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 quarterly period ended September 27, 2013
Commission File Number 1-16137
GREATBATCH, INC.
(Exact name of Registrant as specified in its charter)
(State
of incorporation)
(I.R.S. employer
identification no.)
2595 Dallas Parkway
Suite 310
Frisco, TX 75034
(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 checkmark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
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, $0.001 par value per share, as of November 5, 2013 was: 24,135,656 shares.
Greatbatch, Inc.
Table of Contents for Form 10-Q
As of and for the Quarterly Period Ended September 27, 2013
ITEM 1.
Financial Statements
Condensed Consolidated Balance Sheets—Unaudited
Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)—Unaudited
Condensed Consolidated Statements of Cash Flows—Unaudited
Condensed Consolidated Statement of Stockholders’ Equity—Unaudited
Notes to Condensed Consolidated Financial Statements—Unaudited
ITEM 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
ITEM 3.
Quantitative and Qualitative Disclosures About Market Risk
ITEM 4.
Controls and Procedures
Legal Proceedings
ITEM 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
ITEM 5.
Other Information
ITEM 6.
Exhibits
SIGNATURES
EXHIBIT INDEX
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PART I—FINANCIAL INFORMATION
CONDENSED CONSOLIDATED BALANCE SHEETS—Unaudited
(in thousands except share and per share data)
ASSETS
Current assets:
Cash and cash equivalents
Accounts receivable, net of allowance for doubtful accounts of $2.0 million in 2013 and $2.4 million in 2012
Inventories
Refundable income taxes
Deferred income taxes
Prepaid expenses and other current assets
Total current assets
Property, plant and equipment, net
Amortizing intangible assets, net
Indefinite-lived intangible assets
Goodwill
Other assets
Total assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable
Income taxes payable
Accrued expenses
Total current liabilities
Long-term debt
Other long-term liabilities
Total liabilities
Stockholders’ equity:
Preferred stock, $0.001 par value, authorized 100,000,000 shares; no shares issued or outstanding in 2013 or 2012
Common stock, $0.001 par value, authorized 100,000,000 shares; 24,141,395 shares issued and 24,119,390 shares outstanding in 2013 23,731,570 shares issued and 23,711,838 shares outstanding in 2012
Additional paid-in capital
Treasury stock, at cost, 22,005 shares in 2013 and 19,732 shares in 2012
Retained earnings
Accumulated other comprehensive income
Total stockholders’ equity
Total liabilities and stockholders’ equity
The accompanying notes are an integral part of these condensed consolidated financial statements.
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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)—Unaudited
(in thousands except per share data)
Sales
Cost of sales
Gross profit
Operating expenses:
Selling, general and administrative expenses
Research, development and engineering costs, net
Other operating expenses, net
Total operating expenses
Operating income
Interest expense
Other (income) expense, net
Income (loss) before provision for income taxes
Provision for income taxes
Net income (loss)
Earnings (loss) per share:
Basic
Diluted
Weighted average shares outstanding:
Comprehensive income (loss):
Other comprehensive income:
Foreign currency translation gain (loss)
Net change in cash flow hedges, net of tax
Defined benefit plan liability adjustment, net of tax
Other comprehensive income
Comprehensive income (loss)
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS—Unaudited
(in thousands)
Cash flows from operating activities:
Net income
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Debt related amortization included in interest expense
Stock-based compensation
Other non-cash losses
Changes in operating assets and liabilities, net of acquisitions:
Accounts receivable
Net cash provided by operating activities
Cash flows from investing activities:
Proceeds from sale of orthopaedic product lines (Note 9)
Acquisition of property, plant and equipment
Purchase of cost and equity method investments, net
Acquisitions, net of cash acquired
Other investing activities
Net cash used in investing activities
Cash flows from financing activities:
Principal payments of long-term debt
Proceeds from issuance of long-term debt
Issuance of common stock
Payment of debt issuance costs
Other financing activities
Net cash used in financing activities
Effect of foreign currency exchange rates on cash and cash equivalents
Net decrease in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
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CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY—Unaudited
At December 28, 2012
Net shares issued under stock incentive plans
Shares contributed to 401(k) Plan
Total other comprehensive income
At September 27, 2013
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – Unaudited
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 (Accounting Standards Codification (“ASC”) 270, Interim Reporting) 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 full presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of America (“GAAP”). 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. and its wholly-owned subsidiary, Greatbatch Ltd. (collectively “Greatbatch” or the “Company”), for the periods presented. The preparation of financial statements in conformity with GAAP 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 materially from these estimates. The December 28, 2012 condensed consolidated balance sheet data was derived from audited consolidated financial statements but does not include all disclosures required by GAAP. For further information, refer to the consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 28, 2012. The Company utilizes a fifty-two, fifty-three week fiscal year ending on the Friday nearest December 31st. The third quarter and year-to-date periods of 2013 and 2012 each contained 13 weeks and 39 weeks, respectively, and ended on September 27, and September 28, respectively.
NeuroNexus Technologies, Inc.
On February 16, 2012, the Company purchased all of the outstanding common stock of NeuroNexus Technologies, Inc. (“NeuroNexus”) headquartered in Ann Arbor, MI. NeuroNexus is an active implantable medical device design firm specializing in developing and commercializing neural interface technology, components and systems for neuroscience and clinical markets. NeuroNexus has an extensive intellectual property portfolio, core technologies and capabilities to support the development and manufacturing of neural interface devices across a wide range of applications including neuromodulation, sensing, optical stimulation and targeted drug delivery. The aggregate purchase price of NeuroNexus was $13.2 million. Total assets acquired from NeuroNexus were $14.6 million, of which $2.9 million were amortizing intangible assets and $8.9 million was allocated to goodwill.
This transaction was accounted for under the acquisition method of accounting. Accordingly, the operating results of NeuroNexus were included in the Company’s Implantable Medical segment from the date of acquisition and the purchase price was allocated to the assets acquired and liabilities assumed based on their fair values as of the close of the acquisition, with the amount exceeding the fair value of net assets acquired being recorded as goodwill. The purchase price of NeuroNexus consisted of cash payments of $11.7 million and potential future payments of up to an additional $2 million. These future payments are contingent upon the achievement of certain financial and development-based milestones and had an estimated fair value of $1.5 million as of the acquisition date. The valuation of the assets acquired and liabilities assumed from NeuroNexus was finalized during the first quarter of 2013 and did not result in a material adjustment to the original valuation of net assets acquired, including goodwill.
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Pro Forma Results (Unaudited)
The following unaudited pro forma information presents the consolidated results of operations of the Company and NeuroNexus as if that acquisition occurred as of the beginning of fiscal year 2012 (in thousands, except per share amounts):
The unaudited pro forma information presents the combined operating results of Greatbatch and NeuroNexus, with the results prior to the acquisition date adjusted to include the pro forma impact of the amortization of acquired intangible assets based on the purchase price allocations, the adjustment to interest expense reflecting the amount borrowed in connection with the acquisition at Greatbatch’s interest rate, and the impact of income taxes on the pro forma adjustments utilizing the applicable statutory tax rate. The unaudited pro forma consolidated basic and diluted earnings (loss) per share calculations are based on the consolidated basic and diluted weighted average shares of Greatbatch.
The unaudited pro forma results are presented for illustrative purposes only and do not reflect the realization of potential cost savings, and any related integration costs. Certain cost savings may result from the acquisition; however, there can be no assurance that these cost savings will be achieved. These pro forma results do not purport to be indicative of the results that would have been obtained, or to be a projection of results that may be obtained in the future.
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Noncash investing and financing activities:
Common stock contributed to 401(k) Plan
Property, plant and equipment purchases included in accounts payable
Cash paid during the period for:
Interest
Income taxes
Acquisition of noncash assets
Liabilities assumed
Inventories are comprised of the following (in thousands):
Raw materials
Work-in-process
Finished goods
Total
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Amortizing intangible assets are comprised of the following (in thousands):
Technology and patents
Customer lists
Other
Total amortizing intangible assets
Aggregate intangible asset amortization expense is comprised of the following (in thousands):
Total intangible asset amortization expense
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Estimated future intangible asset amortization expense based on the current carrying value is as follows (in thousands):
Remainder of 2013
2014
2015
2016
2017
Thereafter
Total estimated amortization expense
Indefinite-lived intangible assets are comprised of the following (in thousands):
Indefinite-lived asset write-off
The change in goodwill is as follows (in thousands):
Goodwill disposed (Note 9)
Foreign currency translation
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Long-term debt is comprised of the following (in thousands):
Revolving line of credit
Variable rate term loan
2.25% convertible subordinated notes
Unamortized discount
Total long-term debt
Credit Facility – In September 2013, the Company amended and extended its credit facility (the “Credit Facility”). The new Credit Facility provides a $300 million revolving credit facility (the “Revolving Credit Facility”), a $200 million term loan (the “Term Loan”), a $15 million letter of credit subfacility, and a $15 million swingline subfacility. The Credit Facility can be increased by $200 million upon the Company’s request and approval by the lenders. The Revolving Credit Facility has a maturity date of September 20, 2018, which may be extended to September 20, 2019 upon notice by the Company and subject to certain conditions. The principal of the Term Loan is payable in quarterly installments as specified in the Credit Facility until its maturity date of September 20, 2019 when the unpaid balance is due in full.
