FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 30, 2002
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________ to ___________
Commission file number: 0-26538
Encore Medical Corporation
(Exact name of Registrant as specified in its charter)
Delaware 65-0572565
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
9800 Metric Boulevard
Austin, Texas 78758
(Address of principal executive offices) (Zip code)
512-832-9500
(Registrant's telephone number including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ____
Indicate the number of shares outstanding of each of the Registrant's
classes of common stock, as of the latest practicable date.
Title Outstanding
----- -----------
Common Stock 11,027,347
$5 Warrants 3,536,700
Part I. Financial Information
ITEM 1. FINANCIAL STATEMENTS
Encore Medical Corporation and Subsidiaries
Consolidated Balance Sheets
As of March 30, 2002 and December 31, 2001
(in thousands, except share data)
(unaudited)
March 30, December 31,
2002 2001
---- ----
Assets
Current assets:
Cash and cash equivalents $292 $5,401
Accounts receivable, net of allowance for doubtful accounts of $207 and
$154, respectively. 14,894 5,828
Inventories, net of allowance of $5,018 and $4,477, respectively 29,479 22,911
Deferred tax assets 2,818 2,461
Prepaid expenses and other current assets 1,077 1,327
----------- -----------
Total current assets 48,560 37,928
Property and equipment, net 12,567 7,233
Intangible assets, net 15,998 2,622
Goodwill 13,049 3,422
Other assets 3,618 457
----------- -----------
Total assets $93,792 $51,662
=========== ===========
Liabilities and Stockholders' Equity
Current liabilities:
Current portion of long-term debt $5,026 $9,975
Accounts payable 5,394 2,737
Accrued expenses 7,873 3,355
----------- -----------
Total current liabilities 18,293 16,067
Long-term debt, net of current portion 34,058 2,851
Other non current liabilities 726 567
----------- -----------
Total liabilities 53,077 19,485
Stockholders' equity:
Series A Preferred Stock, $0.001 par value, 1,000,000 shares authorized;
132,353 shares issued and outstanding; aggregate liquidation
preference of $13,500 12,840 12,840
Common stock, $0.001 par value, 35,000,000 shares authorized; 11,663,000
and 11,441,000 shares issued, respectively 12 11
Additional paid-in capital 30,515 22,052
Notes received for sale of common stock (1,187) (1,187)
Deferred compensation (17) (56)
Retained earnings 595 560
Less cost of repurchased stock, warrants and rights (635,000 shares) (2,043) (2,043)
----------- -----------
Total stockholders' equity 40,715 32,177
----------- -----------
Total liabilities and stockholders' equity $93,792 $51,662
=========== ===========
See accompanying notes to unaudited consolidated financial statements.
-2-
Encore Medical Corporation and Subsidiaries
Consolidated Statements of Operations
For the three months ended March 30, 2002 and March 31, 2001
(in thousands, except share and per share amounts)
(unaudited)
Three Months Ended
March 30, March 31,
2002 2001
---- ----
Sales $19,396 $8,719
Cost of goods sold 9,618 3,210
------ ------
Gross margin 9,778 5,509
Operating expenses:
Research and development 618 399
Selling, general and administrative 8,324 4,466
------ ------
Operating income 836 644
Interest income 43 4
Interest expense (817) (364)
Other income 3 61
----- -----
Income before income taxes 65 345
Provision for income taxes 30 117
----- -----
Net income $35 $228
===== =====
Basic earnings per share $0.00 $0.03
Shares used in computing basic earnings
per share 10,018,000 8,893,000
Diluted earnings per share $0.00 $0.02
Shares used in computing diluted earnings
per share 25,755,000 9,362,000
See accompanying notes to unaudited consolidated financial statements.
-3-
Encore Medical Corporation and Subsidiaries
Consolidated Statements of Cash Flow
For the three months ended March 30, 2002 and March 31, 2001
(in thousands)
(unaudited)
Three Months Ended
March 30, March 31,
2002 2001
---- ----
Cash flows from operating activities:
Net income $35 $228
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation 746 503
Amortization of intangibles 230 156
Amortization of debt issuance costs 354 -
Noncash interest expense 57 -
Stock based compensation 91 37
Loss on disposal of assets 7 8
Deferred taxes 12 -
Changes in operating assets and liabilities:
Increase in accounts receivable (102) (926)
Decrease in inventories 1,581 520
(Increase) decrease in prepaid expenses and other
assets/liabilities (213) 53
(Decrease) increase in accounts payable and accrued expenses (2,103) 1,053
-------- -------
Net cash provided by operating activities 695 1,632
-------- -------
Cash flows from investing activities:
Proceeds on sale of assets - 2
Purchases of property and equipment (223) (501)
Acquisition of Chattanooga Group, Inc. (32,578) 0
-------- -------
Net cash used in investing activities (32,801) (499)
-------- -------
Cash flows from financing activities:
Proceeds from issuance of stock 77 30
Proceeds from long-term obligations 39,078 -
Payments on long-term obligations (12,742) (1,163)
-------- -------
Net cash used in financing activities 26,413 (1,133)
-------- -------
Net decrease in cash and cash equivalents (5,693) -
Cash and cash equivalents at beginning of period 5,401 1
-------- -------
Cash and cash equivalents at end of period $292 $1
======== =======
Non-cash investing and financing activities:
Repurchase of treasury stock through issuance of a note - $409
Issuance of stock purchase warrants $7,904 -
Issuance of common stock for services provided in connection with
the Chattanooga acquisition $431 -
See accompanying notes to unaudited consolidated financial statements.
