million and $1.2 million, respectively, based on an estimate of future savings in selling expense, was capitalized as an intangible asset and will be amortized over the period of cost reduction.
Goodwill and Other Intangible Assets
The Company accounts for goodwill and other intangible assets in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 changed the accounting for goodwill from an amortization method to an impairment write-off approach. Under SFAS No. 142, goodwill is tested annually and
59
whenever events or circumstances occur indicating that goodwill might be impaired. On an ongoing basis, absent any indicators of impairment, the Company performs an annual impairment evaluation during the fourth quarter, as of October 1 each year. With the exception of goodwill related to the Regeneration acquisition of $39 million, the Company believes that the goodwill acquired through December 31, 2005 benefits the entire enterprise and since its reporting units share the majority of the Company’s assets, the Company compares the total carrying value of the Company’s consolidated net assets (excluding Regeneration net assets) to the fair value of the Company. With respect to goodwill related to the Regeneration acquisition, the Company compares the carrying value of the goodwill related to the Regeneration segment to the fair value of the Regeneration segment.
The Company has acquired licenses to certain patents aggregating $4.2 million, including patent licenses acquired in 2004 for $0.8 million. These amounts are recorded as intangible assets and are amortized over the remaining life of the patents, through June 2010.
Components of intangible assets acquired in business combinations and acquired as individual assets are as follows (in thousands):
| | December 31, 2005 | | December 31, 2004 | |
| | Useful
Life
(years) | | Gross
Carrying
Amount | | Accumulated
Amortization | | Net
Carrying
Amount | | Gross
Carrying
Amount | | Accumulated
Amortization | | Net
Carrying
Amount | |
| | | | | | | | | | | | | | | |
Intangible assets subject to amortization: | | | | | | | | | | | | | | | |
Patented and existing technology | | 5-20 | | $ | 53,887 | | $ | (20,722 | ) | $ | 33,165 | | $ | 51,886 | | $ | (16,250 | ) | $ | 35,636 | |
Customer base | | 15-20 | | 18,873 | | (7,556 | ) | 11,317 | | 18,026 | | (6,187 | ) | 11,839 | |
Licensing agreements | | 5 | | 4,200 | | (1,076 | ) | 3,124 | | 4,200 | | (654 | ) | 3,546 | |
Other | | 0.3-20 | | 6,765 | | (3,129 | ) | 3,636 | | 5,487 | | (1,791 | ) | 3,696 | |
| | | | $ | 83,725 | | $ | (32,483 | ) | $ | 51,242 | | $ | 79,599 | | $ | (24,882 | ) | $ | 54,717 | |
Intangible assets not subject to amortization: | | | | | | | | | | | | | | | |
Goodwill | | N/A | | $ | 115,183 | | $ | (13,948 | ) | $ | 101,235 | | $ | 110,587 | | $ | (13,948 | ) | $ | 96,639 | |
| | | | | | | | | | | | | | | | | | | | | | | |
Amortization expense related to intangible assets was $7.6 million, $7.0 million and $3.4 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Future amortization expense of intangible assets is estimated to be $51.2 million, as follows: 2006 - $7.5 million, 2007 - $7.2 million, 2008 - $6.4 million, 2009 - $6.2 million, 2010 - $6.0 million and thereafter - $17.9 million.
2. Financial Statement Information
Inventories
Inventories consist of the following at December 31 (in thousands):
| | 2005 | | 2004 | |
Raw materials | | $ | 7,335 | | $ | 7,116 | |
Work-in-progress | | 1,010 | | 1,027 | |
Finished goods | | 18,203 | | 14,109 | |
| | 26,548 | | 22,252 | |
Less reserves, primarily for excess and obsolete inventories | | (2,320 | ) | (3,181 | ) |
| | $ | 24,228 | | $ | 19,071 | |
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Property, Plant and Equipment
Property, plant and equipment consists of the following at December 31 (in thousands):
| | 2005 | | 2004 | |
Leasehold improvements | | $ | 5,514 | | $ | 4,430 | |
Furniture, fixtures and equipment | | 43,537 | | 39,362 | |
| | 49,051 | | 43,792 | |
Less accumulated depreciation and amortization | | (33,655 | ) | (28,329 | ) |
| | $ | 15,396 | | $ | 15,463 | |
Depreciation expense was approximately $5.1 million, $5.3 million and $4.3 million for the years ended December 31, 2005, 2004 and 2003, respectively, and amortization expense related to property, plant and equipment was approximately $0.6 million, $0.7 million and $0.5 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Accrued Compensation
Accrued compensation consists of the following at December 31 (in thousands):
| | 2005 | | 2004 | |
Accrued vacation | | $ | 1,884 | | $ | 1,670 | |
Accrued bonus | | 1,874 | | 683 | |
Accrued workers’ compensation | | 1,558 | | 2,049 | |
Other accrued compensation | | 994 | | 1,082 | |
| | $ | 6,310 | | $ | 5,484 | |
3. Acquisitions
The Company accounts for acquisitions in accordance with SFAS No. 141, Business Combinations. SFAS No. 141 replaced prior accounting standards and eliminated pooling-of-interests accounting prospectively. It also provides guidance on purchase accounting related to the recognition of intangible assets and accounting for negative goodwill.
OSG Acquisition
On August 8, 2005, the Company completed the purchase of substantially all of the assets of the orthopedics soft goods (OSG) business of Encore Medical, L.P. (OSG acquisition) for approximately $9.5 million, paid in cash upon closing, plus the assumption of certain liabilities aggregating approximately $0.6 million. The OSG business is comprised of the manufacture and sale of orthopedic soft goods, patient safety products and pressure care products.
The fair values of the assets acquired and the liabilities assumed in connection with the OSG acquisition were estimated in accordance with SFAS No. 141. The Company used an independent valuation firm to assist management in estimating these fair values. The purchase price was allocated as follows to the fair values of the net tangible and intangible assets acquired (in thousands):
Inventories, net | | $ | 3,870 | |
Fixed assets, net | | 409 | |
Accrued liabilities | | (589 | ) |
Tangible assets, net | | 3,690 | |
Identifiable intangible assets | | 3,500 | |
Goodwill | | 2,301 | |
Net assets acquired | | $ | 9,491 | |
The identifiable intangible assets are being amortized over their estimated useful lives, which range from three to eight years.
The purchase price allocation included values assigned to certain specific identifiable intangible assets aggregating $3.5 million. A value of $2.0 million was assigned to existing technology, determined primarily by estimating the future discounted cash flows to be derived from the OSG products that existed at the date of the acquisition. An aggregate value of $1.5 million was assigned to certain OSG customer relationships existing on the acquisition date based upon an estimate of the future discounted cash flows that would be derived from those customers. A value of $2.3 million, representing the difference
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between the total purchase price and the aggregate fair values assigned to the net tangible assets acquired and liabilities assumed and the identifiable intangible assets acquired, was assigned to goodwill.
The Company acquired the OSG business to expand its portfolio of national contracts and increase its related revenues and also to gain access to the patient safety products and pressure care products, which were not previously included in the Company’s product portfolio. These are among the factors that contributed to a purchase price for the OSG acquisition that resulted in the recognition of goodwill.
Superior Medical Equipment Acquisition
On March 10, 2005, the Company completed the purchase of substantially all of the assets of Superior Medical Equipment, LLC (SME), a Connecticut based distributor of orthopedic products and supplies, for an aggregate purchase price of up to $4.2 million, of which approximately $3.1 million was paid upon closing, $0.1 million was paid as a final purchase price adjustment in April 2005 and $0.5 million will be paid in March 2006. The remaining amount of up to $0.5 million will be paid in March 2006 subject to achievement of certain operating targets. The assets acquired from SME included tangible and intangible assets related to the distribution of orthopedic products and supplies. The SME acquisition has been accounted for using the purchase method of accounting whereby the total purchase price was allocated to tangible and intangible assets acquired based on estimated fair market values with the remainder classified as goodwill.
