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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q/A
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1998
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
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Commission File Number: 000-19168
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Sofamor Danek Group, Inc.
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(Exact name of registrant as specified in its charter)
Indiana 35-1580052
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(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification Number)
1800 Pyramid Place, Memphis, Tennessee 38132
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(Address of principal executive offices) (Zip Code)
(901) 396-2695
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(Registrant's telephone number, including area code)
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(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
[X] Yes [ ] No
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
26,735,114 shares of common stock outstanding as of June 30, 1998
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PART I - FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARES)
JUNE 30, DECEMBER 31,
1998 1997
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ASSETS (UNAUDITED)
Current assets:
Cash and cash equivalents $ 49,042 $ 2,729
Short-term investments 24,925 36
Accounts receivable--trade, less allowance for
doubtful accounts of $1,991 and $1,812 at June
30, 1998 and December 31, 1997, respectively 98,672 88,209
Other receivables 32,888 29,374
Inventories 44,132 40,575
Loaner set inventories 24,399 21,511
Prepaid expenses 5,970 6,061
Prepaid income taxes 11,408 3,052
Current deferred income taxes 5,845 8,013
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Total current assets 297,281 199,560
Property, plant and equipment
Land 1,473 1,477
Buildings 11,060 10,905
Machinery and equipment 39,580 35,677
Automobiles 947 759
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53,060 48,818
Less accumulated depreciation (25,902) (23,797)
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27,158 25,021
Investments 990 954
Intangible assets, net 101,866 97,048
Other assets 31,689 31,649
Non-current deferred income taxes 32,222 31,425
========= =========
Total assets $ 491,206 $ 385,657
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
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SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARES)
JUNE 30, DECEMBER 31,
1998 1997
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LIABILITIES (UNAUDITED)
Current liabilities:
Notes payable and lines of credit $ 14,688 $ 11,731
Current maturities of long-term debt 525 7,586
Current portion of product liability litigation 12,000 8,606
Accounts payable 7,228 4,684
Income taxes payable 16,728 2,473
Accrued expenses 38,807 41,488
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Total current liabilities 89,976 76,568
Long-term debt, less current maturities 22,571 60,650
Product liability litigation, less current portion 21,757 33,970
Minority interest 4,523 3,171
Commitments and contingencies
STOCKHOLDERS' EQUITY
Preferred stock, no par value, 5,000,000 shares
authorized, no shares outstanding
Common stock, no par value 150,000,000 shares
authorized: 30,758,294 and 25,867,749 shares
issued (including 4,023,180 and 685,908 shares
held in treasury) at June 30, 1998 and December
31, 1997, respectively
374,393 74,014
Retained earnings 184,188 154,828
Accumulated other comprehensive loss (4,747) (4,294)
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553,834 224,548
Less:
Cost of common stock held in treasury (198,190) (9,985)
Stockholder notes receivable (3,265) (3,265)
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Total stockholders' equity 352,379 211,298
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Total liabilities and stockholders' equity $ 491,206 $ 385,657
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
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SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
1998 1997 1998 1997
-------- --------- --------- ---------
Revenues $ 93,384 $ 73,613 $ 181,837 $ 143,372
Cost of goods sold 15,839 12,660 31,587 25,030
-------- --------- --------- ---------
Gross profit 77,545 60,953 150,250 118,342
Operating expenses:
Selling, general and administrative 42,904 34,633 83,943 67,331
Research and development 7,156 4,767 13,390 9,497
Special charges 8,000 -- 8,000 --
-------- --------- --------- ---------
58,060 39,400 105,333 76,828
-------- --------- --------- ---------
Income from operations 19,485 21,553 44,917 41,514
Other income 428 179 674 255
Interest expense (670) (1,515) (1,805) (2,691)
-------- --------- --------- ---------
Income from operations before
income taxes and minority interest 19,243 20,217 43,786 39,078
Income taxes 5,645 5,863 12,999 11,333
-------- --------- --------- ---------
Income before minority interest 13,598 14,354 30,787 27,745
Minority interest 733 701 1,427 1,318
-------- --------- --------- ---------
Net income $ 12,865 $ 13,653 $ 29,360 $ 26,427
======== ========= ========= =========
Net income per share - diluted $ 0.44 $ 0.51 $ 1.03 $ 1.00
======== ========= ========= =========
Net income per share - basic $ 0.49 $ 0.55 $ 1.13 $ 1.07
======== ========= ========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
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SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
FOR THE SIX MONTHS
ENDED JUNE 30,
1998 1997
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Cash flows from operating activities:
Net income $ 29,360 $ 26,427
Adjustments to reconcile net income to net cash
provided (used) by operating activities:
Special charges 8,000 --
Depreciation and amortization 8,447 8,498
Provision for doubtful accounts receivable 214 295
Deferred income taxes 1,246 1,018
Loss (gain) on disposal of equipment 285 (4)
Minority interest 1,427 1,318
Changes in assets and liabilities:
Accounts receivable (11,665) (8,674)
Other receivables (3,085) (6,450)
Inventories and loaner set inventories (7,290) (22,720)
Prepaid expenses 557 2,312
Prepaid income taxes (8,355) (4,227)
Other assets (112) (667)
Accounts payable 2,602 3,278
Accrued income taxes 1,179 (3,499)
Accrued expenses (2,362) (7,406)
Product liability litigation (8,732) (2,630)
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Net cash provided by (used by) operating activities 11,716 (13,131)
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Cash flows from investing activities:
Purchase of short-term investments (24,909) (2)
Proceeds from maturities of short-term investments 17 33
The accompanying notes are an integral part
of the consolidated financial statements.
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SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(IN THOUSANDS)
(UNAUDITED)
FOR THE SIX MONTHS
ENDED JUNE 30,
1998 1997
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Payments for purchase of property, plant and equipment (6,536) (4,420)
Proceeds from sale of equipment 80 14
Purchase of intangible assets (9,547) (11,113)
Increase in notes receivable, other (2,979) (367)
Repayments of notes receivable, other 2,427 12
Payments for investment -- (133)
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Net cash used by investing activities (41,447) (15,976)
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Cash flows from financing activities:
Increase in short-term borrowings 3,772 36,287
Proceeds from long-term debt 24,659 136
Repayment of long-term debt and other obligations (77,742) (16,208)
Proceeds from issuance of common stock 126,124 9,797
Cash paid in the SOFYC exchange (1,930) --
Capital contribution by minority shareholder -- 148
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Net cash provided by financing activities 74,883 30,160
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Effect of exchange rate changes on cash 1,161 (1,242)
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Increase (decrease) in cash and cash equivalents 46,313 (189)
Cash and cash equivalents, beginning of period 2,729 2,830
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Cash and cash equivalents, end of period $ 49,042 $ 2,641
========= ========
The accompanying notes are an integral part
of the consolidated financial statements.
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SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. Financial Statement Presentation
The consolidated financial statements of Sofamor Danek Group, Inc. (the
"Company") include the accounts of the Company and its subsidiaries over
which it maintains control. The consolidated balance sheet as of June 30,
1998 and the consolidated statements of income and consolidated statements
of cash flows for the six months ended June 30, 1998 and 1997, are
unaudited but, in the opinion of management, include all adjustments
(consisting only of normal recurring adjustments) necessary for a fair
presentation of financial position, results of operations and cash flows.
Certain amounts for prior periods have been reclassified to conform with
the presentation at June 30, 1998.
Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted. It is suggested that
these consolidated financial statements be read in conjunction with the
financial statements and notes thereto included in the Company's 1997
Annual Report on Form 10-K.
2. Special Charges
During June 1998, the Company announced two strategic development and
licensing agreements under which it acquired exclusive worldwide rights to
new technology for use in bone growth, regeneration and repair and for use
in deep brain electrical stimulation. The Company made payments in June
1998 to the two counterparties to such agreements (the "Licensors")
totaling $8.0 million, which are reflected in the accompanying statements
of income as special charges. Upon the attainment of certain milestones by
the Licensors during the development and commercialization of these
technologies, the Company will be required to make additional
contractually defined payments aggregating $22.0 million, which are
expected to be paid over the next several years. Such payments will be
charged to the statement of income as incurred. Under both agreements, the
Company will also pay royalties to the Licensors based on eventual product
sales to customers. In order to market these products in the United
States, clearance by the Food and Drug Administration ("FDA") will be
necessary, which will require several years of clinical trials by the
Licensors. The accounting for these special charges was changed in
December 1998 to reflect the removal of the liability related to future
payments under these agreements.
