U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarter ended September 30, 2005 Commission File Number 1-16137 GREATBATCH, INC. (Exact name of Registrant as specified in its charter) Delaware (State of incorporation) 16-1531026 (I.R.S. employer identification no.) 9645 Wehrle Drive Clarence, New York 14031 (Address of principal executive offices) (716) 759-5600 (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 by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [ ] Indicate by check mark whether the Registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes [ ] No [X] The number of shares outstanding of the Company's common stock, $.001 par value per share, as of November 4, 2005 was: 21,645,694 shares.
<TABLE> <CAPTION> GREATBATCH, INC. TABLE OF CONTENTS FOR FORM 10-Q AS OF AND FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005 Page <S> <C> COVER PAGE 1 TABLE OF CONTENTS 2 PART I - FINANCIAL INFORMATION (unaudited) ITEM 1. Condensed Consolidated Financial Statements Condensed Consolidated Balance Sheet 3 Condensed Consolidated Statement of Operations and Comprehensive Income 4 Condensed Consolidated Statement of Cash Flows 5 Notes to Condensed Consolidated Financial Statements 6 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 20 ITEM 3. Quantitative and Qualitative Disclosures About Market Risk 34 ITEM 4. Controls and Procedures 34 PART II - OTHER INFORMATION ITEM 1. Legal Proceedings 35 ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds 35 ITEM 3. Defaults Upon Senior Securities 35 ITEM 4. Submission of Matters to a Vote of Security Holders 35 ITEM 5. Other Information 35 ITEM 6. Exhibits 35 SIGNATURES 36 EXHIBIT INDEX 37 </TABLE>
PART I - FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS <TABLE> <CAPTION> GREATBATCH, INC. CONDENSED CONSOLIDATED BALANCE SHEET -- Unaudited (IN THOUSANDS) - ------------------------------------------------------------------------------------------------------ ASSETS September 30, December 31, 2005 2004 (1) Current assets: <S> <C> <C> Cash and cash equivalents $ 39,316 $ 34,795 Short-term investments 62,762 57,437 Accounts receivable, net 34,600 24,288 Inventories 36,157 34,027 Refundable income taxes 5,629 3,673 Deferred income taxes 3,622 3,622 Prepaid expenses and other current assets 4,883 4,637 ----------------- ----------------- Total current assets 186,969 162,479 Property, plant, and equipment, net 99,535 92,210 Intangible assets, net 61,100 63,984 Goodwill 155,039 155,039 Other assets 4,310 4,493 ----------------- ----------------- Total assets $ 506,953 $ 478,205 ================= ================= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable 12,260 8,971 Accrued expenses and other current liabilities 24,400 18,109 Current portion of long-term debt 762 1,000 ----------------- ----------------- Total current liabilities 37,422 28,080 Long-term debt, net of current portion - 652 Convertible subordinated notes 170,000 170,000 Deferred income taxes 29,230 23,296 ----------------- ----------------- Total liabilities 236,652 222,028 ----------------- ----------------- Stockholders' equity: Preferred stock - - Common stock 22 21 Additional paid-in capital 216,766 212,131 Deferred stock-based compensation (1,419) (833) Treasury stock, at cost - (95) Retained earnings 55,010 44,971 Accumulated other comprehensive loss (78) (18) ----------------- ----------------- Total stockholders' equity 270,301 256,177 ----------------- ----------------- Total liabilities and stockholders' equity $ 506,953 $ 478,205 ================= ================= (1) As restated, see Note 14. The accompanying notes are an integral part of these condensed consolidated financial statements </TABLE> - 3 -
<TABLE> <CAPTION> GREATBATCH, INC. CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS AND COMPREHENSIVE INCOME -- Unaudited (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) - ----------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30, September 30, 2005 2004 2005 2004 <S> <C> <C> <C> <C> Sales $ 62,358 $ 45,177 $ 182,240 $ 153,644 Cost of sales 38,178 27,775 112,154 89,249 ------------ ------------ ------------ ------------ Gross profit 24,180 17,402 70,086 64,395 Selling, general and administrative expenses 8,842 6,913 24,089 20,227 Research, development and engineering costs, net 5,124 4,156 13,182 14,725 Amortization of intangible assets 967 1,074 2,883 2,925 Other operating expense, net 7,818 346 14,207 3,524 ------------ ------------ ------------ ------------ Operating income 1,429 4,913 15,725 22,994 Interest expense 1,154 1,144 3,476 3,448 Interest income (796) (244) (2,024) (802) Other (income) expense, net (9) (75) (69) (75) ------------ ------------ ------------ ------------ Income before provision for income taxes 1,080 4,088 14,342 20,423 Provision for income taxes 324 1,042 4,303 6,025 ------------ ------------ ------------ ------------ Net income $ 756 $ 3,046 $ 10,039 $ 14,398 ============ ============ ============ ============ Earnings per share: Basic $ 0.03 $ 0.14 $ 0.47 $ 0.67 Diluted $ 0.03 $ 0.14 $ 0.46 $ 0.65 Weighted average shares outstanding: Basic 21,621 21,387 21,559 21,345 Diluted 21,895 21,495 21,740 25,736 Comprehensive income: Net income $ 756 $ 3,046 $ 10,039 $ 14,398 Net unrealized gain (loss) on available for sale securities, net of deferred income tax expense of $18 in the three month period in 2005 and income tax benefit of $26 in the nine month period in 2005. 41 - (60) - ------------ ------------ ------------ ------------ Comprehensive income $ 797 $ 3,046 $ 9,979 $ 14,398 ============ ============ ============ ============ The accompanying notes are an integral part of these condensed consolidated financial statements </TABLE> - 4 -
<TABLE> <CAPTION> GREATBATCH, INC. CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS -- Unaudited (IN THOUSANDS) - ----------------------------------------------------------------------------------------------------- Nine months ended September 30, 2005 2004 (1) Cash flows from operating activities: <S> <C> <C> Net income $ 10,039 $ 14,398 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 14,038 10,861 Stock-based compensation 2,468 2,061 Deferred income taxes 5,934 4,780 Loss on disposal of assets 5,258 551 Changes in operating assets and liabilities: Accounts receivable (10,312) (5,051) Inventories (2,130) (4,750) Prepaid expenses and other current assets (796) 2,310 Accounts payable 3,327 (1,053) Accrued expenses and other current liabilities 6,718 49 Income taxes (1,712) (159) ------------- ------------- Net cash provided by operating activities 32,832 23,997 ------------- ------------- Cash flows from investing activities: Short-term investments: Purchases (63,178) (162,589) Proceeds from dispositions 58,043 204,934 Acquisition of property, plant and equipment (22,690) (26,124) Proceeds from sale of assets 82 69 (Increase) decrease in other assets (401) 37 Acquisition of subsidiary, net - (45,604) ------------- ------------- Net cash used in investing activities (28,144) (29,277) ------------- ------------- Cash flows from financing activities: Principal payments of long-term debt (890) (924) Payment of debt issue costs (213) - Issuance of common stock 936 1,190 Issuance of treasury stock - 179 ------------- ------------- Net cash (used in) provided by financing activities (167) 445 ------------- ------------- Net increase (decrease) in cash and cash equivalents 4,521 (4,835) Cash and cash equivalents, beginning of year 34,795 23,960 ------------- ------------- Cash and cash equivalents, end of period $ 39,316 $ 19,125 ============= ============= (1) As restated, see Note 14. The accompanying notes are an integral part of these condensed consolidated financial statements </TABLE> - 5 -
GREATBATCH, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- Unaudited - -------------------------------------------------------------------------------- 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of America. Operating results for interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole. In the opinion of management, the condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the results of Greatbatch, Inc. (the "Company") for the periods presented. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, sales, expenses, and related disclosures at the date of the financial statements and during the reporting period. Actual results could differ from these estimates. For further information, refer to the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. We anticipate amending our Form 10-K for the year ended December 31, 2004 in the near future. See Form 8-K filed on November 9, 2005 for additional information. The Company officially changed its name to Greatbatch, Inc. from Wilson Greatbatch Technologies, Inc. during the second quarter of 2005. Certain reclassifications were made to the prior period Condensed Consolidated Statement of Cash Flows to conform with the current period presentation. This reclassification did not affect net income or stockholders' equity. The Company utilizes a fifty-two, fifty-three week fiscal year ending on the Friday nearest December 31st. For 52-week years, each quarter contains 13 weeks. For clarity of presentation, the Company describes all periods as if each quarter end is March 31st, June 30th and September 30th and as if the year-end is December 31st. The third quarter of 2005 and 2004 each contained 13 weeks. 2. STOCK-BASED COMPENSATION The Company accounts for stock-based compensation in accordance with Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation ("SFAS No. 123"). As permitted in SFAS No. 123, the Company has chosen to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board No. 25, Accounting for Stock Issued to Employees, and related interpretations. - 6 -