KD Innovation Acquisition
On August 30, 2004, the Company acquired the outstanding stock of KD Innovation A/S (KDI), its independent distributor in Denmark. The acquired company, renamed dj Orthopedics Nordic ApS (dj Nordic), has direct responsibility for sales, marketing and distribution of dj Orthopedics’ products in Denmark, Finland, Norway and Sweden. The stock purchase agreement provided for the purchase of all of the outstanding capital stock for KDI for an initial cash purchase price of $0.7 million, paid in October 2004, $0.1 million paid in September 2005 for operating income target met, plus amounts aggregating up to an additional $0.4 million through 2009 if certain net operating income targets are met. The acquisition was accounted for using the purchase method of accounting whereby a total purchase price of approximately $1.0 million, including the portion of the contingent future payments that were deemed by management to be probable, was allocated to tangible and intangible assets acquired and liabilities assumed based on their estimated fair market values as of the acquisition date. The assets acquired included cash of approximately $0.1 million.
Regeneration Acquisition
On November 26, 2003, the Company acquired the Regeneration business from OrthoLogic for approximately $93.0 million in cash plus certain assumed liabilities aggregating approximately $0.9 million and transaction costs amounting to approximately $0.9 million. The Company financed the purchase with cash on hand of $12.1 million and a portion of the proceeds of a $100.0 million term loan received in connection with a new credit agreement.
The total purchase price was comprised of the following (in thousands):
Cash paid for Regeneration business | | $ | 93,000 | |
Transaction costs | | 939 | |
Total purchase price | | $ | 93,939 | |
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The fair values of the assets acquired and the liabilities assumed in connection with the Regeneration acquisition were estimated in accordance with SFAS No. 141. The Company used an independent valuation firm to assist management in estimating these fair values. The purchase price was allocated as follows to the fair values of the net tangible and intangible assets acquired (in thousands):
Fair value of net tangible assets acquired and liabilities assumed: | | | | | |
Accounts receivable, net | | $ | 7,927 | | | |
Inventories, net | | 2,611 | | | |
Other current assets | | 42 | | | |
Fixed assets, net | | 922 | | | |
Other assets | | 14 | | | |
Accounts payable | | (401 | ) | | |
Accrued compensation and commissions | | (277 | ) | | |
Other accrued liabilities | | (200 | ) | | |
| | | | 10,638 | |
Fair value of identifiable intangible assets acquired: | | | | | |
Existing technology | | 27,800 | | | |
Patented technology | | 10,100 | | | |
Customer relationships | | 5,200 | | | |
Customer contract | | 800 | | | |
Distribution agreement | | 700 | | | |
Order backlog | | 200 | | | |
| | | | 44,800 | |
Goodwill | | | | 38,501 | |
Total purchase price allocation | | | | $ | 93,939 | |
| | | | | | | |
The intangible assets are being amortized over their estimated useful lives, which range from four months to ten years.
The purchase price allocation included values assigned to certain specific identifiable intangible assets aggregating $44.8 million. A value of $27.8 million was assigned to existing technology, determined primarily by estimating the future discounted cash flows to be derived from the Regeneration technologies and products that existed at the date of the acquisition. A value of $10.1 million was assigned to patented technology, determined primarily by estimating the present value of future royalty or license costs that will be avoided due to the Company’s ownership of the proprietary technologies acquired. A value of $5.2 million was assigned to customer relationships based on an estimate of the present value of future costs that would have been incurred to establish similar relationships with Regeneration customers comparable in type and number to those customers that existed at the date of acquisition. A value of $0.8 million was assigned to one significant long-term customer contract of the Regeneration business based upon an estimate of the future discounted cash flows that would be derived from that contract. A value of $0.7 million was assigned to a distribution agreement in place for the Regeneration business, pursuant to which certain independent sales representatives had been trained to sell certain of the acquired Regeneration products. The value assigned to this contract was determined based upon an estimate of the present value of costs that the Company would have incurred to recruit and train a comparable sales force had the distribution agreement not been in place. A value of $0.2 million was assigned to the order backlog of the Regeneration business as of the date of the acquisition, based on an estimate of the present value of the cost that would be required to recreate a similar order backlog. A value of $38.5 million, representing the difference between the total purchase price and the aggregate fair values assigned to the net tangible assets acquired and liabilities assumed and the identifiable intangible assets acquired, was assigned to goodwill.
The Company acquired the Regeneration business to enter the Regeneration segment of the non-operative orthopedic and spine markets, expanding the addressable markets served by the Company. The Regeneration markets are estimated to grow faster than the rehabilitation markets in which the Company competes and the Regeneration products generate gross margins and operating margins that are higher than the Company’s rehabilitation products. These are among the factors that contributed to a purchase price for the Regeneration acquisition that resulted in the recognition of goodwill.
The accompanying consolidated statement of income reflects the operating results of the Regeneration business since the acquisition date of November 26, 2003. Assuming the purchase of the Regeneration business had occurred on January 1 of the year ended December 31, 2003 the pro forma unaudited results of operations for 2003 would have been as follows (in thousands, except per share data):
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Net revenues | | $ | 240,378 | |
Costs of goods sold | | 92,562 | |
Gross profit | | 147,816 | |
Operating expenses: | | | |
Sales, marketing, general and administrative | | 98,794 | |
Research and development | | 5,211 | |
Amortization of acquired intangibles | | 4,808 | |
Impairment of long-lived assets | | — | |
Performance improvement, restructuring and other | | (497 | ) |
Total operating expenses | | 108,316 | |
Income from operations | | 39,500 | |
Interest expense, net of interest income | | (14,434 | ) |
Other income | | 466 | |
Income before income taxes | | 25,532 | |
Provision for income taxes | | (10,162 | ) |
Net income | | $ | 15,370 | |
| | | |
Net income per share: | | | |
Basic | | $ | 0.86 | |
Diluted | | $ | 0.82 | |
| | | |
Weighted average shares outstanding used to calculate per share information: | | | |
Basic | | 17,963 | |
Diluted | | 18,791 | |
DuraKold acquisition
In June 2003, the Company completed the purchase of specified assets and assumed certain liabilities of Dura*Kold Corporation (DuraKold) for an aggregate purchase price of $3.0 million. The assets acquired from DuraKold included tangible and intangible assets related to a line of proprietary cold wrap products for orthopedic and medical applications. The Company began selling the products manufactured by DuraKold in July 2001 under a distribution agreement. The DuraKold acquisition was accounted for using the purchase method of accounting whereby the total purchase price was allocated to tangible and intangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date, as follows:
Goodwill | | $ | 2,446 | |
Other intangible assets | | 368 | |
Tangible assets | | 186 | |
Net assets acquired | | $ | 3,000 | |
The other intangible assets include a covenant not to compete and the acquired customer base, which are being amortized over their estimated useful lives.
4. Restructuring Costs
In August 2004, the Company began the integration of its Regeneration sales organization into its DonJoy sales organization and most of its remaining Regeneration operations in Tempe, Arizona into its corporate facility in Vista, California. The objectives of the Regeneration integration were to strengthen the distribution activities of the Regeneration business and to reduce both costs of goods sold and operating expenses as a percentage of net revenues in future periods, after the related costs of the integration were incurred. In addition, in August 2004, the Company completed construction of a new leased 200,000 square foot manufacturing facility in Tijuana, Mexico to replace three separate facilities it operated in the same area. All of the Company’s existing Mexico facilities were moved to this new facility in 2004. The Company also relocated the manufacturing of its cold therapy products and machine shop activities from Vista, California to the new Mexico plant in 2004. The relocation to Mexico of these California-based activities resulted in reduced manufacturing costs in 2005. The Regeneration integration and the move of the U.S. manufacturing operations resulted in the elimination of approximately 130 positions, including temporary employees, by December 31, 2004. Approximately 110 new positions were added in Vista and
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Mexico in the aggregate to accommodate the operations moved to each of those locations. The Regeneration integration and manufacturing moves were both substantially completed by December 31, 2004.
The Company accounts for restructuring costs in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with exit or disposal activities. SFAS No. 146 requires that costs associated with an exit or disposal activity be recorded as an expense and a liability when incurred. The results for the year ended December 31, 2004 include charges totaling $4.7 million ($2.9 million net of tax) including $3.8 million related to the Company’s Regeneration integration and $0.9 million related to the manufacturing moves.
Restructuring costs accrued in 2004 in connection with these activities are as follows (in thousands):
| | Total Costs
Incurred | | Completed
Activity
(Cash) | | Completed
Activity
(Non-Cash) | | Accrued Liability
at December 31,
2005 | |
| | | | | | | | | |
Employee severance and retention costs | | $ | 2,435 | | $ | (2,435 | ) | $ | — | | $ | — | |
Other | | 2,258 | | (2,091 | ) | (167 | ) | — | |
Total | | $ | 4,693 | | $ | (4,526 | ) | $ | (167 | ) | $ | — | |
Accrued restructuring costs in the accompanying consolidated balance sheet at December 31, 2005, includes $0.4 million of lease termination and other exit costs remaining from an amount accrued in 2002. This amount relates to vacant land previously leased by the Company (see Note 10).