The Credit Facility is secured by the Company’s non-realty assets including cash, accounts receivable and inventories. Interest rates on the revolving and term loans under the Credit Facility are, at the Company’s option either at: (i) the prime rate plus the applicable margin, which ranges between 0.0% and 0.75%, based on the Company’s total leverage ratio or (ii) the applicable LIBOR rate plus the applicable margin, which ranges between 1.375% and 2.75%, based on the Company’s total leverage ratio. Loans under the swingline subfacility will bear interest at the prime rate plus the applicable margin, which ranges between 0.0% and 0.75%, based on the Company’s total leverage ratio. The Company is also required to pay a commitment fee, which varies between 0.175% and 0.25% depending on the Company’s total leverage ratio.
The Credit Facility contains limitations on the incurrence of indebtedness, liens and licensing of intellectual property, investments and certain payments. The Credit Facility permits the Company to engage in the following activities up to an aggregate amount of $300 million: 1) engage in permitted acquisitions in the aggregate not to exceed $250 million; 2) make other investments in the aggregate not to exceed $100 million; 3) make stock repurchases and declare dividends not to exceed $150 million in the aggregate; and 4) make investments in foreign subsidiaries not to exceed $20 million in the aggregate. At any time that the total leverage ratio of the Company for the two most recently ended fiscal quarters is less than 2.75 to 1.0, the Company may make an election to reset each of the amounts specified above. Additionally, these limitations can be waived upon the Company’s request and approval of a majority of the lenders. As of September 27, 2013, the Company had available to it 100% of the above limits except for the aggregate limit and other investments limit which are now $299 million and $99 million, respectively.
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The Credit Facility requires the Company to maintain a rolling four quarter ratio of adjusted EBITDA to interest expense of at least 3.0 to 1.0, and a total leverage ratio of not greater than 4.5 to 1.0 and a total leverage ratio not greater than 4.25 to 1.0 after January 2, 2016. The calculation of adjusted EBITDA and total leverage ratio excludes non-cash charges, extraordinary, unusual, or non-recurring expenses or losses, non-cash stock-based compensation, and non-recurring expenses or charges incurred in connection with permitted acquisitions. As of September 27, 2013, the Company was in compliance with all covenants under the Credit Facility.
The Credit Facility contains customary events of default. Upon the occurrence and during the continuance of an event of default, a majority of the lenders may declare the outstanding advances and all other obligations under the Credit Facility immediately due and payable.
As of September 27, 2013, the weighted average interest rate on borrowings under the Credit Facility, which does not take into account the impact of the Company’s interest rate swap, was 1.81%. As of September 27, 2013, the Company had $290 million of borrowing capacity available under the Credit Facility. This borrowing capacity may vary from period to period based upon the debt and EBITDA levels of the Company, which impacts the covenant calculations described above.
Interest Rate Swap – From time to time, the Company enters into interest rate swap agreements in order to hedge against potential changes in cash flows on the outstanding borrowings on the Credit Facility. The variable rate received on the interest rate swaps and the variable rate paid on the debt have the same rate of interest, excluding the credit spread, and resets and pays interest on the same date. During 2012, the Company entered into a three-year $150 million interest rate swap, which amortizes $50 million per year. This swap was entered into in order to hedge against potential changes in cash flows on the outstanding Credit Facility borrowings, which are also indexed to the one-month LIBOR rate. This swap is being accounted for as a cash flow hedge. Information regarding the Company’s outstanding interest rate swap as of September 27, 2013 is as follows (dollars in thousands):
Instrument
Interest rate swap
The estimated fair value of the interest rate swap agreement represents the amount the Company expects to receive (pay) to terminate the contract. No portion of the change in fair value of the Company’s interest rate swap during the nine months ended September 27, 2013 was considered ineffective. The amount recorded as Interest Expense during the three and nine months ended September 27, 2013 related to the Company’s interest rate swap was $0.1 million and $0.3 million, respectively.
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Convertible Subordinated Notes – In March 2007, the Company issued $197.8 million of convertible subordinated notes (“CSN”) at a 5% discount. CSN accrued interest at 2.25% per annum. The effective interest rate of CSN, which took into consideration the amortization of the discount and deferred fees related to the issuance of these notes, was 8.5%. On February 20, 2013, the Company redeemed all outstanding CSN.
The contractual interest and discount amortization for CSN were as follows (in thousands):
Contractual interest
Discount amortization
The expected future minimum principal payments under the Credit Facility as of September 27, 2013 is as follows (in thousands):
The Company has the ability and intent to use availability under the Revolving Credit Facility to fund principal payments on the Term Loan.
Deferred Financing Fees - The change in deferred financing fees is as follows (in thousands):
Financing costs deferred
Write-off during the period
Amortization during the period
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The Company is required to provide its employees located in Switzerland, Mexico and France certain statutorily mandated defined benefits. Under these plans, benefits accrue to employees based upon years of service, position, age and compensation. The defined benefit plan provided to employees located in Switzerland is a funded contributory plan while the plans that provide benefits to employees located in Mexico and France are unfunded and noncontributory. The liability and corresponding expense related to these benefit plans is based on actuarial computations of current and future benefits for employees.
During 2012, the Company transferred manufacturing and development operations performed at its facilities in Switzerland into other existing facilities. As a result, the Company curtailed its defined benefit plan provided to employees at those Swiss facilities during the third quarter of 2012. In accordance with ASC 715, the gain recognized in connection with this curtailment is realized as the related employees are terminated. As nearly all of the Swiss pension liability is expected to be paid in 2013, the Company moved all Swiss pension plan assets into cash accounts during 2012. Swiss plan assets are expected to be sufficient to cover plan liabilities. During 2013, the Company settled approximately $7.7 million of its defined benefit obligation.
The change in net defined benefit plan liability is as follows (in thousands):
Service cost
Interest cost
Curtailment
Actuarial gain
Benefit payments
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Amounts recognized in Accumulated Other Comprehensive Income are as follows (in thousands):
Net gain occurring during the period
Amortization of losses
Prior service cost
Pre-tax adjustment
Taxes
Net gain
Net defined benefit cost (income) is comprised of the following (in thousands):
Curtailment gain (Other Operating Expenses, Net)
Amortization of net loss
Expected return on plan assets
Net defined benefit (income) cost
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The components and classification of stock-based compensation expense were as follows (in thousands):
Stock options
Restricted stock and units
401(k) stock contribution
Total stock-based compensation expense
Selling, general and administrative
Research, development and engineering
2013 operating unit realignment modification expense – Other Operating Expenses, Net (Note 9)
The weighted average fair value and assumptions used to value options granted are as follows:
Weighted average fair value
Risk-free interest rate
Expected volatility
Expected life (in years)
Expected dividend yield
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The following table summarizes time-vested stock option activity:
Outstanding at December 28, 2012
Granted
Exercised
Forfeited or expired
Outstanding at September 27, 2013
Exercisable at September 27, 2013
The following table summarizes performance-vested stock option activity:
The following table summarizes time-vested restricted stock and unit activity:
Nonvested at December 28, 2012
Vested
Forfeited
Nonvested at September 27, 2013
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The following table summarizes performance-vested restricted stock and unit activity:
Other Operating Expenses, Net is comprised of the following (in thousands):
2013 operating unit realignment
Orthopaedic facility optimization
Medical device facility optimization
ERP system upgrade
Acquisition and integration (income) costs
Asset dispositions, severance and other
2013 operating unit realignment. In June 2013, the Company initiated a plan to realign its operating structure in order to optimize its continued focus on profitable growth. As part of this initiative, the sales and marketing and operations groups of its Implantable Medical and Electrochem segments were combined into one sales and marketing and one operations group serving the entire Company. Total restructuring charges expected to be incurred in connection with this realignment is between $6.2 million and $7.0 million, of which $3.1 million has been incurred to date. Expenses related to this initiative will be recorded within the applicable segment and corporate cost centers that the expenditures relate to and include the following:
Other costs primarily consist of relocation, recruitment and travel expenditures.
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The change in accrued liabilities related to the 2013 operating unit realignment is as follows (in thousands):
Restructuring charges
Non-cash settlement (modification expense – Note 8)
Cash payments
Orthopaedic facility optimization. In 2010, the Company began updating its Indianapolis, IN facility to streamline operations, consolidate two buildings, increase capacity, further expand capabilities and reduce dependence on outside suppliers. This initiative was completed in 2011.
In 2011, the Company began construction on an orthopaedic manufacturing facility in Fort Wayne, IN and transferred the manufacturing operations being performed at its Columbia City, IN facility into this new facility. This initiative was completed in 2012.
During 2012, the Company transferred manufacturing and development operations performed at its facilities in Orvin and Corgemont, Switzerland into existing facilities in Fort Wayne, IN and Tijuana, Mexico. In connection with this consolidation, in 2012, the Company entered into an agreement to sell assets related to certain non-core Swiss orthopaedic product lines to an independent third party including inventory, machinery, equipment, customer lists and technology related to these product lines. As these product lines were considered a business, goodwill was allocated to the transaction (See Note 5). As these product lines did not have cash flows that were clearly distinguishable, both operationally and for financial reporting purposes, from the rest of the Company, they were not considered discontinued operations. This transaction closed in the first quarter of 2013 and no additional loss on sale was recognized. During 2013, the Company received payments totaling $3.2 million in connection with this transaction and the third party assumed $2.4 million of severance liabilities.
The total capital investment expected for these initiatives is between $25 million and $30 million, of which $22.0 million has been expended to date. Total expense expected to be incurred for these initiatives is between $40 million and $41 million, of which $39.9 million has been incurred to date. All expenses will be recorded within the Implantable Medical segment and are expected to include the following:
Other costs include production inefficiencies, moving, revalidation, personnel, training and travel costs associated with these consolidation projects.