The Company has determined the pro forma information as if the Company had accounted for stock options granted under the fair value method of SFAS No. 123. The Black-Scholes option-pricing model was used with the following weighted average assumptions. These pro forma calculations assume the common stock is freely tradable for all periods presented and, as such, the impact is not necessarily indicative of the effects on reported net income of future periods. Three months ended Nine months ended September 30, September 30, 2005 2004 2005 2004 Risk-free interest rate 3.99% 3.48% 3.94% 3.65% Expected volatility 46.2% 50% 46.2% 50% Expected life (in years) 5 5 5 5 Expected dividend yield 0% 0% 0% 0% The Company's net income and earnings per share as if the fair value based method had been applied to all outstanding and unvested awards in each period is as follows (in thousands except per share data): Three months ended Nine months ended September 30, September 30, 2005 2004 2005 2004 Net income as reported $ 756 $ 3,046 $ 10,039 $ 14,398 Stock-based employee compensation cost included in net income as reported, net of related tax effects $ 714 $ 396 $ 1,728 $ 1,484 Stock-based employee compensation cost determined using the fair value based method, net of related tax effects $ 1,259 $ 1,082 $ 3,278 $ 2,747 Pro forma net income $ 211 $ 2,360 $ 8,489 $ 13,135 Earnings per share: Basic -- as reported $ 0.03 $ 0.14 $ 0.47 $ 0.67 Basic -- pro forma $ 0.01 $ 0.11 $ 0.39 $ 0.62 Diluted -- as reported $ 0.03 $ 0.14 $ 0.46 $ 0.65 Diluted -- pro forma $ 0.01 $ 0.11 $ 0.39 $ 0.60 - 7 -
3. SUPPLEMENTAL CASH FLOW INFORMATION Nine months ended September 30, 2005 2004 Noncash investing and financing activities (in thousands): Acquisition of property utilizing capital leases $ - $ 1,089 Common stock contributed to 401(k) Plan $ 2,729 $ 2,723 Liabilities incurred in connection with capital expenditures $ 2,268 $ 2,230 4. SHORT-TERM INVESTMENTS Short-term investments at September 30, 2005 and December 31, 2004 consist of investments expected to be settled or reset within a twelve month period. Short-term investments comprised the following (in thousands): As of September 30, 2005 Gross Gross unrealized unrealized Estimated Cost gains losses fair value Available-for-sale: Equity Securities $ 276 $ - $ (86) $ 190 Auction Rate Securities 62,572 - - 62,572 ----------- ----------- ----------- ----------- Short-term investments $ 62,848 $ - $ - $ 62,762 =========== =========== =========== =========== As of December 31, 2004 Gross Gross unrealized unrealized Estimated Cost gains losses fair value Available-for-sale: Equity Securities $ 276 $ - $ (18) $ 258 Auction Rate Securities 54,678 - - 54,678 ----------- ----------- ----------- ----------- Total available-for-sale securities 54,954 - (18) 54,936 Held-to-maturity: Municipal Bonds 2,501 1 - 2,502 ----------- ----------- ----------- ----------- Short-term investments $ 57,455 $ 1 $ (18) $ 57,438 =========== =========== =========== =========== - 8 -
5. INVENTORIES Inventories comprised the following (in thousands): September 30, December 31, 2005 2004 Raw materials $ 18,309 $ 14,053 Work-in-process 11,400 11,275 Finished goods 6,448 8,699 -------------- -------------- Total $ 36,157 $ 34,027 ============== ============== 6. INTANGIBLE ASSETS Intangible assets comprised the following (in thousands): As of September 30, 2005 Gross carrying Accumulated Net carrying amount amortization Amount Amortizing intangible assets: Patented technology $ 21,462 $ (11,338) $ 10,124 Unpatented technology 30,886 (8,194) 22,692 Other 1,340 (1,308) 32 -------------- -------------- -------------- 53,688 (20,840) 32,848 Non-amortizing intangible assets: Trademark and names 31,420 (3,168) 28,252 -------------- -------------- -------------- Total intangible assets $ 85,108 $ (24,008) $ 61,100 ============== ============== ============== As of December 31, 2004 Gross carrying Accumulated Net carrying amount amortization Amount Amortizing intangible assets: Patented technology $ 21,462 $ (10,137) $ 11,325 Unpatented technology 30,886 (6,525) 24,361 Other 1,340 (1,294) 46 -------------- -------------- -------------- 53,688 (17,956) 35,732 Non-amortizing intangible assets: Trademark and names 31,420 (3,168) 28,252 -------------- -------------- -------------- Total intangible assets $ 85,108 $ (21,124) $ 63,984 ============== ============== ============== Aggregate amortization expense for third quarter 2005 and 2004 was $1.0 million and $1.1 million, respectively. Aggregate amortization expense for each of the nine month periods ended September 30, 2005 and 2004 was $2.9 million. Annual amortization expense is estimated to be $1.0 million for the remainder of 2005, $3.8 million for 2006 to 2008, $3.2 million for 2009, and $2.7 million for 2010. - 9 -
7. DEBT Long-term debt comprised the following (in thousands): September 30, December 31, 2005 2004 2.25% convertible subordinated notes, due 2013 $ 170,000 $ 170,000 Capital lease obligations 762 1,652 -------------- -------------- 170,762 171,652 Less current portion (762) (1,000) -------------- -------------- Total long-term debt $ 170,000 $ 170,652 ============== ============== Revolving Line of Credit On May 31, 2005, the Company amended its Senior Secured Credit Facility, which included changes to the underlying covenants. The amended facility replaced the old $20.0 million revolving credit facility with a new three-year $50.0 million Revolving Credit Facility ("new revolver"), which contains a $10.0 million sub-limit for the issuance of commercial or standby letters of credit. The new revolver is secured by the Company's non-realty assets including cash, accounts and notes receivable, and inventories. The new revolver requires the Company to comply with two quarterly financial covenants, as defined. The first relates to the ratio of consolidated net earnings or loss before interest, taxes, depreciation, and amortization ("EBITDA") to Fixed Charges. The second is a Leverage ratio, which is calculated based on the ratio of Consolidated Funded Debt less Cash, Cash Equivalent Investments and Short-Term Investments to Consolidated EBITDA. Interest rates under the new revolver vary with the Company's leverage. The Company is required to pay a commitment fee of between .125% and .250% per annum on the unused portion of the new revolver based on the Company's leverage. As of September 30, 2005, the Company had no balance outstanding on the new revolver. Debt issue expenses for the new revolver totaled $0.2 million and are being amortized using the straight-line method over a three-year term. The revolver refinancing transaction resulted in the write-off of $0.1 million of existing deferred financing fees associated with the prior revolving line of credit. - 10 -
8. EARNINGS PER SHARE The following table reflects the calculation of basic and diluted earnings per share (in thousands, except per share amounts): Three months ended Nine months ended September 30, September 30, 2005 2004 2005 2004 ---------- ---------- ---------- ---------- Numerator for basic earnings per share: Net income $ 756 $ 3,046 $ 10,039 $ 14,398 Effect of dilutive securities: Interest expense on convertible notes and related deferred financing fees, net of tax - - - 2,337 ---------- ---------- ---------- ---------- Numerator for diluted earnings per share $ 756 $ 3,046 $ 10,039 $ 16,735 ========== ========== ========== ========== Denominator for basic earnings per share: Weighted average shares outstanding 21,621 21,387 21,559 21,345 Effect of dilutive securities: Convertible notes - - - 4,219 Stock options and unvested restricted stock 274 108 181 172 ---------- ---------- ---------- ---------- Dilutive potential common shares 274 108 181 4,391 ---------- ---------- ---------- ---------- Denominator for diluted earnings per share 21,895 21,495 21,740 25,736 ========== ========== ========== ========== Basic earnings per share $ 0.03 $ 0.14 $ 0.47 $ 0.67 ========== ========== ========== ========== Diluted earnings per share $ 0.03 $ 0.14 $ 0.46 $ 0.65 ========== ========== ========== ========== For the three months ended September 30, 2004 and 2005 as well as for the nine months ended September 30, 2005, the impact of the convertible notes was anti-dilutive. 9. COMPREHENSIVE INCOME For the three and nine month periods ended September 30, 2004, the Company's only component of comprehensive income is its net income. For the third quarter ended September 30, 2005, the Company's comprehensive income includes net income and a net unrealized gain on available-for-sale securities. For the nine months ended September 30, 2005, the Company's comprehensive income includes net income and a net unrealized loss on available-for-sale securities. 10. COMMITMENTS AND CONTINGENCIES Litigation -- During 2002, a former non-medical customer commenced an action alleging that the Company had used proprietary information of the customer to develop certain products. We have meritorious defenses and are vigorously - 11 -
