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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 October 2, 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 8,971,340
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ENCORE MEDICAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF OCTOBER 2, 1998 AND DECEMBER 31, 1997
(in thousands, except share data)
October 2, December 31,
1998 1997
-------- --------
(unaudited) (audited)
ASSETS
Cash $ 1 $ 9
Accounts receivable, net 5,244 5,063
Inventories 16,501 13,359
Prepaid expenses and other current assets 929 704
-------- --------
Total current assets 22,675 19,135
Property, plant and equipment, net 6,267 5,099
Other noncurrent assets 1,352 1,487
-------- --------
Total assets $ 30,294 $ 25,721
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable and accrued liabilities $ 4,020 $ 3,841
Current portion - long-term debt 452 312
Current portion - payable to a related party 800 300
-------- --------
Total current liabilities 5,272 4,453
Long-term debt, net of current portion 5,636 2,444
Payable to a related party, net of current portion 0 800
Other long-term liabilities 48 0
-------- --------
Total liabilities 10,956 7,697
Preferred stock, $1.00 par value, 1,000,000 shares
authorized, 0 and 0 shares issued and
outstanding, respectively (See Note 3) -- --
Common stock, $0.001 par value, 35,000,000 shares
authorized, 9,154,040 and 9,047,000 shares issued
and outstanding, respectively (See Note 3) 9 9
Additional paid-in capital and deferred
compensation 18,438 18,128
Accumulated surplus/deficit 891 (113)
-------- --------
Total stockholders' equity 19,338 18,024
-------- --------
Total liabilities and stockholders' equity $ 30,294 $ 25,721
======== ========
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 AND NINE MONTHS ENDED OCTOBER 2, 1998 AND SEPTEMBER 26, 1997
(in thousands, except per share amounts)
(unaudited)
Three Months Ended Nine Months Ended
October 2, September 26, October 2, September 26,
1998 1997 1998 1997
---------- ---------- ---------- ----------
Sales $ 6,363 $ 5,821 $ 20,500 $ 18,062
Cost of goods sold 2,035 1,905 6,688 5,849
---------- ---------- ---------- ----------
Gross margin 4,328 3,916 13,812 12,213
Operating expenses:
Research and development 421 383 1,273 1,134
Selling, general and administrative 3,265 2,944 10,755 9,028
---------- ---------- ---------- ----------
Operating income 642 589 1,784 2,051
Interest income 0 9 0 71
Interest expense (130) (70) (319) (548)
Other (expense) income (2) (63) 3 (106)
---------- ---------- ---------- ----------
Income before extraordinary loss and taxes 510 465 1,468 1,468
Provision for (benefit from) income taxes 158 158 455 (71)
---------- ---------- ---------- ----------
Income before extraordinary item 352 307 1,013 1,539
Extinguishment of debt (net of income taxes) -- -- -- 598
---------- ---------- ---------- ----------
Net income $ 352 $ 307 $ 1,013 $ 941
========== ========== ========== ==========
Basic earnings per share .04 .03 .11 .12
Shares used in computing basic earnings per share 9,149 8,873 9,104 7,846
Diluted earnings per share .03 .03 .09 .09
Shares used in computing diluted earnings per share 10,582 10,808 10,708 10,104
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 NINE MONTHS ENDED OCTOBER 2, 1998 AND SEPTEMBER 26, 1997
(in thousands) (unaudited)
Nine Months Ended
October 2, September 26,
1998 1997
---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,013 $ 941
Adjustments to reconcile net income to net cash provided
by (used in) operating activities:
Depreciation and amortization 1,446 1,081
Amortization of debt discount -- 65
Extinguishment of debt discount -- 588
Benefit from deferred tax asset -- (537)
Other (8) 10
Changes in operating assets and liabilities:
Increase in accounts receivable (181) (2,393)
Increase in inventories (3,142) (2,192)
(Inc.)/dec. in prepaid expenses and other assets (156) 20
Increase in accounts payable and accrued expenses 227 889
---------- ----------
Net cash used in operating activities (801) (1,528)
---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (1,840) (1,614)
---------- ----------
Net cash used in investing activities (1,840) (1,614)
---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of stock 162 7,461
Payments on payable to a related party (300) (300)
Proceeds from long-term debt 3,051 3,043
Payments on long-term debt (280) (5,153)
Dividends paid -- (4)
Net proceeds (payments) on line of credit -- (2,300)
---------- ----------
Net cash provided by financing activities 2,633 2,747
---------- ----------
Net decrease in cash equivalents (8) (395)
Cash and cash equivalents at beginning of period 9 472
---------- ----------
Cash and cash equivalents at end of period $ 1 $ 77
========== ==========
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 nine month period ended October 2, 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.