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3. Inventories and Loaner Set Inventories
Net inventories and loaner set inventories consist of the following (in
thousands):
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June 30, December 31,
1998 1997
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Finished goods $37,031 $35,029
Work-in-process 4,897 3,405
Raw materials 2,204 2,141
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Net inventories $44,132 $40,575
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Loaner set inventories, net $24,399 $21,511
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4. Income Taxes
During the second quarter of 1998 the Company's effective tax rate was
29.3%. Excluding the impact of special charges, the Company's effective
income tax rate would have been 31% compared with 29% for the prior year
second quarter. The difference between the Company's effective and
statutory tax rates for both 1998 and 1997 resulted primarily from the
impact of certain elections made for U.S. tax purposes following the
combination (the "Combination") of Danek Group, Inc. with Sofamor S.A.
("Sofamor"), and the subsequent reorganization of Sofamor from a Societe
Anonyme (S.A.) under French law to a Societe en Nom Collectif (S.N.C.) in
late 1993. Management cannot be certain that such a favorable effective
income tax rate will be achieved in future periods, since the effective
tax rate calculation is dependent upon the Company's pre-tax income dollar
amount. Higher future pre-tax income could lead to higher future effective
tax rates. At June 30, 1998, the balance sheet of the Company reflected a
net deferred tax asset of $38.1 million. No valuation allowance was
recorded since sufficient taxable income exists in available carryback
periods to recognize fully these net deferred tax assets.
During the first six months of 1998 and 1997, charges in lieu of income
taxes of $7.0 million and $3.5 million, respectively, were recorded by the
Company as a result of certain common stock options being exercised and
vesting of certain restricted common stock.
5. Net Income Per Common Share
The Company computes its earnings per share ("EPS") in accordance with
Statement of Financial Accounting Standard ("SFAS") No. 128. Basic EPS
excludes dilution and is
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computed by dividing income available to common stockholders by the
weighted-average number of common shares outstanding for the period.
Diluted EPS reflects the potential dilution that could occur if securities
or other contracts to issue common stock were exercised or converted into
common stock or resulted in the issuance of common stock that then shared
in the earnings of the entity.
Potential common stock is in the form of stock options which have an
effect on the diluted net income per common share calculations for the
periods ended June 30, 1998 and 1997. Potential common stock also includes
assumed converted debt securities. In computing diluted EPS, net income is
adjusted by the amount of interest expense, net of taxes, from convertible
debt which is assumed to have been converted for the diluted weighted
average number of shares calculation.
The following table presents information necessary to calculate diluted
EPS for the periods ended June 30, 1998 and 1997 (in thousands):
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THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
1998 1997 1998 1997
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Weighted average shares
outstanding - Basic 26,516 24,674 26,005 24,594
Shares equivalents 2,559 1,840 2,512 1,812
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Weighted average shares
outstanding - Diluted 29,075 26,514 28,517 26,406
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6. Comprehensive Income
As of January 1, 1998, the Company adopted the provisions of SFAS No. 130,
"Reporting Comprehensive Income," which establishes standards for the
reporting and display of comprehensive income and its components within
financial statements. The adoption of this statement had no impact on the
Company's net income or stockholders' equity. Comprehensive income
consists of all changes, including net income, in the Company's equity
during a period, except those resulting from investments by, or
distributions to, the Company's stockholders.
Components of comprehensive income, net of related tax, for the periods
ended June 30, 1998 and 1997, are as follows (in thousands):
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THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
1998 1997 1998 1997
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Net income $12,865 $13,653 $29,360 $26,427
Foreign currency translation
adjustment 533 (1,088) (453) (4,375)
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Comprehensive income $13,398 $12,565 $28,907 $22,052
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7. Stock Exchange and Public Offering
On January 26, 1998, the Company purchased all of the outstanding capital
stock of SOFYC, S.A. ("SOFYC") for an aggregate of 2,806,080 privately
placed shares of the Company's common stock, $1.0 million in cash (less
certain expenses relating to the repurchase) and an agreement to repay
certain outstanding loans of SOFYC equal to approximately $0.9 million
(the "SOFYC Exchange"). In connection with the SOFYC Exchange, a foreign
tax liability of $13.0 million was reflected at June 30, 1998, which
represents an estimate of the tax the Company will incur upon retiring the
shares owned by SOFYC. SOFYC, which was the personal holding company of
the Cotrel family, owns 3,337,272 shares of the Company's Common Stock. As
a result of the SOFYC Exchange, the outstanding shares of common stock of
the Company were reduced by 531,192 shares. In connection with the
transaction, certain registration rights were granted to the former SOFYC
shareholders. In accordance with these rights, the Company filed a
registration statement with the Securities and Exchange Commission related
to a public offering on behalf of the former SOFYC shareholders of
1,600,000 of their 3,689,711 shares of Sofamor Danek common stock that
they owned in aggregate. The registration also provided for a public
offering of up to 1,200,000 shares of common stock to be sold by the
Company for its own account. In addition, Sofamor Danek granted to the
underwriters a maximum over-allotment option of 420,000 shares of common
stock. The over-allotment option was exercised. The net proceeds received
by the Company pursuant to the offering totaled $110.1 million. These
proceeds were invested in cash equivalents and short-term investments and
are carried at historical cost, which approximates fair value due to the
short maturities of the securities.
8. Commitments and Contingencies
The Company is involved from time to time in litigation on various matters
which include intellectual property, commercial affairs and product
liability. Given the nature of the Company's business activities, these
lawsuits are considered routine to the conduct of its business. The result
of any particular lawsuit cannot, because, among other things, of the very
nature of litigation, the litigation process and its adversarial nature,
and the jury system, be predicted.
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PRODUCT LIABILITY LITIGATION
Beginning in 1994, the Company and other spinal implant manufacturers were
named as defendants in a number of product liability lawsuits brought in
various federal and state courts around the country. These lawsuits allege
that plaintiffs were injured by spinal implants manufactured by the
Company and others. Although the plaintiffs have advanced claims under
many different legal theories, the essence of the plaintiff's claims
appears to be that the Company (including Sofamor and its former U.S.
distributor) marketed some of its spinal systems for pedicle fixation in
contravention of FDA rules and regulations (governing marketing and
labeling of medical devices), that pedicle fixation has not been proven
safe and effective in the context of FDA labeling standards, that some or
all of the spinal systems are defectively designed and manufactured and
that plaintiffs have suffered a variety of injuries as a result of their
physicians' use of such systems in pedicle fixation. The Company has also
been named as a defendant in a number of lawsuits instituted by plaintiffs
who have received spinal implants manufactured by other manufacturers and
in which the Company is alleged to have participated in a conspiracy among
doctors, manufacturers, hospitals, teaching institutions, professional
societies and others to promote, in violation of applicable law, the use
of spinal implants.
In a number of cases, plaintiffs have sought to proceed as representatives
of classes of spinal implant recipients. All efforts to obtain class
certification have been denied or withdrawn, except with respect to a
class-action settlement entered into between the plaintiffs and another
spinal implant manufacturer, AcroMed Corporation ("Acromed") (see below
under the heading entitled "AcroMed Corporation Settlement"). Some
plaintiffs have filed individual lawsuits, whereas other lawsuits list
multiple plaintiffs and, in certain instances, multiple lawsuits have been
filed on behalf of the same individual plaintiffs. Plaintiffs typically
seek relief in the form of monetary damages, often in unspecified amounts.
Many of the plaintiffs only allege as monetary damages an amount in excess
of the jurisdictional minimum for the court in which the case has been
filed. A few suits also name as defendants various officers and directors
of the Company.
As of June 30, 1998, the claims of approximately 2,200 plaintiffs remain
active in litigation against the Company. The majority of these plaintiffs
filed their claims in 1995. A number of plaintiffs have failed to pursue
their claims, and such claims have been dismissed without prejudice. The
Company is also named as a defendant in lawsuits involving about 2,700
plaintiffs where the Company is alleged to have conspired with competitors
and others, in violation of applicable law, to promote the use of spinal
implant systems.
The Company believes that it has defenses, including, without limitation,
defenses based upon the failure of a cause of action to exist where no
malfunction of the implant has occurred or the plaintiff has suffered no
injury attributable to the Company's product, the expiration of the
applicable statute of limitations and the learned intermediary defense.
The Company has asserted and will continue to assert these defenses
primarily through the filing of dispositive motions. The Company believes
that all product liability lawsuits currently pending against it are
without merit and will continue to defend against them vigorously.