5. Long-Term Debt
The Company’s long-term debt consists of the following at December 31 (in thousands):
| | 2005 | | 2004 | |
Term loan due in installments through May 5, 2010 bearing interest at LIBOR plus 1.25% (5.35% at December 31, 2005) | | $ | 47,500 | | $ | 95,000 | |
Less current portion | | (5,000 | ) | (5,000 | ) |
Long-term portion of term loan | | $ | 42,500 | | $ | 90,000 | |
Redemption of Senior Subordinated Notes
In June 2004, the Company redeemed all of its outstanding senior subordinated notes for $79.7 million, including a redemption premium of $4.7 million. The redemption was funded by net proceeds of $56.5 million from the Company’s February 2004 sale of common stock and from existing cash. As a result of the redemption, the Company recorded a charge in 2004 of $7.8 million, including a redemption premium of $4.7 million, unamortized debt issuance costs of $2.3 million and original issue discounts of $0.8 million.
Credit Agreement Amendment
On May 5, 2005, the Company completed an amendment to its credit agreement. Previously, the credit agreement consisted of a $100.0 million term loan, of which approximately $93.8 million was owed as of the date of the amendment, and a $30.0 million revolving line of credit on which no amounts had been drawn. The amended credit agreement provides for total borrowings of $125.0 million, consisting of a term loan of $50.0 million, which was fully drawn at closing and $75.0 million available under a revolving line of credit, of which approximately $43.8 million was drawn at closing. Prior to December 31, 2005, the Company repaid all of the amounts outstanding under the revolving line of credit. The Company was contingently liable for outstanding letters of credit aggregating approximately $4.0 million at December 31, 2005. Under the amended agreement, up to $25.0 million of outstanding borrowings may be denominated in British Pounds or Euros. As of December 31, 2005, all borrowings under the credit agreement were denominated in U.S. dollars. Borrowings under the term loan and on the revolving credit facility bear interest at variable rates (either a London Inter-Bank Offered Rate (LIBOR) or the lenders’ base rate, as elected by the Company) plus an applicable margin, which varies based on the Company’s leverage ratio. The amended agreement reduced the Company’s interest rate to LIBOR plus an applicable margin of 1.25% to 2.00%, or the lenders’ base rate plus an applicable margin of 0.25% to 1.00%. At the Company’s current leverage ratio, the applicable interest rate is either
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LIBOR plus 1.25% or base rate plus 0.25%. The weighted average interest rate applicable to the Company’s borrowings as of December 31, 2005 was 5.35%.
Repayment. The Company is required to make quarterly principal payments on the term loan of $1.25 million, beginning in September 2005 and increasing to $1.875 million in September 2007, $3.125 million in September 2008 and $5.0 million in September 2009. The balance of the term loan, if any, and any borrowings under the revolving credit facility are due in full on May 5, 2010. The Company is also required to make mandatory prepayments under certain circumstances. Prior to December 31, 2005, the Company repaid $2.5 million of the amounts outstanding under the term loan and $47.5 million remained outstanding under the term loan as of December 31, 2005.
Security; Guarantees. The obligations of dj Ortho under the credit agreement are irrevocably guaranteed, jointly and severally, by the Company, dj Development, DJ Capital and future U.S. subsidiaries. In addition, the credit agreement and the guarantees thereunder are secured by substantially all the assets of the Company.
Covenants. The credit facility contains a number of covenants that, among other things, restrict the ability of the Company to (i) incur additional indebtedness; (ii) incur or guarantee obligations; (iii) pay dividends or make other distributions (except for certain tax distributions); (iv) redeem or repurchase equity, make investments, loans or advances, make acquisitions; (v) engage in mergers or consolidations; (vi) change the business conducted by the Company; (vii) grant liens on or sell its assets; or (viii) engage in certain other activities. The amended agreement provides less restriction than the Company’s previous agreement in most of these areas. In addition, the amended credit agreement requires the Company to maintain specified financial ratios, including a maximum leverage ratio and a minimum fixed charge coverage ratio. The Company was in compliance with all covenants as of December 31, 2005.
Debt Issuance Costs
The Company has capitalized debt issuance costs aggregating $3.6 million in association with its current credit agreement, as amended. The total costs related to the credit agreement are being amortized as interest expense over the term of the credit agreement and are reflected in the accompanying consolidated balance sheets, net of accumulated amortization of $1.1 million and $0.5 million at December 31, 2005 and 2004, respectively.
6. Related Party Transactions
In 2005 and 2004, certain management stockholders who previously purchased shares of the Company’s stock in exchange for promissory notes, repaid the entire balances of such notes, including interest, owed to the Company. Amounts repaid included $1.8 million paid in 2005 and $0.3 million paid in each of 2004 and 2003.
7. Common and Preferred Stock
At December 31, 2005, the Company had a total of 22,137,860 shares of common stock outstanding.
In June 2004, the Company completed a public offering of 3,072,379 shares of its common stock. All of these shares were sold by certain of the Company’s stockholders and the Company did not receive any of the net proceeds. The Company incurred costs of $0.2 million related to this offering, which were recorded as a reduction in the Company’s additional paid-in capital.
In February 2004, the Company completed a public offering of 8,625,000 shares of its common stock. The offering consisted of 3,162,500 shares of common stock sold by the Company at $19.00 per share for net proceeds, after underwriters’ commissions and other costs, of $56.5 million and 5,462,500 shares sold by certain of the Company’s stockholders.
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Stock Options
2001 Omnibus Plan
The 2001 Omnibus plan provides for awards of stock options, stock appreciation rights, performance awards, restricted stock, restricted stock units, stock bonuses, stock unit awards and cash bonuses to key personnel, including consultants and advisors. Except as hereafter described and subject to equitable adjustments to reflect certain corporate events, the maximum number of shares of the Company’s common stock with respect to which awards may be granted under the Omnibus Plan is 6,517,732 at December 31, 2005. On each January 1, commencing with January 1, 2003, the number of shares of common stock available for issuance under the Omnibus Plan is automatically increased by a number of shares equal to 3% of the number of shares of common stock outstanding on the previous December 31. In addition, shares of common stock reserved for but not subject to options granted under the 1999 Option Plan or subject to awards that are forfeited, terminated, canceled or settled without the delivery of common stock under the Omnibus Plan and the 1999 Option Plan will increase the number of shares available for awards under the Omnibus Plan. Also, shares tendered to dj Orthopedics, Inc. in satisfaction or partial satisfaction of the exercise price of any award under the Omnibus Plan or the 1999 Option Plan will increase the number of shares available for awards under the Omnibus Plan to the extent permitted by Rule 16b-3 under the Securities Exchange Act of 1934, as amended. The Omnibus Plan is administered by the Compensation Committee of the Company’s Board of Directors, which has the sole and complete authority to grant awards under the Omnibus Plan to eligible employees and officers of, and consultants and advisors to, dj Orthopedics, Inc. and its subsidiaries. Most options granted under the Omnibus Plan are subject to vesting in equal annual installments over four years. Options granted under the Omnibus Plan expire ten years from the date of grant. At December 31, 2005 options to purchase 3,303,387 shares had been granted. At December 31, 2005 and 2004, 828,520 and 610,343 shares were exercisable, respectively. On December 31, 2005, 3,214,345 shares were available for future grant under the Omnibus Plan. On January 1, 2006, the shares available for future grant were increased by 664,136 shares to 3,878,481 shares.
1999 Option Plan
Under the Company’s Fifth Amended and Restated 1999 Option Plan (the 1999 Option Plan), 1,993,174 common shares have been reserved for issuance upon exercise of options granted under the plan. The 1999 Option Plan is administered by the Compensation Committee. The plan will expire on August 19, 2015 unless the Company terminates it before that date. The 1999 Option Plan provides for the grant of nonqualified options to officers, directors and employees of, and consultants and advisors to, dj Orthopedics, Inc.
The Company granted options to purchase an aggregate of 944,542 shares of common stock under the 1999 Option Plan. As of December 31, 2005, options to purchase 236,733 shares issued under the 1999 Option Plan were outstanding and all exercisable. No future options will be granted under the 1999 Option Plan, and all shares of common stock, which would otherwise have been available for issuance under the 1999 Option Plan are available for issuance under the 2001 Omnibus Plan.
