Back to GetFilings.com
FORM 10-K
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 [FEE REQUIRED]
For the fiscal year ended December 31, 2001
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________ to ___________
Commission file number: 0-26538
ENCORE MEDICAL CORPORATION
(Exact name of Registrant as specified in its charter)
DELAWARE 65-0572565
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
9800 METRIC BLVD.
AUSTIN, TEXAS 78758
(Address of principal executive offices) (Zip code)
512-832-9500
(Registrant's telephone number including area code)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to section 12(g) of the Act:
Common Stock, $0.001 par value
$5 Warrant
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ____
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. Yes ____ No X
The aggregate market value of the voting and non-voting common equity
held by non-affiliates of Encore Medical Corporation, computed by reference to
the last sales price of such stock as of March 15, 2002, was $25,717,496.
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of March 15, 2002, the latest practicable date.
Title Outstanding
----- -----------
Common Stock, par value $0.001 10,994,036
$5 Warrants 3,536,700
DOCUMENTS INCORPORATED BY REFERENCE
List hereunder the following documents, if incorporated by reference,
and the Part of the Form 10-K (e.g., Part I, Part II, etc.) into which the
document is incorporated: (1) any annual report to security holders; (2) any
proxy or information statement; and (3) any prospectus filed pursuant to Rule
424(b) or (c) under the Securities Act of 1933:
PORTIONS OF THE PROXY STATEMENT TO BE FILED WITH THE SECURITIES AND EXCHANGE
COMMISSION PURSUANT TO REGULATION 14A UNDER THE SECURITIES EXCHANGE ACT OF 1934
IN CONNECTION WITH THE COMPANY'S ANNUAL MEETING OF SHAREHOLDERS ARE INCORPORATED
BY REFERENCE INTO PART III HEREOF (TO THE EXTENT SET FORTH IN ITEMS 10, 11, 12
AND 13 OF PART III OF THIS ANNUAL REPORT ON FORM 10-K.)
This annual report on Form 10-K of Encore Medical Corporation for the
year ended December 31, 2001 contains certain 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, which are
intended to be covered by the safe harbors created thereby. To the extent that
such statements are not recitations of historical fact, such statements
constitute forward-looking statements that, by definition, involve risks and
uncertainties. In any forward-looking statement, where Encore Medical
Corporation expresses an expectation or belief as to future results or events,
such expectation or belief is expressed in good faith and believed to have a
reasonable basis, but there can be no assurance that the statement of
expectation or belief will be achieved or accomplished.
The following are factors that could cause actual results or events to
differ materially from those anticipated, and include, but are not limited to:
general economic, financial and business conditions; the success and costs of
advertising and promotional efforts; changes in and compliance with governmental
healthcare and other regulations; changes in tax laws; the ability to obtain
financing for one or more acquisitions; the ability to successfully complete and
integrate one or more acquisitions; technological obsolescence of one or more
products; changes in product strategies; the availability of management
personnel and other important employees; and the costs and effects of legal
proceedings.
-2-
Item 1. Business
Overview
- --------
Encore Medical Corporation ("EMC") is seeking to expand to be a broad
based, diversified medical products company that designs, manufactures and
markets high quality medical products around the world. From its roots as an
orthopedic implant company, it is broadening its focus into additional areas of
orthopedic patient care and surgical products. It will seek to accomplish this
through internal growth and acquisitions of profitable, well positioned
companies that can allow EMC to build several platforms in the medical products
industry. This strategy commenced during the last half of 2001 and has continued
into 2002.
EMC has only a single operating subsidiary. This company, Encore
Medical, L.P. ("Encore" or the "Company") [see discussion below on the recent
changes in the legal structure of the Company], designs, markets and distributes
orthopedic products and supplies. Its products are used primarily by orthopedic
medical specialists to treat patients with musculoskeletal conditions resulting
from degenerative diseases, deformities, traumatic events and participation in
sporting events. Encore's implant products cover a broad variety of orthopedic
needs and include hip, knee and shoulder implants to reconstruct damaged joints,
trauma products to reconstruct bone fractures, and spinal implants to aid in the
repair of the spinal column. The Company has one of the broadest lines of
orthopedic soft goods in the marketplace for non-surgical products that repair,
regenerate and rehabilitate soft tissue and bone, and protect against injury.
The Chattanooga Group division of Encore has a complete line of all items
necessary for rehabilitation of orthopedic injuries, serving the needs of
physical therapists, chiropractors and sports medicine professionals.
Encore was formed in April 1992, when several executives with
significant experience in the orthopedics industry joined with a small original
equipment manufacturer of orthopedic implants and related instruments. Encore's
first product, the Foundation(R) Knee System, was introduced in Europe in late
1992 and in the United States in February 1993 after receiving Food and Drug
Administration ("FDA") 510(k) approval. Since that time Encore has developed and
obtained regulatory approval for over one hundred additional orthopedic total
joint products, trauma products, spinal products, and product improvements.
Through its recently begun acquisition campaign, it has added hundreds of
products to its offerings, many of which require and have received FDA 510(k)
approval.
On July 2, 2001, EMC purchased from Tecnol, Inc. ("Tecnol"),
Kimberly-Clark Corporation ("KCC"), and Kimberly-Clark Worldwide, Inc. ("KCW"
and, together with Tecnol and KCC, "Kimberly-Clark"), Kimberly-Clark's line of
orthopedic soft goods, patient safety devises and pressure care products (the
"OSG Products"). These products include the Kallassy(R) Ankle Support, the
Sports Supports(R) product line of braces and supports, the Rebound(R) line of
consumer orthopedics products, the Secure-All(R) brand of patient safety
devices, and the Turtle Neck(R) and 911 First Response(R) safety collars.
Kimberly-Clark had acquired the product lines in 1997 when it purchased Tecnol
Medical Products.
On February 8, 2002, EMC purchased Chattanooga Group, Inc. ("CGI"), a
privately-held, Tennessee based provider of orthopedic rehabilitation equipment.