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The change in accrued liabilities related to the orthopaedic facility optimization is as follows (in thousands):
Write-offs
Liability assumed by third party
Medical device facility optimization. Near the end of 2011, the Company initiated plans to upgrade and expand its manufacturing infrastructure in order to support its medical device strategy. This includes the transfer of certain product lines to create additional capacity for the manufacture of medical devices, expansion of two existing facilities, as well as the purchase of equipment to enable the production of medical devices. These initiatives are expected to be completed over the next year. Total capital investment under these initiatives is expected to be between $15 million and $20 million of which approximately $12.4 million has been expended to date. Total expenses expected to be incurred on these projects is between $2.0 million and $3.0 million, of which $1.8 million has been incurred to date. All expenses will be recorded within the Implantable Medical segment and are expected to include the following:
The change in accrued liabilities related to the medical device facility optimization is as follows (in thousands):
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ERP system upgrade. In 2011, the Company initiated plans to upgrade its existing global ERP system. This initiative is expected to be completed over the next six months. Total capital investment under this initiative is expected to be between $4.5 million to $5 million of which approximately $4.3 million has been expended to date. Total expenses expected to be incurred on this initiative is between $6 million to $7 million, of which $5.3 million has been incurred to date. Expenses related to this initiative will be recorded within the applicable segment and corporate cost centers that the expenditures relate to and include the following:
The change in accrued liabilities related to the ERP system upgrade is as follows (in thousands):
Charges
Acquisition and integration (income) costs. During 2013 and 2012, the Company incurred costs (income) related to the integration of Micro Power Electronics, Inc. and NeuroNexus, which were acquired in December 2011 and February 2012, respectively. These expenses were primarily for retention bonuses, travel costs in connection with integration efforts, training, severance, and the change in fair value of the contingent consideration recorded in connection with these acquisitions.
Asset dispositions, severance and other. During 2013 and 2012, the Company recorded (gains) losses in connection with various asset disposals and/or write-down’s. Additionally, during the second quarter of 2012, the Company incurred $1.2 million of costs related to the relocation of its global headquarters to Frisco, Texas.
The income tax provision for interim periods is determined using an estimate of the annual effective tax rate, adjusted for discrete items, if any, that are taken into account in the relevant period. Each quarter, the estimate of the annual effective tax rate is updated, and if the estimated effective tax rate changes, a cumulative adjustment is made. There is a potential for volatility of the effective tax rate due to several factors, including changes in the mix of the pre-tax income and the jurisdictions to which it relates, changes in tax laws and foreign tax holidays, business reorganizations, settlements with taxing authorities and foreign currency fluctuations.
As of September 27, 2013, the balance of unrecognized tax benefits is approximately $1.4 million. It is reasonably possible that a reduction of up to $0.1 million of the balance of unrecognized tax benefits may occur within the next twelve months as a result of potential audit settlements. Approximately $1.2 million of the balance of unrecognized tax benefits would favorably impact the effective tax rate, net of federal benefit on state issues, if recognized.
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As a result of the repayment of CSN during the first quarter of 2013, the Company reclassified $30.4 million of Long-Term Deferred Income Taxes to Income Taxes Payable of which approximately $8.0 million was paid in the third quarter of 2013 and $19.6 million was paid in the first nine months of 2013.
Litigation – The Company is a party to various legal actions arising in the normal course of business. While the Company does not believe that the ultimate resolution of any such pending actions will have a material effect on its results of operations, financial position, or cash flows, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material impact in the period in which the ruling occurs.
During 2012, Electrochem and several other unaffiliated parties were named as defendants in a personal injury and wrongful death action filed in the 113th Judicial District Court of Harris County, Texas. The complaint seeks damages alleging marketing defects and failure to warn, negligence and gross negligence relating to a product Electrochem manufactured and sold to a customer, one of the other named defendants, which, in turn, incorporated the Electrochem product into its own product which it sold to its customer, another named defendant. The cost of defense in this matter is the responsibility of Electrochem’s customer. Electrochem also has product liability insurance coverage. Electrochem believes that it has meritorious defenses and it intends to vigorously defend the matter. Given the early stages of this action, the amount of loss or range of possible loss cannot be reasonably estimated at this time.
Product Warranties– The Company generally warrants that its products will meet customer specifications and will be free from defects in materials and workmanship. The change in aggregate product warranty liability is as follows (in thousands):
Additions to warranty reserve
Warranty claims paid
Contractual Obligations – Contractual obligations are defined as agreements that are enforceable and legally binding on the Company and that specify all significant terms, including: fixed or minimum obligations; fixed or minimum price provisions; and the approximate timing of the transaction. The Company’s contractual obligations are normally fulfilled within short time horizons. The Company also enters into blanket orders with vendors that have preferred pricing and terms, however these orders are normally cancelable without penalty. As of September 27, 2013, the total contractual obligations of the Company are approximately $24.1 million and will primarily be funded by existing cash and cash equivalents, cash flow from operations, or the Credit Facility. The Company also enters into contracts for outsourced services; however, the obligations under these contracts were not significant and the contracts generally contain clauses allowing for cancellation without significant penalty.
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Operating Leases – The Company is a party to various operating lease agreements for buildings, equipment and software. Estimated future operating lease expense is as follows (in thousands):
Total estimated operating lease expense
Foreign Currency Contracts – The Company enters into forward contracts to purchase Mexican pesos in order to hedge the risk of peso-denominated payments associated with the operations at its Tijuana, Mexico facility. The impact to the Company’s results of operations from these forward contracts was as follows (in thousands):
Increase (reduction) in cost of sales
Ineffective portion of change in fair value
Type ofHedge
Balance Sheet Location
FX Contract
Self-Insured Medical Plan – The Company self-funds the medical insurance coverage provided to its U.S. based employees. The risk to the Company is being limited through the use of stop loss insurance, which has specific stop loss coverage per associate for claims in the year exceeding $225 thousand per associate with no annual maximum aggregate stop loss coverage. As of September 27, 2013, the Company has $1.9 million accrued related to the self-insurance of its medical plan, which is recorded in Accrued Expenses in the Condensed Consolidated Balance Sheet, and is primarily based upon claim history.
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The following table illustrates the calculation of Basic and Diluted EPS (in thousands, except per share amounts):
Numerator for basic and diluted EPS:
Denominator for basic EPS:
Weighted average shares outstanding
Effect of dilutive securities:
Stock options, restricted stock and restricted stock units
Denominator for diluted EPS
Basic EPS
Diluted EPS
The diluted weighted average share calculations do not include the following securities, which are not dilutive to the EPS calculations or the performance criteria have not been met:
Time-vested stock options, restricted stock and restricted stock units
Performance-vested stock options and restricted stock units
For the 2013 and 2012 periods, no shares related to CSN were included in the diluted EPS calculations as the average share price of the Company’s common stock for those periods did not exceed CSN’s conversion price per share.
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Accumulated Other Comprehensive Income for the quarter and year to date periods are as follows (in thousands):
At June 28, 2013
Unrealized loss on cash flow hedges
Realized gain on foreign currency hedges
Realized loss on interest rate swap hedges
Foreign currency translation gain
Unrealized gain on cash flow hedges
Net defined benefit plan gain (Note 7)
The realized (gain) loss relating to the Company’s foreign currency and interest rate swap hedges was reclassified from Accumulated Other Comprehensive Income and included in Cost of Sales and Interest Expense, respectively, in the Condensed Consolidated Statements of Operations.
Assets and Liabilities Measured at Fair Value on a Recurring Basis
Fair value measurement standards apply to certain financial assets and liabilities that are measured at fair value on a recurring basis (each reporting period). For the Company, these financial assets and liabilities include its derivative instruments and accrued contingent consideration. The Company does not have any nonfinancial assets or liabilities that are measured at fair value on a recurring basis.
Foreign currency contracts – The fair value of foreign currency contracts are determined through the use of cash flow models that utilize observable market data inputs to estimate fair value. These observable market data inputs include foreign exchange rate and credit spread curves. In addition to the above, the Company receives fair value estimates from the foreign currency contract counterparty to verify the reasonableness of the Company’s estimates. The Company’s foreign currency contracts are categorized in Level 2 of the fair value hierarchy. The fair value of the Company’s foreign currency contracts will be realized as Cost of Sales as the inventory, which the contracts are hedging the cash flows to produce, is sold, of which approximately $0.04 million is expected to be realized within the next twelve months.
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Interest rate swap – The fair value of the Company’s interest rate swap outstanding at September 27, 2013 was determined through the use of a cash flow model that utilizes observable market data inputs. These observable market data inputs include LIBOR, swap rates, and credit spread curves. In addition to the above, the Company received a fair value estimate from the interest rate swap counterparty to verify the reasonableness of the Company’s estimate. This fair value calculation was categorized in Level 2 of the fair value hierarchy. The fair value of the Company’s interest rate swap will be realized as Interest Expense as interest on the Company’s Credit Facility is accrued.
Accrued contingent consideration – In circumstances where an acquisition involves a contingent consideration arrangement, the Company recognizes a liability equal to the fair value of the contingent payments it expects to make as of the acquisition date. The Company re-measures this liability each reporting period and records changes in the fair value through Other Operating Expenses, Net. Increases or decreases in the fair value of the contingent consideration liability can result from changes in discount periods and rates, as well as changes in the timing, amount of, or the likelihood of achieving the applicable milestones.