2001 Non-Employee Director’s Stock Option Plan
The Company has adopted the dj Orthopedics, Inc. 2001 Non-Employee Directors’ Stock Option Plan. In December 2005, the Company’s Board amended this plan as follows: (1) upon initial election to the Board, a director will receive an option grant covering 15,000 options at an exercise price equal to 100% of the fair market value of the common stock as of such date, such options will be fully vested upon date of grant; and (2) ongoing director options granted after the effective date of the amendment will vest over a three-year period, with one-third vesting on each of the first three anniversary dates of the grant. Options granted under this plan expire ten years from the date of grant. A total of 1,500,000 shares of the Company’s common stock have been reserved for issuance under the plan. A total of 355,000 and 255,000 options had been granted under the Plan at December 31, 2005 and 2004, respectively. No options were granted under this plan prior to 2002. As of December 31, 2005, options to purchase 320,000 shares issued under the Director Plan were exercisable.
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The following table summarizes option activity under all plans from December 31, 2002 through December 31, 2005:
| | Number of
Shares | | Price per Share | | Weighted Average Exercise
Price per Share | |
Outstanding at December 31, 2002 | | 2,207,400 | | $2.97 | - | $17.00 | | $ | 8.03 | |
Granted | | 1,715,500 | | 3.91 | - | 25.92 | | 19.82 | |
Exercised | | (358,141 | ) | 2.97 | - | 17.00 | | 10.22 | |
Cancelled | | (232,528 | ) | 3.52 | - | 17.00 | | 9.16 | |
Outstanding at December 31, 2003 | | 3,332,231 | | 2.97 | - | 25.92 | | 13.78 | |
Granted | | 1,234,200 | | 17.99 | - | 26.65 | | 21.75 | |
Exercised | | (483,040 | ) | 2.97 | - | 17.00 | | 8.51 | |
Cancelled | | (264,416 | ) | 3.52 | - | 25.92 | | 19.10 | |
Outstanding at December 31, 2004 | | 3,818,975 | | 2.97 | - | 26.65 | | 16.74 | |
Granted | | 395,000 | | 20.07 | - | 31.81 | | 26.47 | |
Exercised | | (618,665 | ) | 2.97 | - | 26.65 | | 12.47 | |
Cancelled | | (452,227 | ) | 3.52 | - | 25.92 | | 22.09 | |
Outstanding at December 31, 2005 | | 3,143,083 | | 2.97 | - | 31.81 | | | 18.22 | |
The following table summarizes information concerning currently outstanding and exercisable options:
| | Options Outstanding | | Options Exercisable | |
Range of
Exercise Prices | | Options
Outstanding as of
December 31, 2005 | | Weighted Average
Remaining Life in
Years | | Weighted
Average Exercise
Price | | Options
Exercisable as of
December 31, 2005 | | Weighted
Average
Exercise Price | |
$ | 2.97 | - | $ | 4.10 | | 498,100 | | 6.9 | | $ | 3.75 | | 305,946 | | $ | 3.71 | |
7.24 | - | 10.80 | | 451,082 | | 5.7 | | 8.69 | | 299,332 | | 8.82 | |
12.25 | - | 18.00 | | 106,051 | | 6.7 | | 15.40 | | 75,801 | | 14.63 | |
19.35 | - | 25.92 | | 1,817,850 | | 8.5 | | 23.24 | | 601,674 | | 23.60 | |
26.35 | - | 31.81 | | 270,000 | | 9.3 | | 28.12 | | 102,500 | | 27.38 | |
2.97 | - | 31.81 | | 3,143,083 | | 7.8 | | 18.22 | | 1,385,253 | | 15.80 | |
| | | | | | | | | | | | | | | | | |
Employee Stock Purchase Plan
The Employee Stock Purchase Plan provides for the issuance of up to 1,576,365 shares of the Company’s common stock. During each purchase period, eligible employees may designate between 1% and 15% of their cash compensation, subject to certain limitations, to be deducted from their cash compensation for the purchase of common stock under the plan. Through December 31, 2005, the purchase price of the shares under the plan is equal to 85% of the lesser of the fair market value per share on the first day of each twenty-four month offering period or the last day of each six-month purchase period during the offering period. Effective January 1, 2006, the offering period of the plan was reduced to six months. On January 1 of each year, the aggregate number of shares reserved for issuance under this plan increases automatically by a number of shares equal to 1.0% of the Company’s outstanding shares on December 31 of the preceding year. The Company’s Board of Directors or the Compensation Committee may reduce the amount of the increase in any particular year. The aggregate number of shares reserved for issuance under the Employee Stock Purchase Plan may not exceed 5,000,000 shares. Through December 31, 2005, 497,248 shares had been issued under the Employee Stock Purchase Plan. On January 1, 2006, the number of shares reserved for issuance under the Employee Stock Purchase Plan was increased by 221,379, shares and total shares reserved for issuance were 1,300,496.
Repurchases of Common Stock
The Company’s board of directors authorized a stock repurchase program in September 2004 that allowed the Company to repurchase up to $20 million of its common stock. The shares could be repurchased at times and prices as determined by management and could be completed through open market or privately negotiated transactions. The repurchase program provided that repurchases would be made in accordance with applicable state and federal law and in accordance with the terms and subject to the restrictions of Rule 10b-18 under the Securities Exchange Act of 1934, as amended. Shares would be retired and cancelled upon repurchase. Through December 31, 2004, the Company had repurchased 837,300 shares of its common stock at an average price of $17.62 per share, for an aggregate total cost of approximately $14.8 million. No additional shares were repurchased in 2005 and the stock repurchase program expired in September 2005.
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8. Income Taxes
The provision for income taxes, including deferred taxes, on income before income taxes is as follows for the years ended December 31 (in thousands):
| | 2005 | | 2004 | | 2003 | |
Current | | | | | | | |
Federal | | $ | (631 | ) | $ | (30 | ) | $ | (15 | ) |
State | | (422 | ) | 184 | | (380 | ) |
Foreign | | (629 | ) | (268 | ) | (647 | ) |
| | (1,682 | ) | (114 | ) | (1,042 | ) |
Deferred | | | | | | | |
Federal | | (14,709 | ) | (7,097 | ) | (5,064 | ) |
State | | (2,914 | ) | (1,403 | ) | (1,874 | ) |
Foreign | | 42 | | (408 | ) | — | |
| | (17,581 | ) | (8,908 | ) | (6,938 | ) |
| | | | | | | |
Provision for income taxes | | $ | (19,263 | ) | $ | (9,022 | ) | $ | (7,980 | ) |
Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Significant components of the Company’s deferred tax assets and liabilities as of December 31 are as follows (in thousands):
| | 2005 | | 2004 | |
Deferred tax assets/(liabilities): | | | | | |
Amortization of intangible assets | | $ | 26,766 | | $ | 33,091 | |
Accrued expenses | | 2,169 | | 2,810 | |
Allowance for doubtful accounts | | 3,149 | | 2,650 | |
Provision for excess and obsolete inventories | | 2,167 | | 2,442 | |
Net operating loss carryforwards | | 5,627 | | 14,481 | |
Depreciation of fixed assets | | (752 | ) | (1,156 | ) |
Other, net | | 377 | | (316 | ) |
Net deferred tax assets | | $ | 39,503 | | $ | 54,002 | |
Realization of the Company’s deferred tax assets is dependent on the Company’s ability to generate future taxable income prior to the expiration of net operating loss carryforwards. Based on the Company’s historical and expected future taxable earnings, management believes it is more likely than not that the Company will realize the benefit of the existing net deferred tax assets at December 31, 2005. No valuation allowance was provided for any of the Company’s deferred tax assets at December 31, 2005 or 2004.
As of December 31, 2005, the Company has U.S. federal net operating loss carryforwards of $14.5 million, which begin to expire in 2022. As a result of the Company’s 2004 stock offerings (see Note 7), certain changes in the Company’s ownership may limit future annual utilization of the Company’s federal net operating loss carryforwards. The Company also has $10.8 million of various state net operating loss carryforwards, which begin to expire in 2007 and $0.3 million of various foreign net operating loss carryforwards, which begin to expire in 2008.