defending the case. No accrual for an adverse judgment has been made as such outcome is not deemed probable. The Company's estimate of the potential risk of loss is between $0.0 and $1.75 million. Product Warranties -- The change in aggregate product warranty liability for the quarter ended September 30, 2005, is as follows (in thousands): Beginning balance at June 30, 2005 $1,265 Additions to warranty reserve 267 Warranty claims paid (180) ------- Ending balance at September 30, 2005 $1,352 ======= Capital Expenditures -- During 2004, the Company commenced the build out of its medical battery and capacitor manufacturing facility in Alden, NY and its value-add manufacturing facility in Tijuana, Mexico. These facilities will enable the Company to further consolidate its operations and implement state of the art manufacturing capabilities at both locations. The total remaining contractual obligation for construction of these facilities at September 30, 2005 is $3.4 million and will be financed by existing cash, short-term investments, or cash generated from operations. 11. BUSINESS SEGMENT INFORMATION The Company operates its business in two reportable segments: Implantable Medical Components ("IMC") and Electrochem Commercial Power ("ECP"), (formerly "Electrochem Power Solutions"). The IMC segment designs and manufactures critical components used in implantable medical devices. The principal components are batteries, capacitors, filtered feedthroughs, coated components, enclosures and machined and molded precision components. The principal medical devices are pacemakers, defibrillators and neurostimulators. The ECP segment designs and manufactures high performance cells and battery packs; principal markets for these products are for oil and gas exploration, oceanographic equipment, and aerospace. The Company defines segment income from operations as gross profit less costs and expenses attributable to segment-specific selling, general and administrative, research, development and engineering expenses, intangible amortization and other operating expenses. Segment income also includes a portion of non-segment specific selling, general and administrative, and research, development and engineering expenses based on allocations appropriate to the expense categories. The remaining unallocated operating expenses along with other income and expense are not allocated to reportable segments. Transactions between the two segments are not significant. The accounting policies of the segments are the same as those described and referenced in Note 1. - 12 -
An analysis and reconciliation of the Company's business segment information to the respective information in the consolidated financial statements is as follows (in thousands): Three months ended Nine months ended September 30, September 30, 2005 2004 2005 2004 Sales: IMC ICD batteries $ 11,345 $ 7,734 $ 34,783 $ 27,273 Pacemaker and other batteries 5,424 4,092 16,917 15,149 ICD Capacitors 5,349 4,103 15,600 18,750 Feedthroughs 16,386 9,533 45,927 35,521 Enclosures 6,203 5,631 18,769 16,170 Other 9,378 6,653 24,740 19,359 ---------- ---------- ---------- ---------- Total IMC 54,085 37,746 156,736 132,222 ECP 8,273 7,431 25,504 21,422 ---------- ---------- ---------- ---------- Total sales $ 62,358 $ 45,177 $ 182,240 $ 153,644 ========== ========== ========== ========== Segment income from operations: IMC $ 3,383 $ 5,272 $ 20,744 $ 24,490 ECP 1,992 2,267 6,300 6,170 ---------- ---------- ---------- ---------- Total segment income from operations 5,375 7,539 27,044 30,660 Unallocated operating expenses (3,946) (2,626) (11,319) (7,666) ---------- ---------- ---------- ---------- Operating income as reported 1,429 4,913 15,725 22,994 Unallocated other income and expense (349) (825) (1,383) (2,571) ---------- ---------- ---------- ---------- Income before income taxes as reported $ 1,080 $ 4,088 $ 14,342 $ 20,423 ========== ========== ========== ========== The changes in the carrying amount of goodwill are as follows (amounts in thousands): IMC ECP Total Balance at December 31, 2004 $ 154,206 $ 2,566 $ 156,772 Goodwill adjustments during the year (1) (1,733) - (1,733) ----------- ----------- ----------- Balance at September 30, 2005 $ 152,473 $ 2,566 $ 155,039 =========== =========== =========== (1) See Note 14. - 13 -
12. OTHER OPERATING EXPENSE During the third quarter and nine months ended September 30, 2005, the following charges were recorded in other operating expense in the Company's Condensed Consolidated Statement of Operations (in millions). Three months ended Nine months ended September 30, 2005 September 30, 2005 (a) Severance $ - $ 1.5 (b) Alden facility consolidation 1.4 2.3 (c) Carson City facility shutdown 0.9 1.8 (d) Tijuana start-up 1.0 1.5 (e) Costs to exit development agreement - 1.2 (f) Asset dispositions 4.5 5.9 ------------------- ------------------- $ 7.8 $ 14.2 =================== =================== (a) Severance charges. During the first quarter of 2005, the Company implemented a 4% workforce reduction as a continuation of cost containment efforts initiated mid-year 2004, which resulted in a severance charge of $1.5 million. Accrued liabilities at September 30, 2005 related to the severance charges comprised the following (in thousands): IMC ECP Corporate Total Severance charges $ 860 $ 210 $ 430 $ 1,500 Cash payments (860) (210) (430) (1,500) Write-offs - - - - ----------- ------------ ------------ ------------ Balance, September 30, 2005 $ - $ - $ - $ - =========== ============ ============ ============ The severance charges related to corporate employees are included in unallocated operating expenses under business segment information. (b) Alden Facility Consolidation -- On February 23, 2005, the Company announced its intent to consolidate the medical capacitor manufacturing operations, currently in Cheektowaga, NY, and the implantable medical battery manufacturing operations, currently in Clarence, NY, into the advanced power source manufacturing facility in Alden, NY ("Alden Facility"). The Company is also consolidating the capacitor research, development and engineering operations from the Cheektowaga, NY, facility into the existing implantable medical battery research, development, and engineering operations in Clarence, NY. The total cost estimated for these consolidation efforts is anticipated to be between $3.5 and $4.0 million. The Company expects to incur and pay the remaining cost in the next two quarters. The expenses for the Alden Facility consolidation are included in the IMC business segment. The major categories of costs, which will primarily be cash expenditures, include the following: - 14 -
o Production inefficiencies and revalidation -- $1.5 to $1.7 million; o Training -- $0.6 to $0.7 million; o Moving and facility closures -- $0.9 million to $1.0 million; and o Infrastructure -- $0.5 to $0.6 million. Accrued liabilities at September 30, 2005 related to the Alden Facility consolidation comprised the following (in thousands): <TABLE> <CAPTION> Production inefficiencies Moving and and facility revalidation Training closures Infrastructure Total <S> <C> <C> <C> <C> <C> Restructuring charges $ 193 $ 23 $ 1,734 $ 351 $ 2,301 Cash payments (193) (23) (583) (351) (1,150) Write-offs - - (466) - (466) --------------- --------------- --------------- --------------- --------------- Balance, September 30, 2005 $ - $ - $ 685 $ - $ 685 =============== =============== =============== =============== =============== </TABLE> (c) Carson City Facility shutdown and (d) Tijuana Facility consolidation - On March 7, 2005, the Company announced its intent to close the Carson City, NV facility ("Carson City Facility") and consolidate the work performed at the Carson City Facility into the Tijuana, Mexico facility ("Tijuana Facility"). The total estimated cost for this facility consolidation plan is anticipated to be between $4.5 million and $5.4 million. The Company expects to incur and pay the remaining cost over the next three fiscal quarters. The major categories of costs include the following: o Costs related to the shutdown of the Carson City Facility: a. Severance and retention -- $1.4 to $1.6 million; b. Accelerated depreciation -- $0.5 to $0.6 million; and c. Other -- $0.6 to $0.7 million. o Costs related to the Tijuana Facility consolidation: a. Production inefficiencies and revalidation -- $0.4 to $0.5 million; b. Relocation and moving -- $0.3 to $0.5 million; c. Personnel (including travel, training and duplicate wages) -- $1.0 to $1.1 million; and d. Other - $0.3 to $0.4 million. All categories of costs are considered to be cash expenditures, except accelerated depreciation. The expenses for the Carson City facility shutdown and the Tijuana Facility consolidation are included in the IMC business segment. - 15 -