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FEDERAL MULTIDISTRICT LITIGATION (MDL 1014)
On August 4, 1994, the Federal Judicial Panel for Multidistrict Litigation
ordered all federal court lawsuits to be transferred to and consolidated
for pretrial proceedings, including the determination of class
certification, in the United States District Court for the Eastern
District of Pennsylvania in Philadelphia (the "Multidistrict Litigation").
Lawsuits filed in federal court after August 4, 1994 have also been
transferred to and consolidated in the Multidistrict Litigation in the
Eastern District of Pennsylvania. In addition, a number of lawsuits filed
in state courts around the country were removed to federal courts and then
transferred into the Multidistrict Litigation. On February 22, 1995, Chief
Judge Emeritus, Louis C. Bechtle ("Judge Bechtle"), denied class
certification. A large number of plaintiffs filed individual lawsuits as a
result of the denial of class certification. In some instances, lawsuits
that had been removed and transferred into the Multidistrict Litigation
have been remanded to the state courts in which they were filed because
there was no federal court jurisdiction. As of June 30, 1998, the Company
is a defendant in approximately 850 individual claims and 1,000 conspiracy
claims consolidated in the Multidistrict Litigation. On April 16, 1997,
Judge Bechtle dismissed conspiracy claims alleging fraud on the FDA, but
deferred the remaining conspiracy claims for later consideration by the
federal trial courts to whom the cases will be remanded for trial.
Discovery has been completed in a number of the federal court cases and is
continuing in the remainder. A small number of cases have been transferred
to the federal courts in which they were filed for further proceedings and
trial. Judge Bechtle has begun the process of transferring the remaining
federal court cases to various federal courts throughout the United
States. As of June 30, 1998, the Federal Judicial Panel on Multidistrict
Litigation ordered the remand of approximately 270 cases to transferor
courts for further proceedings. It is anticipated that the first federal
court cases will be tried in 1998.
STATE COURT LITIGATION
A number of cases filed in state courts were not eligible for removal and
transfer into the Multidistrict Litigation. As of June 30, 1998, there
were approximately 1,300 individual claims pending against the Company in
several courts around the country, principally in Tennessee, Oklahoma,
Texas and Pennsylvania. In addition, there were approximately 1,600
conspiracy claims pending in state courts.
Approximately 1,550 plaintiffs, who had joined together in several
complaints which had been removed to the Multidistrict Litigation
proceedings, have had their cases remanded to the state court in Memphis,
Tennessee, where they were originally filed when it was determined that
the federal court lacked jurisdiction over their claims. A number of
plaintiffs have failed to pursue claims made on their behalf and their
claims were dismissed without prejudice. As of June 30, 1998, the lawsuits
of approximately 1,100 plaintiffs remain active in the litigation pending
in Memphis, Tennessee. The presiding state court judge in Memphis has
established a case management plan which calls for the preparation of
eight representative cases for preparation and trial. The first case in
Memphis against the Company is scheduled for trial in September, 1998. It
is anticipated that a number of other
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state court cases around the country will be scheduled for trial in 1998,
although delays in trial dates are common.
Discovery is proceeding in all remaining state court cases. In May, 1998,
a jury in Houston, Texas rendered a verdict adverse to the Company in the
amount of $0.4 million. The Company does not believe that that verdict was
justified by the evidence. The Company intends to appeal.
ACROMED CORPORATION SETTLEMENT
In December 1996, AcroMed, a spinal implant manufacturer and a defendant
in many of the cases pending in the Multidistrict Litigation, and the
Plaintiff's Legal Committee in the Multidistrict Litigation announced that
they had entered into a conditional settlement regarding all product
liability claims involving the use of AcroMed devices to achieve pedicular
fixation with screws in spinal fusion surgery. Under the terms of the
settlement, AcroMed will establish a settlement fund consisting of $100
million in cash plus the proceeds of its product liability insurance
policies. In January 1997, the parties submitted a formal class settlement
agreement and related documentation for approval by Judge Bechtle. By
order dated October 17, 1997, Judge Bechtle certified the proposed
settlement class and approved the proposed settlement. All appeals of
Judge Bechtle's certification and approval order have been withdrawn. As a
consequence of the class-certified settlement, all federal proceedings
involving AcroMed devices have been stayed.
INSURANCE
Several insurance carriers have asserted reservation of rights concerning
the scope and timing of the Company's remaining insurance coverage, but
have not denied insurance coverage to the Company. Three of the carriers,
Royal Surplus Lines Insurance Company ("Royal"), Steadfast Insurance
Company ("Steadfast") and Agricultural Excess and Surplus Insurance
Company ("Agricultural"), have each filed declaratory judgment actions
against the Company seeking clarification of their rights and obligations,
if any, under their respective policies. Neither Royal nor Agricultural
has paid amounts due to the Company; Steadfast has paid only a portion of
the amounts due to the Company.
The Royal and Steadfast lawsuits are pending in the United States District
Court for the Western District of Tennessee in Memphis. The Agricultural
lawsuit is pending in the United States District Court for the Southern
District of Ohio in Cincinnati. The Company believes that the receivables
are recoverable under the terms of the Royal, Steadfast and Agricultural
policies. The Company has filed an answer and counterclaim in the Royal
litigation and a motion seeking the interim payment of the Company's
defense costs. The Company has filed answers and counterclaims in the
Steadfast litigation and a motion to transfer the Agricultural litigation.
These litigations are in the preliminary stages. The Company believes that
Royal's, Steadfast's and Agricultural's claims are without merit and will
defend against them vigorously.
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As is common in the insurance industry, the Company's insurance policies
covering product liability claims must be renewed annually. The Company
has in force insurance coverage for product liability claims including
orthopedic bone screw claims, subject to the terms, conditions and limits
of the individual insurance policies. Except for a policy issued by Royal,
the Company's insurance policies are reduced by the costs of defense. In
some instances, the cost of defending these claims has been reimbursed by
certain of the primary and excess insurance carriers. Although the Company
has been able to obtain insurance relating to product liability claims at
a cost and on other terms and conditions that are acceptable to the
Company, there can be no assurance that in the future it will be able to
do so.
On January 6, 1997, the Company announced that its 1996 financial results
would include a pre-tax charge of $50.0 million relating to costs
associated with the product liability litigation described above. The
charge, which was reflected in the Company's 1996 financial statements,
covers the reasonable foreseeable costs that the Company was positioned in
late December 1996 to estimate because the litigation had progressed and
because changes in the fourth quarter of 1996 had occurred in facts and
circumstances relating to the litigation. Among the changed facts and
circumstances were the announcement of the AcroMed settlement described
above, the likelihood that the litigation will continue for several years,
in part, due to the additional financial resources provided to the
plaintiff's attorneys as a result of the AcroMed settlement, the absence
of AcroMed as a member of the joint defense group, the status of the
Company's insurance described above and the continuing absence of
dispositive rulings relating to the Company's defense motions.
While it is not possible to accurately predict the outcome of litigation,
the amount of the accrual, which remained on the Company's consolidated
balance sheet at June 30, 1998, represents the Company's best judgment of
the probable reasonable costs (in excess of amount of insurance the
Company believes are recoverable) to defend and conclude the lawsuits
based on the facts and circumstances currently existing. The costs
provided for in the accrued liability include, but are not limited to,
legal fees paid or anticipated to be paid and other costs related to the
Company's defense and conclusion of these matters.
The actual costs to the Company could differ from the estimated charge and
will be dependent upon a number of factors that will not be known for some
time, including, among other things, the resolution of defense motions and
the extent of further discovery. Although an adverse resolution of
lawsuits could have a material effect on the Company's results of
operations and cash flows in future periods, the Company does not believe
that these matters will in the future have a material adverse effect on
its consolidated financial position. The Company is unable to predict the
ultimate outcome or the financial impact of the product liability
litigation.
SECURITIES LAWS ACTIONS
Beginning in April 1994, the Company and four of its officers and
directors were named in five shareholder lawsuits filed in the United
States District Court in Memphis, Tennessee. Four of the lawsuits
purported to be class actions. All of the lawsuits were consolidated into
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one case in the United States District Court in Memphis through an amended
complaint which added four new individual defendants who are either
current or former directors of the Company. The lawsuit alleged that the
defendants made false and misleading statements and failed to disclose
material facts to the investing public and sought money damages. The
alleged securities law violations were based on the claim that the
defendants failed to disclose that the Company sold its products
illicitly, illegitimately and improperly and to timely disclose facts
concerning the termination of the former U.S. distributor of Sofamor
products, National Medical Specialties, Inc. The allegations relating to
illicit and illegitimate sales of product were, for the most part, copies
from product liability complaints filed against the Company and other
manufacturers currently being coordinated in improper sales related to one
of the Company's selling programs which has been publicly disclosed since
May 1991. On October 3, 1995, the United States District Court Judge in
Memphis dismissed with prejudice the entire case against the Company and
each of the individual defendants. On August 14, 1997, the Court of
Appeals for the Sixth Circuit affirmed the dismissal of the plaintiffs'
complaint. On May 4, 1998 the United States Supreme Court declined to
review the plaintiffs' case. The dismissal of the plaintiffs' case is now
final.