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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying consolidated financial statements include the accounts of
Encore Medical Corporation ("EMC"), a Delaware corporation, and its wholly owned
subsidiaries (individually and collectively referred to as the "Company" or
"Encore"). All significant intercompany balances and transactions have been
eliminated in consolidation. The unaudited consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
for interim financial information and with the instructions to Form 10-Q and
Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the
information and notes required by generally accepted accounting principles for
complete financial statements. In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair
presentation have been included. Operating results for the three-month period
ended March 30, 2002, are not necessarily indicative of the results that may be
expected for the year ending December 31, 2002. For further information, refer
to the consolidated financial statements and footnotes thereto included in the
Company's Form 10-K dated December 31, 2001. Certain amounts in the prior period
have been reclassified to conform to the current period presentation.
Encore Orthopedics, Inc., a Delaware corporation and the primary operating
subsidiary of EMC, was converted on February 7, 2002, from a Delaware
corporation to a Delaware limited partnership, Encore Medical, L.P. It has two
partners, Encore Medical GP, Inc. ("EGP") and Encore Medical Asset Corporation
("EMAC"), the general partner and limited partner, respectively. Both of these
corporations are wholly owned subsidiaries of Encore Medical Corporation. Prior
to February 7, 2002, neither EGP nor EMAC had any operations. On March 1, 2002,
Chattanooga Group, Inc. was merged into and with Encore Medical, L.P., Encore
Medical, L.P. being the surviving entity. All of the assets, liabilities,
operations and financial results of Encore Medical L.P., EGP and EMAC are
consolidated in the financial statements of EMC.
2. NEW ACCOUNTING STANDARDS
The Company adopted the non-amortization provisions of Statement of
Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible
Assets," on January 1, 2002, which resulted in a $37,000 increase to the first
quarter's net earnings and is expected to increase full-year net earnings by
approximately $148,000. The Company has not yet determined the financial impact
that the impairment provisions of SFAS No. 142 will have on its consolidated
financial statements. Any impairment charge resulting from the transitional
impairment testing will be reflected as a cumulative effect of a change in
accounting principle.
The following table provides comparative earnings and earnings per share
had the non-amortization provisions of SFAS No. 142 been adopted for all periods
presented:
Three Months Ended
March 30, March 31,
2002 2001
---- ----
Reported net income $35 $228
Goodwill amortization - 46
----- -----
Adjusted net income $35 $274
===== =====
BASIC EARNINGS PER SHARE:
As reported $0.00 $0.03
Goodwill amortization - -
----- -----
Adjusted $0.00 $0.03
===== =====
DILUTED EARNINGS PER SHARE:
As reported $0.00 $0.02
Goodwill amortization - 0.01
----- -----
Adjusted $0.00 $0.03
===== =====
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As of March 31, 2002, the Company had $6 million of indefinite-lived
intangible assets (trademarks). The Company also had $11 million of other
intangible assets which will continue to be amortized over their remaining
useful lives ranging from 1 to 40 years.
In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations," which addresses financial accounting and reporting for
obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. This statement applies to all entities that
have legal obligations associated with the retirement of long-lived assets that
result from the acquisition, construction, development or normal use of the
asset. SFAS 143 is effective for fiscal years beginning after June 15, 2002. The
Company does not expect the adoption of SFAS 143 to have a significant impact on
its financial condition or results of operations.
On January 1, 2002, the Company adopted SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." There was no impact to the
Company's operating results or financial position related to the adoption of
this standard.
3. DESCRIPTION OF BUSINESS
EMC has only a single operating subsidiary. This company designs,
manufactures, markets and distributes orthopedic products and supplies. Its
products are used primarily by orthopedic medical specialists to treat patients
with musculoskeletal conditions resulting from degenerative diseases,
deformities, traumatic events and participation in sporting events. EMC's
surgical products cover a broad variety of orthopedic needs and include hip,
knee and shoulder implants to reconstruct damaged joints, trauma products to
reconstruct bone fractures, and spinal implants to aid in the repair of the
spinal column. The Company has one of the broadest lines of orthopedic soft
goods in the marketplace for non-surgical products that repair, regenerate and
rehabilitate soft tissue and bone, and protect against injury. The Chattanooga
Group Division of Encore has a complete line of all items necessary for
rehabilitation of orthopedic injuries, serving the needs of physical therapists,
chiropractors and sports medicine professionals.
The Company's products are subject to regulation by the Food and Drug
Administration ("FDA") with respect to their sale in the United States, and the
Company must, in many cases, obtain FDA authorization to market its products
before they can be sold in the United States. Additionally, the Company is
subject to similar regulations in many of the international countries in which
it sells products.