The reconciliation of income tax attributable to income before provision for income taxes at the U.S. federal statutory rate to income tax provision in the accompanying statements of income for the years ended December 31 is as follows:
| | 2005 | | 2004 | | 2003 | |
Federal tax at statutory rate | | 35.0 | % | 35.0 | % | 35.0 | % |
State income tax, net of federal benefit | | 4.2 | % | 3.4 | % | 7.3 | % |
Other | | 0.6 | % | 0.8 | % | (2.5 | )% |
| | 39.8 | % | 39.2 | % | 39.8 | % |
The Company made income tax payments, net of (refunds), totaling $1.3 million, $0.6 million and ($0.1) million in the years ended December 31, 2005, 2004 and 2003, respectively.
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Income before income taxes includes the following components for the years ended December 31 (in thousands):
| | 2005 | | 2004 | | 2003 | |
United States | | $ | 46,862 | | $ | 21,270 | | $ | 18,757 | |
Foreign | | 1,599 | | 1,767 | | 1,294 | |
| | $ | 48,461 | | $ | 23,037 | | $ | 20,051 | |
Undistributed earnings of the Company’s foreign subsidiaries amounted to approximately $3.3 million at December 31, 2005. Those earnings are considered to be indefinitely reinvested, and accordingly, no provision for U.S. federal and state income taxes has been provided thereon. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes and withholding taxes payable to the foreign countries, but would also be able to generate foreign tax credits. Determination of the amount of unrecognized deferred U.S. income tax liability is not practicable because of the complexities associated with its hypothetical calculation; however, the Company does not believe the amount would be material.
The Company is subject to ongoing audits from various taxing authorities in the jurisdictions in which it does business. It does not have a history of significant adjustments to its tax accruals as a result of these audits. The Company believes that its accruals for tax liabilities are adequate for all tax periods subject to audit.
9. Segment and Related Information
Prior to 2005, the Company disclosed the following reportable segments, which, except for Regeneration, were based on the Company’s sales channels: DonJoy, ProCare, OfficeCare, Regeneration and International. Effective 2005, the Company has aggregated the DonJoy, ProCare and OfficeCare segments into one new segment, Domestic Rehabilitation. In accordance with the aggregation criteria in SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, the historical segments have been aggregated due to changes in the Company’s management and compensation structure that focus on the results of Domestic Rehabilitation, taken as a whole, rather than on its separate components. Segment data for all prior periods have been restated (aggregated) to conform to the new segmentation. The following are the Company’s current reportable segments.
• Domestic Rehabilitation consists of the sale of the Company’s rehabilitation products (rigid knee braces, soft goods and pain management products) in the United States through three sales channels, DonJoy, ProCare and OfficeCare.
Through the DonJoy sales channel, the Company sells its rehabilitation products utilizing a few of the Company’s direct sales representatives and a network of approximately 300 independent commissioned sales representatives who are employed by approximately 45 independent sales agents. These sales representatives are primarily dedicated to the sale of the Company’s products to orthopedic surgeons, podiatrists, orthopedic and prosthetic centers, hospitals, surgery centers, physical therapists, athletic trainers and other healthcare professionals. Because certain of the DonJoy product lines require customer education on the application and use of the product, these sales representatives are technical specialists who receive extensive training both from the Company and the agent and use their expertise to help fit the patient with the product and assist the orthopedic professional in choosing the appropriate product to meet the patient’s needs. After a product order is received by a sales representative, the Company generally ships the product directly to the orthopedic professional and pays a sales commission to the agent. These commissions are reflected in sales and marketing expense in the Company’s consolidated financial statements.
Through the ProCare sales channel, which is comprised of approximately 45 direct and independent representatives that manage over 310 dealers focused on primary and acute facilities, the Company sells its rehabilitation products to national third-party distributors, other regional medical supply dealers and medical product buying groups, generally at a discount from list prices. The majority of these products are soft goods which require little or no patient education. The distributors and dealers generally resell these products to large hospital chains, hospital buying groups, primary care networks and orthopedic physicians for use by the patients.
Through the OfficeCare sales channel, the Company maintains an inventory of rehabilitation products (mostly soft goods) on hand at orthopedic practices for immediate distribution to the patient. For these products, the Company arranges billing to the patient or third-party payor after the product is provided to the patient. As of
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December 31, 2005, the OfficeCare program was located at over 850 physician offices throughout the United States. The Company has contracts with over 700 third-party payors.
• Regeneration consists of the sale of the Company’s bone growth stimulation products in the United States. The Company’s OL1000 product is sold through a combination of the DonJoy channel direct sales representatives and approximately 120 additional sales representatives dedicated to selling the OL1000 product, of which approximately 60 are employed by the Company. The SpinaLogic product is also included in this segment and was, until the end of 2004, sold by DePuy Spine in the U.S. under an exclusive sales agreement. In January 2005, the Company amended the agreement with DePuy to divide the U.S. into territories in which DePuy Spine has exclusive sales rights and non-exclusive territories in which the Company is permitted to engage in its own sales efforts or retain another sales agent. In early 2006, the agreement was further modified to be non-exclusive in all territories. These products are sold either directly to the patient or to independent distributors. The Company arranges billing to the third-party payors or patients, for products sold directly to the patient.
• International consists of the sale of the Company’s products in foreign countries through wholly-owned subsidiaries or independent distributors. The Company sells its products in over 50 foreign countries, primarily in Europe, Australia, Canada and Japan.
Set forth below is net revenues, gross profit and operating income information for the Company’s reporting segments for the years ended December 31 (in thousands). This information excludes the impact of expenses not allocated to segments, which are comprised of (i) general corporate expenses for all periods presented and (ii) the restructuring costs associated with certain manufacturing moves in 2004. Information for the Regeneration segment includes operations for the period subsequent to the Regeneration acquisition on November 26, 2003 and includes the impact of purchase accounting and related amortization of acquired intangible assets. For the years ended December 31, 2005, 2004 and 2003, Regeneration income from operations was reduced by amortization of acquired intangible assets amounting to $4.6 million, $4.7 million and $0.5 million, respectively. For the year ended December 31, 2005, Domestic Rehabilitation income from operations was reduced by amortization of acquired intangible assets amounting to $0.3 million for 2005 acquisitions. For the year ended December 31, 2004, Regeneration income from operations was also reduced by restructuring charges of $3.8 million related to the integration of the business operations of the segment.
| | 2005 | | 2004 | | 2003 | |
Net Revenues: | | | | | | | |
Domestic Rehabilitation | | $ | 197,279 | | $ | 177,481 | | $ | 168,842 | |
Regeneration | | 55,474 | | 49,658 | | 3,989 | |
International | | 33,414 | | 28,860 | | 25,108 | |
Consolidated net revenues | | $ | 286,167 | | $ | 255,999 | | $ | 197,939 | |
| | | | | | | |
Gross Profit: | | | | | | | |
Domestic Rehabilitation | | $ | 109,752 | | $ | 100,200 | | $ | 93,791 | |
Regeneration | | 49,710 | | 43,032 | | 3,145 | |
International | | 21,416 | | 17,603 | | 15,076 | |
Consolidated gross profit | | $ | 180,878 | | $ | 160,835 | | $ | 112,012 | |
| | | | | | | |
Income from operations: | | | | | | | |
Domestic Rehabilitation | | $ | 41,878 | | $ | 36,341 | | $ | 35,462 | |
Regeneration | | 14,623 | | 7,836 | | 537 | |
International | | 8,430 | | 5,398 | | 6,255 | |
Income from operations of reportable segments | | 64,931 | | 49,575 | | 42,254 | |
Expenses not allocated to segments | | (11,072 | ) | (10,502 | ) | (10,485 | ) |
Consolidated income from operations | | $ | 53,859 | | $ | 39,073 | | $ | 31,769 | |
For the years ended December 31, 2005, 2004 and 2003, the Company had no individual customer or distributor that accounted for 10% or more of total annual revenues.
The accounting policies of the reportable segments are the same as the accounting policies of the Company. The Company allocates resources and evaluates the performance of segments based on income from operations and therefore has not disclosed certain other items, such as interest, depreciation and amortization by segment as permitted by SFAS No. 131.
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The Company does not allocate assets to reportable segments because a significant portion of assets are shared by the segments.