The fair value of accrued contingent consideration recorded by the Company represents the estimated fair value of the contingent consideration the Company expects to pay to the former shareholders of NeuroNexus based upon the achievement of certain financial and development-based milestones. The fair value of the contingent consideration liability was estimated by discounting to present value, the probability weighted contingent payments expected to be made. The maximum amount of future contingent consideration (undiscounted) that the Company could be required to pay is $2.0 million. The Company’s accrued contingent consideration is categorized in Level 3 of the fair value hierarchy. Changes in accrued contingent consideration were as follows (in thousands):
Fair value adjustments
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The recurring Level 3 fair value measurements of the Company’s contingent consideration liability include the following significant unobservable inputs (dollars in thousands):
Liability
Technique
Inputs
Financial milestones
Development milestones
The following table provides information regarding assets and liabilities recorded at fair value on a recurring basis in the Condensed Consolidated Balance Sheet (in thousands):
Description
Assets
Foreign currency contracts (Note 11)
Liabilities
Interest rate swap (Note 6)
Accrued contingent consideration
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Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
Fair value standards also apply to certain nonfinancial assets and liabilities that are measured at fair value on a nonrecurring basis. As of September 27, 2013, the fair value of the Company’s variable rate Long-Term Debt approximates its carrying value. A summary of the valuation methodologies for the Company’s assets and liabilities measured on a nonrecurring basis is as follows:
Long-lived assets – The Company reviews the carrying amount of its long-lived assets to be held and used, other than goodwill and indefinite-lived intangible assets, for potential impairment whenever certain indicators are present such as: a significant decrease in the market price of the asset or asset group; a significant change in the extent or manner in which the long-lived asset or asset group is being used or in its physical condition; a significant change in legal factors or in the business climate that could affect the value of the long-lived asset or asset group, including an action or assessment by a regulator; an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the asset; a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of the long-lived asset or asset group; or a current expectation that it is more likely than not the long-lived asset or asset group will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. The term more likely than not refers to a level of likelihood that is more than 50 percent.
If an indicator is present, potential recoverability is measured by comparing the carrying amount of the long-lived asset or asset group to its related total future undiscounted cash flows. If the carrying value is not recoverable, the asset or asset group is considered to be impaired. Impairment is measured by comparing the asset or asset group’s carrying amount to its fair value, which is determined by using independent appraisals or discounted cash flow models. The discounted cash flow model requires inputs such as a risk-adjusted discount rate, terminal values, operating budgets, long-term strategic plans and remaining useful lives of the asset or asset group. If the carrying value of the long-lived asset or asset group exceeds the fair value, the carrying value is written down to the fair value in the period identified. The Company did not record any impairment charge related to its long-lived assets, other than goodwill and indefinite-lived intangible assets, during the first nine months of 2013. During the first nine months of 2012, the Company recorded an impairment charge to Other Operating Expenses, Net of $0.3 million relating to the write-off of a definite-lived intangible asset.
Goodwill and indefinite-lived intangible assets– The Company assess the impairment of goodwill and other indefinite-lived intangible assets on the last day of each fiscal year, or more frequently if certain indicators are present as described above under long-lived assets. The Company assesses goodwill for impairment by comparing the fair value of its reporting units to their carrying amounts. If the fair value of a reporting unit is less than its carrying value, an impairment loss is recorded to the extent that the implied fair value of the goodwill within the reporting unit is less than its carrying value. Fair values for reporting units are determined based on discounted cash flow models and market multiples. The discounted cash flow model requires inputs such as a risk-adjusted discount rate, terminal values, operating budgets, and long-term strategic plans. The fair value from the discounted cash flow model is then combined, based on certain weightings, with market multiples in order to determine the fair value of the reporting unit. These market multiples include revenue multiples and multiples of earnings before interest, taxes, depreciation and amortization.
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Indefinite-lived intangible assets are assessed for impairment by comparing the fair value of the intangible asset to its carrying value. If the carrying value of the indefinite-lived intangible asset exceeds the fair value, the carrying value is written down to the fair value in the period identified. The fair value of indefinite-lived intangible assets is determined by using a discounted cash flow model. The discounted cash flow model requires inputs such as a risk-adjusted discount rate, royalty rates, operating budgets, and long-term strategic plans.
The Company recorded impairment charges in Other Operating Expenses, Net related to its indefinite-lived intangible assets, excluding goodwill, of $0.4 million and $0 during the first nine months of 2013 and 2012, respectively. No impairment loss was recorded for goodwill during the first nine months of 2013 or 2012. Note 5 “Intangible Assets” contains additional information on the Company’s intangible assets.
Cost and equity method investments – The Company holds investments in equity and other securities that are accounted for as either cost or equity method investments and are classified as Other Assets. The total carrying value of these investments is reviewed quarterly for changes in circumstance or the occurrence of events that suggest the Company’s investment may not be recoverable. The fair value of cost or equity method investments is not adjusted if there are no identified events or changes in circumstances that may have a material effect on the fair value of the investments. Gains and losses realized on cost and equity method investments are recorded in Other (Income) Expense, Net, unless separately stated. The aggregate recorded amount of cost and equity method investments at September 27, 2013 and December 28, 2012 was $10.6 million and $9.1 million, respectively. The Company recorded losses related to its cost and equity method investments of $0.6 million and $0 during the first nine months of 2013 and 2012, respectively.
The Company currently operates its business in two reportable segments – Implantable Medical and Electrochem. The Implantable Medical segment is comprised of Greatbatch Medical and QiG Group and designs and manufactures medical devices and components for the cardiac, neuromodulation, vascular and orthopaedic markets. The Implantable Medical segment offers complete medical devices including design, development, manufacturing, regulatory submission and supporting worldwide distribution, which is facilitated through the QiG Group and leverages the component technology of Greatbatch Medical. The devices designed and developed by the QiG Group are manufactured by Greatbatch Medical. The Implantable Medical segment also offers individual components for implantable medical devices as well as value-added assembly and design engineering services for its component products. Examples of these components include batteries, capacitors, filtered and un-filtered feedthroughs, machined components, enclosures, leads, introducers, catheters, as well as orthopaedic implants, instruments and cases and trays.
Electrochem is an industry leader in designing and manufacturing total power solutions for critical applications with market-leading OEMs, largely in the portable medical and energy space. Electrochem offers its customers components, consultation, design, development and testing for medical device applications, in high-value markets, including those that support the transition of delivery of health care from clinical to outpatient and home settings, as well as those that enhance the quality of life for an aging population. Examples of these devices include powered surgical tools, automated external defibrillators, portable ultrasound devices, portable oxygen concentrators, and ventilators, among others. Electrochem provides cell and battery pack configurations for rechargeable and non-rechargeable battery power systems, charging and docking stations, and power supplies, for devices where failure is not an option.
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As discussed further in Note 9 “Other Operating Expenses, Net,” in June 2013, the Company initiated a plan to realign its operating structure in order to optimize its continued focus on profitable growth. As part of this initiative, the sales and marketing and operations groups of its Implantable Medical and Electrochem segments were combined into one sales and marketing and one operations group serving the entire Company. As a result of this realignment initiative, which includes changing the management and reporting structure, the Company is re-evaluating its operating and reportable segments.
The Company defines segment income from operations as sales less cost of sales including amortization and expenses attributable to segment-specific selling, general, administrative, research, development, engineering and other operating activities. Segment income also includes a portion of non-segment specific selling, general, and administrative expenses based on allocations appropriate to the expense categories. The remaining unallocated operating and other expenses are primarily administrative corporate headquarters expenses and capital costs that are not allocated to reportable segments. Transactions between the two segments are not significant.
An analysis and reconciliation of the Company’s business segment, product line and geographic information to the respective information in the Condensed Consolidated Financial Statements follows. Sales by geographic area are presented by allocating sales from external customers based on the location to which products are shipped (in thousands):
Sales:
Implantable Medical
Cardiac/Neuromodulation
Orthopaedic
Vascular
Total Implantable Medical
Electrochem
Portable Medical
Energy
Total Electrochem
Total sales
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Segment income from operations:
Total segment income from operations
Unallocated operating expenses
Operating income as reported
Unallocated other expense
Sales by geographic area:
United States
Non-Domestic locations:
Puerto Rico
Belgium
Rest of world
Three customers accounted for a significant portion of the Company’s sales as follows:
Customer A
Customer B
Customer C
Long-lived tangible assets by geographic area are as follows (in thousands):
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In the normal course of business, management evaluates all new accounting pronouncements issued by the Financial Accounting Standards Board (“FASB”), Securities and Exchange Commission, Emerging Issues Task Force, American Institute of Certified Public Accountants or other authoritative accounting bodies to determine the potential impact they may have on the Company’s Condensed Consolidated Financial Statements. Based upon this review except as noted below, management does not expect any of the recently issued accounting pronouncements, which have not already been adopted, to have a material impact on the Company’s Condensed Consolidated Financial Statements.
On February 5, 2013, the FASB issued Accounting Standards Update (“ASU”) 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” This ASU added new disclosure requirements regarding the effect of significant amounts reclassified from each component of accumulated other comprehensive income (“AOCI”) based on its source and the income statement line items affected by the reclassification. This ASU gave companies the flexibility to present the information either in the notes or parenthetically on the face of the financial statements provided that all of the required information is presented in a single location. This ASU was effective prospectively for annual and interim reporting periods beginning after December 15, 2012. This ASU was adopted during the first quarter of 2013 and did not have a material impact on the Company’s Condensed Consolidated Financial Statements as it only changed the disclosures surrounding AOCI.