4. INVENTORIES
Inventories at March 30, 2002 and December 31, 2001 are as follows (in
thousands):
March 30, 2002 December 31, 2001
-------------- -----------------
Components and raw materials $8,009 $6,323
Work in process 1,309 805
Finished goods 25,179 20,260
------- -------
34,497 27,388
Less-inventory reserves (5,018) (4,477)
------- -------
$29,479 $22,911
======= =======
5. EARNINGS PER SHARE
The reconciliation of the denominators used to calculate the basic and
diluted earnings per share for the periods ended March 30, 2002 and March 31,
2001, respectively, are as follows (in thousands):
Three Months Ended
March 30, March 31,
2002 2001
---- ----
Shares used in computing basic earnings per
share attributable to common
stockholders 10,018 8,893
Plus: Convertible preferred stock 13,235 -
Plus: Warrants issued in connection with
financing the acquisition of
Chattanooga Group, Inc. 1,267 -
- 6-
Plus: Remaining common stock equivalents 1,235 469
------ -----
Shares used in computing diluted earnings
per share attributable to common
stockholders 25,755 9,362
====== =====
The Company has excluded certain stock options and warrants from the
calculation of diluted earnings per share because their exercise price was
greater than the average market price of the common shares. The total number of
common stock equivalents excluded from the calculations of diluted earnings per
common share were 4,017,232 for the first quarter ended March 30, 2002 and
5,715,481 for the quarter ended March 31, 2001.
6. ACQUISITION OF CHATTANOOGA GROUP, INC.
On February 8, 2002, EMC acquired all of the issued and outstanding shares
of capital stock of Chattanooga Group, Inc. ("Chattanooga") pursuant to a Stock
Purchase Agreement for a cash purchase price of $31,500,000. This price was
subject to adjustment for the change in the net worth of Chattanooga between
October 1, 2001 and February 8, 2002. The Company has determined this adjustment
amount to be $3,547,000 and has recorded this increase in the purchase price at
March 30, 2002. Payment on this amount is due in the second quarter of 2002. In
order to finance this acquisition, EMC entered into a Credit Agreement with Bank
of America, N.A. (the "Credit Agreement") for maximum borrowings up to
$30,000,000, subject to limitations based upon the Company's Borrowing Base, as
defined therein, and a Note and Equity Purchase Agreement with CapitalSource
Finance LLC (the "Note Agreement") for $24,000,000.
The total purchase price paid for Chattanooga approximating $36,685,000,
including cash payments of $31,500,000, the adjustment of $3,547,000, and
issuance costs of approximately $1,638,000, was preliminary allocated as follows
based upon the fair value of the assets acquired and liabilities assumed
(dollars in thousands):
Current assets $ 18,612
Tangible and other noncurrent assets 5,864
Liabilities assumed (10,949)
Intangible assets 13,531
Goodwill 9,627
--------
$ 36,685
========
The tangible assets are being depreciated over their useful lives of three
to twenty years. The acquired intangible assets consist of the following, and
are being amortized over their estimated economic life, where applicable:
Asset class Fair value Wtd. Avg. Useful life
----------- ---------- ---------------------
Patents $ 1,829 11 years
Trademarks/ Trade names 6,425 Indefinite
Distributor network 5,277 20 years
Goodwill 9,627 Indefinite
-------
$23,158
=======
In connection with this acquisition and financing, EMC paid off the
outstanding balances of certain Chattanooga debt totaling approximately
$4,800,000. EMC also repaid all amounts outstanding under its current revolving
credit facility, which approximated $6,600,000, with proceeds from a similar
revolving credit facility as part of the Credit Agreement.
The results of Chattanooga have been included within the consolidated
statement of operations since the date of acquisition, February 8, 2002.
The following unaudited pro forma information presents results of
operations of Encore Medical Corporation as if the acquisition of Chattanooga
occurred as of January 1 of the respective year. These pro forma results assume
debt service costs associated with the Chattanooga acquisition, calculated at
the Company's effective tax rate for the applicable period. Although prepared on
a basis consistent with EMC's consolidated financial statements, these unaudited
pro forma results do not purport to be indicative of the actual results of
operations of the combined companies which would have been achieved had these
events occurred at the beginning of the periods presented nor are they
indicative of future results (in thousands, except for share and per share
data):
- 7 -
Three Months Ended
March 30, March 31,
2002 2001
---- ----
Revenue $25,352 $19,761
Income (loss) before income taxes $45 $(254)
Net (loss) income $24 $(168)
Basic earnings (loss) per share $0.00 ($0.02)
Shares used in computing basic earnings (loss) per share 10,018,000 8,893,000
Diluted earnings (loss) per share $0.00 ($0.02)
Shares used in computing diluted earnings (loss) per share 26,683,000 8,893,000
7. LONG-TERM DEBT
Long-term debt (including capital lease obligations) consists of the
following (in thousands):
March 30, December 31,
2002 2001
----------- ------------
$30,000,000 credit facility from a financial institution consisting of two term $ 16,155 $ -
loans and a revolving line of credit; interest at the institution's base rate
or LIBOR rate plus an applicable margin based upon the type of loan and the
ratio of debt to EBITDA; the term loans are payable monthly through March 2005
and September 2003; the line of credit is due February 2005; collateralized by
all assets of EMC; commitment fee of 0.5% of unused line balance; available
borrowings at March 30, 2002 of $4,800,000 based upon the current Borrowing Base
$24,000,000 senior subordinated note payable to a financial institution in 17,639 -
connection with the acquisition of Chattanooga Group, Inc.; interest at the
greater of 13% or the prime rate plus 4% (subject to a maximum cap of 15%);
plus payment in kind interest of 2.75%, payable monthly, due February 2007;
less unamortized deferred charges of $6,417
$10,500,000 revolving credit facility from a financial institution; interest at the - 6,572
lesser of the institution's base rate plus 1.5% or LIBOR plus 2.75% (5.5% at
December 31, 2001), payable monthly; collateralized by all assets of Encore and
guaranteed by EMC; commitment fee of 0.375% of unused balance; due October
2002; available borrowings at December 31, 2001 of $3,864,000, calculated as
the credit limit less total borrowings and letters of credit of $64,000
8% unsecured note payable to a corporation in connection with the OSG Products 2,090 2,482
acquisition, payable in monthly installments of $130,000 through July 1, 2003
6.5% unsecured note payable to a former employee in connection with a stock purchase 261 291
agreement payable in bi-weekly installments of $5,000 (principal and interest)
through January 23, 2004
8.9% unsecured note payable to individuals in connection with the BTI acquisition, 2,116 2,240
payable in varying quarterly installments through March 31, 2005.