Accrued liabilities at September 30, 2005 related to the Carson City Facility shutdown comprised the following (in thousands): <TABLE> <CAPTION> Severance and Accelerated retention Depreciation Other Total <S> <C> <C> <C> <C> Restructuring charges $ 1,195 $ 390 $ 198 $ 1,783 Cash payments - - (198) (198) Write-offs - (390) - (390) ------------- ------------- ------------- ------------- Balance, September 30, 2005 $ 1,195 $ - $ - $ 1,195 ============= ============= ============= ============= </TABLE> Accrued liabilities at September 30, 2005 related to the Tijuana Facility consolidation comprised the following (in thousands): <TABLE> <CAPTION> Production inefficiencies and Relocation and revalidation moving Personnel Other Total <S> <C> <C> <C> <C> <C> Restructuring charges $ - $ 104 $ 471 $ 110 $ 685 Cash payments - (104) (471) (110) (685) Write-offs - - - - - --------------- --------------- --------------- --------------- --------------- Balance, September 30, 2005 $ - $ - $ - $ - $ - =============== =============== =============== =============== =============== </TABLE> Other Tijuana start-up expenses (not associated with Carson City consolidation) amount to $865 thousand. (e) Costs to exit development agreement. There was a $1.15 million charge recorded in other operating expenses for the IMC segment during the second quarter for charges associated with the discontinuation of a drug pump development agreement. (f) Asset dispositions. Third quarter and year-to-date amounts include $2.8 million write-down of automated cathode assembly equipment for the IMC segment during the third quarter of 2005. This charge was primarily related to a decision not to continue to use some battery production equipment. The manufacturing process related to this equipment did not match the Company's overall manufacturing strategy. The remainder of the expense is for other property, plant, and equipment dispositions. 13. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS In June 2005 the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 154, Accounting Changes and Error Corrections, ("SFAS 154") a replacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 changes the requirements for the accounting for and the reporting of a change in accounting principle. Previously, most voluntary changes in accounting principles required recognition by recording a cumulative effect adjustment within net income in - 16 -
the period of change. SFAS 154 requires retrospective application to prior periods' financial statements, unless it is impracticable to determine either the specific period effects or the cumulative effect of the change. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The Company does not expect that adoption of SFAS No. 154 will have a material effect on its consolidated financial position, consolidated results of operations, or liquidity. In March 2005, the FASB issued Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143" ("FIN 47"). FIN 47 requires the recognition of a liability for the fair value of a legally-required conditional asset retirement obligation when incurred, if the liability's fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. The Company does not expect that adoption of FIN 47 will have a material effect on its consolidated financial position, consolidated results of operations, or liquidity. In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment ("SFAS No. 123(R)"). This statement is a revision of SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. This standard requires the Company to measure the cost of employee services received in exchange for equity awards based on the grant date fair value of the awards. The cost will be recognized as compensation expense over the vesting period of the awards. The Company anticipates adopting the provisions of SFAS No. 123(R) on January 1, 2006 using the modified prospective method. Accordingly, compensation expense will be recognized for all newly granted awards and awards modified, repurchased, or cancelled after January 1, 2006. Compensation cost for the unvested portion of awards that are outstanding as of January 1, 2006 will be recognized ratably over the remaining vesting period. The compensation cost for the unvested portion of awards will be based on the fair value at date of grant as calculated for the Company's pro forma disclosure under SFAS 123. The Company estimates that the effect on net income and earnings per share in the periods following adoption of SFAS 123(R) will be consistent with the Company's pro forma disclosure under SFAS No. 123, except that estimated forfeitures will be considered in the calculation of compensation expense under SFAS 123(R). Additionally, the actual effect on net income and earnings per share will vary depending upon the number of options granted in subsequent periods compared to prior years. In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4 ("SFAS No. 151"). SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to clarify the accounting for abnormal amounts of idle facility expense, handling costs and wasted material (spoilage). Among other provisions, the new rule requires that such items be recognized as current-period charges, regardless of whether they meet the criterion of "so abnormal" as stated in ARB No. 43. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The company does not expect that adoption of SFAS No. 151 will have a material effect on its consolidated financial position, consolidated results of operations, or liquidity. - 17 -
14. RESTATEMENTS The Company has restated its condensed consolidated balance sheet as of December 31, 2004 to change the classification of auction rate securities from cash and cash equivalents to short-term investments. Auction rate securities are securities that have stated maturities beyond three months, but are priced and traded as short-term investments due to the liquidity provided through the auction mechanism that generally resets interest rates every 7 to 35 days. Although management had determined the risk of failure of an auction process to be remote, the definition of a cash equivalent in SFAS No. 95, Statement of Cash Flows, requires reclassification to short-term investments. The condensed consolidated cash flow statement for the nine month period ended September 30, 2004 has also been restated in order to conform to this change in classification. Due to the short term nature of the interest rate resets, the fair market value of the auction rate securities approximates their recorded value. During the quarter ended September 30, 2005, the Company determined that it had not accounted for a deferred tax asset in purchase accounting related to net operating losses acquired in the Company's acquisition of NanoGram in 2004. The recording of these net operating losses decreased long-term deferred income tax liabilities and correspondingly decreased goodwill. The restatements have been made to the unaudited Condensed Consolidated Balance Sheet and Condensed Consolidated Statement of Cash Flows as follows: Condensed Consolidated Balance Sheet as of - ------------------------------------------ December 31, 2004 - ----------------- As previously reported Adjustment As restated ----------- ----------- ----------- Current assets: Cash and cash equivalents $ 89,473 $ (54,678) $ 34,795 Short-term investments $ 2,759 $ 54,678 $ 57,437 Goodwill $ 156,772 $ (1,733) $ 155,039 Total assets $ 479,938 $ (1,733) $ 478,205 Long term liabilities: Deferred income taxes $ 25,029 $ (1,733) $ 23,296 Total liabilities $ 223,761 $ (1,733) $ 222,028 Total liabilities and stockholder's equity $ 479,938 $ (1,733) $ 478,205 - 18 -
Condensed Consolidated Statement of Cash Flows for the nine months ended - ------------------------------------------------------------------------ September 30, 2004 - ------------------ As previously reported Adjustment As restated ----------- ----------- ----------- Cash flows from investing activities: Net cash used in investing activities $ (66,127) $ 36,850 $ (29,277) Net increase (decrease) in cash and cash equivalents $ (41,685) $ 36,850 $ (4,835) Cash and cash equivalents, beginning of year $ 119,486 $ 95,526 $ 23,960 Cash and cash equivalents, end of period $ 77,801 $ 58,676 $ 19,125 15. SUBSEQUENT EVENT On October 25, 2005, the Company and Medtronic, Inc. ("Medtronic") entered into a license agreement which grants Medtronic the right to use certain intellectual property relating to tantalum capacitors. The license is perpetual and, except for the Company's right to make and sell capacitors, exclusive to Medtronic. The license provides for an initial license fee (due after Medtronic's first US sale) and royalties (some of which the Company must pay to a third party). The royalties are subject to a maximum royalty amount and may be eliminated within specified contract periods if Medtronic purchases a certain percentage of its tantalum capacitor requirements from the Company. The Company cannot provide any assurances that Medtronic will utilize its capacitor technology or purchase any capacitors. The Company does not anticipate any significant financial impact from this agreement in the near term. - 19 -