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 a wholly owned subsidiary of HCAC, a
publicly traded, specified purpose acquisition company, executed a definitive
agreement and plan of merger. The merger was contingent upon, among other
things, the approval of the shareholders of both Encore and HCAC at meetings,
which were held in March 1997. 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 Agreement and Plan of Merger. 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. The capital
accounts of Encore at December 31, 1997, however, have been reflected on an
equivalent share basis to give effect to the exchange ratios discussed above.
The accompanying statements of income for the nine months ended September 26,
1997 include 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 October 2, 1998 and December 31, 1997 are as follows
(in thousands):
October 2, December 31,
1998 1997
---------- ----------
Components and raw materials $ 4,029 $ 2,711
Work in process 1,946 1,549
Finished goods 10,526 9,099
---------- ----------
$ 16,501 $ 13,359
========== ==========
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 October 2, 1998 and September
26, 1997 respectively are as follows (in thousands):
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
October 2, September 26, October 2, September 26,
1998 1997 1998 1997
(unaudited) (unaudited) (unaudited) (unaudited)
--------- --------- --------- ---------
Weighted average shares outstanding-basic 9,149 8,873 9,104 7,846
Plus: Common stock equivalents 1,433 1,935 1,604 2,258
--------- --------- --------- ---------
Weighted average shares outstanding-diluted 10,582 10,808 10,708 10,104
========= ========= ========= =========
Options and warrants to purchase 1,332,064 and 5,842,072 shares of common
stock, respectively, were outstanding at October 2, 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 OCTOBER 2, 1998, AS COMPARED
TO THE THREE MONTHS ENDED SEPTEMBER 26, 1997.
Sales were $6,363,000 for the quarter ended October 2, 1998, representing an
increase of $542,000 or 9.3% over the quarter ended September 26, 1997. U.S.
sales increased 23.4% 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
have dropped $262,000 or 10.9% compared to the third quarter of 1997 due to
timing associated with orders from stocking distributors and the economic
environment in Japan. 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 $4,328,000 in the third quarter of 1998, or 68.0% of
sales, as compared to $3,916,000 or 67.3% of sales for the third quarter of
1997. Gross margin as a percent of sales increased due to geographical and
product mix.
Research and development expenses increased by $38,000 or 9.9% in 1998 when
compared to the same period in 1997. 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. Another component of the increased
research and development expenses was the continuation of activities that
address polyethylene wear in hip implants which included a FDA feasibility
study for metal/metal articulation as well as the initiation of full clinical
studies for metal/metal and ceramic/ceramic hips after receiving FDA approval.
Selling, general and administrative expenses increased by $321,000, or 10.9%,
in 1998 when compared to the same period in 1997. This increase was
attributable to the continual investment in the expansion of the business and
the development of the U.S. sales infrastructure, costs associated with an
unsuccessful acquisition attempt, and increases in royalties and sales
commissions in conjunction with the increase in overall sales.
Operating income increased 9.0% to $642,000 for the third quarter of 1998, as
compared to $589,000 for the quarter ended September 26, 1997.
Interest expense increased to $130,000 for the quarter ended October 2, 1998,
compared to $70,000 for the third quarter of 1997 due to the increase in
borrowings from the revolving line of credit.
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED OCTOBER 2, 1998, AS COMPARED TO
THE NINE MONTHS ENDED SEPTEMBER 26, 1997.
Sales increased to $20,500,000 for the nine months ended October 2, 1998, as
compared to $18,062,000 in the prior year. This represented a 13.5% increase in
overall sales. Sales in the U.S. grew by 29.3% to $13,062,000. U.S. sales
continue to grow at a rapid pace due to the growth of volume with the existing
sales force 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 $1,105,000 or approximately
71.9% to Asia as compared to sales in that region in 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. Overall, 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, as well as the new hip systems introduced in the first
quarter of 1998, increased 19.4% to $18,762,597 for the nine months ended
October 2, 1998 as compared to the nine months ended September 26, 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.
Gross margin as a percentage of sales was 67.4% of sales for the nine months
ended October 2, 1998, as compared to 67.6% of sales in 1997. Gross margin as a
percent of sales decreased slightly 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.