CGI designs, manufactures and distributes around the world a wide range of
rehabilitation products including Intelect(R) Electrotherapy units, OptiFlex(R)
Continuous Passive Motion devices, Triton(R) and Adapta(R) therapy tables, along
with Hydrocollator(R) heating and chilling units. In business for over 50 years,
Chattanooga Group, Inc. started manufacturing and selling the Hydrocollator(R)
Steam Pack and has since expanded its product line to include a large variety of
rehabilitation and home health products making it capable of providing turn-key
clinics for orthopedic professionals.
As a result of these activities, EMC offers three broad platforms of
orthopedic products - implants, soft goods and rehabilitation equipment. These
products provide solutions for patients and orthopedic professionals throughout
the patient's continuum of care.
Basis Of Presentation
- ---------------------
This Form 10-K is dated as of March 15, 2002 and will, except for the
audited financial statements and the notes, which are an integral part of such
financial statements, reflect the status of EMC as of that date. Therefore, the
narrative portion of the Form 10-K will include the recently acquired business,
assets, liabilities and operations of Chattanooga Group, Inc. The audited
financial statements and accompanying notes will reflect the status of EMC as of
December 31, 2001.
In connection with the acquisition of Chattanooga Group, Inc., and for
purposes of efficiency and state tax minimization, Encore Orthopedics, Inc. was
converted on February 7, 2002, from a Delaware corporation to a Delaware limited
partnership. It has two partners, Encore Medical GP, Inc. ("EGP") and Encore
Medical Asset Corporation ("EMAC"), the general partner and limited partner,
respectively. Both of these corporations are wholly owned subsidiaries of Encore
-3-
Medical Corporation. All of the assets, liabilities, operations and financial
results of Encore, EGP and EMAC are consolidated in the financial statements of
EMC. Prior to February 7, 2002, neither EGP or EMAC has any operations. On March
1, 2002, Chattanooga Group, Inc. was merged into and with Encore Medical, L.P.
Encore Medical, L.P. being the surviving entity.
Industry Background
- -------------------
Certain of the information contained in this Form 10-K, generally, and
in this section concerning the definition, size and development of the various
product markets in which Encore participates, and Encore's general expectations
concerning the development of such product markets, both domestically and
internationally, are based on estimates prepared by Encore using data from
various sources (primarily Medical Data International, Inc., Dain Raucher
Wessel, US Bancorp, Merrill Lynch, Piper Jaffray and Knowledge Enterprises, as
well as data from Encore's internal research), which data Encore has no reason
to believe are unreliable, and on assumptions made by Encore, based on such
data, and Encore's knowledge of the orthopedic product industry, which Encore
believes to be reasonable.
Over the last two decades, the orthopedic products market, which
consists of implants for joint replacement, spinal implants, trauma products,
certain arthroscopic, sports medicine and soft goods products, bone cement and
related products and instrumentation, has experienced growth in both revenues
and unit sales. Recent advances in technology require the addition to the
orthopedic products market tissue technology image-guided surgery,
osteobiologics and diagnostic products related to osteoporosis. Based on this
expanded scope, in 2001, the worldwide market for orthopedic products produced
approximately $12.0 billion in revenue. In the United States, the orthopedic
products market represented approximately $6.3 billion in revenue in 2001. From
1992 to 1998 the average annual revenue growth rate was approximately 10%. Unit
growth accounted for approximately half of this growth; the remainder of the
growth was attributable to technology driven price increases.
Implants
- --------
Joint reconstruction products accounted for approximately $2.3 billion
of the overall orthopedic market in the U.S. in 2001 and approximately $5.3
billion worldwide. Among the joint replacement products, hip and knee
replacement products account for approximately 92% of worldwide revenues (with
approximately $4.9 billion in worldwide sales in 2001) and shoulder replacement
and other related products (elbow, wrist, finger, toe, ankle and ligament
prostheses) account for approximately 8% of worldwide revenues (with
approximately $425 million in worldwide sales in 2001). The trauma, or fracture
fixation, segment of the orthopedic products market approached $1.5 billion in
2001, representing approximately 8% growth over 2000. The trauma product market
is divided between internal and external fixation products. In 2001, internal
fixation products accounted for about 79% of the revenues from the sale of all
trauma products.
Of particular note is the dynamic growth of both the spinal and
tissue/osteobiological market segments. It is estimated that the U.S. spinal
market exceeded $1.2 billion in 2001 and was approaching $1.8 billion worldwide.
Rapid advances in technology and product design are predicted to produce growth
rates exceeding 20% per year for several years. Interbody fusion devices have
contributed greatly to this rapid growth, achieving approximately a 25% market
share since appearing on the market in 1996.
Soft Goods
- ----------
This area of the orthopedic medical device industry encompasses
primarily products that are used to assist the patient in the recovery from an
injury or a surgical procedure and/or to protect against re-injury or damage to
the surgical repair site. These soft goods products include knee, shoulder,
ankle and wrist braces; neoprene supports; slings and cervical collars; and
immobilizers for various joints in the body. They also include patient safety
devices that aid in assisting medical professionals treat patients who might be
of risk of injury due to unadvised movement. This market is estimated to total
approximately $700 million in 2001, a 10% increase over the previous year.
Rehabilitation Equipment
- ------------------------
These products are used by physical therapists, chiropractors and
sports medicine physicians to aid in the recovery from an injury or surgical
procedure. Products in this segment of the orthopedic industry include
therapeutic ultrasound, electrotherapy, continuous passive motion devices, hot
and cold therapy products, and a large variety of other devices and soft goods
used by clinicians and physicians. This market is estimated to approach $1
billion in sales and is anticipated to grow at 5% per year. The market is made
up of a large number of smaller product segments which range from $1 million to
$150 million in size.
-4-
Strategy
- --------
EMC's strategy is to grow its business both through continued expansion
of its core product lines and through acquisition of complimentary businesses.
It seeks to offer a full continuum of care to the patient of orthopedic
professionals, including orthopedic surgeons, sports medicine physicians,
physical therapists and related service providers. This strategy has as its
foundation, the continued increasing of the sales, product line and distribution
channels related to the implant business. However, it also envisions growth
through acquisitions, such as the recent acquisition of the orthopedic soft
goods, patient safety device and pressure care product lines from Kimberly-Clark
and the acquisition of Chattanooga Group, Inc., which added the rehabilitation
equipment product line into the Company. EMC will continue to search for and
seek to acquire other companies or product lines whose product mix, distribution
network, or manufacturing capabilities compliment its overall strategy.