9.5% note payable to a corporation, payable in quarterly installments of $231,250 463 925
plus interest through September 30, 2002, secured by inventory purchased in
connection with this note
Capital lease obligations, collateralized by related equipment 360 316
------------ ----------------
39,084 12,826
Less - current portion (5,026) (9,975)
------------ ----------------
$ 34,058 $ 2,851
------------ ----------------
The debt agreements related to the $30,000,000 credit facility and the
$24,000,000 senior subordinated note payable contain warranties and covenants
and require maintenance of certain financial ratios. Default on any warranty or
covenant could affect the ability to borrow under the agreement and, if not
waived or corrected, could
- 8 -
accelerate the maturity of any borrowings outstanding under the applicable
agreement. The Company is either in compliance with, or has obtained waivers
from, all debt covenants and warranties.
Pursuant to the terms of the senior subordinated note payable, the Company
issued a warrant to the lender, pursuant to which the lender has the right to
acquire for a period of five years up to an aggregate of 2,198,614 shares of the
Company's Common Stock (the "Warrants"). Further, under the terms of the Note
Agreement, if the Company fails to generate certain amounts of earnings before
interest, taxes, deprecation and amortization, the Company would have the right,
commencing on March 31, 2003 and ending on August 15, 2003, to prepay without
penalty up to $6,000,000 of the aggregate principal under the Note Agreement. If
the Company exercises this right, then a pro-rata portion of the Warrants (the
"Conveyed Warrants") will be conveyed by the lender to the Galen Entities (as
defined below). In the event the Company has the right to prepay but does not
choose to exercise this right, then the Galen Entities will purchase the amount
of notes that the Company has the right to prepay. In the event the Galen
Entities purchase any notes from the lender, then upon such purchase, (a) those
notes will automatically convert into additional shares of Series A Preferred
Stock and (b) a pro-rata portion of the Warrants will also be conveyed by the
lender to the Galen Entities.
The Galen Entities and the lender have entered into an agreement (the
"Agreement") to evidence certain of the foregoing obligations. As an inducement
for the Galen Entities to enter into the Agreement, the Company granted the
Galen Entities options (the "Option") dated as of February 8, 2002 to acquire up
to the number of shares of Common Stock which have a value equal to $6,000,000,
at an exercise price equal to the greater of $3.50 per share or one-half of the
trailing ten-day average closing price of the Common Stock on the date of
exercise. If the Galen Entities choose to exercise the Option, then any Conveyed
Warrants will automatically be terminated. Conversely, if the Galen Entities
choose to exercise any Conveyed Warrants, then the Option will automatically be
terminated. The Option will otherwise automatically terminate on the earlier of
(i) the 30th day following the date the Galen Entities are no longer obligated
to purchase any notes under the Agreement, (ii) the date the Galen Entities
acquire any senior subordinated notes, or (iii) August 15, 2003.
The Warrants and Option granted above were valued at $6,596,000 and
$1,308,000, respectively. The value of the Warrant is recorded as a reduction of
long-term debt on the balance sheet and is being amortized to interest expense
over the term of the Note Agreement (five years). The value of the Option is
recorded as an other asset on the balance sheet and is being amortized to
interest expense over the life of the Option (eighteen months). During the
period ended March 30, 2002, amortization expense relating to the Warrants and
Option was $178,000 and $117,000, respectively.
8. ACQUISITION OF ORTHOPEDIC SOFT GOODS PRODUCTS
On July 2, 2001, the Company acquired Kimberly-Clark Corporation's line of
orthopedic soft goods, patient safety devices and pressure care products (the
"OSG Products") pursuant to an Asset Purchase Agreement dated July 2, 2001. The
Company acquired fixed assets, inventory and intangible assets for a total
purchase price of $8,835,206, consisting of $5,700,000 in cash and a promissory
note in the amount of $3,135,206, bearing interest at 8% per annum and payable
over 24 months.
Of the total purchase price, $2,111,802 was allocated to acquired
intangible assets having a weighted-average useful life of approximately 9
years. The intangible assets that make up that amount include customer lists of
$316,770 (2-year weighted-average useful life), transferable licenses of
$1,583,852 (17-year weighted-average useful life), and intellectual property of
$211,180 (15-year weighted-average useful life).
