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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 July 3, 1998
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 9,096,409
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ENCORE MEDICAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF JULY 3, 1998 AND DECEMBER 31, 1997
(in thousands, except share data)
(unaudited)
July 3, December 31,
1998 1997
---------- ----------
ASSETS
Cash $ 1 $ 9
Accounts receivable, net 5,804 5,063
Inventories 15,329 13,359
Prepaid expenses and other current assets 575 704
---------- ----------
Total current assets 21,709 19,135
Property, plant and equipment, net 6,070 5,099
Other noncurrent assets 1,430 1,487
---------- ----------
Total assets $ 29,209 $ 25,721
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LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable and accrued liabilities $ 3,582 $ 3,841
Current portion - long-term debt 411 312
Current portion - payable to a related party 800 300
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Total current liabilities 4,793 4,453
Long-term debt, net of current portion 5,566 2,444
Payable to a related party, net of current portion -- 800
Other long-term liabilities 40 --
---------- ----------
Total liabilities 10,399 7,697
Preferred stock, $1.00 par value, 1,000,000 shares
authorized, 0 and 0 shares issued and
outstanding, respectively -- --
Common stock, $0.001 par value, 35,000,000 shares
authorized, 9,096,409 and 9,047,000 shares issued
and outstanding, respectively 9 9
Additional paid-in capital and deferred compensation 18,262 18,128
Retained earnings (deficit) 539 (113)
---------- ----------
Total stockholders' equity 18,810 18,024
---------- ----------
Total liabilities and stockholders' equity $ 29,209 $ 25,721
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The accompanying notes are an integral part of the consolidated financial
statements.
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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE MONTHS AND SIX MONTHS ENDED JULY 3, 1998 AND JUNE 27, 1997
(in thousands, except per share amounts)
(unaudited)
Three Months Ended Six Months Ended
-------------------------------- --------------------------------
July 3, June 27, July 3, June 27,
------------- ------------- ------------- -------------
1998 1997 1998 1997
------------- ------------- ------------- -------------
Sales $ 6,887 $ 6,501 $ 14,137 $ 12,241
Cost of goods sold 2,295 2,020 4,653 3,944
------------- ------------- ------------- -------------
Gross margin 4,592 4,481 9,484 8,297
Operating expenses:
Research and development 374 346 852 751
Selling, general and administrative 3,669 3,355 7,490 6,084
------------- ------------- ------------- -------------
Operating income 549 780 1,142 1,462
Interest income -- 58 -- 62
Interest expense (107) (219) (189) (478)
Other income (expenses) 4 (41) 5 (43)
------------- ------------- ------------- -------------
Income before extraordinary loss and taxes $ 446 $ 578 $ 958 $ 1,003
Provision for (benefit from) income taxes 122 (349) 297 (229)
------------- ------------- ------------- -------------
Income before extraordinary loss $ 324 $ 927 $ 661 $ 1,232
Extinguishment of debt (net of income taxes) -- 598 -- 598
------------- ------------- ------------- -------------
Net income $ 324 $ 329 $ 661 $ 634
============= ============= ============= =============
Basic earnings per share $ 0.04 $ 0.04 $ 0.07 $ 0.09
Shares used in computing basic earnings
per share 9,087,000 8,299,000 9,072,000 7,347,000
Diluted earnings per share $ 0.03 $ 0.03 $ 0.06 $ 0.07
Shares used in computing diluted earnings
per share 10,907,000 10,654,000 10,927,000 9,686,000
The accompanying notes are an integral part of the consolidated financial
statements.