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction We are a leading developer and manufacturer of batteries, capacitors, feedthroughs, enclosures, and other components used in implantable medical devices ("IMDs") through our Implantable Medical Components ("IMC") business. We offer technologically advanced, highly reliable and long lasting products for IMDs and enable our customers to introduce IMDs that are progressively smaller, longer lasting, more efficient and more functional. We also leverage our core competencies in technology and manufacturing through our Electrochem Commercial Power ("ECP") business (formerly "Electrochem Power Solutions") to develop and produce cells and battery packs for commercial applications that demand high performance and reliability, including oil and gas exploration, oceanographic equipment and aerospace. Most of the IMC products that we sell are utilized by customers in cardiac rhythm management ("CRM") devices. The CRM market comprises devices utilizing high-rate batteries and capacitors such as implantable cardioverter defibrillators ("ICDs") and cardiac resynchronization therapy ("CRT") with backup defibrillation devices ("CRT-D") and devices utilizing low or medium rate batteries but no capacitors (pacemakers and CRTs). All CRM devices utilize other components such as enclosures and feedthroughs, and certain CRM devices utilize electromagnetic interference ("EMI") filtering technology. We utilize a fifty-two, fifty-three week fiscal year ending on the Friday nearest December 31st. For 52-week years, each quarter contains 13 weeks. For clarity of presentation, we describe all periods as if each quarter end is March 31st, June 30th and September 30th and as if the year-end is December 31st. The third quarters of 2005 and 2004 each contained 13 weeks. The commentary that follows should be read in conjunction with our consolidated financial statements and related notes and with the Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Form 10-K for the fiscal year ended December 31, 2004. We anticipate amending our Form 10-K for the year ended December 31, 2004 in the near future. See Form 8-K filed on November 9, 2005 for additional information. Overview During and subsequent to the third quarter 2005, there were several developments affecting our business: o Achieved sales growth of 38% consisting of 43% growth in Implantable Medical Components and 11% growth in Electrochem Commercial Power products. o Installation of the remaining assembly equipment at the Greatbatch Mexico facility is expected to be completed in the fourth quarter of 2005. The move of the filtered feedthrough operation in Carson City to Tijuana is progressing as planned. Manufacturing equipment is currently being installed and validated. The project is expected to be completed in its entirety during the first half of 2006. - 20 -
o The move of the manufacturing equipment from the existing capacitor plant to the Alden facility is in process. The move is expected to essentially be complete by the end of the fourth quarter of 2005. However, due to increased capacitor volume, the final manufacturing equipment moves may extend into next year to ensure production requirements are met. o On October 25, 2005, the Company and Medtronic, Inc. entered into a royalty-based licensing agreement with respect to certain intellectual property pertaining to tantalum capacitors. The use of tantalum technology and any purchase of tantalum capacitors by Medtronic are subject to their further evaluation. Product Development IMC. As mentioned in our annual report (which is available on our website, www.greatbatch.com), our near term focus for growth in the medical battery market, a portion of our IMC business, is the introduction of our Q-Series batteries. Initially they will be available in two configurations -- QHR (High Rate) and QMR (Medium Rate). These batteries hold the promise of unparalleled performance in a wide range of implantable device and neurostimulation applications and allow our customers to incorporate advanced power-hungry features into these devices. While companies typically announce new products that have modest improvements in form and/or function regularly, we believe the Q-Series firmly establishes a new industry standard. It delivers advanced performance criteria to an industry that historically embraces new products. We believe the Q-Series will represent a major breakthrough by combining a smaller size with greater energy density (more power). ECP. ECP continues to develop new and innovative power solutions for the world's most demanding commercial applications. ECP has developed a new high energy lithium cell for a customer in the telematics market. Due to their exceptional high energy, 2 of these new cells are capable of providing power for the entire 10-year life of the telematics device. ECP developed a battery pack capable of withstanding the customer's harsh operating conditions such as high vibration, high shock, salt spray, high temperature, low temperature, and high humidity. ECP developed a modular battery pack for a customer's fleet of underwater sonabuoys which measure water characteristics. The long life of ECP cells, coupled with their ability to withstand harsh conditions, make them ideally suited for buoys. The customer's expense of commissioning a ship to replace the batteries in each buoy is reduced when using ECP batteries due to their long life. Cost savings and consolidation efforts During third quarter 2005, we recorded charges in other operating expense related to our ongoing cost savings and consolidation efforts. Severance charges. The Company implemented a 4% workforce reduction during the first quarter of 2005, which resulted in a severance charge of $1.5 million. Of that amount, $0.8 million, $0.5 million, and $0.2 million were paid in cash during the first, second and third quarters, respectively. - 21 -
Alden Facility Consolidation. On February 23, 2005, we announced our intent to consolidate the medical capacitor manufacturing operations, currently in Cheektowaga, NY, and the implantable medical battery manufacturing operations, currently in Clarence, NY, into the advanced power source manufacturing facility in Alden, NY ("Alden Facility"). We are also consolidating the capacitor research, development and engineering operations from the Cheektowaga, NY, facility into the existing implantable medical battery research, development, and engineering operations in Clarence, NY. The total cost estimated for these consolidation efforts is anticipated to be between $3.5 million and $4.0 million. Expenses of $2.3 million have been incurred through the third quarter. Of these, $1.2 million were paid in cash, $0.4 million were for assets written-off, and $0.7 million remain to be paid. We expect to incur the remaining expense over the next two fiscal quarters. Carson City Facility shutdown and Tijuana Facility consolidation. On March 7, 2005, we announced our intent to close the Carson City, NV facility ("Carson City Facility") and consolidate the work performed at the Carson City Facility into the Tijuana, Mexico facility ("Tijuana Facility"). The total estimated cost for this facility consolidation plan is anticipated to be between $4.5 million and $5.4 million, comprised of between $2.5 million to $2.9 million for the Carson City Facility shutdown and $2.0 million to $2.5 million for the Tijuana Facility consolidation. We expect to incur the remaining costs over the next three fiscal quarters. All categories of costs are considered to be cash expenditures, except accelerated depreciation. Carson City Facility shutdown expenses of $1.8 million have been accrued year to date, of which $0.2 million were paid in cash, $0.4 million have been recorded as accelerated depreciation and $1.2 million remain to be paid. Tijuana Facility consolidation expenses of $0.7 million have been incurred and paid year to date. - 22 -
<TABLE> <CAPTION> Results of Operation and Financial Condition Three months ended Nine months ended In thousands, except per share September, $ % September 30, $ % data 2005 2004 Change Change 2005 2004 Change Change - ------------------------------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- IMC <S> <C> <C> <C> <C> <C> <C> <C> <C> ICD batteries $ 11,345 $ 7,734 3,611 47% $ 34,783 $ 27,273 7,510 28% Pacemaker and other batteries 5,424 4,092 1,332 33% 16,917 15,149 1,768 12% ICD Capacitors 5,349 4,103 1,246 30% 15,600 18,750 (3,150) -17% Feedthroughs 16,386 9,533 6,853 72% 45,927 35,521 10,406 29% Enclosures 6,203 5,631 572 10% 18,769 16,170 2,599 16% Other 9,378 6,653 2,725 41% 24,740 19,359 5,381 28% ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total IMC 54,085 37,746 16,339 43% 156,736 132,222 24,514 19% ECP 8,273 7,431 842 11% 25,504 21,422 4,082 19% ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total sales 62,358 45,177 17,181 38% 182,240 153,644 28,596 19% Cost of sales 38,178 27,775 10,403 37% 112,154 89,249 22,905 26% ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Gross profit 24,180 17,402 6,778 39% 70,086 64,395 5,691 9% Gross margin 38.8% 38.5% 0.3% 38.5% 41.9% -3.4% Selling, general, and administrative expenses (SG&A) 8,842 6,913 1,929 28% 24,089 20,227 3,862 19% SG&A as a % of sales 14.2% 15.3% -1.1% 13.2% 13.2% 0.0% Research, development and engineering costs, net (RD&E) 5,124 4,156 968 23% 13,182 14,725 (1,543) -10% RD&E as a % of sales 8.2% 9.2% -1.0% 7.2% 9.6% -2.4% Intangible amortization 967 1,074 (107) -10% 2,883 2,925 (42) -1% Other operating expense, net 7,818 346 7,472 2160% 14,207 3,524 10,683 303% ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Operating income 1,429 4,913 (3,484) -71% 15,725 22,994 (7,269) -32% Operating margin 2.3% 10.9% -8.6% 8.6% 15.0% -6.4% Interest expense 1,154 1,144 10 1% 3,476 3,448 28 1% Interest income (796) (244) (552) 226% (2,024) (802) (1,222) 152% Other expense (income), net (9) (75) 66 -88% (69) (75) 6 -8% Provision for income taxes 324 1,042 (718) -69% 4,303 6,025 (1,722) -29% Effective tax rate 30.0% 25.5% 4.5% 30.0% 29.5% 0.5% ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Net income $ 756 $ 3,046 $ (2,290) -75% $ 10,039 $ 14,398 $ (4,359) -30% ========== ========== ========== ========== ========== ========== ========== ========== Net margin 1.2% 6.7% -5.5% 5.5% 9.4% -3.9% Diluted earnings per share $ 0.03 $ 0.14 $ (0.11) -79% $ 0.46 $ 0.65 $ (0.19) -29% </TABLE> - 23 -