9. SEGMENT INFORMATION
EMC has three reportable segments as defined by SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information." EMC's reportable
segments are business units that offer different products that are managed
separately because each business requires different manufacturing and marketing
strategies. The surgical segment sells reconstructive products including knee,
hip, shoulder and spinal implants and trauma-related products. The soft goods
segment sells knee, shoulder, ankle and wrist braces; neoprene supports; slings;
cervical collars; and immobilizers for various joints in the body. The
rehabilitation segment sells electrotherapy units, therapeutic ultrasound
equipment, continuous passive motion devices, and therapy tables, along with
heating and chilling units.
- 9 -
Information regarding business segments is as follows (in thousands):
Three Months Ended
March 30, March 31,
2002 2001
------- ------
Sales:
Surgical $8,195 $8,719
Soft goods 4,738 -
Rehabilitation 6,463 -
------- ------
Consolidated net sales $19,396 $8,719
======= ======
Gross margin:
Surgical $5,688 $5,509
Soft goods 1,613 -
Rehabilitation 2,477 -
------- ------
Consolidated gross margin $9,778 $5,509
======= ======
EMC allocates resources and evaluates the performance of segments based on
gross margin and therefore has not disclosed certain other items, such as
interest, depreciation and income taxes as permitted by SFAS 131. EMC does not
allocate assets to reportable segments because all property and equipment are
shared by all segments of EMC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Critical Accounting Policies and Estimates
Management's discussion and analysis of financial condition and results of
operations is based upon the financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America. The preparation of these financial statements requires the Company to
make estimates and judgments that affect the reported amounts of assets,
liabilities and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, management evaluates estimates, including
those related to inventory, accounts receivable, deferred taxes, and
contingencies and litigation. EMC 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.
Financial Reporting Release No. 60, which was recently released by the
Securities and Exchange Commission, proposes a new requirement that all public
companies include a discussion of critical accounting policies or methods used
in the preparation of financial statements. The Company applies the following
critical accounting policies in the preparation of its financial statements:
Inventory Reserves
- ------------------
The nature of EMC's surgical business requires it to maintain sufficient
inventory on hand at all times to meet the requirements of its customers. EMC
records inventory at the lower of cost or market, with cost based upon average
actual cost. General inventory reserves are maintained for the possible
impairment of the inventory for such issues as slow moving, excess, product
obsolescence and valuation. In determining the adequacy of its reserves, at each
reporting period EMC analyzes the following, among other things:
1. Current inventory quantities on hand;
2. Product acceptance in the marketplace;
3. Customer demand;
4. Historical sales;
5. Forecasted sales;
6. Product obsolescence; and
- 10 -
7. Technological innovations.
Any modifications to EMC's estimates of its reserves are reflected in cost
of goods sold within the statement of operations during the period in which such
modifications are determined necessary by management.
Revenue Recognition
- -------------------
The Company's products are sold through (i) a network of sales
representatives and foreign distributors, (ii) through large medical/surgical
product distributors, and (iii) through a worldwide network of distributors and
durable medical equipment suppliers. Revenues from sales made by
representatives, who are paid commissions upon the ultimate sale of the
products, are recorded at the time the product is utilized in a surgical
procedure and a purchase order is received. Revenues from sales to foreign
customers are recorded when the product is shipped to the customer. The foreign
distributors, who sell the products to other customers, take title to the
products, have no special rights of return, and assume the risk for credit and
obsolescence. For the soft goods and rehabilitation divisions, sales are
recorded at the time the product is shipped to the customer.
EMC must make estimates of potential future product returns and rebates
related to current period product revenue. To do so, management analyzes
historical returns, current economic trends, and changes in customer demand and
acceptance of EMC's products when evaluating the adequacy of the sales returns
and other allowances. Significant management judgments and estimates must be
made and used in connection with establishing the sales returns, rebates and
other allowances in any accounting period.
Allowance for Doubtful Accounts
- -------------------------------
EMC must make estimates of the uncollectibility of accounts receivables. In
doing so, management analyzes accounts receivable and historical bad debts,
customer concentrations, customer credit-worthiness, current economic trends and
changes in customer payment patterns when evaluating the adequacy of the
allowance for doubtful accounts.
Deferred Tax Asset Valuation Allowance
- --------------------------------------
In assessing the potential realization of deferred tax assets, management
considers whether it is more likely than not that some portion or all of the
deferred tax assets will be realized. The ultimate realization of deferred tax
assets is dependent upon EMC attaining future taxable income during the periods
in which those temporary differences become deductible. Based upon management's
projections of future taxable income and the periods and manner in which EMC's
deferred tax assets will be available, management estimates that it is more
likely than not that all of EMC's deferred tax assets will be available to
offset future taxable income. As such, no valuation allowance has been provided
against the deferred tax asset balance at March 30, 2002.
Results of Operations
Three Months Ended March 30, 2002, as Compared to the Three Months Ended
March 31, 2001.
Sales were $19,396,000 for the quarter ended March 30, 2002, representing
an increase of $10,677,000 or 123% over the quarter ended March 31, 2001. The
primary reason for this significant increase was the acquisition by the Company
during 2001 of the OSG Products and the acquisition during February 2002 of
Chattanooga. In the Surgical Division (which is responsible for designing,
manufacturing and selling total joint and trauma implants and spinal implant
products) sales decreased 6% when compared to sales levels during 2001 to
$8,195,000. However, this overall decrease masks the improvements made in
domestic sales, where the greatest concentration of efforts has occurred. Sales
of reconstructive devices in the United States increased 15% over the levels of
the prior year; with spine implant sales increasing 197% over the first quarter
of 2001. During the last quarter of 2001, a competitor acquired the Company's
primary European distributor and as a result, sales outside the U.S. decreased
57% when compared to the sales levels of 2001. It is expected that this decrease
in non-domestic sales will continue during the remainder of 2002. The Soft Goods
Division, a July 2001 acquisition, reported sales of $4,738,000 and the
Chattanooga Group Division, a first quarter 2002 acquisition, reported sales of
$6,463,000 for the period beginning on February 8, 2002, the date of the
acquisition, through the end of the quarter.