Encore has established its knee, hip and shoulder total joint products
as the core of its product line. Encore's management believes that it must offer
a complete line of reconstructive total joint implant products, along with
specialty trauma, biologic and spinal products, to remain competitive in the
orthopedic products marketplace. Encore will continue to design and acquire
technology to assemble complete, high quality, competitively-priced,
globally-designed product lines and will continue to expand its network of
independent sales agents and direct sales representatives for the sale of its
products in the United States and its customer relationships worldwide. Encore's
goal is to increase its penetration in the United States and foreign markets by
introducing line extensions to its already broad array of total joint
replacement products, entering the revision total hip market, growing its line
of trauma products, concentrating on specialty and niche products, and entering
the biologic and spinal implant marketplace through internal development,
distribution agreements and the acquisition of existing products or companies.
Outside the United States, Encore's strategy is to explore alternative
avenues for distribution in Europe and Japan and enter into new distribution
agreements in other parts of the world. For both its United States and its
international products, Encore will continue to work with a team of experienced
orthopedic surgeons to help design and promote its products, develop clinical
results, assist in marketing the products and participate in educational
programs focusing on Encore's products.
One element of the Company's growth strategy is to pursue acquisitions,
such as the recent Chattanooga acquisition, as well as investment and strategic
alliances that either expand or complement the Company's business. EMC might not
be able to identify acceptable opportunities, complete any additional
acquisitions, investment or strategic alliances, or license products or
technologies on favorable terms in a timely manner. Acquisition and, to a lesser
extent, investments and strategic alliances involve a number of risks,
including, (i) the diversion of management's attention from its existing
business while evaluating acquisitions and thereafter while assimilating the
operations and personnel of the new business; (ii) adverse short term affects on
operating results; (iii) the inability to successfully and rapidly integrate the
new businesses, personnel and products with the Company's existing business,
including financial reporting, management and information technology systems;
(iv) higher than anticipated cost of integration; (v) unforeseen operating
difficulties and expenditures; (vi) the need to manage a significantly larger
business; (vii) the lack of prior experience in new markets or countries that
the Company may enter; (viii) the loss of employees of an acquired business,
including employees who may have been instrumental to the success or growth of
that business; and (ix) the use of the substantial amount of available cash to
consummate the acquisition. In addition, as was required in connection with the
Chattanooga acquisition, the Company may require additional debt or equity
financing for future acquisitions, investments or strategic alliances. Such
financing may not be available on favorable terms, if at all.
Products
- --------
Implant Division
- ----------------
Encore currently designs, manufactures and markets a wide variety of
orthopedic reconstructive joint products, trauma products, spinal products and
instruments used by surgeons to perform orthopedic surgery. Encore plans to
continue to develop or acquire new hip, knee and shoulder systems as well as new
trauma products, spinal products, and line extensions that address the differing
preferences of surgeons, and new systems for new indications. Encore embarked in
the fourth quarter of 2000 on a product rationalization review whereby it
reviewed all of its existing product lines and offerings to determine which were
appropriate to continue to offer and which were necessary to discontinue based
on lack of sales performance or product line overlap.
Reconstructive Products
Encore currently offers the Foundation(R) Knee System in both cruciate
sparing and posterior stabilized versions, for both primary and revision
applications, all of which are designed to duplicate as closely as possible the
anatomical function of
-5-
the patient's knee, thereby improving its range of motion and stability. Sales
of knee products accounted for approximately 45% of Encore's total implant sales
in 2001. Encore is currently marketing a number of internally designed or
licensed hip systems. These include the Foundation(R) Hip System, the
Vitality(R) Hip Stem, the Linear(R) Hip Stem, the Stamina(R) Hip Stem, the
Keystone(R) Revision Hip Stem and the Revelation(R) Hip Stem. Sales of hip
products accounted for approximately 32% of Encore's total implant sales in
2001. Encore markets its internally designed Foundation(R) Shoulder System.
Encore's shoulder implant consists of the same basic parts as the normal
shoulder, including a humeral stem with a spherical humeral head (ball) and a
glenoid component on which the humeral head articulates. Sales of shoulder
products accounted for approximately 5% of Encore's total implant sales in 2001.
Trauma - Fixation Products
Encore has built its trauma product line through a series of
acquisitions. The first acquisition, Applied Osteo Systems in 1996, gave Encore
the True/Flex(R) intramedullary nails, a patented system of intramedullary nails
used in repairing bone fractures, primarily for use in correcting upper
extremity fractures, and the True/Lok(TM) external fixation system, developed by
Texas Scottish Rite Hospital. The acquisition of Biodynamic Technologies, Inc.
("BTI") in March 1999 allowed Encore to offer a more complete line of specialty
products for use in the treatment of upper extremity orthopedic trauma and added
other trauma products used in the hip and ankle areas of the body. These are
marketed under the name True/Fix(R). Sales of trauma products accounted for
approximately 8% of Encore's total implant sales in 2001.
Spinal Products
In 1999 Encore entered into a distribution agreement to begin selling
spinal products within the United States for products produced by Scient'x, a
French company. Encore began to obtain FDA approval to market these products in
1999 and the FDA approval process continued into the first half of 2000. The
Isolock(TM) and Isobar(TM) systems consist of rods, plates, cortical screws, and
pedicle screws used to achieve fusion of the spine. In addition, Encore also
markets the PASS(TM) Spinal System, designed and manufactured by Medicrea, a
French company based in La Rochelle, France. FDA approval for this product line
was obtained during the third quarter of 2000 and marketing efforts and sales of
this product commenced during the fourth quarter of 2000. Sales of spinal
products accounted for approximately 6% of Encore's total implant sales in 2001.