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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
FOR THE SIX MONTHS ENDED JULY 3, 1998 AND JUNE 27, 1997
(in thousands)
(unaudited)
Six Months Ended
July 3, June 27,
1998 1997
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CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 661 $ 634
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization 915 702
Amortization of debt discount -- 65
Extinguishment of debt discount -- 588
Benefit from deferred tax asset -- (537)
Other (9) 10
Changes in operating assets and liabilities:
Increase in accounts receivable (741) (1,731)
Increase in inventories (1,970) (1,210)
Decrease in prepaid expenses and other assets 149 67
(Dec.) inc. in accounts payable and accrued expenses (219) 166
---------- ----------
Net cash used in operating activities (1,214) (1,246)
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NET CASH FLOWS FROM INVESTING ACTIVITIES:
Net purchases of property and equipment (1,299) (1,346)
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Net cash used in investing activities (1,299) (1,346)
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CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of stock 46 7,456
Payments on payable to a related party (300) (300)
Payments on long-term debt (174) (5,793)
Net proceeds on line of credit 2,933 920
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Net cash provided by financing activities 2,505 2,283
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Net (decrease) increase in cash equivalents (8) (309)
Cash and cash equivalents at beginning of period 9 472
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Cash and cash equivalents at end of period $ 1 $ 163
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The accompanying notes are an integral part of the 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 and its wholly owned subsidiaries (individually
and collectively referred to as the "Company"). 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 and six month periods ended July 3, 1998 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 1998. For further information, refer to the consolidated financial
statements and footnotes thereto included in the Company's Form 10-K dated
December 31, 1997 (the "Form 10-K").
2. DESCRIPTION OF BUSINESS
The Company designs, manufactures, markets and sells products for the
orthopedic implant industry primarily in the United States, Europe and Asia. 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
obtain FDA authorization to market each of 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.
As explained in Note 3, during the first quarter of 1997, Encore
Orthopedics, Inc. ("Encore") merged with Healthcare Acquisition, Inc., a
wholly-owned subsidiary of Healthcare Acquisition Corp. ("HCAC").
3. HCAC MERGER
In November 1996, Encore and Healthcare Acquisition, Inc., a
wholly-owned subsidiary of Healthcare Acquisition Corp. ("HCAC"), a publicly
traded, specified purpose acquisition company, executed a definitive agreement
and plan of merger (the "Merger Agreement"). Effective March 25, 1997, the
merger was completed and HCAC's name was changed to Encore Medical Corporation.
The merger was effected by HCAC issuing 0.8884 HCAC common shares and
0.13326 HCAC warrants with an exercise price of $7.00 ("HCAC $7.00 warrants")
for each common share of Encore and 1.11049 HCAC common shares and 0.16657 HCAC
$7.00 warrants for each preferred share of Encore in accordance with the
exchange ratio set forth in the Merger Agreement. In addition, outstanding
options and warrants to purchase common stock of Encore were exchanged for
options and warrants to purchase HCAC common stock and HCAC $7.00 warrants based
on the exchange ratio discussed above.
For financial reporting and accounting purposes, the merger was
accounted for as a recapitalization of Encore, with the issuance of shares by
Encore for the net assets of HCAC, consisting primarily of cash. As such, Encore
is considered the predecessor company. The accompanying statement of income for
the three and six months ended June 27, 1997 includes the results of operations
of HCAC from the effective date of the merger (March 25, 1997) through the end
of the period.
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4. INVENTORIES
Inventories at July 3, 1998 and December 31,1997 are as follows (in
thousands):
July 3, December 31,
1998 1997
---------- ----------
Components and raw materials $ 2,985 $ 2,711
Work in process 2,201 1,549
Finished goods 10,143 9,099
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$ 15,329 $ 13,359
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5. NET INCOME PER SHARE
Net income per share is computed based on the weighted average number
of outstanding common and common equivalent shares, using methodology required
in Statement of Financial Accounting Standards No. 128, "Earnings per Share"
("FAS 128"). Common equivalent shares are not included in the per share
calculation where the effect of their inclusion would be anti-dilutive.
The reconciliation of the denominators used to calculate the basic and
diluted earnings per share for the periods ended July 3, 1998 and June 27, 1997
respectively are as follows (in thousands):
Three Months Three Months Six Months Six Months
Ended Ended Ended Ended
July 3, 1998 June 27, 1997 July 3, 1998 June 27, 1997
---------- ---------- ---------- ----------
(unaudited) (unaudited) (unaudited) (unaudited)
Weighted average shares outstanding-basic 9,087 8,299 9,072 7,347
Plus: Common stock equivalents 1,820 2,355 1,855 2,339
---------- ---------- ---------- ----------
Weighted average shares outstanding-diluted 10,907 10,654 10,927 9,686
========== ========== ========== ==========
Options and warrants to purchase 1,208,667 and 5,842,072 shares of common stock,
respectively, were outstanding at July 3, 1998, but were not included in the
computation of diluted EPS because their exercise price was greater than the
average market price of the common shares.