Gross margin increased by $4,269,000 to $9,778,000 as compared to
$5,509,000 for the first quarter of 2001. This increase was a result of three
factors. First, the addition of the Chattanooga Group Division accounted
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for $2,477,000 of the increase. Second, sales of the OSG Products accounted for
$1,613,000. The remainder was generated in the Surgical Division where the gross
margin increased 3%. While the gross margin grew by absolute dollar amounts,
gross margin as a percent of sales decreased from 63% to 50% when compared to
the first quarter of 2001. This is because sales of OSG Products and
rehabilitation equipment in the Chattanooga Group Division yield lower gross
margins than sales of surgical products. These divisions gross margins were 34%
and 38% of sales, respectively. Surgical gross margins as a percent of sales
improved for the quarter from 63% to 69% due to the change in geographical mix
in favor of U.S. sales that yield higher margins.
Research and development expenses increased $219,000 or 55% from the first
quarter of 2001. The acquisition of Chattanooga accounted for $179,000 of the
increase while surgical division expenditures increased by $40,000. This was due
to continuing clinical studies on a mobile bearing knee product.
Selling, general, and administrative expenses increased $3,858,000 or 86%
compared to the first quarter of 2001. These expenses increased in part due to
the acquisitions of Chattanooga, which incurred $1,502,000 of selling, general
and administrative expenses, and OSG Products, which incurred $1,683,000 for
these expenses in this division during the first quarter of 2002. Royalties and
commissions associated with increased sales of surgical products had an impact
on increased expenses. However, as a percent of sales, selling, general and
administrative expenses decreased to 43% for the quarter from 51% in the first
quarter of 2001.
The combination of all of these factors resulted in a 30% increase in
operating income to $836,000 compared to $644,000 in the first quarter of 2001.
Interest expense increased $453,000 for the three months ended March 30, 2002,
to $817,000 as compared to $364,000 during the same period in the prior year.
This was primarily due to interest expense related to the note payable to
Kimberly-Clark arising from the acquisition of the OSG Products and interest
expense relating to the acquisition of Chattanooga.
Overall, net income for the quarter ended March 30, 2002 was $35,000 as
compared to net income of $228,000 during the first quarter of 2001.
Liquidity and Capital Resources
Since inception, EMC has financed its operations through the sale of equity
securities, borrowings and cash flow from operations. As of March 30, 2002, EMC
had borrowed approximately $16,000,000 under the Credit Agreement, with the
availability (based upon the current Borrowing Base) of approximately an
additional $4,800,000 to borrow for working capital and general corporate
purposes.
During the first quarter of 2002, operating activities provided cash and
cash equivalents of $695,000. This compares unfavorably to 2001 when operating
activities provided cash and cash equivalents of $1.6 million. The decline from
year to year was primarily due to a decrease in accounts payable and accrued
liabilities, as compared to an increase in the prior year, which was offset by a
decrease in inventory which was a larger decrease than in the prior year.
In June 2001, EMC raised $12.8 million, net of issuance costs of $660,000,
in connection with the sale of Series A Preferred Stock. The purpose of raising
this money was to fund acquisitions EMC had previously announced it was
pursuing. The first of these acquisitions was completed on July 2, 2001, with
the purchase of the OSG Products from Kimberly-Clark Corporation.
In order to finance the acquisition of Chattanooga, EMC and its
subsidiaries entered into the Credit Agreement dated as of February 8, 2002 with
Bank of America, National Association, as agent, and the lenders signatory
thereto, for a maximum borrowing capacity of up to $30,000,000, subject to
limitations based upon EMC's Borrowing Base, as defined (the "Senior Credit
Facility"), pursuant to the Credit Agreement. EMC and its subsidiaries executed
various security documents in order to secure the financing under the Credit
Agreement, including security agreements, a mortgage, guaranty agreements, a
copyright security agreement, patent security agreements, trademark security
agreements and various Uniform Commercial Code financing statements.
Further, in order to finance the acquisition of Chattanooga, EMC and its
subsidiaries entered into a Note Agreement dated as of February 8, 2002 with
CapitalSource Finance LLC, as agent and purchaser ("CapitalSource"), pursuant to
which EMC sold $24,000,000 in Senior Subordinated Notes (the "Senior
Subordinated Notes") to CapitalSource. EMC and its subsidiaries executed various
security documents in order to secure the financing under the Note Agreement,
including security agreements, a mortgage, guaranty agreements, a copyright
security
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agreement, patent security agreements, trademark security agreements and various
Uniform Commercial Code financing statements. The security interests created by
the security documents executed pursuant to the Note Agreement are junior and
subordinate to the security interests created by the security documents executed
pursuant to the Credit Agreement.