Soft Goods Division
- -------------------
Orthopedic Soft Goods
Encore offers a broad selection of traditional soft goods. Included in
this line are abdominal binders and rib belts; ankle, foot and heel supports;
arm slings; cast boots and post-operative shoes; cervical collars; clavicle
splints; elbow supports; finger splints; knee immobilizers and supports; back
supports; shoulder immobilizers; thigh and groin supports; wrist and forearm
supports; and a small offering of traction products. The products are widely
used in many areas within the healthcare setting, including the emergency room,
operating room, outpatient surgery, physicians offices, pharmacies, and sports
medicine clinics. Some of the most recognizable brand names include the
Kallassy(R) Ankle Support, the Sports Supports(R) line of braces and supports,
the Rebound(R) line of consumer orthopedics products and the Turtle Neck(R) and
911 First Response(R) safety collars.
Patient Safety Devices
Encore currently sells a full array of limb and body holders. These
devices are designed to provide security for the patient and staff while being
comfortable and easy to use. In addition, Encore sells a line of less
restrictive devices, which are focused on the safety of the patient. The devices
include finger control mitts, body belts and pelvic holders.
Pressure Care Products
Encore's line of pressure care products includes heel and elbow
protectors; operating room table pads; and knee crutch pads. These products are
designed to provide cushioning for protection of various pressure points.
Although this product grouping represents a very small portion of the overall
sales for the soft goods division, it is a strategic line that is a very solid
seller in the international market.
Rehabilitation Equipment Division
- ---------------------------------
Encore's rehabilitation products are sold through its Chattanooga Group
Division. Chattanooga Group is a leading provider of products used by a variety
of healthcare professionals involved in the field of physical medicine. This
includes
-6-
physical therapists, athletic trainers, chiropractors, sports medicine
physicians and a number of other healthcare professionals. Chattanooga Group
sells many of the leading products in this industry including: Intelect(R),
CPS(R) and Vectra(R) electrotherapy and ultrasound systems, Hydrocollator(R),
Hotpac(R), Colpac(R), Thermawrap(R) and Flexipac(R) hot and cold therapy
products. Opti-Flex(R) continuous passive motion devices, Triton(R), Adapta(R),
and Ergostyle therapy tables and traction devices, and Retrainer(R) EMG systems.
Chattanooga Group focuses significant resources on the development of new
product lines to fuel future growth.
Marketing and Sales
- -------------------
Within the United States, healthcare reform and managed care continue
to change the dynamics of the healthcare industry in response to the needs to
control rising healthcare cost. As a result of healthcare reform, the U.S.
healthcare industry has seen a rapid expansion of managed care at the expense of
traditional private insurance. The development of managed care programs in which
the providers contract to provide comprehensive healthcare to a patient
population at a fixed cost per person (referred to as capitation) has put
pressure on, and is expected to continue to lead, healthcare providers to a
lower cost. The advent of managed care has also resulted in greater attention to
the tradeoff between patient need and product cost, so called demand matching,
where patients are evaluated as to age, need for mobility and other parameters
and then matched with orthopedic product that is cost effective in light of such
evaluation. One result of demand matching has been, and is expected to continue
to be, a shift towards lower cost products, and any such shift in the Company's
product mix to lower margin products, could have an adverse impact on the
Company's operating results.
A further result in managed care and the related pressure on cost has
been the advent of buying groups in the United States. Such buying groups enter
into preferred supplier arrangements with one or more manufacturers of
orthopedic or other medical products in return for price discounts. The extent
to which such buying groups are able to obtain compliance by their members with
such preferred supplier agreements varies considerably depending on the
particular buying groups. With respect to the Company's implant products, it is
not participating in any of these buying group arrangements. In the
rehabilitation product lines, only minimum levels of sales are made to these
buying groups. In the soft goods product area, however, the Company has entered
into national contracts with selected groups and believes that the high level of
product sales to such groups and the opportunity for increased market share have
the potential to offset the financial impact of discounting. It will be
important to our future success and the growth of our revenue to be able to
maintain such existing arrangements. However, the Company might not be able to
obtain new preferred supplier commitments from major buying groups, in which
case it would lose significant potential sales, to the extent these groups are
able to command a high level of compliance by their members. Conversely, if the
Company does receive preferred supplier commitments from particular groups that
do not deliver high level of compliance, the Company may not be able to offset
the negative impact of lower per unit prices or lower margins with any increase
unit sales or market share, which could have a material adverse affect on the
Company's business, financial condition or results of operations.
Implant Division
- ----------------
Encore's implant products are currently marketed and sold in the United
States, Japan, Germany, and certain countries in the Middle East. In the United
States, products are sold to hospitals and orthopedic surgeons through a network
of independent commissioned sales agents. Outside the United States, Encore's
total joint products are sold through distributors. Beginning in 1999, Encore
began rebuilding its international sales force which prior to that year had been
exclusively with the PLUS Endoprothetik AG family based in Switzerland. The
distribution agreement between Encore and PLUS Endoprothetik AG
("PLUS-Switzerland") concluded as of December 31, 2000. However, one affiliate
of PLUS-Switzerland, EndoPLUS GmbH, continues to sell Encore products in
Germany. This rebuilding is being accomplished on a territory by territory
basis. In Japan, certain of Encore's trauma products are sold by Century
Medical, Inc. while Senko Medical Trading Co. carries both Encore's total joint
and the remainder of the Encore trauma products.
Encore strives to place its United States sales agents in sales
territories whose populations contain significant concentrations of individuals
over 55 years of age. As of December 31, 2001, Encore had independent sales
agents selling either reconstructive products, trauma products, spinal products
or all of these systems, in 30 sales territories in 31 states of the United
States. Sales agents are generally granted a contract with a term of one to five
years. Agents are typically paid a sales commission based on the selling price
of all products sold and are eligible for bonuses if sales exceed certain preset
objectives. Each of Encore's sales agents is assigned an exclusive sales
territory. In some cases, sales agents may sell non-competing and/or
complimentary lines of orthopedic products manufactured by other companies.
Encore provides its agents with product inventories on consignment for their use
in marketing Encore products and for filling customer orders.
Soft Goods Division
- -------------------
The orthopedic soft good products are sold primarily to clinicians
through third party distributors. These distributors
-7-
include large, national third party distributors such as Allegiance Healthcare,
Owens & Minor, Inc., McKesson/HBOC, The Burrows Company, and PSS World Medical
Inc., regional medical/surgical distributors and medical product buying groups,
which consist of distributors who make purchases or hospitals that make
purchases through the buying groups. These distributors generally resale the
soft good products to large hospital chains, hospital buying groups, primary
care networks and orthopedic physicians for use by the patients. In addition,
the Company has entered into national contracts for soft good products to large
healthcare providers and buying groups, such as AmeriNet, U.S.
government/military hospitals, HealthSouth Corporation, Concentra and Consorta.