Net revenues, attributed to geographic location based on the location of the customer, for the years ended December 31, were as follows (in thousands):
| | 2005 | | 2004 | | 2003 | |
| | | | | | | |
United States | | $ | 252,753 | | $ | 227,139 | | $ | 172,831 | |
Europe | | 23,424 | | 20,369 | | 16,265 | |
Other countries | | 9,990 | | 8,491 | | 8,843 | |
Total consolidated net revenues | | $ | 286,167 | | $ | 255,999 | | $ | 197,939 | |
Total assets by region at December 31 were as follows (in thousands):
| | 2005 | | 2004 | |
| | | | | |
United States | | $ | 295,257 | | $ | 296,923 | |
International | | 9,407 | | 9,927 | |
Total consolidated assets | | $ | 304,664 | | $ | 306,850 | |
10. Commitments and Contingencies
The Company is obligated under various noncancellable operating leases for land, buildings, equipment and vehicles through approximately June 2021. Certain of the leases provide that the Company pay all or a portion of taxes, maintenance, insurance and other operating expenses, and certain of the rents are subject to adjustment for changes as determined by certain consumer price indices and exchange rates. The Company is headquartered in Vista, California and operates manufacturing locations in Vista, California and Tijuana, Mexico. The Company also leases warehouse and office space in Indiana, Arizona, Germany, Canada, France, the United Kingdom and Denmark. All of the Company’s facilities are leased, none are owned.
Minimum annual lease payment commitments for noncancellable operating leases as of December 31, 2005 are as follows (in thousands):
2006 | | $ | 6,950 | |
2007 | | 4,465 | |
2008 | | 3,692 | |
2009 | | 3,699 | |
2010 | | 3,610 | |
2011 and thereafter | | 30,312 | |
| | $ | 52,728 | |
In late 2004, the Company entered into a lease agreement with Professional Real Estate Services, Inc. (PRES) under which PRES has undertaken to build a new 110,000 square foot corporate headquarters facility for the Company on vacant land near the Company’s current headquarters in Vista, California. Construction of the new facility is underway and once completed, the Company will occupy the facility under a 15-year lease with two five-year options to extend the term and will move out of its existing facilities in Vista. Rent for the new facility will be based on an agreed percentage of the total project cost for the construction of the facility and is not expected to exceed the rent currently paid by the Company for its existing Vista facilities.
The new lease with PRES was contingent on PRES closing a transaction to purchase the existing facilities in Vista, California leased by the Company, as well as the real property underlying the new lease. The purchase transaction closed in February 2005. Effective on the closing date, a lease for the vacant land on which the Company was previously obligated was terminated, and when the new headquarters facility is completed and occupied, the Company’s leases for its existing Vista facilities will be terminated. Those leases would otherwise have continued until February 2008. Upon occupancy of the new facility, expected to occur in mid-2006, the Company will make a lump sum rent payment to PRES, equal to 40% of the rent that would have been due under the existing facilities leases from the termination date of the existing leases through the original expiration date, estimated at approximately $1.6 million. If PRES is able to lease the Company’s former facilities
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during what would have remained of the term of the Company’s existing leases, a portion of that sum may be refunded to the Company. This lump sum rent payment, net of the remaining $0.4 million accrual related to lease termination costs originally accrued in 2002 (see Note 4), will be accounted for as additional rent expense over the term of the new lease. The minimum annual lease commitments table above assumes a July 2006 occupancy date for the Company’s new corporate headquarters and includes both estimated rent for the Company’s new facility beginning in July 2006 and the estimated lump sum rent payment of approximately $1.6 million for termination of the Company’s existing facilities in July 2006.
Aggregate rent expense was approximately $6.4 million, $5.4 million and $3.4 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Contingencies
From time to time, the Company has been involved in lawsuits arising in the ordinary course of business. This includes patent and other intellectual property disputes between its various competitors and the Company. With respect to these matters, management believes that it has adequate insurance coverage or has made adequate accruals for related costs, and it may also have effective legal defenses. The Company is not aware of any pending lawsuits that could have a material adverse effect on its business, financial condition and results of operations.
11. Employee Benefit Plan
The Company has a qualified 401(k) profit-sharing plan covering substantially all of its U.S. employees. Through December 31, 2005, the Company matched 100% of the first $500 contributed annually by each employee and 30 percent of additional employee contributions up to six percent of total compensation. The Company’s matching contributions related to this plan were $0.5 million, $0.5 million and $0.3 million for the years ended December 31, 2005, 2004 and 2003, respectively. The plan also provides for discretionary Company contributions as approved by the Board of Directors. There have been no such discretionary contributions through December 31, 2005. Effective January 1, 2006, the Company will match 50 percent of employee contributions up to six percent of total compensation.
12. Quarterly Results (unaudited)
The Company operates its business on a manufacturing calendar, with its fiscal year always ending on December 31. Each quarter is 13 weeks, consisting of on five-week and two four-week periods. The first and fourth quarters may have more or less working days from year to year based on the days of the week on which holidays and December 31 fall.
The following table summarizes certain of the Company’s operating results by quarter for 2005 and 2004:
| | Year Ended December 31, 2005 | |
| | First
Quarter | | Second
Quarter | | Third
Quarter | | Fourth
Quarter | | Total
Year | |
| | (In thousands, except per share data) | |
Net revenues | | $ | 70,250 | | $ | 68,827 | | $ | 72,133 | | $ | 74,957 | | $ | 286,167 | |
Gross profit | | 44,029 | | 44,254 | | 45,632 | | 46,963 | | 180,878 | |
Income from operations | | 12,421 | | 13,022 | | 13,926 | | 14,490 | | 53,859 | |
Net income | | $ | 6,597 | | $ | 6,929 | | $ | 7,536 | | $ | 8,136 | | $ | 29,198 | |
Basic net income per share | | $ | 0.31 | | $ | 0.32 | | $ | 0.34 | | $ | 0.37 | | $ | 1.34 | |
Diluted net income per share | | $ | 0.29 | | $ | 0.31 | | $ | 0.33 | | $ | 0.35 | | $ | 1.29 | |
Number of operating days | | 65 | | 64 | | 63 | | 61 | | 253 | |
| | | | | | | | | | | | | | | | | | | |
| | Year Ended December 31, 2004 | |
| | First
Quarter | | Second
Quarter | | Third
Quarter | | Fourth
Quarter | | Total
Year | |
| | (In thousands, except per share data) | |
Net revenues | | $ | 62,241 | | $ | 63,186 | | $ | 62,471 | | $ | 68,101 | | $ | 255,999 | |
Gross profit | | 38,882 | | 40,233 | | 39,438 | | 42,282 | | 160,835 | |
Income from operations | | 10,294 | | 11,104 | | 8,688 | | 8,987 | | 39,073 | |
Net income | | $ | 3,980 | | $ | 67 | | $ | 4,668 | | $ | 5,300 | | $ | 14,015 | |
Basic net income per share | | $ | 0.20 | | $ | — | | $ | 0.21 | | $ | 0.25 | | $ | 0.66 | |
Diluted net income per share | | $ | 0.19 | | $ | — | | $ | 0.20 | | $ | 0.24 | | $ | 0.63 | |
Number of operating days | | 61 | | 64 | | 63 | | 65 | | 253 | |
| | | | | | | | | | | | | | | | | | | |
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13. Subsequent Events (unaudited)
On January 2, 2006, the Company completed the acquisition, under an agreement originally signed on December 15, 2005, of the shares of Newmed for cash payments aggregating 13 million Euros (approximately $15.4 million), which included payment of certain debts of Newmed. Certain sellers may also receive up to an additional 1 million Euros (approximately $1.2 million) based on achievement of certain revenue targets for 2006. The Company also incurred certain transaction costs and other expenses in connection with the acquisition that are estimated to be approximately $0.4 million. Newmed, through wholly-owned subsidiaries in France and Spain, operating under the trade name Axmed, is engaged in the design, manufacture and sale of orthopedic rehabilitation devices including rigid knee braces and soft goods. Newmed also owns 70% of a manufacturing subsidiary in Tunisia, which provides low cost manufacturing capabilities to the Axmed group. The Newmed acquisition will be accounted for in the first quarter of 2006 using the purchase method of accounting whereby the total purchase price, including transaction expenses, will be allocated to tangible and intangible assets acquired based on estimated fair market values, with the remainder classified as goodwill. The Company acquired Newmed to increase its revenue and improve its market share in France and Spain. The Company funded the cash paid on January 2, 2006 and the transaction expenses with the proceeds of a $16.0 million draw on its revolving line of credit. The Company repaid $3.0 million of this amount on January 31, 2006.