These debt arrangements contain operating and financial restrictions that
may restrict EMC's business and financing activities. These debt agreements
restrict EMC's ability to (i) incur additional indebtedness; (ii) issue
redeemable equity interests and preferred equity interests; (iii) pay dividends
or make distributions, repurchase equity interests or make other restricted
payments; (iv) make capital expenditures; (v) create liens; (vi) enter into
transactions with our affiliates; (vii) make investments; (viii) sell assets; or
(ix) enter into mergers or consolidations.
Under the Note Agreement, if EMC generates less than certain amounts of
earnings before interest, taxes, depreciation and amortization, then EMC would
have the right, commencing on March 31, 2003 and ending on August 15, 2003, to
prepay without penalty up to $6,000,000 aggregate principal amount of the Senior
Subordinated Notes. If EMC exercises this right, then a pro-rata portion of the
CS Warrants (as defined below) (the "Conveyed Warrants") will be conveyed by
CapitalSource to the Galen Entities (as defined below). In the event EMC does
not choose to exercise this right, then three related entities, Galen Partners
III, L.P., Galen Partners International III, L.P. and Galen Employee Fund III,
L.P. (collectively, the "Galen Entities"), have agreed to purchase the amount of
Senior Subordinated Notes that EMC has the right to prepay. The Galen Entities
beneficially own approximately 51% of the outstanding shares of common stock (on
an as-converted basis) of EMC. In the event the Galen Entities purchase any
Senior Subordinated Notes from CapitalSource, then upon such purchase, (a) those
notes will automatically convert into additional shares of EMC's Series A
Preferred Stock at a conversion price equal to the lower of (i) $150 per share
or (ii) 50 times the greater of $1 or the trailing ten-day average closing price
of the Company's common stock on the date of conversion, and (b) a pro-rata
portion of the Warrants will also be conveyed by CapitalSource Holdings LLC to
the Galen Entities. As an inducement for the Galen Entities to enter into the
CapitalSource/Galen Agreement, EMC granted the Galen Entities options dated as
of February 8, 2002 (the "Option") to acquire up to that number of shares of EMC
common stock with a value equal to $6,000,000 at an exercise price equal to the
greater of $3.50 per share or one-half of the trailing ten-day average closing
price of EMC's common stock on the date of exercise. If the Galen Entities
choose to exercise their rights under the Option, then any Conveyed Warrants
will automatically be terminated. Conversely, if the Galen Entities choose to
exercise any Conveyed Warrants, then the Option will automatically be
terminated. The Option will otherwise automatically terminate on the earlier of
(i) the 30th day following the date the Galen Entities are no longer obligated
to purchase any Senior Subordinated Notes under the CapitalSource/Galen
Agreement, (ii) the date the Galen Entities acquire any Senior Subordinated
Notes or (iii) August 15, 2003.
EMC is either in compliance with, or had obtained waivers from, all of its
financial covenants under its credit agreements. While EMC's current forecast
shows that the Company will be able to meet the financial covenants during 2002
and will be able to keep the need for outstanding debt under the maximum
ceilings for amounts outstanding, there is no assurance that the forecasts will
prove accurate or that the bank's requirements will be able to be met. There
exists the possibility that EMC will need to obtain additional equity financing,
although there is no assurance as to the amount, availability or cost of such
financing.
In addition to the current restrictions and requirements contained in the
current credit arrangements, EMC's significant debt level may limit its
flexibility in obtaining additional financing and in pursuing other business
opportunities. EMC's high degree of leverage could have negative consequences
for it, including the following: (i) the ability to obtain additional financing,
if necessary, for working capital, capital expenditures, acquisitions or other
purposes may be impaired, or financing may not be available to it on favorable
terms; (ii) EMC will need a substantial portion of its cash flow to pay the
principal and interest on its indebtedness, including indebtedness that it may
incur in the future; (iii) payments on the EMC's indebtedness will reduce the
funds that would otherwise be available for operations and future business
opportunities; (iv) a substantial decrease in net operating cash flows could
make it difficult for EMC to meet its debt service requirements and force it to
modify its operations; (v) EMC's debt level may make it more vulnerable than its
competitors to a downturn in either its business or the economy generally; and
(vi) since some of the debt has a variable rate of interest, it exposes EMC to
the risk of increased interest rates.
EMC is exposed to certain market risk as part of its ongoing business
operations. Primary exposure includes changing in interest rates. EMC is exposed
to interest rate risk in connection with the term loans and borrowings under the
Credit Agreement, which bears interest at floating rates based on the London
Interbank Offered Rate ("LIBOR") or the prime rate plus an applicable borrowing
margin. EMC manages its interest rate risk by
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balancing the amount of fixed and variable debt. For fixed rate debt, interest
rate changes affect the market value, but do not impact earnings or cash flow.
Conversely, for variable rate debt, interest rate changes generally do not
affect the fair market value, but do impact future earnings and cash flows,
assuming other factors are held constant. With the new financing incurred in
connection with the acquisition of Chattanooga Group, Inc., all of the Senior
Credit Facility is variable rate debt, while the Senior Subordinated Notes,
while having the possibility for interest rate fluctuation, are structured so as
to remain at no less than 13% interest and no more than 15% interest. EMC may
use derivative financial instruments where appropriate to manage its interest
rate risk. However, as a matter of policy, it does not enter into derivative or
other financial investments for trading or speculative purposes. To date, it has
entered into no derivative financial instruments. All of the Company's sales
have been denominated in U.S. dollars, and therefore the Company has not been
subject to foreign currency exchange risks. However, as the Company begins to
directly distribute its products in selected foreign markets, it is expected
that future sales of these products in these markets will be denominated in the
applicable foreign currencies, which would cause currency fluctuations to more
directly impact its operating results.