Under these contracts, Encore provides discounted pricing to the buying groups
and are generally designated as one of several preferred purchasing sources for
the members of the buying group for specified products. However, all the members
are not obligated to purchase the Company's products.
Rehabilitation Equipment Division
- ---------------------------------
Encore's rehabilitation products are currently marketed and sold
through a worldwide network of over 5,000 distributors. These distributors sell
the Chattanooga Group branded products to a variety of healthcare professionals
including physical therapists, athletic trainers, chiropractors and sports
medicine physicians. Except for distributors outside of the United States, the
Chattanooga Group does not maintain formal distribution contracts. In addition,
no one distributor accounts for more than 3.5% of total sales. Distributors
purchase product from Chattanooga Group at discounts which vary from 30-50% off
of a published list price. The Chattanooga Group maintains an aggressive
internal marketing and sales support program which supports the dealer network.
This is comprised of a group of individuals who provide dealer and end-user
training, develop promotional materials, and attend over 30 trade shows each
year.
Affiliated Surgeons
- -------------------
The sale of implants depends a significant extent on the prescription
and/or recommendation of such products by orthopedic surgeons and other sports
medicine professionals. Encore has developed and maintained close relationships
with a number of widely recognized orthopedic surgeons who assist in product
research, development and marketing. These professionals often become product
champions, speaking about the Company's products at medical seminars, assisting
in the training of other professionals in the use and implantation of these
products and provide the Company with feedback on the industry's acceptance of
Encore's products. The failure of our existing implants to retain the support of
these surgeons and specialists could have a material adverse affect on the
business, financial conditions and results of operations.
A key aspect in Encore's development, marketing and sale of its implant
products is the use of designing and consulting surgeons. Each major product is
supported by several designing surgeons who assist Encore not only with the
design of the product, but who also give demonstrations using the product,
assist in developing marketing materials and participate at symposia addressing
both clinical and economic aspects of the product. The designing surgeons
working on a product are compensated with a royalty, which is typically split
among the group members. The designing and consulting surgeons may also receive
stock options. Encore has encouraged interaction among the surgeons with visits
to designing surgeons' institutions (e.g., viewing surgeries, training meetings
and regional workshops) by attempting to regionalize the designing surgeon
groups. Encore also has established relationships with consulting surgeons, who
perform various consulting services for Encore. Such services include conducting
clinical studies on various products, analysis of economic issues relating to
use of the products, establishment of protocols for use of the products and
participation at various symposia. Current consulting surgeons do not receive
royalty payments but may be granted stock options under the 1997 Surgeon
Advisory Panel Stock Option Plan. Consulting surgeons are also occasionally paid
consulting fees for their services to Encore in support of Encore products.
Research And Development
- ------------------------
Encore conducts a number of research and development programs at its
facilities in Austin, Texas and in Chattanooga, Tennessee. Such activities are
focused on making improvements to existing products, developing new products
using new materials and surgical applications and obtaining regulatory approval
to market products in the United States and around the world.
The Company's future success and the ability to grow its revenues and
earnings require the continued development or licensing of new products and the
enhancement of existing products. EMC may not be able to continue to develop
successful new products and enhance existing products, obtain regulatory
clearances and approval of such products, market such products in a commercially
viable manner, or gain market acceptance for such products. The failure to
develop or license and market new products and product enhancements could have a
material adverse effect on the Company's business, financial conditions and
results of operations. In addition, competitors may develop new medical
procedures, technology or products that are more effective than the ones the
Company has or that would render its technology or products obsolete or
uncompetitive, which could have a material adverse effect on EMC.
-8-
Competition
- -----------
The market for orthopedic products is highly competitive and is
dominated by a number of large companies, each of which have research and
development, sales, marketing and manufacturing capabilities greater than those
of EMC. These competitors also feature a wider range of product offerings than
Encore, and many have the endorsement of leading orthopedic surgeons for their
products. The Company's competitors include a few large, diversified general
orthopedic product companies and numerous smaller niche companies. Some of our
competitors are parts of corporate groups that have significantly greater
finance, marketing and other resources than the Company does. Accordingly, EMC
may be at a competitive disadvantage with respect to those competitors. Our
primary competitors in the implant business include Johnson & Johnson DePuy,
Stryker, Zimmer Holdings, Inc., Biomet, Inc., Smith & Nephew, and Sulzer Medica,
Inc. Our primary competitors in the soft good products segment include DeRoyal
Industries, dj Orthopedics, Inc., and Zimmer Holdings, Inc. Our primary
competitors in the rehabilitation marketplace include Dynatronics, Smith &
Nephew, and Mettler Electronics.
In the last ten years, new technologies and product concepts have been
introduced into the orthopedic market at a rapid rate, often before prior
technologies and concepts have been fully integrated. Many of Encore's
competitors have entered into various agreements and joint ventures with other
companies to develop innovative products for the industry. Furthermore, most
orthopedic product companies are attempting to develop new implant surfaces to
enhance bone ingrowth. In addition they are experimenting with new materials
such as biologics and ceramics. It is the opinion of Encore's management that
this evolution in high technology products will continue for the foreseeable
future.
In addition to the race for technology, orthopedic product companies
must now devote attention to the prices of their products. Price has become
increasingly important as a competitive factor, due particularly to governmental
and third party payors' adoption of prospective payment systems. Thus, although
Encore's management believes that the design and quality of its products compare
favorably with those of its competitors, should Encore be unable to offer
products with the latest technological advances at competitve prices, its
ability to successfully compete with its competitors could be materially and
adversely affected. Currently, Encore competes favorably on price with most of
its competitors.
Manufacturing
- -------------
Encore uses both in-house manufacturing capabilities and relationships
with third-party vendors to supply products. The third-party vendors may have
special manufacturing capabilities (e.g., casting, forging, porous coating or
sterilization), may be able to supply needed labor at a competitive rate, or may
be general suppliers of finished components. With the exception of those vendors
supplying special capabilities, the choice of in-house or vendor supply is based
on available in-house capacity, lead time control, and cost control.