In July 2012, the FASB issued ASU No. 2012-02, “Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment.” This ASU simplified the guidance for testing the decline in the realizable value (impairment) of indefinite-lived intangible assets other than goodwill. The amendment allowed an organization the option to first assess qualitative factors to determine whether it is necessary to perform the quantitative impairment test. An organization electing to perform a qualitative assessment is no longer required to calculate the fair value of an indefinite-lived intangible asset unless the organization determines, based on a qualitative assessment, that it is “more likely than not” that the asset is impaired. The amendments in this ASU were effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. This ASU did not have a material impact on the Company’s Condensed Consolidated Financial Statements as it only impacted the timing of when the Company was required to perform the two-step impairment test of its indefinite-lived intangible assets other than goodwill.
In December 2011, the FASB issued ASU No. 2011-11 “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” This ASU requires companies to provide expanded disclosures about trading in financial instruments and related derivatives, and creates new disclosure requirements about the nature of an entity’s rights of offset and related arrangements associated with its financial instruments and derivative instruments. The disclosure requirements are effective for annual reporting periods beginning on or after January 1, 2013, and interim periods therein, with retrospective application required. This ASU did not have a material impact on the Company’s Condensed Consolidated Financial Statements as it only changes the disclosures surrounding the Company’s offsetting assets and liabilities.
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Our Business
We currently operate our business in two reportable segments – Implantable Medical and Electrochem Solutions (“Electrochem”). The Implantable Medical segment is comprised of our Greatbatch Medical and QiG Group and designs and manufactures medical devices and components for the cardiac, neuromodulation, vascular and orthopaedic markets. The Implantable Medical segment offers complete medical devices including design, development, manufacturing, regulatory submission and supporting worldwide distribution, which is facilitated through the QiG Group and leverages the component technology of Greatbatch Medical. The devices designed and developed by the QiG Group are manufactured by Greatbatch Medical. The Implantable Medical segment also offers individual components for implantable medical devices as well as value-added assembly and design engineering services for its component products. Examples of these components include batteries, capacitors, filtered and unfiltered feedthroughs, machined components, enclosures, leads, introducers, catheters, as well as orthopaedic implants, instruments and cases and trays.
Electrochem is an industry leader in designing and manufacturing total power solutions for critical applications with market-leading OEMs, largely in the portable medical and energy space. Electrochem offers its customers components, consultation, design, development and testing for medical device applications in high-value markets, including those that support the transition of delivery of health care from clinical to outpatient and home settings, as well as those that enhance the quality of life for an aging population. Examples of these devices include powered surgical tools, automated external defibrillators, portable ultrasound devices, portable oxygen concentrators, and ventilators, among others. Electrochem provides cell and battery pack configurations for rechargeable and non-rechargeable battery power systems, charging and docking stations, and power supplies, for devices where failure is not an option.
As discussed in Note 9 “Other Operating Expenses, Net” of the Notes to Condensed Consolidated Financial Statements in Item 1 of this report, in June 2013, we initiated a plan to realign our operating structure in order to optimize our continued focus on profitable growth. Under this initiative, the sales and marketing and operations groups of our Implantable Medical and Electrochem segments were combined into one sales and marketing and one operations group serving the entire Company. As a result of this realignment initiative, which includes changing the management and reporting structure, we are re-evaluating our operating and reportable segments.
Our Customers
Implantable Medical customers include leading original equipment manufacturers (“OEMs”), in alphabetical order here and throughout this report, such as Biotronik, Boston Scientific, Johnson & Johnson, Medtronic, Smith & Nephew, Sorin Group, St. Jude Medical, Stryker and Zimmer. The nature and extent of our selling relationships with each OEM varies in terms of breadth of products purchased, purchased product volumes, length of contractual commitment, ordering patterns, inventory management and selling prices. During the nine months ended September 27, 2013, Johnson & Johnson, Medtronic and St. Jude Medical collectively accounted for 49% of our total Company sales.
Electrochem’s customers are primarily companies involved in demanding markets with sophisticated total power solutions needs, such as in the portable medical and energy markets. Some of Electrochem’s larger OEM customers are, in alphabetical order here and throughout this report, Carefusion, Covidien, Ethicon Endo-Surgery, Halliburton, Phillips Healthcare, Physio-Control, and Weatherford International.
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Financial Overview
Third quarter 2013 sales increased $6.4 million over the prior year period to $167.7 million. After adjusting sales by $3.2 million for the divestiture of certain non-core orthopaedic product lines during the first quarter of 2013 and approximately $1 million for the positive impact of foreign currency exchange rate fluctuations in comparison to the prior year, sales increased $8.6 million or 5% organically. This growth was primarily due to increased sales and marketing investment in our cardiac/neuromodulation product line, as well as orthopaedic market share gains, which helped drive 8% and 22% organic constant currency growth, respectively. This growth was partially offset by a $1.4 million and $1.9 million decline in vascular and Electrochem sales, respectively, due to the previously disclosed voluntary recall of two vascular medical devices and continued pricing discipline in our Electrochem product lines resulting in the rationalization of some lower-margin business. For the first nine months of 2013, sales of $487.3 million were consistent with the prior year period. On an organic constant currency basis, sales for the first nine months of 2013 increased 2% in comparison to 2012 as strong cardiac/neuromodulation and orthopaedics sales in the second and third quarter of 2013 were partially offset by slower demand in the first quarter of 2013 due to customer inventory adjustments and the impact of our Swiss consolidation. For the remainder of 2013, we expect Implantable Medical revenue to remain strong as new product introductions are commercialized, as we further partner across business lines with our large OEM customers, and as we further leverage our sales and marketing resources to drive core business growth.
We prepare our condensed consolidated financial statements in accordance with generally accepted accounting principles in the United States of America (“GAAP”). Additionally, we consistently report and discuss in our quarterly earnings releases and investor presentations adjusted operating income and margin, adjusted net income and adjusted earnings per diluted share. These adjusted amounts consist of GAAP amounts excluding the following adjustments to the extent they occur during the period: (i) acquisition-related charges, (ii) facility consolidation, optimization, manufacturing transfer and system integration charges, (iii) asset write-down and disposition charges, (iv) severance charges in connection with corporate realignments or a reduction in force, (v) litigation charges and gains, (vi) the impact of certain non-cash charges to interest expense, (vii) unusual or infrequently occurring items, (viii) certain R&D expenditures (such as medical device design verification (“DVT”) expenses in connection with developing our neuromodulation platform), (ix) gain/loss on the sale of investments, (x) the income tax (benefit) related to these adjustments and (xi) certain tax charges related to the consolidation of our Swiss Orthopaedic facility. We believe that reporting these amounts provides important supplemental information to our investors and creditors seeking to understand the financial and business trends relating to our financial condition and results of operations. Additionally, certain performance-based compensation incentives provided to our executives are determined utilizing these adjusted amounts.
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A reconciliation of GAAP operating income (loss) to adjusted amounts is as follows (dollars in thousands):
Operating income (loss) as reported
Adjustments:
Medical device DVT expenses (RD&E)
Consolidation and optimization costs
Acquisition and integration expenses (income)
Adjusted operating income (loss)
Adjusted operating margin
Medical device related adjusted expenses (excluding DVT)
Adjusted operating income (loss) excluding medical device related adjusted expenses
Adjusted operating margin excluding medical device related adjusted expenses
Inventory step-up amortization (COS)
GAAP operating income for the third quarter and year-to-date periods of 2013 was $17.0 million and $48.5 million, respectively, compared to $2.1 million and $24.4 million, respectively, for the comparable 2012 periods. Adjusted operating income, which excludes consolidation, optimization and DVT costs, increased 18% and 20% for the third quarter and year-to-date periods of 2013, respectively, to $22.0 million and $63.5 million, respectively. These GAAP and adjusted operating income variances are primarily due to the following:
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A reconciliation of GAAP net income and diluted EPS to adjusted amounts is as follows (in thousands, except per share amounts):
Net income (loss) as reported
Consolidation and optimization costs(a)
Acquisition and integration expenses (income)(a)
Asset dispositions, severance and other(a)
Loss (gain) on cost and equity method investments, net(a)(b)
CSN conversion option discount and deferred fee accelerated amortization(a)(c)
2012 R&D Tax Credit(d)
Swiss tax impact
Adjusted net income and diluted EPS(e)
Adjusted diluted weighted average shares(f)
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GAAP and adjusted diluted EPS for the third quarter of 2013 were $0.44 and $0.57, respectively, compared to a loss of $0.32 and income of $0.46, respectively, for the third quarter 2012. For the first nine months of 2013, GAAP and adjusted diluted EPS were $1.06 and $1.56 per share, respectively, compared to $0.03 and $1.25 per share, respectively, for the 2012 periods. These variances were primarily due to the same factors impacting GAAP and adjusted operating income as well as the following:
Financial Guidance
Based upon our results for the first three quarters, as well as our expectations for the remainder of the year, we believe that our adjusted diluted EPS for 2013 will be near the middle to high end of our raised guidance range provided last quarter of $2.05 to $2.15. We continue to believe that our revenue for 2013 will be closer to the lower end of our revenue guidance of $660 to $680 million provided at the beginning of the year and we expect operating margin to approximate 13%. Finally, we expect our full year GAAP effective tax rate will be approximately 31% and that diluted shares will be around 25 million as a result of our higher stock price.