INTERNAL REVENUE SERVICE DOCUMENT PRODUCTION
On April 29, 1998, the Internal Revenue Service (the "IRS") served the
Company with a summons covering the 1993, 1994 and 1995 taxable years.
Generally, the IRS is requiring the production of (i) documents supporting
expenses incurred in connection with trips attended by physicians, (ii)
documents relating to payments made to physicians for consulting, (iii)
documents relating to stock options granted, royalty agreements and
payments, fellowship grants/awards, scholarships and honorariums, (iv) a
list of Company customers, (v) certain revenue information and (vi) a
report with respect to governmental customers. The Company is cooperating
fully with the IRS in this matter.
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Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF
OPERATIONS AND FINANCIAL CONDITION
The following table sets forth for the periods indicated selected unaudited
financial information, excluding special charges, expressed as a percentage of
revenues and the period-to-period change in such information:
PERIOD-TO-PERIOD
CHANGE
--------------------------
THREE SIX
MONTHS MONTHS
JUNE 30, JUNE 30,
THREE MONTHS SIX MONTHS 1998 1998
ENDED JUNE 30, ENDED JUNE 30, VS VS
1998 1997 1998 1997 1997 1997
----------- ---------- ---------- ---------- ----------- -----------
Revenues 100.0% 100.0% 100.0% 100.0% 26.9% 26.8%
Cost of goods sold 17.0 17.2 17.4 17.5% 25.1 26.2
---------- ---------- ---------- ----------
Gross profit 83.0 82.8 82.6 82.5% 27.2 27.0
Operating expenses:
Selling, general and administrative 45.9 47.0 46.1 47.0 23.9 24.7
Research and development 7.7 6.5 7.4 6.5 50.1 41.0
---------- ---------- ---------- ----------
Total operating expenses 53.6 53.5 53.5 53.5 27.1 26.7
Income from operations 29.4 29.3 29.1 29.0 27.5 27.5
Other income 0.5 0.2 0.4 0.2 139.1 164.3
Interest expense (0.7) (2.0) (1.0) (1.9) (55.8) (32.9)
---------- ---------- ---------- ----------
Income from operations before income
taxes and minority interest 29.2 27.5 28.5 27.3 34.8 32.5
Income taxes 9.1 8.0 8.7 7.9 44.0 39.4
---------- ---------- ---------- ----------
Income before minority interest 20.1 19.5 19.8 19.4 31.0 29.7
Minority interest 0.8 1.0 0.8 1.0 4.6 8.3
---------- ---------- ---------- ----------
Net income 19.3% 18.5% 19.0% 18.4% 32.3% 30.8%
========== ========== ========== ==========
RESULTS OF OPERATIONS*
For the second quarter and six months ended June 30, 1998, the Company reported
record revenues of $93.4 million and $181.8 million, respectively, representing
increases of 26.9% and 26.8% over the respective prior year periods. For the
quarter, volume growth increased revenues by 28.2%. The Company's conversion of
certain portions of its international distribution network to direct sales and
other net pricing changes contributed a 3.8% increase. These factors were offset
by changes in exchange rates, which negatively impacted second quarter revenues
by 5.1%. For the six-month period, higher volume resulted in revenue growth of
27.8%, and pricing
- ---------------
* Except for the historical information contained in this Quarterly Report on
Form 10-Q, the matters discussed herein (including, in particular, those
discussed in Part II, Item 1, "Legal Proceedings") are forward-looking
statements that involve risks and uncertainties, including (without limitation)
the timely development and acceptance of new products, the impact of competitive
products, the timely receipt of regulatory clearances required for new products,
the regulation of the Company's products generally, the disposition of certain
litigation involving the Company and certain other risks and uncertainties
detailed from time to time in the Company's periodic reports (including the
Annual Report on Form 10-K for the year ended December 31, 1997 and the Current
Report on Form 8-K dated February 3, 1998) filed with the Securities and
Exchange Commission.
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changes increased revenues by 4.2%. The negative impact of exchange rate
fluctuations for the six month period was 5.2%.
U.S. revenues grew to $65.7 million for the quarter ended June 30, 1998, a 34.4%
increase from the same period in 1997. For the six month period, U.S. revenues
increased to $127.4 million, representing growth of 31.2% from the prior year
period. The Company believes the improvement in U.S. revenues is primarily the
result of an increased number of instrumented fusions. This growth in the number
of fusions has occurred, in part, due to the broad range of quality products
provided by the Company to assist physicians in treating their patients.
Non-U.S. revenues advanced 12.0%, to $27.7 million, during second quarter 1998,
when compared to second quarter 1997. The increase would have been 27.2% if
exchange rates had been constant. For the six month period, international
revenues increased to $54.4 million, an increase of 17.7% from 1997 levels.
Ignoring the effect of changes in exchange rates, international revenues would
have increased 33.8% over the prior year six month period. Higher volume was the
primary source of the non-U.S. revenue growth in 1998 as compared with the same
period of 1997. Non-U.S. revenue growth has also resulted in part from
strengthening the Company's presence in key countries where direct sales
operations have been established in recent years.
The Company's gross margin of 83.0% during the second quarter of 1998 increased
slightly from 82.8% for the same period of 1997. For the six month period, the
gross margin also increased slightly to 82.6% from 82.5%.
Selling, general and administrative expenses were 45.9% of revenues in the
second quarter of 1998, compared with 47.0% during the same period of 1997. For
the six-month period, these expenses represented 46.1% of revenues in 1998
versus 47.0% in 1997. Though total selling, general and administrative expenses
have increased as the Company continues its rapid growth, these expenses,
expressed as a percentage of revenues, have decreased as the Company has been
able to leverage certain of its fixed costs over greater revenue volume.
Research and development expenses totaled $7.2 million, or 7.7% of revenues, for
the second quarter of 1998, compared with $4.8 million, or 6.5% of revenues, for
the second quarter of 1997. For the six-month periods, these expenses totaled
$13.4 million and $9.5 million in 1998 and 1997, respectively. As a percentage
of revenues, research and development increased to 7.4% in 1998 from 6.5% in
1997. The second quarter 1998 dollar spending represents an increase of 50.1%
over the same period in 1997. These development and clinical costs are incurred
as the Company continues to enhance existing product lines and develop new and
complementary products, such as the interbody fusion devices, biological
products for use in spinal applications, and products related to frameless
stereotactic surgery in the spinal and neurological fields of use. These
expenditures demonstrate the Company's continued commitment to producing product
opportunities through the application of new medical technologies.
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During June 1998, the Company announced two strategic development and licensing
agreements under which it acquired exclusive worldwide rights to new technology
for use in bone growth, regeneration and repair and for use in deep brain
electrical stimulation. The Company made payments in June 1998 to the two
counterparties to such agreements (the "Licensors") totaling $8.0 million, which
are reflected in the accompanying statements of income as special charges. Upon
the attainment of certain milestones by the Licensors during the development and
commercialization of these technologies, the Company will be required to make
additional contractually defined payments aggregating $22.0 million, which are
expected to be paid over the next several years. Such payments will be charged
to the statement of income as incurred. Under both agreements, the Company will
also pay royalties to the Licensors based on eventual product sales to
customers. In order to market these products in the United States, clearance by
the Food and Drug Administration ("FDA") will be necessary, which will require
several years of clinical trials by the Licensors. The accounting for these
special charges was changed in December 1998 to reflect the removal of the
liability related to future payments under these agreements.
The Company reported other income of $0.4 million for the quarter ended June 30,
1998, compared with $0.2 million for the same period in 1997. For the six-month
period, other income increased to $0.7 million in the current year from $0.3
million in 1997. Improvements in both periods related principally to higher
interest income on cash equivalents and short term investments generated from
the first quarter public offering (see "Liquidity and Capital Resources"
section). Interest expense for the second quarter of 1998 was $0.7 million
compared with $1.5 million during the same period in 1997. For the six-month
period, interest expense was $1.8 million in 1998, compared with expense of $2.7
million in 1997. These decreases were also related to the first quarter public
offering, as the Company reduced its borrowings against credit facilities in
March of 1998 after receiving the proceeds of its public offering.