Encore's in-house capacity for its Implant Division includes CNC
machine tools, belting, polishing, cleaning, packaging and quality control.
Encore obtained ISO 9001 qualification and Medical Device Directive "CE"
certification for this division in 1996. At present, the machining capacity is
used to produce about 75% of the implant units; third party manufacturers
produce the remainder. The primary raw materials used in the manufacture of
Encore's reconstructive products are cobalt chromium alloy, stainless steel
alloys, titanium alloy and ultra high molecular weight polyethylene. Encore has
alternate sources for all of its vendors and suppliers and believes that
adequate capacity exists at its suppliers to meet all anticipated needs. All
implants and instruments go through in-house quality control, cleaning and
packaging operations. Quality control measures begin with an inspection of all
raw materials and castings to be used. Each piece is appropriately inspected at
intervals during the manufacturing process. As a final step, products pass
through a "clean room" environment designed and maintained to reduce product
exposure to particulate matter.
For the OSG Product division, Encore has entered into a contract
manufacturing relationship with a third party supplier in Mexico to supply the
labor component necessary to assemble and finish the soft goods products that
Encore sells. Encore supplies the raw materials and equipment necessary to make
the products. This vendor employs the laborers and manages the assembly process,
under Encore supervision.
Encore's Chattanooga Group division manufactures products which account
for 80% of its revenues. These products are produced in manufacturing facilities
located in Chattanooga, Tennessee. Chattanooga's facilities are capable of
producing products which require metal fabrication, powder coating, electronic
assembly, mechanical assembly, wood working, sewing and a variety of other
processes. The Chattanooga Group is ISO 9001 certified. Manufacturing planning
is accomplished through a state of the art IBM AS400, and Computer Associates
PRMS material requirement planning software.
EMC currently has no manufacturing operations in any foreign country
other than Mexico. The cost of transporting products to foreign countries is
currently borne by the Company's customers, who are also often required to pay
foreign
-9-
import duties on the products. As a result, the cost of these products to
customers who use or distribute them outside the United States is often greater
than products manufactured in that country. In addition, foreign manufacturers
of competitive products often receive various local tax concessions which lower
their overall manufacturing costs. In order to compete successfully in
international markets, the Company may be required to open or acquire
manufacturing operations abroad, which would be costly to implement and would
increase the exposure to the risks of doing business in international countries.
If the Company were to do this, EMC may not be able to successfully operate
off-shore manufacturing operations, which could have a material adverse effect
on its international operations or on its business, financial condition and
results of operations.
Intellectual Property
- ---------------------
EMC holds a number of United States and foreign patents. The quantity
of intellectual property owned by EMC significantly increased as a result of the
CGI acquisition and the purchase of the OSG Products from Kimberly-Clark. It has
approximately twenty-two (22) exclusive patents, which protect Encore both in
the United States and in several foreign countries. Encore has forty-seven (47)
trademarks registered in the United States, a number of which are also
registered in countries around the world, such as Germany, Switzerland, Austria,
China, Japan, Australia, and/or the European Community. Encore also depends on
numerous unregistered trademarks, some of which have been submitted for
registration in the United States and foreign countries. In the future, Encore
will apply for such additional patents and trademarks as it deems appropriate.
However, the Company cannot guarantee that its existing or future patents, if
any, will afford it adequate protection, whether any of its existing patent
applications will result in issued patents, or whether its patents will not be
circumvented or invalidated. Finally, Encore relies on non-patented proprietary
know-how, trade secrets, process and other proprietary information, which it
protects through a variety of methods, including confidentiality agreements and
proprietary information agreements. However, these methods may not provide the
Company with adequate protection. Its proprietary information may become known
to, or be independently developed by, competitors, or EMC's proprietary rights
in intellectual property may be challenged, any of which could have a material
adverse effect on the business, financial condition and results of operations of
the Company.
The Company has distribution rights to certain products that are
manufactured by others and hold licenses from third parties to utilize selected
patents, patents pending and technology utilized in the design of some of the
Company's existing products and products under development. Currently the
revenues from these distribution agreements and licenses represent a small
portion of the Company's net revenue. However, if any of the distribution
agreements were terminated or if the Company lost any of these licenses, the
Company would not be able to manufacture and/or sale related products, which
could have an adverse affect on its future business, financial conditions and
results of operations.
Government Regulation
- ---------------------
Encore's products are subject to rigorous government agency regulation
in the United States and certain other countries. In the United States, the FDA
regulates the testing, labeling, manufacturing and marketing of medical devices
to ensure that medical products distributed in the United States are safe and
effective for their intended uses. The FDA also regulates the export of medical
devices manufactured in the United States to international markets. Encore's
products are subject to such FDA regulation.
Under the Food, Drug and Cosmetic Act, as amended, medical devices are
classified into one of three classes depending on the degree of risk imparted to
patients by the medical device. Class I devices are those for which safety and
effectiveness can be assured by adherence to General Controls, which include
compliance with Quality System Regulations ("QSRs"), facility and device
registrations and listings, reporting of adverse medical events, and appropriate
truthful and non-misleading labeling, advertising and promotional materials.
Some Class I devices also require pre-market review and clearance by the FDA
through the 510(k) Premarket Notification process described below. Class II
devices are subject to General Controls, as well as premarket demonstration of
adherence to certain performance standards or other special controls as
specified by the FDA. Premarket review and clearance by the FDA is accomplished
through the 510(k) Premarket Notification procedure. In the 510(k) Premarket
Notification procedure, the manufacturer submits appropriate information to the
FDA in a Premarket Notification submission. If the FDA determines that the
device is "substantially equivalent" to a device that was legally marketed prior
to May 28, 1976, the date upon which the Medical Device Amendments of 1976 were
enacted, or to another similar commercially available device subsequently
cleared through the 510(k) Premarket Notification process, it will grant
clearance to commercially market the device. It generally takes three to six
months from the date of submission to obtain clearance of a 510(k) Premarket
Notification submission, but the process may take longer. If the FDA determines
that the device, or its "labeled" intended use, is not "substantially
equivalent," the FDA will automatically place the device into Class III.