Our CEO’s View
We are very pleased with our performance in the third quarter as adjusted diluted EPS increased 24% to $0.57 per share. The key highlights for the quarter are as follows:
Our 2013 initiatives are all progressing as planned. Our approach to commercializing Algostim has not changed, and is proceeding as planned with FDA and CE Mark submissions. Our core business is well positioned because our OEM customers leverage our portfolio of intellectual property, and we are building a healthy pipeline of diverse medical technology opportunities. Our new organization structure allows dedicated resources to focus on growth. Combined with stronger discipline to ensure we have adequate returns for all investments, our bottom line performance and our return on invested capital continues to improve. In this new structure we have retained and enhanced the leadership team and the capabilities that have driven our operational excellence. This foundation we stand on when working with our OEM partners will continue to drive our growth strategy. We expect these initiatives to continue to pay dividends for the remainder of 2013 and will position the Company to meet its long-term objective of maintaining at least 5% organic constant currency revenue expansion and at least double that growth rate for adjusted diluted EPS over time.
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Product Development
Medical Devices – We provide our Implantable Medical customers with complete medical devices. This medical device strategy is being facilitated through the QiG Group and includes strategic equity investments and medical devices developed independently as well as in conjunction with our OEM partners. While we do not intend to discuss each of these projects individually each quarter, we will discuss significant milestones as they occur.
Algostim, our spinal cord stimulator for the treatment of chronic pain in the trunk and limbs, continues to progress on schedule. FDA submission is planned for the fourth quarter 2013 and Europe CE Mark submission is planned for early 2014. Collaboration continues with our investment bankers who are assisting us in identifying commercial partners.
Medical Device Components – Our core business is well positioned because our OEM customers leverage our portfolio of intellectual property, and we are building a healthy pipeline of diverse medical technology opportunities. We continue to deepen our relationships with our OEM customers and continue to see an increased pace of product development opportunities, and in particular, from our cardiac/neuromodulation customers. New cardiac/neuromodulation product introductions are scheduled for the fourth quarter of 2013, which, when combined with our increased sales and marketing resources, we expect will allow us to continue to grow this product line faster than the underlying market.
Our Electrochem product development activities are centered around the portable medical market. Gaining better access to this attractive market is one of our strategic priorities as it provides us with a significant opportunity for growth given its $1 billion market size. Additionally, this market is benefiting from favorable market trends as patient care shifts from clinical settings to the home and as an aging population drives the need for lightweight and portable devices for patients and caregivers. These favorable trends are expected to allow this market to grow faster than our legacy markets over the next several years. Finally, this market is also attractive to us given that it has long product life cycles that should provide stability and diversification to our revenue base.
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Cost Savings and Consolidation Efforts
In 2013 and 2012, we recorded charges in Other Operating Expenses, Net related to various cost savings and consolidation initiatives. These initiatives were undertaken to improve our operational efficiencies and profitability. Additional information regarding the timing, cash flow impact and amount of future expenditures is set forth in Note 9 “Other Operating Expenses, Net” of the Notes to the Condensed Consolidated Financial Statements contained in Item 1 of this report.
In June 2013, the Company initiated a plan to realign its operating structure in order to optimize its continued focus on profitable growth. As part of this initiative, the sales and marketing and operations groups of our Implantable Medical and Electrochem segments were combined into one sales and marketing and one operations group serving the entire Company. Total restructuring charges expected to be incurred in connection with this realignment is between $6.2 million to $7.0 million, of which $3.1 million has been incurred to date. Expenses related to this initiative will be recorded within the applicable segment and corporate cost centers to which the expenditures relate. When fully implemented, this plan is expected to result in annual savings of approximately $7.0 to $7.7 million.
In addition, in 2010, we initiated a multi-faceted plan to further enhance, optimize and leverage our orthopaedics operations. This plan includes the construction of an orthopaedic manufacturing facility in Fort Wayne, IN, updating our Indianapolis, IN facility to streamline operations, increase capacity, and further expand capabilities, and transferring manufacturing and development operations performed at our facilities in Orvin and Corgemont, Switzerland into our Fort Wayne, IN and Tijuana, Mexico facilities. The total capital investment expected for these initiatives is between $25 million and $30 million, of which $22.0 million has been expended to date. Total expense expected to be incurred for these initiatives is between $40 million and $41 million, of which $39.9 million has been incurred to date.
Near the end of 2011, we initiated plans to optimize and expand our manufacturing infrastructure in order to support our medical device strategy. This included the transfer of certain product lines to lower cost facilities, expansion of two of our existing facilities, as well as the purchase of equipment to create additional capacity for the manufacture of medical devices and to create additional cost savings. Total capital investment under these initiatives is expected to be between $15 million and $20 million, of which approximately $12.4 million has been expended to date. Total expenses expected to be incurred on these projects is between $2.0 million and $3.0 million, of which $1.8 million has been incurred to date.
These orthopaedic and medical device initiatives are nearly complete and were expected to generate approximately $10 million to $15 million of annual cost savings, a significant portion of which are already reflected in our 2013 results. Additionally, these initiatives increased our capacity in order to support anticipated future growth and the manufacturing of complete medical devices.
In 2011, we initiated plans to upgrade our existing global ERP system. This initiative is expected to be completed over the next six months. Total capital investment under this initiative is expected to be approximately $4.5 million to $5 million, of which approximately $4.3 million has been expended to date. Total expenses expected to be incurred on this initiative is between $6 million to $7 million, of which $5.3 million has been incurred to date.
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Our Financial Results
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. The third quarter and year-to-date periods of 2013 and 2012 ended on September 27, and September 28, respectively, and each contained 13 weeks and 39 weeks, respectively. The fourth quarter of 2013 will contain 14 weeks compared to the fourth quarter of 2012 which had 13 weeks. The commentary that follows should be read in conjunction with our Condensed Consolidated Financial Statements and related notes and with the Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the fiscal year ended December 28, 2012. The following table presents certain selected financial information derived from our Condensed Consolidated Financial Statements for the periods presented (dollars in thousands, except per share data):
CRM/Neuromodulation
Gross profit as a % of sales
Selling, general and administrative expenses (SG&A)
SG&A as a % of sales
Research, development and engineering costs, net (RD&E)
RD&E as a % of sales
Operating margin
Effective tax rate
Net margin
Diluted earnings (loss) per share
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Implantable Medical – Cardiac/neuromodulation sales for the third quarter of 2013 increased 8% compared to the prior year to $87.0 million. This increase was driven by stronger market performance and continued deepening relations with OEM partners as a result of a better managed and an expanded sales force, our manufacturing excellence, and our strong intellectual property portfolio. More specifically, during the quarter we experienced double digit growth in medical batteries, capacitors, leads and feedthroughs. Cardiac/neuromodulation revenues for the first nine months of 2013 were 3% above the comparable 2012 period. We continue to see an increased pace of product development opportunities from our cardiac customers. We believe that these opportunities, combined with our increased sales and marketing resources, will allow the Company to continue to grow this product line faster than the underlying market.
Orthopaedic sales of $30.1 million and $92.0 million for the third quarter and year-to-date periods of 2013 increased 11% and 1%, respectively, versus the comparable 2012 periods. During the first quarter of 2013, the Company divested certain non-core orthopaedic product lines which reduced quarter and year-to-date 2013 orthopaedic revenue by approximately $3.2 million and $11.9 million, respectively, in comparison to the prior year periods. Foreign currency exchange rate fluctuations did not have a material impact on the first two quarters of 2013 results but benefited third quarter 2013 sales by approximately $1 million. On a constant currency organic basis, orthopaedic product line sales increased 22% and 15% in comparison to the prior year periods, respectively, which was primarily due to implant, and cases and tray market share gains, which benefitted from our increased sales and marketing efforts. Backlog, which resulted from our consolidation activities, began to be relieved in the third quarter and is expected to benefit the fourth quarter of 2013.
Vascular sales decreased 10% and 7%, respectively, to $12.3 million and $35.2 million, respectively, for the third quarter and year-to-date periods of 2013. These decreases were primarily due to the previously communicated voluntary recall of two vascular medical devices near the end of 2012. Our Vascular sales force, in targeting underpenetrated markets, has seen success with existing products. We expect to re-introduce one of our voluntarily recalled products in the fourth quarter although this re-launch will not materially impact 2013 revenue.
Electrochem – Third quarter and year-to-date 2013 Electrochem sales decreased 5% and 4%, respectively, in comparison to the 2012 periods. We are experiencing lower revenue from our portable medical, environmental and military customers as a result of our increased pricing discipline, as well as reduced government funding on certain military and environmental projects. Our increased pricing discipline resulted in the rationalization of two lower margin portable medical programs, which totaled approximately $9 million of annualized revenues in 2013. We expect these factors to continue to impact our business for the foreseeable future.
During the third quarter of 2013, we saw a rebound in our energy product line, with sales growing 4% in comparison to the prior year as customer ordering patterns normalized. We expect nominal growth in the fourth quarter of 2013 from this product line. We expect that this growth, combined with the slow start in the first half of the year will cause this product line to be flat to slightly positive versus 2012.
We are not satisfied with our Electrochem revenue growth performance and have re-focused resources to drive improvements.
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Gross Profit
Changes to gross profit as a percentage of sales from the prior year were due to the following:
Impact of Swiss consolidation(a)
Performance-based compensation(b)
Cost savings and production efficiencies(c)
Total percentage point change to gross profit as a percentage of sales
Over the short-term, we expect our gross margin to remain strong as a result of the various productivity improvement initiatives that were implemented (See Cost Savings and Consolidation Efforts section of this Item).