Forward Looking Statements
The foregoing Management's Discussion and Analysis contains various
"forward looking statements" within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934 which
represent Encore's expectations or beliefs concerning future events, including,
but not limited to, statements regarding growth in sales of Encore's products,
profit margins and the sufficiency of Encore's cash flow for its future
liquidity and capital resource needs. These forward looking statements are
further qualified by important factors that could cause actual results to differ
materially from those in the forward looking statements. These factors include,
without limitation, the effect of competitive pricing, Encore's dependence on
the ability of its third-party manufacturers to produce components on a basis
which is cost-effective to Encore, market acceptance of Encore's products, the
ability to attract and retain competent employees, technological obsolescence of
one or more products, changes in product strategies, the availability to locate
acceptable acquisition candidates and then finance and integrate those
acquisitions, and effects of government regulation. Results actually achieved
may differ materially from expected results included in these statements as a
result of these or other factors.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In the fall of 2001, Encore began a number of legal proceedings against
Akthea S.A.R.L. ("Akthea"), its former distributor in France. The nature of the
claims revolves around monies that were not paid to Encore by Akthea in
connection with the distribution agreement and lease agreement that were entered
into by the parties. The cases by Encore were filed in both United States
District Court in Texas related to the lease agreement issues, and with the
International Chamber of Commerce Arbitration Panel in London related to the
distribution agreement issues. On February 25, 2002, Encore was awarded a
judgment against Akthea in connection with the United States District Court case
in the amount of $377,000. The International Chamber of Commerce Arbitration
case is in the process of appointing arbitrators and scheduling arguments. In
partial response to these actions, Akthea has brought suit against Encore, along
with Endo Plus France S.A.R.L., Plus Endoprothetik AG and Plus Endoprothetik
GmbH (collectively "Plus"), in Commercial Court located in Nanterre, France,
alleging, as best as can be determined, that the defendants have conspired to
introduce into commerce in France implants which combine the products of Encore
and Plus and hence have caused a risk of injury to the French public, as well as
have violated the exclusivity provisions of the Distribution Agreement between
Encore and Akthea. Encore is vigorously challenging the facts, conclusions and
jurisdiction of the French case and has requested that this case be stayed until
such time as the International Chamber of Commerce Arbitration case is resolved.
The French Commercial Court recently stayed the first of the Akthea-brought
cases to come before it pending resolution of the dispute under the
International Chamber of Commerce Arbitration case.
During 2000, the Company had brought suit against one of its former sales
agents and two other corporations alleging, inter alia, that the sales agent had
violated his non-competition provisions of this Sales Representative Agreement
with the Company and that the two corporations had tortuously interfered with
the Company's contract rights with respect to such sales agent. In the first
quarter of 2002, the case was settled with all parties. As a result, the Company
obtained a judgment that the non-competition provisions of the Sales
Representative Agreement were valid and enforceable as written, the sales agent
paid the Company certain sums of money, one of the two corporations agreed to
pay monetary amounts to the Company, and the other agreed to renegotiate an
agreement it had with the Company so as to make the terms more favorable to the
Company.
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ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
1. In connection with the Note Agreement, EMC granted CapitalSource a
warrant to purchase up to an aggregate of 2,198,614 shares of common stock of
the Company (the "CS Warrants") (constituting 8.25% of the issued and
outstanding common stock (calculated on a fully diluted, as converted basis,
determined using the treasury stock method) of EMC as of February 8, 2002). The
number of shares of common stock that may be acquired under the CS Warrant is
initially 2,150,000. In the event that EMC obtains the approval of its
stockholders, as is required in order to comply with NASDAQ Marketplace Rule
4350(i)(1)(D), prior to July 1, 2002, the number of shares that may be acquired
under the CS Warrant will be increased to 2,198,614. If that approval is not
obtained, then EMC would be obligated to pay CapitalSource a fee equal to the
greater of (i) $324,255.38 and (ii) the product of 48,614 multiplied by the per
share fair market value of EMC's common stock as of July 1, 2002.
2. In connection with the financing of the Chattanooga acquisition, the
terms of the Series A Preferred Stock were modified to extend from May 2, 2002
until November 15, 2003, the date on which the Company could exercise certain
rights to require the conversion of the Series A Preferred Stock into Common
Stock of the Company. In addition, the number of shares of preferred stock that
were designated as Series A Preferred Stock was increased from 135,000 to
255,000.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
1. Exhibits. None
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2. Reports on Form 8-K.
-------------------
A. On February 25, 2002, the Company filed a Form 8-K in connection
with its acquisition of Chattanooga Group, Inc.
B. On April 17, 2002, the Company filed a Form 8-K/A in connection
with its acquisition of Chattanooga Group, Inc.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
May 14, 2002 By: /s/ Kenneth W. Davidson
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Date Kenneth W. Davidson, Chairman of the Board, Chief
Executive Officer and President
May 14, 2002 By: /s/ August Faske
- ------------ ----------------
Date August Faske, Executive Vice President - Chief
Financial Officer
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