Sales IMC. The nature and extent of our selling relationship with each CRM customer is different in terms of component products purchased, selling prices, product volumes, ordering patterns and inventory management. We have pricing arrangements with our customers that at times do not specify minimum order quantities. Our visibility to customer ordering patterns is over a relatively short period of time. Our customers may have inventory management programs and alternate supply arrangements of which we are unaware. Additionally, the relative market share among the CRM device manufacturers changes periodically. Consequently, these and other factors can significantly impact our sales in any given period. The results for the third quarter of 2005 did receive benefit from the field issues surrounding ICD products. However, it is extremely difficult to identify how much benefit we received during the third quarter. We do not have specific information on the nature of the orders and can only assume that some percentage of the increase relates to the ICD field actions in the marketplace. It is likely that the impact on our sales will continue to be favorably affected by these field issues into the fourth quarter. Our customers may initiate field actions with respect to market-released products. These actions may include product recalls or communications with a significant number of physicians about a product or labeling issue. The scope of such actions can range from very minor issues affecting a small number of units to more significant actions. There are a number of factors, both short-term and long-term related to these field actions that may impact our results. In the short-term, if product has to be replaced, or customer inventory levels have to be restored, this will result in increased component demand. Also, changing customer order patterns due to market share shifts or accelerated device replacements may also have a positive impact on our sales results in the near-term. These same factors may have longer-term implications as well. Customer inventory levels may ultimately have to be rebalanced to match demand. These dynamics should be become clearer in early 2006 and will have to be carefully considered when we provide our 2006 outlook. Moving beyond the field actions, the increase in demand is not isolated to any one customer. We are seeing strength across all of our products and our entire customer base. We believe that the market continues to exhibit strong underlying growth fundamentals (as evidenced by the increased number of CRM device implants) and that we are well positioned to participate in this market growth. The increase in IMC sales of 43% during the third quarter was primarily due to increased demand for ICD batteries, filtered feedthroughs, feedthroughs, and wet tantalum capacitors offset by an average 1% reduction in selling prices. The increase in IMC sales of 19% for the year to date were primarily due to increased demand for ICD batteries, filtered feedthroughs, coated components and medical enclosures offset by an average 2% reduction in selling prices. - 24 -
ECP. Similar to IMC customers, we have pricing arrangements with our customers that many times do not specify minimum quantities. Our visibility to customer ordering patterns is over a relatively short period of time. The ECP sales increases of 11% in the third quarter and 19% year to date have been driven by volume increases due to a number of factors. First and foremost, we have expanded our commercial sales force. We are aggressively pursuing new business opportunities and have been successful on many of these fronts. Second, we have significantly reduced our manufacturing lead times at our Canton, Massachusetts facility, which has allowed us to be more responsive to our customers needs. We will continue to expand on these efforts from various lean manufacturing initiatives that are underway in our Canton facility and throughout the Company. The third factor that has contributed to our positive commercial results has been favorable market dynamics. The oil and gas exploration market remains robust due to the increased demand for products used in pipeline inspections, pressure monitoring and measurement while drilling applications. In addition, we have seen an increase in demand for power sources used in wave monitoring and seismic recording, due to increased Tsunami related concerns, mainly in the international markets. Gross profit The basis point impact in gross margin for the third quarter and year to date 2005 were primarily due to the following factors: <TABLE> <CAPTION> Basis point impact ----------------------------- Quarter Year to Date <S> <C> <C> (1) Production efficiencies primarily associated with higher volumes 550 310 (2) Excess capacity at wet tantalum capacitor and Tijuana facilities (340) (270) (3) Lower IMC selling prices (110) (150) (4) Profit sharing accruals and incentive compensation (50) (50) (5) Higher platinum costs & other items (20) (130) (6) Mix - (50) -------------- -------------- Total basis point impact on gross margin 30 (340) ============== ============== </TABLE> 1) This improvement in gross margin is primarily due to the fact that as production volumes increase, fixed costs such as plant overhead and depreciation do not increase at the same rate. 2) During 2005, two facilities are not being utilized to their full capacity. The capacitor facility was initially established to handle higher levels of production quantities. The capacitor facility is expected to be fully consolidated into the Alden facility by the end of the first quarter 2006. This should eliminate the costs associated with the original capacitor facility. The Tijuana facility is new for 2005 and as a result its floor - 25 -
space and infrastructure are considered under utilized at this time. The production of filtered feedthroughs (currently being performed in Carson City) is in the process of being relocated to the Tijuana facility. 3) Sales prices for Implantable Medical Components are subject to pricing agreements with customers. Many times these agreements allow for changes in price due to customer specific levels of demand. 4) Based on a several metrics, this year's profit sharing and incentive calculations are estimated to be higher than in 2004. 5) Some of the Company's products utilize platinum as a raw material product. The cost of platinum to the company has increased in 2005. 6) On a year to date basis, the percentage of higher margin products sold has decreased in comparison to the same nine month period in 2004. SG&A expenses The increase in SG&A expenses for the third quarter and year to date 2005 is primarily due to the following factors (in thousands): Quarter Year to Date Higher incentive compensation $ 1,800 $ 3,000 Increase in sales and marketing workforce 400 400 Depreciation related to ERP system 400 1,000 Costs associated with Sarbanes-Oxley compliance (400) (300) Other (300) (200) ------------- ------------- Net increase in SG&A $ 1,900 $ 3,900 ============= ============= RD&E expenses Net research, development and engineering costs are as follows (in thousands): Three Months Ended Nine Months Ended September 30, September 30, 2005 2004 2005 2004 Research and development costs $ 4,534 $ 3,816 $ 12,187 $ 11,832 --------- --------- --------- --------- Engineering costs 1,384 1,630 4,250 5,140 Less cost reimbursements (794) (1,290) (3,255) (2,247) --------- --------- --------- --------- Engineering costs, net 590 340 995 2,893 --------- --------- --------- --------- Total research and development and engineering costs, net $ 5,124 $ 4,156 $ 13,182 $ 14,725 ========= ========= ========= ========= - 26 -
The increase in RD&E expenses in the third quarter is primarily due to increased personnel costs for research and development programs, coupled with decreased reimbursement on new product development projects in the current quarter compared to last year. In terms of the development costs billed, reimbursements for development projects were 38% lower in the current quarter due to the timing of the achievement of revenue milestones. Reimbursements for achieving certain development milestones are netted against gross spending. We expect that RD&E costs will increase in the fourth quarter similar to the third quarter due to increased investment in future development programs. Gross RD&E spending declined by 3% for the year to date versus last year. The majority of this decrease is due to the QHR battery product line moving from the development stage into production. Reimbursements year to date were 45% higher in 2005 in comparison to 2004 due to a significant new development project in 2005. Amortization expense Amortization expense for the third quarter of 2005 declined as the result of the completion of amortization of a noncompete/employment agreement during 2004. The result is a $0.1 million reduction in amortization expense per quarter in 2005. Amortization expense for the year to date reflects an incremental $0.3 million of intangible asset amortization resulting from the NanoGram acquisition in March 2004 offset by the $0.3 million reduction of expense due to the completion of the amortization of the noncompete/employment agreement during 2004. Other operating expense Other operating expense for the quarter and year to date 2005 is comprised of the following costs (in millions): Quarter Year to Date Severance * - 1.5 Alden facility consolidation * $ 1.4 $ 2.3 Carson City facility shutdown * 0.9 1.8 Costs to exit development agreement - 1.2 Tijuana start-up * 1.0 1.5 Asset dispositions 4.5 5.9 ------------ ------------ $ 7.8 $ 14.2 ============ ============ The $1.2 million charge for "costs to exit a development agreement" was recorded in other operating expenses during the second quarter of 2005 for charges associated with the discontinuation of a drug pump development agreement. The "asset dispositions" caption includes a $2.8 million write-down of automated cathode assembly equipment. This charge was primarily related to a decision not - 27 -