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SG&A Expenses
Changes to SG&A expenses from the prior year were due to the following (in thousands):
Selling and marketing(a)
Swiss consolidation(c)
Net increase in SG&A
RD&E Expenses, Net
Net RD&E costs are comprised of the following (in thousands):
Research and development costs
Engineering costs
Less cost reimbursements
Engineering costs, net
Total RD&E, net
Net RD&E for the 2013 third quarter increased $0.6 million and for the year-to-date period decreased $2.3 million, versus the comparable 2012 periods. The increase for the third quarter was primarily attributable to a decrease in customer cost reimbursements compared to the prior year of $0.9 million, due to the timing of achievement of milestones on various projects. The year-to-date decrease compared to the prior year is a result of the Company’s efforts, beginning in 2012, to refocus medical device RD&E investment and discontinue certain non-core RD&E projects, as well as higher customer cost reimbursements in the first quarter of 2013. DVT expenses totaled $1.5 million ($4.5 million year-to-date) for the third quarter of 2013 compared to $1.2 million ($3.8 million year-to-date) for the comparable 2012 period. In total, medical device related expenses declined $0.9 million ($2.7 million year-to-date) from the third quarter of 2012 to the third quarter of 2013. The Company’s medical device technology investment is focused on successfully commercializing Algostim and being selective in opportunities that leverage our strengths in the core business units and drive exceptional and sustainable growth.
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Other Operating Expenses, Net
Other operating expenses, net is comprised of the following (in thousands):
2013 operating unit realignment(a)
Orthopaedic facility optimization(a)
Medical device facility optimization(a)
ERP system upgrade(a)
Acquisition and integration (income) costs(b)
Asset dispositions, severance and other(c)
Total other operating expenses, net
Interest Expense
Interest expense for the third quarter and year to date periods of 2013 decreased $2.9 million and $3.2 million, respectively, in comparison to the prior year periods. These decreases were primarily due to lower discount amortization as a result of the repayment of our convertible subordinated notes during the first quarter of 2013. Additionally, interest expense was lower for the third quarter and year-to-date periods due to lower outstanding debt balances, and lower interest rates paid on outstanding debt. During the third quarter and for the first nine months of 2013 we made net repayments of $27 million and $21 million on long-term debt, respectively. For the fourth quarter of 2013, interest expense is expected to decline in comparison to 2012, due to lower discount amortization expense and as excess cash flow from operations is used to pay down outstanding debt.
Other (Income) Expense, Net
Other (income) expense, net increased $0.05 million and $0.5 million, respectively, for the 2013 third quarter and year-to-date periods in comparison to 2012. The increase in expense for the year-to-date period is primarily due to $0.6 million of losses incurred on our cost and equity method investments during the second quarter of 2013. Other (income) expense, net also includes the impact of foreign currency exchange rate fluctuations on transactions denominated in foreign currencies. We generally do not expect foreign currency exchange rate fluctuations to have a material impact on our financial results.
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Provision for Income Taxes
The effective tax rate (including discrete items) for the first nine months of 2013 was 29.6% compared to 93.0% for 2012. This decrease was primarily attributable to the reinstatement of the research and development tax credit in the first quarter of 2013 and higher income in lower tax rate jurisdictions. Additionally, the 2012 effective tax rate was impacted by tax charges recorded in connection with the Company’s Swiss orthopaedic consolidation of $5.0 million. During 2013, the Company recognized a $1.6 million discrete tax benefit related to the 2012 portion of the research and development tax credit. The benefit of the 2013 portion of the research and development tax credit is being recognized through the 2013 effective tax rate.
On September 13, 2013, the IRS and U.S. Treasury Department released final regulations on the deduction and capitalization of expenditures related to tangible property (the “Repair Regulations”). The final Repair Regulations apply to tax years beginning on or after January 1, 2014. The Company is planning to adopt the regulations in a timely manner, and is in the process of assessing the impact, if any, to the consolidated financial statements.
We currently expect our 2013 annual GAAP effective tax rate to be approximately 31%. We expect continued volatility of this effective tax rate due to several factors, including changes in the mix of pre-tax income and the jurisdictions to which it relates, changes in tax laws and foreign tax holidays, business reorganizations, settlements with taxing authorities and foreign currency fluctuations.
Government Regulation
The Patient Protection and Affordable Care Act and the Health Care and Education Affordability Reconciliation Act (collectively “Health Care Reform”) legislated broad-based changes to the U.S. health care system that could significantly impact our business operations and financial results, including higher or lower revenue, as well as higher employee medical costs and taxes. Health Care Reform imposes significant new taxes on medical device OEMs, which will result in a significant increase in the tax burden on our industry and which could have a material negative impact on our financial condition, results of operations and our cash flows. Other elements of Health Care Reform such as comparative effectiveness research, an independent payment advisory board, payment system reforms including shared savings pilots and other provisions could meaningfully change the way healthcare is developed and delivered, and may materially impact numerous aspects of our business, results of operations and financial condition. Many significant parts of Health Care Reform will be phased in over the next several years and require further guidance and clarification in the form of regulations. Management has evaluated the impact that the new medical device tax, which began in 2013, will have on our results from operations, and has estimated that it will reduce gross profit annually by approximately $0.6 million to $1.0 million.
On August 22, 2012, the U.S. Securities and Exchange Commission (“SEC”) issued a rule under Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requiring companies to publicly disclose their use of conflict minerals that originated in the Democratic Republic of the Congo (“DRC”) or an adjoining country. Under the rule, issuers are required to conduct a reasonable due diligence process to ascertain the source of conflict minerals, defined as tantalum, tin, gold or tungsten, that are necessary to the functionality or production of their manufactured or contracted to be manufactured products. Companies are required to provide this disclosure on a new form to be filed with the SEC called Form SD. Companies are required to file Form SD on May 31, 2014 for the 2013 calendar period and annually on May 31 every year thereafter. We anticipate additional, new compliance costs to be incurred since we utilize all of the minerals specified in the rule. We are unable to quantify the cost of implementing this new regulation at this time.
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Liquidity and Capital Resources
Working capital
Current ratio
The decrease in cash and cash equivalents from the end of 2012 was primarily due to an increase in working capital levels in anticipation of our higher sales, maintenance level property plant and equipment purchases, as well as repayments made on our long-term debt. Our current ratio for the first nine months of 2013 remained consistent with the prior year. Of the $5.0 million of cash on hand as of September 27, 2013, $2.2 million is being held at our foreign subsidiaries.
Credit Facility – We have a secured credit facility (the “Credit Facility”), which provides a $300 million revolving credit facility (the “Revolving Credit Facility”), a $200 million term loan (the “Term Loan”), a $15 million letter of credit subfacility, and a $15 million swingline subfacility. The Credit Facility can be increased by $200 million upon our request and approval by the lenders. The Revolving Credit Facility has a maturity date of September 20, 2018, which may be extended to September 20, 2019 upon notice by us and subject to certain conditions. The principal of the Term Loan is payable in quarterly installments as specified in the Credit Facility until its maturity date of September 20, 2019 when the unpaid balance is due in full.
The Credit Facility is supported by a consortium of fifteen banks with no bank controlling more than 18% of the facility. As of September 27, 2013, 98% of the Credit Facility is supported by banks that have an S&P credit rating of at least BBB+ or better, which is considered investment grade.
The Credit Facility requires us to maintain a rolling four quarter ratio of adjusted EBITDA to interest expense of at least 3.0 to 1.0. For the twelve month period ended September 27, 2013, our ratio of adjusted EBITDA to interest expense, calculated in accordance with our credit agreement, was 21.6 to 1.0, well above the required limit. The Credit Facility also requires us to maintain a total leverage ratio of not greater than 4.5 to 1.0 and not greater than 4.25 to 1.00 after January 2, 2016. As of September 27, 2013, our total leverage ratio, calculated in accordance with our credit agreement, was 1.9 to 1.0, well below the required limit.
The Credit Facility contains customary events of default. Upon the occurrence and during the continuance of an event of default, a majority of the lenders may declare the outstanding advances and all other obligations under the Credit Facility immediately due and payable. See Note 6 “Debt” of the Notes to Condensed Consolidated Financial Statements in this report for a more detailed description of the Credit Facility.
As of September 27, 2013, we had $290 million of borrowing capacity available under the Credit Facility. This amount may vary from period to period based upon our debt and EBITDA levels, which impacts the covenant calculations discussed above. We believe that our cash flow from operations and the Credit Facility provide adequate liquidity to meet our short- and long- term funding needs.
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Operating activities – Cash provided by operations for the first nine months of 2013 was $16.1 million versus $39.5 million for the comparable 2012 period. This decrease was primarily due to an increase in accounts receivable and inventory balances during the period, due to higher actual and expected sales levels, as well as $19.6 million of estimated tax payments made in connection with the retirement of our convertible subordinated notes during the first nine months of 2013. Excluding these estimated tax payments, cash flow from operations was $35.7 million for the first nine months of 2013, which is consistent with the prior year. We are not seeing any issues with the collectability of our receivables and are taking measures to reduce our receivable and inventory balances in the near term in order to improve our cash flows from operations. During the third quarter of 2013, we reduced our receivable balances by $7.6 million and continue to remain highly focused on cash flow generation. As of September 27, 2013 we had $3.9 million accrued for product warranties. Approximately $2 million of this amount is expected to be paid in the fourth quarter of 2013.
Investing activities – Net cash used in investing activities for the first nine months of 2013 was $13.8 million. This included $3.2 million of proceeds received from the sale of our Swiss orthopaedic product lines which closed during the first quarter of 2013. The proceeds received were offset by $15.0 million used for the purchase of property, plant and equipment to support normal operations as well as our cost savings and consolidation initiatives, and purchases of equity method investment of $1.9 million during the period. Our current expectation is that capital spending for the full year of 2013 will be in the range of $20 million to $25 million, of which approximately half is discretionary in nature. We anticipate that cash on hand, cash flow from operations and availability under our Credit Facility will be sufficient to fund these capital expenditures. As part of our growth strategy, we have and will continue to consider targeted and opportunistic acquisitions.