6. REPORTING COMPREHENSIVE INCOME
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income." The new standard, which is effective for financial
statements issued for periods ending after December 15, 1997, established
standards for reporting, in addition to net income, comprehensive income and its
components including, as applicable, foreign currency items, minimum pension
liability adjustments and unrealized gains and losses on certain investments in
debt and equity securities. Upon adoption, the Company is also required to
reclassify financial statements for earlier periods provided for comparative
purposes. The Company adopted this standard in the first quarter of 1998. The
impact of this standard on the Company's results is considered immaterial for
disclosure.
7. SEGMENT REPORTING
In June 1997, FASB issued SFAS No. 131, "Disclosure about Segments of
an Enterprise and Related Information," which the Company adopted in the first
quarter of 1998. The standard establishes requirements for reporting information
about operating segments in annual financial statements and requires selected
information about operating segments in interim financial reports issued to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas and major customers. Under SFAS No. 131,
operating segments are to be determined consistent with the way management
organizes and evaluates financial information internally for making operating
decisions and assessing performance. The disclosure provisions of this standard
are not applicable for interim periods in the year of adoption. The adoption of
this new standard is not expected to have a material impact on the Company's
consolidated balance sheet or statement of income.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JULY 3, 1998, AS COMPARED TO
THE THREE MONTHS ENDED JUNE 27, 1997.
Sales were $6,887,000 for the quarter ended July 3, 1998, representing an
increase of $386,000 or 5.9% over the quarter ended June 27, 1997. U.S. sales
increased 17.4% over the same period in 1997. The increase in U.S. sales was
primarily due to the continual growth of the U.S. sales force in the number of
sales agents and more productive sales territories. Outside the U.S., sales to
Asia, primarily Japan, have dropped over $660,000 or approximately 83% compared
to the second quarter of 1997. This situation will likely continue into the
third quarter. Going forward, U.S. geographical expansion and introduction of
new products will generate additional increases in sales in both the total joint
and trauma segments of the business.
Gross margin increased to $4,592,000 in the second quarter of 1998, or 66.7% of
sales, as compared to $4,480,000 or 68.9% of sales for the second quarter of
1997. Gross margin as a percent of sales decreased due to discounts given to
hospitals and higher costs associated with the initial production of the
Revelation(TM) and Linear(TM) Hip Systems, which were introduced to the market
at the end of the first quarter of 1998.
Research and development expenses increased by $29,000 or 8.4% in 1998 when
compared to the same period in 1997. Research and development activities
increased to complete the design of two new hip stems and two acetabular systems
that were released early this year. A joint design effort with Norton
Desmarquest Fine Ceramics of France was initiated in late 1997, which has
continued into 1998, to develop a ceramic knee femoral component to address the
issue of polyethylene wear in the knee. Initiation of activities that address
polyethylene wear in hip implants included a FDA feasibility study for
metal/metal articulation as well as FDA approval to begin full clinical studies
for metal/metal and ceramic/ceramic hips.
Selling, general and administrative expenses increased by $314,000, or 9.4%, in
1998 when compared to the same period in 1997. This increase was attributable to
inventory discrepancies at consigned locations, an increase in royalties in
conjunction with the increase in overall sales, increased instrumentation
depreciation associated with additional loaner instrument sets, and the
continual investment in the expansion of the business and the development of the
U.S. sales infrastructure resulting in higher advertising and travel expenses.
Operating income decreased 29.6% to $549,000 for the second quarter of 1998, as
compared to $780,000 for the quarter ended June 27, 1997. Increased research and
development, selling, and general and administrative expenses offset the
increase in sales.
Interest expense decreased to $107,000 for the quarter ended July 3, 1998,
compared to $219,000 for the second quarter of 1997. This decrease was primarily
due to the existence of $5 million of term debt in the first five months of 1997
that was retired at the end of May 1997.
RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JULY 3, 1998, AS COMPARED TO THE
SIX MONTHS ENDED JUNE 27, 1998.