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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the timelines specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can only provide reasonable assurance of achieving the desired control objectives, and in reaching a reasonable level of assurance, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we carried out an evaluation of the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in SEC Rules 13a – 15(e) and 15d – 15(e)) as of December 31, 2005. Based on such evaluation, such officers have concluded that, as of such date, the Company’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic filings under the Securities Exchange Act of 1934.
Management’s Report on Internal Control over Financial Reporting
Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and includes those policies and procedures that:
(1) Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;
(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company.
Management has used the framework set forth in the report entitled Internal Control—Integrated Framework published by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission to evaluate the effectiveness of the Company’s internal control over financial reporting. Management has concluded that the Company’s internal control over financial reporting was effective as of December 31, 2005. Ernst & Young LLP, the Company’s independent registered public accounting firm, has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting which is included herein.
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Changes in Internal Control over Financial Reporting
There has been no change to our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Board of Directors and Stockholders
dj Orthopedics, Inc.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that dj Orthopedics, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). dj Orthopedics, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that dj Orthopedics, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, dj Orthopedics, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of dj Orthopedics, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2005 of dj Orthopedics, Inc. and our report dated February 3, 2006 expressed an unqualified opinion thereon.
| /s/ ERNST & YOUNG LLP | |
|
|
San Diego, California |
February 3, 2006 |
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Item 9B. Other Information
None.
PART III
Item 10. Directors and Executive Officers of the Registrant
The Company’s Code of Business Conduct and Ethics and Corporate Governance Guidelines can be accessed on the Company’s website under the investor relations page, and are available in print to stockholders who submit a written request to the Secretary of the Company at the address of the Company’s principal executive offices. In addition, the Audit, Compensation and Nominating and Corporate Governance Committees have each adopted a charter governing the activities of such committee. In accordance with New York Stock Exchange rules, these documents are also available either on the website or by written request no later than the date of the Company’s 2006 Annual Stockholders Meeting.
The other information under Item 10 is hereby incorporated by reference from dj Orthopedics, Inc.’s Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 2006. See also the identification of the Executive Officers following Item 4 of this Form 10-K.
Item 11. Executive Compensation
Item 11 is hereby incorporated by reference from dj Orthopedics, Inc.’s Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 2006.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 12 is hereby incorporated by reference from dj Orthopedics, Inc.’s Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 2006.
Item 13. Certain Relationships and Related Transactions
Item 13 is hereby incorporated by reference from dj Orthopedics, Inc.’s Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 2006.
Item 14. Principal Accountant Fees and Services
Item 14 is hereby incorporated by reference from dj Orthopedics, Inc.’s Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 2006.
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PART IV
Item 15. Exhibits, Financial Statement Schedules
(a) The following documents are filed as part of this report:
1. The following consolidated financial statements of dj Orthopedics, Inc., including the report thereon of Ernst & Young LLP, are filed as part of this report under Item 8. Financial Statements and Supplementary Data:
2. Financial Statement Schedules:
Schedule II – Valuation and Qualifying Accounts
All other financial statement schedules are not required under the related instructions or are inapplicable and therefore have been omitted.
3. Exhibits:
Exhibit
Number | | Description |
3.1 | | Amended and Restated Certificate of Incorporation of dj Orthopedics, Inc. (Incorporated by reference to Exhibit 4.1 to the Registration Statement of dj Orthopedics, Inc. on Form S-8 (Reg. No. 333-73966)) |
3.2 | | Certificate of Amendment of Amended and Restated Certificate of Incorporation of dj Orthopedics, Inc. (Incorporated by reference to the Registration Statement of dj Orthopedics, Inc. on Form S-3 (Reg. No. 333-111465)) |
3.3 | | Amended and Restated By-laws of dj Orthopedics, Inc. (Incorporated by reference to Exhibit 4.2 to the Registration Statement of dj Orthopedics, Inc. on Form S-8 (Reg. No. 333-73966)) |
10.1 | | Subleases dated as of June 30, 1999 between dj Orthopedics, LLC and Smith & Nephew (Incorporated by reference to Exhibit 10.7 to the Registration Statement on Form S-4 (Reg. No. 333-86835)) |
10.2 | | Fifth Amended and Restated 1999 Option Plan of dj Orthopedics, Inc. dated October 25, 2001 (Incorporated by reference to Exhibit 4.3 to the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No. 333-73966)) |
10.3 | | dj Orthopedics, Inc. 2001 Omnibus Plan (Incorporated by reference to Exhibit 4.6 to the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No. 333-73966)) |
10.4 | | dj Orthopedics, Inc. 2001 Non-Employee Director Plan (Incorporated by reference to Exhibit 4.5 to the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No. 333-73966)) |
10.5 | | dj Orthopedics, Inc. 2001 Employee Stock Purchase Plan (Incorporated by reference to Exhibit 4.4 to the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No. 333-73966)) |
10.6 | | Outsourcing Agreement, dated as of December 30, 2002 by and between Creditek MediFinancial, Inc. and dj Orthopedics, LLC (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-K for the year ended December 31, 2002) |
10.7 | | Amendment Number One to the DJ Orthopedics, Inc. 2001 Non-Employee Director Stock Option Plan, dated May 29, 2003 (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-Q for the quarter ended June 28, 2003) |
10.8 | | Asset Purchase Agreement, dated October 8, 2003, by and between OrthoLogic Corp. and the Company (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-Q for the quarter ended September 27, 2003) |
10.9 | | Amendment Number One to Outsourcing Agreement, dated December 12, 2003 by and between Creditek MediFinancial, Inc. and dj Orthopedics, LLC. (Incorporated by reference to dj Orthopedics, Inc.’s Report on |
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Exhibit
Number | | Description |
| | Form 10-K for the year ended December 31, 2003) |
10.10 | | Underwriting Agreement, dated June 2, 2004, by and among dj Orthopedics, Inc., the selling stockholders named therein and Lehman Brothers Inc., related to the public offering of 3,072,379 shares of dj Orthopedics, Inc.’s common stock, par value $0.01 per share, pursuant to dj Orthopedics, Inc.’s Registration Statement on Form S-3 (Reg. No. 333-115768). (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated June 2, 2004) |
10.11 | | Stock purchase agreement between dj Orthopedics, LLC and KD Holdings dated as of August 30, 2004. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated September 27, 2004) |
10.12 | | Lease Agreement between Professional Real Estate Services, Inc. and dj Orthopedics, LLC, dated October 20, 2004. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated October 20, 2004) |
10.13 | | Agreement Regarding Termination of Leases among Professional Real Estate Services, Inc., dj Orthopedics, LLC and Smith & Nephew, Inc., dated October 20, 2004. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated October 20, 2004) |
10.14+ | | Amended and Restated Sales Representative Agreement, dated January 24, 2005 between dj Orthopedics LLC (successor to OrthoLogic Corp. with respect to this agreement) and DePuy Spine, Inc. (formally known as DePuy AcroMed, Inc.). (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-K for the year ended December 31, 2004) |
10.15 | | Asset Purchase Agreement, dated March 10, 2005, between dj Orthopedics, LLC, and Superior Medical Equipment, LLC. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated March 10, 2005) |
10.16 | | Amendment Number Two to the dj Orthopedics, Inc. 2001 Non-Employee Director Stock Option Plan, dated May 3, 2005 (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated April 29, 2005) |
10.17 | | Amended and Restated Credit Agreement, dated May 5, 2005, among dj Orthopedics, LLC, dj Orthopedics, Inc., certain foreign subsidiaries party thereto from time to time, Wachovia Bank, National Association, as administrative agent and lenders party thereto. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated May 5, 2005) |
10.18 | | dj Orthopedics Executive Deferred Compensation Plan and related Adoption Agreement (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated July 27, 2005) |
10.19 | | Trust Agreement between dj Orthopedics, LLC and Fidelity Management Trust Company (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated July 27, 2005) |
10.20 | | Asset Purchase Agreement, dated August 8, 2005, between dj Orthopedics, LLC and Encore Medical, L.P. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated August 8, 2005) |
10.21 | | Share Purchase Agreement, dated December 15, 2005, by and among dj Orthopedics, LLC and the Stockholders of Newmed SAS (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated December 15, 2005) |
21.1* | | Subsidiaries of the Registrant |
23.1* | | Consent of Independent Registered Public Accounting Firm |
31.1* | | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. |
31.2* | | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. |
32.0* | | Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
* Filed herewith
+ Confidential treatment has been requested with respect to portions of this exhibit.