to continue to use some battery production equipment. The manufacturing process related to this equipment did not match our overall manufacturing strategy. Refer to "Cost savings and consolidation efforts" discussion for disclosure related to the timing and level of remaining expenditures for items marked with "*". In 2004, charges of $2.0 million related to the acquisition of a patent and $0.8 million for severance costs were recorded in the second quarter of 2004. Interest expense and interest income Interest expense increased during the third quarter of 2005 and year to date in 2005 in comparison to the corresponding periods in 2004 due to the incremental deferred financing fees amortization related to the new revolving credit facility. Interest income increased during the third quarter of 2005 and year to date 2005 in comparison to the corresponding periods in 2004 due to higher interest rates as well as the movement of investments in mid-2004 from tax deferred to taxable securities, which bear higher rates of return. Provision for income taxes Our effective tax rate is below the United States statutory rate primarily as a result of federal research and development tax credits and the allowable Extraterritorial Income Exclusion ("ETI") for 2005. In comparison to last year, the year to date effective tax rate was within 0.5% of the 2004 effective tax rate. Liquidity and Capital Resources The following liquidity and capital resources discussion has been updated for the effects of the restatement discussed in Note 14 to the condensed consolidated financial statements. <TABLE> <CAPTION> September 30, December 31, (Dollars in thousands) 2005 2004 <S> <C> <C> Cash and cash equivalents and short-term investments (1) $ 102,078 $ 92,232 Working capital $ 149,547 $ 134,399 Current ratio 5.0:1.0 5.8:1.0 Net cash position (2) $ (68,684) $ (79,420) </TABLE> (1) Short-term investments consist of investments acquired with maturities that exceed three months and are less than one year at the time of acquisition and equity and auction rate securities classified as available-for-sale securities. (2) Net cash position is the sum of cash and cash equivalents and short term investments less total debt. - 28 -
Revolving Line of Credit On May 31, 2005, we amended our Senior Secured Credit Facility, which included changes to the underlying covenants. The amended facility replaced the old $20.0 million revolving credit facility with a new three-year $50.0 million Revolving Credit Facility ("new revolver"), which contains a $10.0 million sub-limit for the issuance of commercial or standby letters of credit. The new revolver is secured by our non-realty assets including cash, accounts and notes receivable, and inventories. The new revolver requires us to comply with two quarterly financial covenants. The first relates to the ratio of consolidated net earnings or loss before interest, taxes, depreciation, and amortization ("EBITDA") to Fixed Charges. The second is a Leverage ratio, which is calculated based on the ratio of Consolidated Funded Debt less Cash, Cash Equivalent Investments and Short-Term Investments to Consolidated EBITDA. Interest rates under the new revolver vary with our leverage. We are required to pay a commitment fee of between .125% and .250% per annum on the unused portion of the new revolver based on our leverage. As of September 30, 2005, we had no balance outstanding on the new revolver. Our principal sources of liquidity are our operating cash flow combined with our working capital of $149.5 million at September 30, 2005 and availability under the new revolver. Historically we have generated cash from operations sufficient to meet our capital expenditure and debt service needs, other than for acquisitions. At September 30, 2005, our current ratio was 5.0:1. The Company regularly engages in discussions relating to potential acquisitions and may announce an acquisition transaction at any time. Operating activities Net cash flows provided by operating activities for the nine months' ended September 30, 2005 increased by approximately $9.0 million over the comparable period in 2004. Higher sales were primarily responsible for the increase in operating cash flows. Investing activities The majority of the current year increase in acquisition of property, plant and equipment was for the following: a. New medical power manufacturing plant in Alden, NY -- $9.0 million; and b. New assembly plant in Tijuana, Mexico -- $9.3 million. In March 2004, we purchased NanoGram for approximately $45.7 million. The most significant elements of the purchase price allocation were to patented and unpatented technology and goodwill. The costs allocated to patented and unpatented technology are being amortized over the remaining estimated useful life of 11.5 years. The residual amount of the allocation of $35.1 million went to goodwill, which is not amortized but rather subject to periodic testing as part of the total IMC reporting unit goodwill impairment testing. NanoGram is now referred to as our Advanced Research Laboratory. Since the primary function of this operation is research and development, all costs are appropriately classified in that category. - 29 -
On a year-to-date basis short-term investments increased by approximately $5.1 million. Financing activities Payments on capital lease obligations and cash from non-qualified stock option exercises are the primary financing activities for both year-to-date periods presented. Capital Structure At September 30, 2005, our capital structure consisted primarily of $170.0 million of convertible subordinated notes and our 21.6 million shares of common stock outstanding. We have in excess of $102.0 million in cash, cash equivalents and short-term investments and are in a position to facilitate future acquisitions if necessary. We are also authorized to issue 100 million shares of common stock and 100 million shares of preferred stock. The market value of our outstanding common stock since our IPO has exceeded our book value; accordingly, we believe that if needed we can access public markets to sell additional common or preferred stock assuming conditions are appropriate. Our capital structure allows us to support our internal growth and provides liquidity for corporate development initiatives. Our current expectation for 2005 is that capital spending will be in the range of $27.0 million to $32.0 million, primarily as a result of the build-out of the Alden Facility ($11.0 million) and the Tijuana Facility ($10.0 million), and normal maintenance capital expenditures. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements, except for operating leases, within the meaning of Item 303(a)(4) of Regulation S-K. Inflation We do not believe that inflation has had a significant effect on our operations. Impact of Recently Issued Accounting Standards In June 2005 the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 154, Accounting Changes and Error Corrections, ("SFAS 154") a replacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 changes the requirements for the accounting for and the reporting of a change in accounting principle. Previously, most voluntary changes in accounting principles required recognition by recording a cumulative effect adjustment within net income in the period of change. SFAS 154 requires retrospective application to prior periods' financial statements, unless it is impracticable to determine either the specific period effects or the cumulative effect of the change. SFAS 154 is effective for accounting changes made in - 30 -
fiscal years beginning after December 15, 2005. We do not expect that adoption of SFAS No. 154 will have a material effect on our consolidated financial position, consolidated results of operations, or liquidity. In March 2005, the FASB issued Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143" ("FIN 47"). FIN 47 requires the recognition of a liability for the fair value of a legally-required conditional asset retirement obligation when incurred, if the liability's fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. We do not expect that adoption of FIN 47 will have a material effect on its consolidated financial position, consolidated results of operations, or liquidity. In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment ("SFAS No. 123(R)"). This statement is a revision of SFAS No. 123, Accounting for Stock-Based Compensation, and supercedes APB Opinion No. 25, Accounting for Stock Issued to Employees. This standard requires the Company to measure the cost of employee services received in exchange for equity awards based on the grant date fair value of the awards. The cost will be recognized as compensation expense over the vesting period of the awards. We anticipate adopting the provisions of SFAS No. 123(R) on January 1, 2006 using the modified prospective method. Accordingly, compensation expense will be recognized for all newly granted awards and awards modified, repurchased, or cancelled after January 1, 2006. Compensation cost for the unvested portion of awards that are outstanding as of January 1, 2006 will be recognized ratably over the remaining vesting period. The compensation cost for the unvested portion of awards will be based on the fair value at date of grant as calculated for our pro forma disclosure under SFAS 123. We estimate that the effect on net income and earnings per share in the periods following adoption of SFAS 123(R) will be consistent with the our pro forma disclosure under SFAS No. 123 included in the notes to our consolidated financial statements, except that estimated forfeitures will be considered in the calculation of compensation expense under SFAS 123(R) and will reduce the expense accordingly. Additionally, the actual effect on net income and earnings per share will vary depending upon the number of options granted in subsequent periods compared to prior years. In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4 ("SFAS No. 151"). SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to clarify the accounting for abnormal amounts of idle facility expense, handling costs and wasted material (spoilage). Among other provisions, the new rule requires that such items be recognized as current-period charges, regardless of whether they meet the criterion of "so abnormal" as stated in ARB No. 43. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. We do not expect that adoption of SFAS No. 151 will have a material effect on our consolidated financial position, consolidated results of operations, or liquidity. - 31 -