Sales increased to $14,137,000 for the six months ended July 3, 1998, as
compared to $12,241,000 in the prior year. This represented a 15.5% increase in
overall sales. Sales in the U.S. grew by 32.3% to $8,829,000. U.S. sales
continue to grow at a rapid pace due to the growth of existing sales force
volume and the addition of new agents and new sales territories. Outside the
U.S., the economic environment that currently exists in Asia is affecting sales,
primarily to Japan. Sales have dropped over $1,000,000 or approximately 80% to
Asia as compared to the prior year. The Company anticipates a continuation of
the same problem in the near term but is confident that sales from other areas
will partially offset the shortfall in Asia by year end. Sales of reconstructive
products continue to increase while trauma product sales are currently remaining
relatively flat. Reconstructive product sales led by the Foundation(R) Total
Knee, Hip and Shoulder Systems increased 16.7% to $13,281,000 for the six months
ended July 3, 1998 as compared to the six months ended June 27, 1997. The
Company continues to anticipate sales for trauma products to further increase as
the transition to an exclusive sales force is completed in 1998 and the product
base is expanded.
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Gross margin as a percentage of sales was 67.1% of sales for the six months
ended July 3, 1998, as compared to 67.8% of sales in 1997. Gross margin as a
percent of sales decreased due to discounts and higher costs associated with the
initial production of the Revelation(TM) and Linear(TM) Hip Systems. It is
anticipated that future production costs of the new hip systems will decrease as
volumes increase and production methods are made more efficient.
Selling, general and administrative expenses increased to $7,490,000 or 23.1% as
compared to the prior year six month period. These expenses increased due to
higher commissions associated with the overall increase in sales in conjunction
with a higher percentage growth in U.S. sales (as U.S. sales carry higher
commission rates than sales outside the U.S.), inventory discrepancies at
consigned locations, increase in royalties in conjunction with the overall
increase in sales, increased instrumentation depreciation associated with
additional loaner instrument sets, a greater number of clinical support
activities, and expenses associated with acquisition attempts. Also, the Company
is committed to the expansion of the business and the continual development of
the U.S. sales infrastructure. As such, selling, general and administrative
expenses will continue to increase in absolute dollars as the Company supports
new product introductions and expands into new territories. However, the Company
is expecting to manage operating expense growth relative to sales and gross
margin levels going forward.
Interest expense decreased $224,000 for the six months ended July 3, 1998 to
$189,000 as compared to the first six months of the prior year. This was
primarily related to the existence of $5 million in term debt in the first five
months of 1997. Interest expense was affected by both a higher effective
interest rate and the amortization of the related debt discount in the prior
year.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, the Company has financed its operations through the
sale of equity securities, borrowings and cash flow from operations. During the
beginning of the second quarter of 1998, Encore renegotiated its revolving
credit facility (the "Credit Facility") from $10 million to $15 million with an
eligible borrowing base as of July 3, 1998 of $14.7 million. As of July 3, 1998,
the Company had drawn $4.7 million. A distinguishing feature of the Credit
Facility is that Encore's cash management services are intermingled with it.
Encore's bank accounts sweep, on a daily basis, funds to either reduce or
increase the loan balance, as needed, and invest any excess funds if the loan
balance equals zero, in a money market account. As such, the outstanding loan
balance is adjusted daily based on the net amount of cash receipts versus cash
outlays, while the bank cash balance remains at zero as long as Encore is a net
borrower. This sweep feature minimizes interest expense, and automatically
invests any excess funds.
The Company's continued strong growth has resulted in an increase in
its capital requirements. This growth is now primarily funded by the Credit
Facility and cash generated from operations to meet its working capital needs.
As of July 3, 1998, the Company had net working capital of $16.9 million as
compared to $14.7 million at December 31, 1997. This increase was primarily due
to the increases in inventory and accounts receivable offset by the increase in
the current portion of a payment to a related party.
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 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
None.
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
1. Exhibits. See Index to Exhibits
2. Reports on Form 8-K. None.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
ENCORE MEDICAL CORPORATION
8-14-98 By: /s/ NICK CINDRICH
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Date Nick Cindrich, Chairman of the Board
and Chief Executive Officer
8-14-98 By: /s/ AUGUST FASKE
- ------- ----------------------------------------
Date August Faske, Vice President - Finance,
Chief Financial Officer
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INDEX TO EXHIBITS
Number Assigned in
Regulation S-K
Item 601 Description of Exhibit
- -------- ----------------------
(2) No exhibit
(4) No exhibit
(10) No exhibit
(11) No exhibit
(15) No exhibit
(18) No exhibit
(19) No exhibit
(22) No exhibit
(23) No exhibit
(24) No exhibit
(27) Financial data schedules
(99) No exhibit