80
DJ ORTHOPEDICS, INC.
SCHEDULE II — Valuation and Qualifying Accounts
For the Three Years Ended December 31, 2005
| | Allowance for
Doubtful
Accounts and
Sales Returns | | Reserve for
Excess and
Obsolete
Inventory | |
| | | | | |
Balance at December 31, 2002 | | $ | 10,045,000 | | $ | 4,564,000 | |
Provision | | 22,641,000 | | 2,087,000 | |
Write-offs and recoveries, net | | (14,601,000 | ) | (1,449,000 | ) |
Additions from Regeneration acquisition | | 2,632,000 | | 1,167,000 | |
Balance at December 31, 2003 | | 20,717,000 | | 6,369,000 | |
Provision | | 30,556,000 | | (113,000 | ) |
Write-offs and recoveries, net | | (24,645,000 | ) | (3,075,000 | ) |
Balance at December 31, 2004 | | 26,628,000 | | 3,181,000 | |
Provision | | 34,594,000 | | 983,000 | |
Write-offs and recoveries, net | | (34,430,000 | ) | (1,844,000 | ) |
Balance at December 31, 2005 | | $ | 26,792,000 | | $ | 2,320,000 | |
81
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.
Date: February 16, 2006 | DJ ORTHOPEDICS, INC. |
| |
| By: | | /s/ Leslie H. Cross | |
| | | Leslie H. Cross |
| | President and Chief Executive Officer |
| | | | | |
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature | | Title | | Date |
| | | | |
/s/ Leslie H. Cross | | President, Chief Executive Officer and Director | | February 16, 2006 |
Leslie H. Cross | | (Principal Executive Officer) | | |
| | | | |
/s/ Vickie L. Capps | | Senior Vice President, Finance, Chief Financial Officer | | February 16, 2006 |
Vickie L. Capps | | and Treasurer (Principal Financial and Accounting | | |
| | Officer) | | |
| | | | |
/s/ Jack R. Blair | | Chairman of the Board of Directors | | February 16, 2006 |
Jack R. Blair | | | | |
| | | | |
/s/ Mitchell J. Blutt | | Director | | February 16, 2006 |
Mitchell J. Blutt, M.D. | | | | |
| | | | |
/s/ Thomas Mitchell | | Director | | February 16, 2006 |
Thomas Mitchell | | | | |
| | | | |
/s/ Lewis Parker | | Director | | February 16, 2006 |
Lewis Parker | | | | |
| | | | |
/s/ Charles T. Orsatti | | Director | | February 16, 2006 |
Charles T. Orsatti | | | | |
| | | | |
/s/ Lesley H. Howe | | Director | | February 16, 2006 |
Lesley H. Howe | | | | |
| | | | |
/s/ Kirby L. Cramer | | Director | | February 16, 2006 |
Kirby L. Cramer | | | | |
82
INDEX TO EXHIBITS
Exhibit
Number | | Description |
3.1 | | Amended and Restated Certificate of Incorporation of dj Orthopedics, Inc. (Incorporated by reference to Exhibit 4.1 to the Registration Statement of dj Orthopedics, Inc. on Form S-8 (Reg. No. 333-73966)) |
3.2 | | Certificate of Amendment of Amended and Restated Certificate of Incorporation of dj Orthopedics, Inc. (Incorporated by reference to the Registration Statement of dj Orthopedics, Inc. on Form S-3 (Reg. No. 333-111465)) |
3.3 | | Amended and Restated By-laws of dj Orthopedics, Inc. (Incorporated by reference to Exhibit 4.2 to the Registration Statement of dj Orthopedics, Inc. on Form S-8 (Reg. No. 333-73966)) |
10.1 | | Subleases dated as of June 30, 1999 between dj Orthopedics, LLC and Smith & Nephew (Incorporated by reference to Exhibit 10.7 to the Registration Statement on Form S-4 (Reg. No. 333-86835)) |
10.2 | | Fifth Amended and Restated 1999 Option Plan of dj Orthopedics, Inc. dated October 25, 2001 (Incorporated by reference to Exhibit 4.3 to the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No. 333-73966)) |
10.3 | | dj Orthopedics, Inc. 2001 Omnibus Plan (Incorporated by reference to Exhibit 4.6 to the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No. 333-73966)) |
10.4 | | dj Orthopedics, Inc. 2001 Non-Employee Director Plan (Incorporated by reference to Exhibit 4.5 to the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No. 333-73966)) |
10.5 | | dj Orthopedics, Inc. 2001 Employee Stock Purchase Plan (Incorporated by reference to Exhibit 4.4 to the Registration Statement on Form S-8 of dj Orthopedics, Inc. (Reg. No. 333-73966)) |
10.6 | | Outsourcing Agreement, dated as of December 30, 2002 by and between Creditek MediFinancial, Inc. and dj Orthopedics, LLC (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-K for the year ended December 31, 2002) |
10.7 | | Amendment Number One to the DJ Orthopedics, Inc. 2001 Non-Employee Director Stock Option Plan, dated May 29, 2003 (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-Q for the quarter ended June 28, 2003) |
10.8 | | Asset Purchase Agreement, dated October 8, 2003, by and between OrthoLogic Corp. and the Company (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-Q for the quarter ended September 27, 2003) |
10.9 | | Amendment Number One to Outsourcing Agreement, dated December 12, 2003 by and between Creditek MediFinancial, Inc. and dj Orthopedics, LLC. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-K for the year ended December 31, 2003) |
10.10 | | Underwriting Agreement, dated June 2, 2004, by and among dj Orthopedics, Inc., the selling stockholders named therein and Lehman Brothers Inc., related to the public offering of 3,072,379 shares of dj Orthopedics, Inc.’s common stock, par value $0.01 per share, pursuant to dj Orthopedics, Inc.’s Registration Statement on Form S-3 (Reg. No. 333-115768). (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated June 2, 2004) |
10.11 | | Stock purchase agreement between dj Orthopedics, LLC and KD Holdings dated as of August 30, 2004. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated September 27, 2004) |
10.12 | | Lease Agreement between Professional Real Estate Services, Inc. and dj Orthopedics, LLC, dated October 20, 2004. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated October 20, 2004) |
10.13 | | Agreement Regarding Termination of Leases among Professional Real Estate Services, Inc., dj Orthopedics, LLC and Smith & Nephew, Inc., dated October 20, 2004. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated October 20, 2004) |
10.14+ | | Amended and Restated Sales Representative Agreement, dated January 24, 2005 between dj Orthopedics LLC (successor to OrthoLogic Corp. with respect to this agreement) and DePuy Spine, Inc. (formally known as DePuy AcroMed, Inc.). (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 10-K for the year ended December 31, 2004) |
10.15 | | Asset Purchase Agreement, dated March 10, 2005, between dj Orthopedics, LLC, and Superior Medical Equipment, LLC. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated March 10, 2005) |
10.16 | | Amendment Number Two to the dj Orthopedics, Inc. 2001 Non-Employee Director Stock Option Plan, dated May 3, 2005 (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated April 29, 2005) |
10.17 | | Amended and Restated Credit Agreement, dated May 5, 2005, among dj Orthopedics, LLC, dj Orthopedics, Inc., certain foreign subsidiaries party thereto from time to time, Wachovia Bank, National Association, as administrative agent and lenders party thereto. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated May 5, 2005) |
83
Exhibit
Number | | Description |
10.18 | | dj Orthopedics Executive Deferred Compensation Plan and related Adoption Agreement (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated July 27, 2005) |
10.19 | | Trust Agreement between dj Orthopedics, LLC and Fidelity Management Trust Company (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated July 27, 2005) |
10.20 | | Asset Purchase Agreement, dated August 8, 2005, between dj Orthopedics, LLC and Encore Medical, L.P. (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated August 8, 2005) |
10.21 | | Share Purchase Agreement, dated December 15, 2005, by and among dj Orthopedics, LLC and the Stockholders of Newmed SAS (Incorporated by reference to dj Orthopedics, Inc.’s Report on Form 8-K dated December 15, 2005) |
21.1* | | Subsidiaries of the Registrant |
23.1* | | Consent of Independent Registered Public Accounting Firm |
31.1* | | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. |
31.2* | | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. |
32.0* | | Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
* Filed herewith
+ Confidential treatment has been requested with respect to portions of this exhibit.
84