Financing activities – Net cash used in financing activities for the first nine months of 2013 was $17.6 million compared to cash used of $13.0 million in the comparable 2012 period. This cash outflow was primarily the result of net repayments on our long-term debt of $20.8 million. Going forward, we expect excess cash flow from operations to be used to fund our remaining consolidation initiatives and to pay down outstanding debt.
Capital Structure – As of September 27, 2013, our capital structure consisted of $210 million of debt under our Credit Facility and 24.1 million shares of common stock outstanding. Additionally, we had $5.0 million in cash and cash equivalents. If necessary, we currently have access to $290 million under our Credit Facility and are authorized to issue 100 million shares of common stock and 100 million shares of preferred stock. We believe that if needed we can access public markets to raise additional capital. We believe that our capital structure provides adequate funding to meet our growth objectives. We continuously evaluate our capital structure, including our Credit Facility, as it relates to our anticipated long-term funding needs. Changes to our capital structure may occur as a result of this analysis, or changes in market conditions.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements within the meaning of Item 303(a)(4) of Regulation S-K.
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Impact of Recently Issued Accounting Standards
In the normal course of business, we evaluate all new accounting pronouncements issued by the Financial Accounting Standards Board (“FASB”), SEC, Emerging Issues Task Force (“EITF”), American Institute of Certified Public Accountants (“AICPA”) or other authoritative accounting body to determine the potential impact they may have on our Condensed Consolidated Financial Statements. Based upon this review, we do not expect any of the recently issued accounting pronouncements, which have not already been adopted, to have a material impact on our Condensed Consolidated Financial Statements. See Note 16 “Impact of Recently Issued Accounting Standards” of the Notes to the Condensed Consolidated Financial Statements in Item 1 of this report for additional information.
Contractual Obligations
The following table summarizes our significant contractual obligations at September 27, 2013 (in thousands):
CONTRACTUAL OBLIGATIONS
Debt obligations(a)
Operating lease obligations(b)
Purchase obligations(b)
Foreign currency contracts(b)
Pension obligations(c)
Total contractual obligations
This table does not reflect $1.4 million of unrecognized tax benefits as we are uncertain as to if or when such amounts may be settled. Refer to Note 10 “Income Taxes” of the Notes to Condensed Consolidated Financial Statements in Item 1 of this report for additional information about these unrecognized tax benefits.
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We self-fund the medical insurance coverage provided to our U.S. based employees. The Company’s risk is being limited through the use of stop loss insurance, which has specific stop loss coverage per associate for claims in the year exceeding $225 thousand per associate with no annual maximum aggregate stop loss coverage. As of September 27, 2013, we have $1.9 million accrued related to our self-insured medical plan, which is recorded in Accrued Expenses in the Condensed Consolidated Balance Sheet, and is primarily based upon claim history. This table does not reflect any potential future payments for self-insured medical claims.
Forward-Looking Statements
Some of the statements contained in this report 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:
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 variations 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: our dependence upon a limited number of customers; customer ordering patterns; product obsolescence; our inability to market current or future products; pricing pressure from customers; our ability to timely and successfully implement cost reduction and plant consolidation initiatives; our reliance on third party suppliers for raw materials, products and subcomponents; fluctuating operating results; our inability to maintain high quality standards for our products; challenges to our intellectual property rights; product liability claims; our inability to successfully consummate and integrate acquisitions and to realize synergies and to operate these acquired businesses in accordance with expectations; our unsuccessful expansion into new markets; our failure to develop new products including system and device products; our inability to obtain licenses to key technology; regulatory changes or consolidation in the healthcare industry; global economic factors including currency exchange rates and interest rates; the resolution of various legal actions brought against the Company; and other risks and uncertainties that arise from time to time as described in the Company’s Annual Report on Form 10-K and other periodic filings with the SEC.
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Foreign Currency – We have foreign operations in France, Mexico and Switzerland, which expose the Company to foreign currency exchange rate fluctuations due to transactions denominated in Euros, Mexican pesos and Swiss francs, respectively. We continuously evaluate our foreign currency risk and will take action from time to time in order to best mitigate these risks, which includes the use of various derivative instruments such as forward currency exchange rate contracts. A hypothetical 10% change in the value of the U.S. dollar in relation to our most significant foreign currency exposures would have had an impact of approximately $8 million on our annual sales. This amount is not indicative of the hypothetical net earnings impact due to partially offsetting impacts on cost of sales and operating expenses in those currencies. We estimate that foreign currency exchange rate fluctuations during the nine months ended September 27, 2013 increased sales in comparison to the 2012 period by approximately $1 million.
In May 2012, we entered into two forward contracts to purchase 6.9 million and 7.2 million Mexican pesos per month beginning in January 2013 through December 2013 at an exchange rate of $0.0727 and $0.0693 per peso, respectively. These contracts were entered into in order to hedge the risk of peso-denominated payments associated with a portion of the operations at our Tijuana, Mexico facility for 2013 and are being accounted for as cash flow hedges.
In September 2013, we entered into a forward contract to purchase 8.4 million Mexican pesos per month beginning in January 2014 through December 2014 at an exchange rate of $0.0767 per peso, respectively. These contracts were entered into in order to hedge the risk of peso-denominated payments associated with a portion of the operations at our Tijuana, Mexico facility for 2014 and are being accounted for as cash flow hedges.
As of September 27, 2013, these contracts had a negative fair value of $0.04 million. The amount recorded as a reduction of Cost of Sales during the nine months ended September 27, 2013 and nine months ended September 28, 2012 related to our forward contracts was $0.9 million and $0.008 million, respectively. No portion of the change in fair value of our foreign currency exchange rate contracts during the nine months ended September 27, 2013 or September 28, 2012 was considered ineffective.
We translate all assets and liabilities of our foreign operations, where the U.S. dollar is not the functional currency, at the period-end exchange rate and translate sales and expenses at the average exchange rates in effect during the period. The net effect of these translation adjustments is recorded in the Condensed Consolidated Financial Statements as Comprehensive Income. The translation adjustment for the first nine months of 2013 was a gain of $1.1 million and for the first nine months of 2012 a loss of $0.5 million. Translation adjustments are not adjusted for income taxes as they relate to permanent investments in our foreign subsidiaries. Net foreign currency transaction gains and losses included in Other (Income) Expense, Net amounted to a gain of $0.02 million and a loss of $0.2 million for the first nine months of 2013 and 2012, respectively. A hypothetical 10% change in the value of the U.S. dollar in relation to our most significant foreign currency net assets would have had an impact of approximately $8 million on our foreign net assets as of September 27, 2013.
Interest Rates – Interest rates on our Credit Facility reset, at our option, based upon the prime rate or LIBOR rate, thus subjecting us to interest rate risk. To help offset this risk, from time to time, we enter into receive floating-pay fixed interest rate swaps indexed to the same applicable index rate as the debt it is hedging. In October 2012 we entered into a three-year $150 million interest rate swap, which amortizes $50 million per year, which became effective during the first quarter of 2013. Under terms of the contract, we receive a floating interest rate indexed to the one-month LIBOR rate and pay a fixed interest rate of 0.573%. This swap was entered into in order to hedge against potential changes in cash flows on the outstanding debt on the Credit Facility, which is also indexed to the one-month LIBOR rate. The receive variable leg of the interest rate swap and the variable rate paid on the debt is expected to have the same rate of interest, excluding the credit spread, and reset and pay interest on the same dates. This swap is accounted for as a cash flow hedge.
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As of September 27, 2013, we had $210 million outstanding on our Credit Facility, of which $150 million is currently being hedged. See Note 6 “Debt” of the Notes to Condensed Consolidated Financial Statements in Item 1 of this report for additional information about our outstanding debt. A hypothetical one percentage point (100 basis points) change in the prime rate on the $60 million of unhedged floating rate debt outstanding at September 27, 2013 would have an impact of approximately $0.6 million on our interest expense.
a. Evaluation of Disclosure Controls and Procedures.
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 as of September 27, 2013. These disclosure controls and procedures have been designed to provide reasonable assurance 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. Based on their evaluation, as of September 27, 2013, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures are effective.
b. Changes in Internal Control Over Financial Reporting.
We completed the acquisition of NeuroNexus Technologies, Inc. (“NeuroNexus”) on February 16, 2012. We believe that the internal controls and procedures of NeuroNexus are reasonably likely to materially affect our internal control over financial reporting. We are currently in the process of incorporating the internal controls and procedures of NeuroNexus into our internal controls over financial reporting.
The Company continues to extend its Section 404 compliance program under the Sarbanes-Oxley Act of 2002 (the “Act”) and the applicable rules and regulations under such Act to include NeuroNexus. However, the Company has excluded NeuroNexus from management’s assessment of the effectiveness of internal control over financial reporting as of December 28, 2012, as permitted by the guidance issued by the Office of the Chief Accountant of the SEC. The Company will report on its assessment of the internal controls of its combined operations within the time period provided by the Act and the applicable SEC rules and regulations concerning business combinations.
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.
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PART II – OTHER INFORMATION
There have been no material changes to the Company’s legal proceedings as previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 28, 2012.
There have been no material changes from the Company’s risk factors as previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 28, 2012.
None.
Not applicable.
See the Exhibit Index for a list of those exhibits filed herewith.
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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.
President and Chief Executive Officer
(Principal Executive Officer)
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Exhibit No.
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