During the second quarter of 1998, the Company's effective tax rate was 29.3%.
Excluding the impact of special charges, the Company's effective income tax rate
for second quarter 1998 would have been 31.0%, compared with 29.0% for the prior
year second quarter. Tax rates for the six-month periods, excluding the impact
of special charges, were 30.5% and 29.0% in 1998 and 1997, respectively. The
primary difference between the Company's effective and statutory tax rates for
both 1998 and 1997 results from the impact of certain elections made for U.S.
tax purposes following the combination (the "Combination") of Danek Group, Inc.
with Sofamor S.A. ("Sofamor"), and the subsequent reorganization of Sofamor from
a Societe Anonyme (S.A.) under French law to a Societe en Nom Collectif (S.N.C.)
in late 1993. Management cannot be certain that such a favorable effective
income tax rate will be achieved in future periods, since the effective tax rate
calculation is dependent upon the Company's pre-tax income dollar amount. Higher
future pre-tax income could lead to higher future effective tax rates. At June
30, 1998, the balance sheet of the Company reflected a net deferred tax asset of
$38.1 million. No valuation allowance was recorded since sufficient taxable
income exists in available carryback periods to recognize fully these net
deferred tax assets.
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LIQUIDITY AND CAPITAL RESOURCES
On January 26, 1998, the Company purchased all of the outstanding capital stock
of SOFYC, S.A. ("SOFYC") for an aggregate of 2,806,080 privately placed shares
of the Company's common stock, $1.0 million in cash (less certain expenses
relating to the repurchase) and an agreement to repay certain outstanding loans
of SOFYC equal to approximately $0.9 million (the "SOFYC Exchange"). In
connection with the SOFYC Exchange, a foreign tax liability of $13.0 million was
reflected at June 30, 1998, which represents an estimate of the tax the Company
will incur upon retiring the shares owned by SOFYC. SOFYC, which was the
personal holding company of the Cotrel family, owns 3,337,272 shares of the
Company's common Stock. As a result of the SOFYC Exchange, the outstanding
shares of common stock of the Company were reduced by a net 531,192 shares. In
connection with the transaction, certain registration rights were granted to the
former SOFYC shareholders. In accordance with these rights, the Company filed a
registration statement with the Securities and Exchange Commission related to a
public offering on behalf of the former SOFYC shareholders of 1,600,000 of their
3,689,711 shares of Sofamor Danek common stock that they owned in the aggregate
before the offering. The registration statement also provided for a public
offering of up to 1,200,000 shares of common stock to be sold by the Company for
its own account. In addition, Sofamor Danek granted to the underwriters a
maximum over-allotment option of 420,000 shares of common stock. The over
allotment option was exercised. The Company issued 1,620,000 shares and received
net proceeds pursuant to the offering of $110.1 million. The Company invested
these proceeds upon receipt and intends to use them for a variety of purposes as
needed, including the repayment of outstanding borrowings, research and product
development, capital expenditures, certain foreign taxes due in connection with
the SOFYC transaction, acquisitions and working capital.
Cash generated from operations and the Company's revolving lines of credit are
the principal ongoing sources of funding available for growth of the business,
including working capital and additions to property, plant and equipment, as
well as debt service requirements and required contractual payments. The Company
believes that these sources of funding together with the proceeds from the
public offering mentioned above will be sufficient to meet its expected cash
needs for the foreseeable future. Cash, cash equivalents and short-term
investments totaled $74.0 million at June 30, 1998, compared with $2.8 million
at December 31, 1997.
The Company's working capital increased by $84.3 million during the six months
ended June 30, 1998. The increase in working capital resulted primarily from the
proceeds from the public offering, partially offset by the amounts used to repay
long-term debt. Accounts receivable increased $10.5 million, or 11.9% from
December 31, 1997, due to overall sales growth, combined with changes in the
sales mix, both by product type and by territory. Inventories and loaner set
inventories increased by $6.4 million or 10.4% from year-end, due in part to the
production of new inventory items in preparation for their introduction,
combined with overall corporate growth. Other receivables, which consist
primarily of amounts recoverable from insurance carriers relating to the costs
incurred in connection with product liability litigation, increased $3.5
million, or 12.0%, from year-end.
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20
In connection with the Company's 1995 license agreement with Genetics Institute,
the Company paid $7.5 million during the 1998 second quarter, representing the
final payment due under the agreement.
The purchase agreements for two acquisitions made by the Company in 1996 contain
provisions which provide for contingent payments to the former shareholders of
each entity based upon certain calculations relative to revenues and earnings,
as defined, through 1999. Such payments are reflected as purchase price
adjustments. The Company recorded adjustments to the purchase price of these
acquisitions of $5.1 million and $4.2 million in 1997 and 1996, respectively.
The amount recorded in 1996 was paid in April 1997, and the amount recorded in
1997 was paid in March 1998. The Company is unable to determine whether such
adjustments will be required for 1998 or 1999.
Additions to property, plant and equipment during the first six months of 1998
were $6.5 million and related to capital asset expenditures necessary to support
the Company's manufacturing and distribution operations. As a result of the
Company's need of additional office and distribution space at its Memphis
location, management recently entered into an agreement under which the Company
will lease a new facility adjacent to its existing headquarters. This lease has
an initial term of 10 years and will be accounted for as an operating lease. The
Company began moving into the new facility during July 1998.
The Company has committed lines of credit totaling approximately $130 million.
At June 30, 1998, $32.3 million was outstanding under these lines of credit and
other short-term borrowings. The committed lines of credit consist primarily of
the $100.0 million U.S. revolving lines of credit.
In 1996, the Internal Revenue Service began an examination of the Company's
federal income tax returns. The years under examination are 1993, 1994 and 1995.
Management believes that the resolution of any issues that may result from this
examination will not have a significant impact on the Company's results of
operations or financial condition. See Part II, Item 1, "Legal
Proceedings-Internal Revenue Service Document Production."
The Company invests available funds in short-term investment grade instruments,
including commercial paper, certificates of deposit and direct or guaranteed
obligations of state and local governments or the United States of America.
These short-term investments are available to fund the Company's working capital
requirements and acquisitions of capital assets.
The "Year 2000" issue is the result of computer programs being written using two
digits rather than four to define the applicable year. Any computer programs
that have time sensitive software may recognize a date using "00" as the year
1900 rather than the year 2000. This could result in a system failure or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices or engage
in similar normal business activities. Management has conducted an assessment of
its exposure to disruption associated with the Year 2000 issue. The Company is
currently in the process of implementing purchased software that will serve as
an enterprise resource planning system providing enhanced productivity and
customer service benefits in addition to mitigating potential consequences of
the Year 2000 issue. The cost of the software license and the majority of the
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costs of implementation will be capitalized. Management expects the portion of
this implementation related to Year 2000 issues to be completed in the first
quarter of 1999. The Company believes that with modifications to existing
software and conversions to new software, the Year 2000 issue will not pose
significant operational problems for its computer systems. However, if such
modifications are not made, or are not completed in a timely manner, the Year
2000 issue could have an impact on the Company's ability to operate. The Company
does not believe that the costs of addressing this issue will be material to the
Company's operations.
FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS AND FINANCIAL CONDITION
The Company's future operating results and financial condition are subject to
risks and uncertainties, including (without limitation) the following matters:
Regulatory Clearances and Compliance. The preclinical testing, manufacturing,
labeling, distribution and promotion of the Company's products are subject to
extensive government regulation by the FDA in the United States and comparable
regulatory bodies in other countries. Noncompliance with the applicable
regulatory requirements can lead to enforcement actions which may result in,
among other things, warning letters, fines, recalls or seizures of products,
total or partial suspension of production, refusal by governments to grant
pre-market clearances and criminal prosecution. The process of obtaining
marketing clearances can be time-consuming, and there can be no assurance that
all necessary clearances will be granted to the Company with respect to new
devices or that the process will not involve delays adversely affecting the
marketing and sale of new devices. In the United States, even after regulatory
clearance or approval to market a device is obtained from the FDA, the Company
is subject to continuing FDA regulation. FDA approvals or clearances are
required for certain changes to the labeling and marketing of medical devices.
FDA regulations depend heavily on administrative interpretation, and there can
be no assurance that future interpretations made by the FDA or other regulatory
bodies, with possible retroactive effect, will not adversely affect the Company.
The Company is also subject to numerous federal, state and local laws relating
to such matters as safe working conditions, manufacturing practices and
environmental protection. There can be no assurance that the Company will not be
required to incur significant costs to comply with such laws and regulations.