Application of Critical Accounting Estimates Our unaudited condensed consolidated financial statements are based on the selection of accounting policies and the application of significant accounting estimates, some of which require management to make significant assumptions. We believe that some of the more critical estimates and related assumptions that affect our financial condition and results of operations are in the areas of inventories, goodwill and other indefinite lived intangible assets, long-lived assets and income taxes. During the three months ended September 30, 2005, we did not change or adopt new accounting policies that had a material effect on our consolidated financial condition or results of operations. Contractual Obligations During 2004, we commenced the build out of our Alden Facility and our Tijuana Facility. These facilities will enable the Company to further consolidate its operations and implement state of the art manufacturing capabilities at both locations. The total remaining contractual obligation for construction of these facilities is $3.4 million and will be financed by existing cash, short term investments, and cash generated from operations. Litigation During 2002, a former non-medical customer commenced an action alleging that we used proprietary information of the customer to develop certain products. We have meritorious defenses and are vigorously defending the case. No accrual for an adverse judgment has been made as such outcome is not deemed probable. We estimate the potential risk of loss at between $0.0 and $1.75 million. - 32 -
Forward-Looking Statements Some of the statements contained in this Quarterly Report on Form 10-Q and other written and oral statements made from time to time by us and our representatives, are not statements of historical or current fact. As such, they are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We have based these forward-looking statements on our current expectations, which are subject to known and unknown risks, uncertainties and assumptions. They include statements relating to: o future sales, expenses and profitability; o the future development and expected growth of our business and the implantable medical device industry; o our ability to successfully execute our business model and our business strategy; o our ability to identify trends within the implantable medical devices, medical components, and commercial power sources industries and to offer products and services that meet the changing needs of those markets; o projected capital expenditures; and o trends in government regulation. You can identify forward-looking statements by terminology such as "may," "will," "should," "could," "expects," "intends," "plans," "anticipates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially from those suggested by these forward-looking statements. In evaluating these statements and our prospects generally, you should carefully consider the factors set forth below. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary factors and to others contained throughout this report. We are under no duty to update any of the forward-looking statements after the date of this report or to conform these statements to actual results. Although it is not possible to create a comprehensive list of all factors that may cause actual results to differ from the results expressed or implied by our forward-looking statements or that may affect our future results, some of these factors include the following: dependence upon a limited number of customers, product obsolescence, inability to market current or future products, pricing pressure from customers, reliance on third party suppliers for raw materials, products and subcomponents, fluctuating operating results, inability to maintain high quality standards for our products, challenges to our intellectual property rights, product liability claims, inability to successfully consummate and integrate acquisitions, unsuccessful expansion into new markets, competition, inability to obtain licenses to key technology, regulatory changes or consolidation in the healthcare industry, and other risks and uncertainties that arise from time to time as described in the Company's Annual Report on Form 10-K, including Exhibit 99.1 thereto, and other periodic filings with the Securities and Exchange Commission. - 33 -
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk. Under our line of credit any borrowings bear interest at fluctuating market rates. At September 30, 2005, we did not have any borrowings outstanding under our line of credit and thus no interest rate sensitive financial instruments. ITEM 4. Controls and Procedures. a. Evaluation of Disclosure Controls and Procedures. During the third quarter of 2005, our management, including the principal executive officer and principal financial officer, evaluated our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) related to the recording, processing, summarization and reporting of information in our reports that we file with the SEC. These disclosure controls and procedures have been designed to ensure that material information relating to us, including our subsidiaries, is made known to our management, including these officers, by other of our employees, and that this information is recorded, processed, summarized, evaluated and reported, as applicable, within the time periods specified in the SEC's rules and forms. Due to the inherent limitations of control systems, not all misstatements may be detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. Our controls and procedures can only provide reasonable, not absolute, assurance that the above objectives have been met. Based on their evaluation, as of September 30, 2005, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are effective to reasonably ensure that the information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. We evaluated our disclosure controls and procedures in light of the factors that led us to make the restatements reflected in this report. We determined that these adjustments were appropriate based on facts and circumstances as of September 30, 2005. We believe that our disclosure controls and procedures continue to be effective. b. Changes in Internal Control Over Financial Reporting. There have been no changes in our internal control over financial reporting that occurred during our last fiscal quarter to which this Quarterly Report on Form 10-Q relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. - 34 -
PART II -- OTHER INFORMATION ITEM 1. Legal Proceedings. During 2002, a former non-medical customer commenced an action alleging that the Company had used proprietary information of the customer to develop certain products. We have meritorious defenses and are vigorously defending the case. No accrual for an adverse judgment has been made as such outcome is not deemed probable. We estimate the potential risk of loss at between $0.0 and $1.75 million. ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds. None. ITEM 3. Defaults Upon Senior Securities. None. ITEM 4. Submission of Matters to a Vote of Security Holders. None. ITEM 5. Other Information. None. ITEM 6. Exhibits. See the Exhibit Index for a list of those exhibits filed herewith. - 35 -
SIGNATURES Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: November 9, 2005 GREATBATCH, INC. By /s/ Edward F. Voboril ----------------------------------------- Edward F. Voboril Chairman of the Board and Chief Executive Officer (Principal Executive Officer) By /s/ Thomas J. Mazza ---------------------------------------- Thomas J. Mazza Senior Vice President and Chief Financial Officer (Principal Financial Officer) By /s/ Marco F. Benedetti ----------------------------------------- Marco F. Benedetti Corporate Controller (Principal Accounting Officer) - 36 -
EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 3.1 Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to our quarterly report on Form 10-Q ended July 1, 2005). 3.2 Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to our quarterly report on Form 10-Q ended March 29, 2002). 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act. 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. - 37 -