A Class III product is a product that has a wholly new intended use or
is based on advances in technology for which the device's safety and
effectiveness cannot be assured solely by the General Controls, performance
standards and special
-10-
controls applied to Class I and II devices. These devices often require formal
clinical investigation studies to assess their safety and effectiveness. A
Pre-Market Approval ("PMA") from the FDA is required before the manufacturer of
a Class III product can proceed in marketing the product. The PMA process is
much more extensive than the 510(k) Premarket Notification process. In order to
obtain a PMA, Class III devices, or a particular intended use of any such
device, must generally undergo clinical trials pursuant to an application
submitted by the manufacturer for an IDE. An approved IDE exempts the
manufacturer from the otherwise applicable FDA regulations and grants approval
for the conduct of human clinical investigation in order to generate the
clinical data necessary to scientifically evaluate the safety and efficacy of
the Class III device or intended use.
When a manufacturer believes that sufficient pre-clinical and clinical
data has been generated to prove the safety and efficacy of the new device or
new intended use, it may submit a PMA application to the FDA. An FDA review of a
PMA application generally takes one to two years from the date the PMA
application is accepted for filing, but the process may take significantly
longer. In approving a PMA application, the FDA may also require some form of
post-market surveillance whereby the manufacturer follows certain patient groups
for a number of years, making periodic reports to the FDA on the clinical status
of those patients. This helps to ensure that the long-term safety and
effectiveness of the device are adequately monitored for adverse events. Most
pre-amendment devices (those marketed prior to the enactment of the Medical
Device Amendment of 1976) are, in general, exempt from such PMA requirements, as
are Class I and Class II devices.
Encore's products include both pre-amendment and post-amendment Class
I, II and III medical devices. All currently marketed devices hold the relevant
exemptions or premarket clearances or approvals, as appropriate, required under
federal medical device law.
Encore's manufacturing processes are also required to comply with QSR
regulations that cover the methods and documentation of the design, testing,
production, control, quality assurance, labeling, packaging and shipping of
Encore's products. Further, Encore's facilities, records and manufacturing
processes are subject to periodic unscheduled inspections by the FDA or other
agencies. Failure to comply with applicable U.S. medical device regulatory
requirements could result in, among other things, warning letters, fines,
injunctions, civil penalties, repairs, replacements, refunds, recalls or
seizures of products, total or partial suspensions of production, refusal of the
FDA to grant future pre-market clearances or approvals, withdrawals or
suspensions of current clearances or approvals and criminal prosecution. There
are currently no adverse regulatory compliance issues or actions pending with
the FDA, and no FDA QSR audits conducted at Encore's facilities have resulted in
any adverse compliance enforcement actions.
Encore must obtain export certificates from the FDA before it can
export certain of its products and is subject to regulations in many of the
foreign countries in which it sells its products. These include product
standards, packaging requirements, labeling requirements, import restrictions,
tariff regulations, duties and tax requirements. Many of the regulations
applicable to Encore's devices and products in such countries are similar to
those of the FDA. The national health or social security organizations of
certain countries require Encore's products to be qualified before they can be
marketed in those countries. To date, Encore has not experienced any difficulty
in complying with these regulations. Encore has also implemented policies and
procedures allowing it to position itself for the changing international
regulatory environment. The ISO 9000 series of standards has been developed as
an internationally recognized set of guidelines that are aimed at ensuring the
design and manufacture of quality products. A company that passes an ISO audit
and obtains ISO registration becomes internationally recognized as well run and
functioning under a competent quality system. In certain foreign markets, it may
be necessary or advantageous to obtain ISO 9000 series certification, which is
in some ways analogous to compliance with the FDA's QSR requirements. The
European Community promulgated rules requiring medical products to receive a CE
mark by mid-1998. A CE mark is an international symbol of adherence to certain
standards and compliance with applicable European medical device requirements.
ISO 9000 series certification is one of the prerequisites for CE marking for
most of Encore's products. ISO 9001 is the highest level of ISO certification,
covering both the quality system for manufacturing, as well as the quality
system for product design controls. Encore has received an ISO 9001
certification and "CE" certification for its implant products and the
Chattanooga Group division has received ISO 9001 certification and "CE"
certification for the rehabilitation equipment products.
Certain provisions of the Social Security Act, commonly known as the
"Medicare Fraud and Abuse Statute," prohibit entities, such as Encore, from
offering, paying, soliciting or receiving any form of remuneration in return for
the referral of Medicare or state health program patients or patient care
opportunities, or in return for the recommendation, arrangement, purchase, lease
or order of items or services that are covered by Medicare or state health
programs. Violation of this statute is a felony, punishable by fines of up to
$25,000 per violation and imprisonment of up to five years. In addition, the U.
S. Department of Health and Human Services may impose civil penalties excluding
violators from participation in Medicare or state health programs. Many states
have adopted similar prohibitions against payments intended to induce referrals
of Medicaid and other third party payor patients.
-11-
Subject to certain exemptions, federal physician self-referral
legislation prohibits a physician or a member of his immediate family from
referring Medicare or Medicaid patients to an entity providing "designated
health services" in which the physician has an ownership or investment interest,
or with which the physician has entered into a compensation arrangement.
Penalties for violations include a prohibition on payment by these government
programs and civil penalties of as much as $15,000 for each referral in
violation of the statute and $100,000 for participation in a "circumvention
scheme."
To date the Company has not been challenged by a governmental authority
under any of these laws and believe that our operations are in compliance with
such laws. However, because of the far-reaching nature of these laws, the
Company may be required to alter one or more of its practices to be in
compliance with these laws. Health care fraud and abuse regulations are complex
and even minor, inadvertent irregularities in submissions can potentially give
rise to claims that the statue has been violated. Any violations of these laws
could result in a material adverse effect on the Company's business, financial
condition and results of operations. If there is a change in law, regulation or
administrative or judicial interpretations, the Company may have to change its
business practices or its existing business practices could be challenged as
unlawful, which could have a material adverse effect on the Company's business,
financial condition and results of operations.
Employees
- ---------
As of March 15, 2002, the Company had approximately 415 employees. The
Company's workforce is not unionized. It is not experiencing strikes or work
stoppages and management considers its relationship with its employees to be
good.
Item 2. Properties
Encore owns two pieces of real property in Chattanooga, Tennessee.