Unanticipated changes in existing regulatory requirements, failure of the
Company to comply with such requirements or adoption of new requirements could
have a material adverse effect on the Company's business.
Potential Impact of Healthcare Cost Containment Proposals on Profitability.
Sales of a large portion of the Company's products depend to a significant
extent on the availability of reimbursement to the Company's customers by
government and private insurance plans. In recent years, the cost of healthcare
has risen significantly, and there have been numerous proposals by legislatures,
regulators and third party health care payers to curb these cost increases in
the United States and Europe. Some of these proposals have involved limitations
on the amount of reimbursement for specific surgical procedures. These proposals
have been adopted in some cases. The Company is unable to predict the ultimate
timing, scope or effect of any legislation concerning healthcare reform. Any
legislation, if adopted, could result in significant changes in the
availability, delivery, pricing and payment for healthcare services and products
and adversely affect the Company's business. In addition, hospitals and other
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healthcare providers have become increasingly cost sensitive. To date, the
Company does not believe that such healthcare cost containment proposals have
negatively affected the profitability or growth of its business; however, the
Company is not able to predict the future effect of these proposals on its
business.
Rapid Technological Change; Technological Obsolescence; Acceptance Of New
Products. The medical device industry is characterized by rapidly changing
technology and frequent new product introductions. The Company's future success
will depend largely on the Company's ability to develop and introduce in a
timely manner new products and enhancements that meet changing customer
requirements and emerging industry standards. Although the Company's strategy
for growth includes the introduction of new products, the development of new
technologically advanced products and enhancements is a complex and uncertain
process requiring high levels of innovation as well as the anticipation of
technology and market trends. The Company may not be able to respond effectively
to technological changes, emerging industry standards or product announcements
by competitors, it may not be able to identify, develop, manufacture, market,
sell or support new products and enhancements successfully and its new products
or enhancements may not achieve market acceptance. Market acceptance for
products under development could be adversely affected by numerous factors,
including the lack of availability of third-party reimbursement to consumers of
such products, the cost of the products, clinical acceptance thereof and
effective physician training. Market acceptance will also depend on the
Company's ability to demonstrate that such products are an attractive
alternative to existing products, which will depend on physicians' evaluations
of the clinical safety and efficacy, ease of use, reliability and
cost-effectiveness of the products. Furthermore, the Company believes that, once
the products receive approval, recommendations and endorsements by influential
surgeons will be essential to market acceptance of its products. There can be no
assurance that the Company's products under development will adequately
demonstrate these characteristics or that they will receive market acceptance
among consumers or physicians. Any of these events could have a material adverse
effect on the Company's business, financial condition and results of operations.
Product Liability; Insurance. In recent years, physicians, hospitals, and other
participants in the healthcare industry have become subject to an increasing
number of lawsuits alleging malpractice, product liability or related legal
theories, many of which involve large claims and significant defense costs. The
Company is currently involved in product liability litigation. (See Note 8 to
the Consolidated Financial Statements.) There can be no assurance that
additional claims will not be asserted against the Company in the future. A
successful future claim or aggregation of future claims brought against the
Company in excess of insurance coverage could have a material adverse effect
upon the financial condition, results of operations and/or cash flows of the
Company. Claims against the Company, regardless of their merit or eventual
outcome, may also have a material adverse effect upon the reputation and
business of the Company. The Company currently maintains liability insurance at
coverage levels which it deems commercially reasonable. Historically, the
Company has been required to call on its insurance for product liability claims,
and assuming all amounts are paid by the insurance carriers, the Company will
have exhausted its insurance coverage for the coverage year ended November 1995.
There can be no assurance that the coverage limits of such insurance policies
will be adequate or that all amounts will ultimately be collected from each
insurer providing the
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applicable policy (See Part II, Item 1, "Legal Proceedings - Insurance"). Such
insurance is expensive, difficult to obtain and may not be available in the
future on acceptable terms or at all.
Increasing Competition. The medical device industry is subject to intense
competition. The market for products designed to treat spinal conditions is
highly competitive, and the Company expects competition to increase as a result
of new entrants and consolidations. Accordingly, the Company's future success
will depend in part on its ability to respond quickly to medical and
technological change and user preferences through the development and
introduction of new products that are of high quality and that address patient
and surgeon requirements and, in part, on its ability to differentiate its
mature products from those of its competitors. Worldwide, there are many firms
producing spinal implant devices, and certain of the Company's competitors
currently manufacture and sell interbody fusion cages that have received a
pre-market approval from the FDA. A number of these firms have greater
financial, research and development, manufacturing and sales and marketing
resources than the Company. The Company's inability to compete effectively
against existing or future competitors would have a material adverse effect on
its business, financial condition and results of operations.
Dependence On Key Personnel. The Company's future success depends in significant
part upon the continued service of certain key scientific, technical and
managerial personnel and its continuing ability to attract and retain highly
qualified scientific, technical and managerial personnel. Competition for such
personnel is intense, and there can be no assurance that the Company can retain
its current personnel or that it can attract, assimilate or retain other highly
qualified scientific, technical and managerial personnel in the future. The
Company has taken steps to retain its key employees, including the granting of
stock options that vest over time. The loss of key personnel, especially if
without advanced notice, or the inability to hire or retain qualified personnel
could have a material adverse effect upon the Company's business, financial
condition and results of operations.
Risks Associated With International Sales. A significant portion of the
Company's revenues relate to international sales of its products, which are
subject to numerous risks. Regulatory requirements, as well as pricing,
marketing and distribution structures, vary significantly from country to
country. Additionally, international sales can be adversely affected by
limitations or disruptions caused by the imposition of government controls,
export licenses, political instability, trade restrictions, changes in foreign
tax laws or tariffs, or other trade regulations and difficulties coordinating
communications among and managing international operations. Moreover, the
Company's business, financial condition and results of operations may be
adversely effected by fluctuations in overseas economic conditions and
international currency exchange rates, as well as by increases in duty rates,
difficulty in obtaining export licenses, constraints on its ability to maintain
or increase prices and competition. There can be no assurance that the Company
will be able to successfully commercialize its existing products or any of its
future products in any international market, which could have a material adverse
effect on the Company's business, financial condition and results of operations.
Dependence On Patents And Proprietary Technology. The patent and trade secret
positions of medical device companies, including those of the Company, are
uncertain and involve complex and evolving legal and factual questions. The
coverage sought in a patent application either can
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be denied or significantly reduced before or after the patent is issued.
Consequently, there can be no assurance that any patents from pending
applications or from any future patent application will be issued, that the
scope of the patent protection will exclude competitors or provide competitive
advantages to the Company, that any of the Company's patents will be held valid
if subsequently challenged or that others will not claim rights in or ownership
of the patents and other proprietary rights held by the Company. Since patent
applications are secret until patents are issued in the United States, or
corresponding applications are published in other countries, and since
publication of discoveries in the scientific or patent literature lags behind
actual discoveries, the Company cannot be certain that it was the first to file
patent applications for its inventions. In addition, there can be no assurance
that competitors, many of which have substantial resources, will not seek to
apply for and obtain patents that will prevent, limit or interfere with the
Company's ability to make, use or sell its products either in the United States
or in international markets. Further, the laws of certain foreign countries do
not protect the Company's intellectual property rights to the same extent as do
the laws of the United States. Litigation or regulatory proceedings, which could
result in substantial cost and uncertainty to the Company, may also be necessary
to enforce patent or other intellectual property rights of the Company or to
determine the scope and validity of other parties' proprietary rights. There can
be no assurance that the Company will have the financial resources to defend its
patents from infringement or claims of invalidity.
The Company also relies upon unpatented proprietary technology, and no assurance
can be given that others will not independently develop substantially equivalent
proprietary information and techniques or otherwise gain access to or disclose
the Company's proprietary technology or that the Company can meaningfully
protect its rights in such unpatented proprietary technology. The Company's
policy is to require each of its key employees, consultants, investigators and
advisors to execute a confidentiality agreement upon the commencement of an
employment or consulting relationship with the Company. There can be no
assurance, however, that these agreements will provide meaningful protection for
the Company's proprietary information in the event of unauthorized use or
disclosure of such information.
Dependence On Suppliers. The Cortical Bone Dowel, a product the Company markets
on behalf of Regeneration Technologies, Inc. ("RTI"), an affiliate of the
University of Florida Tissue Bank, is made of human bone tissue obtained from
cadavers. RTI supplies significant amounts of such tissue pursuant to an
exclusive agreement with the Company. There can be no assurance that the supply
of bone tissue will continue to meet current demand, or that the Company, if
required, will be able to locate alternative sources of human bone tissue on a
timely and cost-effective basis. To date, constrained supply of human bone
tissue has limited growth in this area. There can be no assurance that the RTI
will meet the Company's future delivery requirements of human bone tissue. The
inability to procure an adequate supply of such tissue could have a material
adverse effect on the Company's business, financial condition and results of
operations.