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Research and development expenses increased by $139,000 or 12.3% 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 $1,727,000 or 19.1%
as compared to the same period in the prior year. These expenses increased due
to additional instrumentation depreciation and continual investment in the
development of the U.S. sales infrastructure, increase in commission and
royalty expenses in conjunction with the increase in sales, a charge for
inventory discrepancies at consigned locations and costs associated with
unsuccessful acquisition attempts. Due to factors such as commissions and
royalties and additional instrumentation depreciation, selling, general and
administrative expenses will continue to increase in absolute dollars as the
Company supports new product introductions and expands into new territories,
but should decrease as an overall percent of net sales. However, the Company is
expecting to manage operating expense growth relative to sales and gross margin
levels going forward.
Interest expense decreased by $229,000 for the nine months ended October 2,
1998 to $319,000 as compared to the first nine 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, which was paid off as of the end of May 1997. Interest
expense was affected by both a higher effective interest rate and the
amortization of the related debt discount in the prior year.
Income before extraordinary item for the nine months ended October 2, 1998
decreased by 34.2% or $526,000 when compared to the same period in 1997 due to
a one time benefit in 1997 from the reversal of the $537,000 deferred tax asset
valuation allowance.
There was no extinguishment of debt expense during the nine months ended
October 2, 1998, as compared to $598,000 for the same period in 1997. During
the second quarter of fiscal year 1997, the Company repaid $5 million of long
term debt, plus accrued interest of $39,000. The Company had previously
capitalized approximately $476,000 of financing costs and established a debt
discount of $821,000 associated with detachable put warrants issued in
accordance with the debt. The unamortized portions of these two items were
expensed in conjunction with the repayment of the debt, resulting in an
extraordinary charge to earnings of $598,000, net of an income tax benefit of
$308,000.
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
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 October 2, 1998 of $9.9 million. As of October 2, 1998, the Company
had drawn $4.85 million. A distinguishing feature of the Credit Facility is
that Encore's cash management services are intermingled with it. Encore's bank
accounts sweep funds, on a daily basis, 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 October 2, 1998, the Company had net working capital of $17.4 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.
During the third quarter of 1998, the Company began actively
purchasing its equity securities, both common stock and $5 Warrants, in
connection with the buyback program it announced at the beginning of 1998. This
program was initiated because Company management and the Board of Directors
felt that the Company's equity was undervalued. Through November 9, 1998, the
Company has repurchased 172,700 shares of common stock and 63,600 $5 warrants.
This program is ongoing.
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YEAR 2000 COMPLIANCE
The Year 2000 ("Y2K") issue stems from the way dates are recorded and
computed in many computer systems because such programs use only the last two
digits to indicate the year. If uncorrected, these computer programs will be
unable to interpret dates beyond the year 1999, which could cause computer
system failure or other computer errors, thereby disrupting operations. The
Company understands the importance of being prepared for Y2K. The Company's
objective is to ensure an uninterrupted transition into Y2K and is progressing
in a comprehensive plan to assure the achievement of that goal. The scope of
the Year 2000 readiness effort includes (1) evaluating information technology
such as software and hardware; (2) investigating other systems or embedded
technology such as microcontrollers contained in various manufacturing and lab
equipment, environmental and safety systems, and facilities and utilities, and
(3) assessing the readiness of key third parties, including suppliers,
customers, and key financial institutions.
The majority of the most vital information systems of the Company are
now Y2K compliant. The Company expects that the remainder of the information
systems will be Y2K compliant by mid 1999. The Company expects to complete
compliance testing and finalize contingency plans in 1999. The Company is in
contact with key suppliers and financial institutions to assure no interruption
in the relationship between the Company and these important third parties
concerning Y2K compliance issues. If third parties do not convert their systems
in a timely manner, Y2K could have a material adverse affect on the Company's
operations.
The Company is expensing all costs related to the assessment and
remediation of the Y2K issue as incurred. These costs are being funded through
operating cash flows and are not material to the Company's consolidated
financial condition or results of operations.
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.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
1. Exhibits. See Index to Exhibits
2. Reports on Form 8-K. No Form 8-K's were filed during the quarter ended
October 2, 1998.
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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
11/13/98 By: /s/ NICK CINDRICH
- --------------- --------------------------------------
Date Nick Cindrich, Chief Executive Officer
11/13/98 By: /s/ AUGUST FASKE
- --------------- --------------------------------------
Date August Faske, 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
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