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PART II -- OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
The Company is involved from time to time in litigation on various matters which
include intellectual property, commercial affairs and product liability. Given
the nature of the Company's business activities, these lawsuits are considered
routine to the conduct of its business. The result of any particular lawsuit
cannot, because, among other things, of the very nature of litigation, the
litigation process and its adversarial nature, and the jury system, be
predicted.
PRODUCT LIABILITY LITIGATION
Beginning in 1994, the Company and other spinal implant manufacturers were named
as defendants in a number of product liability lawsuits brought in various
federal and state courts around the country. These lawsuits allege that
plaintiffs were injured by spinal implants manufactured by the Company and
others. Although the plaintiffs have advanced claims under many different legal
theories, the essence of the plaintiff's claims appears to be that the Company
(including Sofamor and its former U.S. distributor) marketed some of its spinal
systems for pedicle fixation in contravention of Food and Drug Administration
("FDA") rules and regulations (governing marketing and labeling of medical
devices), that pedicle fixation has not been proven safe and effective in the
context of FDA labeling standards, that some or all of the spinal systems are
defectively designed and manufactured and that plaintiffs have suffered a
variety of injuries as a result of their physicians' use of such systems in
pedicle fixation. The Company has also been named as a defendant in a number of
lawsuits instituted by plaintiffs who have received spinal implants manufactured
by other manufacturers and in which the Company is alleged to have participated
in a conspiracy among doctors, manufacturers, hospitals, teaching institutions,
professional societies and others to promote, in violation of applicable law,
the use of spinal implants.
In a number of cases, plaintiffs have sought to proceed as representatives of
classes of spinal implant recipients. All efforts to obtain class certification
have been denied or withdrawn, except with respect to a class-action settlement
entered into between the plaintiffs and another spinal implant manufacturer,
AcroMed Corporation ("Acromed") (see below under the heading entitled "AcroMed
Corporation Settlement"). Some plaintiffs have filed individual lawsuits,
whereas other lawsuits list multiple plaintiffs and, in certain instances,
multiple lawsuits have been filed on behalf of the same individual plaintiffs.
Plaintiffs typically seek relief in the form of monetary damages, often in
unspecified amounts. Many of the plaintiffs only allege as monetary damages an
amount in excess of the jurisdictional minimum for the court in which the case
has been filed. A few suits also name as defendants various officers and
directors of the Company.
As of June 30, 1998, the claims of approximately 2,200 plaintiffs remain active
in litigation against the Company. The majority of these plaintiffs filed their
claims in 1995. A number of plaintiffs have failed to pursue their claims, and
such claims have been dismissed without prejudice. The Company is also named as
a defendant in lawsuits involving about 2,700
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plaintiffs where the Company is alleged to have conspired with competitors and
others, in violation of applicable law, to promote the use of spinal implant
systems.
The Company believes that it has defenses, including, without limitation,
defenses based upon the failure of a cause of action to exist where no
malfunction of the implant has occurred or the plaintiff has suffered no injury
attributable to the Company's product, the expiration of the applicable statute
of limitations and the learned intermediary defense. The Company has asserted
and will continue to assert these defenses primarily through the filing of
dispositive motions. The Company believes that all product liability lawsuits
currently pending against it are without merit and will continue to defend
against them vigorously.
FEDERAL MULTIDISTRICT LITIGATION (MDL 1014)
On August 4, 1994, the Federal Judicial Panel for Multidistrict Litigation
ordered all federal court lawsuits to be transferred to and consolidated for
pretrial proceedings, including the determination of class certification, in the
United States District Court for the Eastern District of Pennsylvania in
Philadelphia (the "Multidistrict Litigation"). Lawsuits filed in federal court
after August 4, 1994 have also been transferred to and consolidated in the
Multidistrict Litigation in the Eastern District of Pennsylvania. In addition, a
number of lawsuits filed in state courts around the country were removed to
federal courts and then transferred into the Multidistrict Litigation. On
February 22, 1995, Chief Judge Emeritus, Louis C. Bechtle ("Judge Bechtle"),
denied class certification. A large number of plaintiffs filed individual
lawsuits as a result of the denial of class certification. In some instances,
lawsuits that had been removed and transferred into the Multidistrict Litigation
have been remanded to the state courts in which they were filed because there
was no federal court jurisdiction. As of June 30, 1998, the Company is a
defendant in approximately 850 individual claims and 1,000 conspiracy claims
consolidated in the Multidistrict Litigation. On April 16, 1997, Judge Bechtle
dismissed conspiracy claims alleging fraud on the FDA, but deferred the
remaining conspiracy claims for later consideration by the federal trial courts
to whom the cases will be remanded for trial.
Discovery has been completed in a number of the federal court cases and is
continuing in the remainder. A small number of cases have been transferred to
the federal courts in which they were filed for further proceedings and trial.
Judge Bechtle has begun the process of transferring the remaining federal court
cases to various federal courts throughout the United States. As of June 30,
1998, the Federal Judicial Panel on Multidistrict Litigation ordered the remand
of approximately 270 cases to transferor courts for further proceedings. It is
anticipated that the first federal court cases will be tried in 1998.
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STATE COURT LITIGATION
A number of cases filed in state courts were not eligible for removal and
transfer into the Multidistrict Litigation. As of June 30, 1998, there were
approximately 1,300 individual claims pending against the Company in several
courts around the country, principally in Tennessee, Oklahoma, Texas and
Pennsylvania. In addition, there were approximately 1,600 conspiracy claims
pending in state courts.
Approximately 1,550 plaintiffs, who had joined together in several complaints
which had been removed to the Multidistrict Litigation proceedings, have had
their cases remanded to the state court in Memphis, Tennessee, where they were
originally filed when it was determined that the federal court lacked
jurisdiction over their claims. A number of plaintiffs have failed to pursue
claims made on their behalf and their claims were dismissed without prejudice.
As of June 30, 1998, the lawsuits of approximately 1,100 plaintiffs remain
active in the litigation pending in Memphis, Tennessee. The presiding state
court judge in Memphis has established a case management plan which calls for
the preparation of eight representative cases for preparation and trial. The
first case in Memphis against the Company is scheduled for trial in September,
1998. It is anticipated that a number of other state court cases around the
country will be scheduled for trial in 1998, although delays in trial dates are
common.
Discovery is proceeding in all remaining state court cases. In May, 1998, a jury
in Houston, Texas rendered a verdict adverse to the Company in the amount of
$0.4 million. The Company does not believe that that verdict was justified by
the evidence. The Company intends to appeal.
ACROMED CORPORATION SETTLEMENT
In December 1996, AcroMed, a spinal implant manufacturer and a defendant in many
of the cases pending in the Multidistrict Litigation, and the Plaintiff's Legal
Committee in the Multidistrict Litigation announced that they had entered into a
conditional settlement regarding all product liability claims involving the use
of AcroMed devices to achieve pedicular fixation with screws in spinal fusion
surgery. Under the terms of the settlement, AcroMed will establish a settlement
fund consisting of $100 million in cash plus the proceeds of its product
liability insurance policies. In January 1997, the parties submitted a formal
class settlement agreement and related documentation for approval by Judge
Bechtle. By order dated October 17, 1997, Judge Bechtle certified the proposed
settlement class and approved the proposed settlement. All appeals of Judge
Bechtle's certification and approval order have been withdrawn. As a consequence
of the class-certified settlement, all federal proceedings involving AcroMed
devices have been stayed.
INSURANCE
Several insurance carriers have asserted reservation of rights concerning the
scope and timing of the Company's remaining insurance coverage, but have not
denied insurance coverage to the Company. Three of the carriers, Royal Surplus
Lines Insurance Company ("Royal"), Steadfast Insurance Company ("Steadfast") and
Agricultural Excess and Surplus Insurance Company ("Agricultural"), have each
filed declaratory judgment actions against the Company seeking
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clarification of their rights and obligations, if any, under their respective
policies. Neither Royal nor Agricultural has paid amounts due to the Company;
Steadfast has paid only a portion of the amounts due to the Company.
The Royal and Steadfast lawsuits are pending in the United States District Court
for the Western District of Tennessee in Memphis. The Agricultural lawsuit is
pending in the United States District Court for the Southern District of Ohio in
Cincinnati. The Company believes that the receivables are recoverable under the
terms of the Royal, Steadfast and Agricultural policies. The Company has filed
an answer and counterclaim in the Royal litigation and a motion seeking the
interim payment of the Company's defense costs. The Company has filed answers
and counterclaims in the Steadfast litigation and a motion to transfer the
Agricultural litigation. These litigations are in the preliminary stages. The
Company believes that Royal's, Steadfast's and Agricultural's claims are without
merit and will defend against them vigorously.
As is common in the insurance industry, the Company's insurance policies
covering product liability claims must be renewed annually. The Company has in
force insurance coverage for product liability claims including orthopedic bone
screw claims, subject to the terms, conditions and limits of the individual
insurance policies. Except for a policy issued by Royal, the Company's insurance
policies are reduced by the costs of defense. In some instances, the cost of
defending these claims has been reimbursed by certain of the primary and excess
insurance carriers. Although the Company has been able to obtain insurance
relating to product liability claims at a cost and on other terms and conditions
that are acceptable to the Company, there can be no assurance that in the future
it will be able to do so.
On January 6, 1997, the Company announced that its 1996 financial results would
include a pre-tax charge of $50.0 million relating to costs associated with the
product liability litigation described above. The charge, which was reflected in
the Company's 1996 financial statements, covers the reasonable foreseeable costs
that the Company was positioned in late December 1996 to estimate because the
litigation had progressed and because changes in the fourth quarter of 1996 had
occurred in facts and circumstances relating to the litigation. Among the
changed facts and circumstances were the announcement of the AcroMed settlement
described above, the likelihood that the litigation will continue for several
years, in part, due to the additional financial resources provided to the
plaintiff's attorneys as a result of the AcroMed settlement, the absence of
AcroMed as a member of the joint defense group, the status of the Company's
insurance described above and the continuing absence of dispositive rulings
relating to the Company's defense motions.
While it is not possible to accurately predict the outcome of litigation, the
amount of the accrual, which remained on the Company's consolidated balance
sheet at June 30, 1998, represents the Company's best judgment of the probable
reasonable costs (in excess of amount of insurance the Company believes are
recoverable) to defend and conclude the lawsuits based on the facts and
circumstances currently existing. The costs provided for in the accrued
liability include, but are not limited to, legal fees paid or anticipated to be
paid and other costs related to the Company's defense and conclusion of these
matters.
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The actual costs to the Company could differ from the estimated charge and will
be dependent upon a number of factors that will not be known for some time,
including, among other things, the resolution of defense motions and the extent
of further discovery. Although an adverse resolution of lawsuits could have a
material effect on the Company's results of operations and cash flows in future
periods, the Company does not believe that these matters will in the future have
a material adverse effect on its consolidated financial position. The Company is
unable to predict the ultimate outcome or the financial impact of the product
liability litigation.
SECURITIES LAWS ACTIONS
Beginning in April 1994, the Company and four of its officers and directors were
named in five shareholder lawsuits filed in the United States District Court in
Memphis, Tennessee. Four of the lawsuits purported to be class actions. All of
the lawsuits were consolidated into one case in the United States District Court
in Memphis through an amended complaint which added four new individual
defendants who are either current or former directors of the Company. The
lawsuit alleged that the defendants made false and misleading statements and
failed to disclose material facts to the investing public and sought money
damages. The alleged securities law violations were based on the claim that the
defendants failed to disclose that the Company sold its products illicitly,
illegitimately and improperly and to timely disclose facts concerning the
termination of the former U.S. distributor of Sofamor products, National Medical
Specialties, Inc. The allegations relating to illicit and illegitimate sales of
product were, for the most part, copies from product liability complaints filed
against the Company and other manufacturers currently being coordinated in
improper sales related to one of the Company's selling programs which has been
publicly disclosed since May 1991. On October 3, 1995, the United States
District Court Judge in Memphis dismissed with prejudice the entire case against
the Company and each of the individual defendants. On August 14, 1997, the Court
of Appeals for the Sixth Circuit affirmed the dismissal of the plaintiffs'
complaint. On May 4, 1998 the United States Supreme Court declined to review the
plaintiffs' case. The dismissal of the plaintiffs' case is now final.
INTERNAL REVENUE SERVICE DOCUMENT PRODUCTION
On April 29, 1998, the Internal Revenue Service (the "IRS") served the Company
with a summons covering the 1993, 1994 and 1995 taxable years. Generally, the
IRS is requiring the production of (i) documents supporting expenses incurred in
connection with trips attended by physicians, (ii) documents relating to
payments made to physicians for consulting, (iii) documents relating to stock
options granted, royalty agreements and payments, fellowship grants/awards,
scholarships and honorariums, (iv) a list of Company customers, (v) certain
revenue information and (vi) a report with respect to governmental customers.
The Company is cooperating fully with the IRS in this matter.
See Item 2, "Management's Discussion and Analysis of Results of Operations and
Financial Condition--Factors That May Affect Future Operating Results and
Financial Condition--Product Liability; Insurance and Dependence on Patents and
Proprietary Technology."
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Item 4. Submission of Matters to a Vote of Security Holders
a) The Company's annual shareholders' meeting was held on May
20, 1998, to elect the directors of the Company for the
ensuing year and to approve the Sofamor Danek Group, Inc.
Long-Term Incentive Plan, as amended.
b) The following directors were elected at the Annual Meeting
of Shareholders:
For Withheld
---------- --------
E. R. Pickard 23,554,209 423,406
James J. Gallogly 23,559,437 418,178
L. D. Beard 23,535,644 441,971
George W. Bryan, Sr. 23,627,387 350,228
Robert A. Compton 23,536,287 441,328
Yves Paul Cotrel, M.D. 23,586,741 390,874
Samuel F. Hulbert, Ph.D. 23,657,787 319,828
Marie-Helene Plais, M.D. 23,558,230 419,385
George F. Rapp, M.D. 23,654,070 323,545
c) The resolution passed was as follows:
Act upon a proposal to approve the Sofamor Danek Group, Inc.
Long-Term Incentive Plan, as amended.
For 14,960,267
Against 7,113,250
Abstain 34,671
No Vote 1,869,427
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Item 5. OTHER INFORMATION
If any shareholder intends to present a proposal for consideration at
the 1999 Annual Meeting of Shareholders, such proposal must be received by the
Company not later than December 1, 1998 to be eligible for inclusion in the
Company's proxy statement and form of proxy for such meeting. Any proxy received
by the Company in connection with the 1999 Annual Meeting of Shareholders may
confer discretionary authority to vote on any shareholder proposal not received
by the Company not earlier than February 19, 1999 or later than March 22, 1999,
but if the first public announcement of the date of the 1999 Annual Meeting of
Shareholders is later than March 22, 1999, then on the seventh day following
that first public announcement. If the date of the 1999 Annual Meeting of
Shareholders of the Company is changed by more than 30 days from the date of the
1998 Annual Meeting of Shareholders, then this change will be disclosed in the
earliest possible Form 10-Q of the Company and any shareholder proposal to be
presented at the 1999 Annual Meeting of Shareholders must be received by a
reasonable time before the Company mails its proxy materials for the 1999 Annual
Meeting of Shareholders.
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Item 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibit No. Description
----------- -----------
10.1 Second Amendment to Loan Agreement between SunTrust Bank,
Nashville, N.A., and Sofamor Danek Group, Inc. dated
July 22, 1997.
27.1 Financial Data Schedule
(For SEC use only)
27.2 Amended June 30, 1997 Financial Data
Schedule (For SEC use only)
a) 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.
SOFAMOR DANEK GROUP, INC.
---------------------------------------
(Registrant)
DATE: December 10, 1998 BY: /s/ E.R. Pickard
--------------------- ---------------------------------
E.R. Pickard
Chairman, Chief Executive Officer
and Director
(Principal Executive Officer)
DATE: December 10, 1998 BY: /s/ George G. Griffin, III
--------------------- ---------------------------------
George G. Griffin, III
Executive Vice President
and Chief Financial Officer
(Principal Financial Officer)
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SOFAMOR DANEK GROUP, INC.
QUARTERLY REPORT ON FORM 10-Q
INDEX TO EXHIBITS
Exhibit Number Description of Exhibit
- -------------- ----------------------
10.1 Second Amendment to Loan Agreement between SunTrust Bank,
Nashville, N.A., and Sofamor Danek Group, Inc. dated
July 22, 1997.
27.1 Financial Data Schedule
(For SEC use only)
27.2 Amended June 30, 1997 Financial Data Schedule
(For SEC use only)
34