These are a 160,000 square foot facility that houses the corporate headquarters
and principal manufacturing operations of the Chattanooga Group, as well as a
60,000 square foot building that houses additional manufacturing operations for
the Chattanooga Group. Encore leases an approximately 70,000 square foot
facility in Austin, Texas for its corporate headquarters, manufacturing
facilities and warehouse for its business operations. This lease is a 10-year
lease that commenced on April 1, 1997, with the option to renew for five years
and with an option to terminate the lease after 5 years upon the payment of the
unamortized leasehold improvement costs. The Company's monthly lease payments
are approximately $45,755, for an annual lease payment of approximately
$549,060, which amounts do not include the Company's share of applicable common
area maintenance, property taxes and public utility charges. Encore also leases
two other smaller warehouse facilities in the same general area of Austin for
excess warehousing operations related to the OSG Products division business
lines. These total 26,500 square feet (16,500 and 10,000). The larger of the two
warehouses is on a renewable six-month lease, while the smaller is on a
month-to-month rental.
Item 3. Legal Proceedings
In the fall of 2001, Encore began a number of legal proceedings against
Akthea S.A.R.L. ("Akthea"), its former distributor in France. The nature of the
claims revolve around monies that were not paid to Encore by Akthea in
connection with the distribution agreement and lease agreement that were entered
into by the parties. The cases by Encore were filed in both United States
District Court in Texas related to the lease agreement issues, and with the
International Chamber of Commerce Arbitration Panel in London related to the
distribution agreement issues. On February 25, 2002, Encore was awarded a
judgment against Akthea in connection with the United States District Court case
in the amount of $377,000. The International Chamber of Commerce Arbitration
case is in the process of appointing arbitrators and scheduling arguments. In
partial response to these actions, Akthea has brought suit against Encore, along
with Endo Plus France S.A.R.L., Plus Endoprothetik AG and Plus Endoprothetik
GmbH, in Commercial Court located in Nanterre, France, alleging, as best as can
be determined, that the defendants have conspired to introduce into commerce in
France implants which combine the products of Encore and Plus and hence have
caused a risk of injury to the French public, as well as have violated the
exclusivity provisions of the Distribution Agreement between Encore and Akthea.
Encore is vigorously challenging the facts, conclusions and jurisdiction of the
French case and has requested that this case be stayed until such time as the
International Chamber of Commerce Arbitration case is resolved.
Chattanooga Group, Inc. is the subject of the Department of Commerce
("DOC") investigation of its export practices with respect to (i) unlawfully
trading with an embargoed country, and (ii) unlawfully preparing export
documentation. This investigation is based in part on allegations to the DOC
made by a former CGI export department clerk (who is awaiting trial for theft of
CGI property). These allegations resulted in the DOC executing a search warrant
at CGI on or about May 31, 2001. Independent counsel for CGI has reviewed the
data obtained by the DOC, as well as additional information provided to it by
CGI. Based on their review, it appears that none of the chief executive officer,
chief financial officer or any member of the board of directors of CGI had any
prior or contemporaneous knowledge of intentional mislabeling of export
documents or the unlicensed shipment of CGI products to an embargoed country. It
also appears that this activity, to the extent that it did occur,
-12-
was minimal in scope and occurred prior to the summer of 2000, which was the
first time that anyone from the DOC visited CGI in connection with potential
export irregularities. To the extent that there are monetary fines or legal
expenses, the sellers of the stock of Chattanooga have agreed to indemnify the
Company to the extent that such fines or expenses are greater than the amount
that was accrued on the financial statements of Chattanooga Group, Inc. as of
the date of the acquisition.
During the year 2000, Encore was a defendant in a lawsuit styled Wright
Medical Technology, Inc. v. Encore Orthopedics, Inc., et al., C. A. No.
99CV4900(SSB), filed in the United States District Court of New Jersey. In this
case, Wright alleged that Encore tortuously interfered with certain of Wright's
contractual relationships and conspired to cause a former Wright sales person to
breach its contract with Wright. This case was settled without any admission of
liability in October 2000. Concurrently with the settlement, Encore entered into
an exclusive supply and distribution agreement with Wright covering the
WRIGHTLOCK(R) spinal product line. Encore purchased a certain amount of stocking
inventory and gained the worldwide exclusive rights to distribute this product
line. In addition, Encore acquired certain rights to intellectual property
related to the product line. Encore recognized a charge of $700,000 during the
fourth quarter of 2000 related to the impairment of this intellectual property.
The manufacturing marketing of orthopedic medical products entails risk
of product liability. From time to time Encore has been subject to product
liability claims. In the future, the Company may again be subject to additional
product liability claims, which may have a negative impact on its business. The
existing product liability insurance coverage may be inadequate to protect the
Company from any liabilities it might incur. If a product liability claim or
series of claims is brought against the Company for uninsured liabilities which
are in excess of the insurance coverage, the business could suffer. In addition,
as a result of a product liability claim, the Company may have to recall some of
its products, which could result in significant cost to it. The Company
currently carries product liability insurance in an amount of $30 million, a
level which it considers adequate. However, there is no assurance that such
amounts can continue to be carried at a reasonable premium or that such amounts
are adequate for any future possibility.
Item 4. Submission of Matters to a Vote Of Security Holders
No matters were submitted during the fourth quarter of the fiscal year
covered by this report to a vote of security holders through the solicitation of
proxies or otherwise.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
EMC's Common Stock and $5 Warrants are traded on the NASDAQ National
Market System under the symbols "ENMC" and "ENMCW," respectively. The following
tables set forth for the periods indicated the high and low sales prices of
EMC's Common Stock and $5 Warrants as reported on the NASDAQ National Market
since January 1, 2000:
Common Shares $5 Warrants
------------- -----------
High Low High Low
---- --- ---- ---
2001
First Quarter $2.06 $1.13 $0.50 $0.16
Second Quarter $1.98 $0.95 $0.42 $0.15
Third Quarter $2.00 $1.33 $0.45 $0.11
Fourth Quarter $3.65 $1.33 $0.54 $0.14
2000
First Quarter $4.46 $2.00 $1.63 $0.31
Second Quarter $3.13 $1.88 $0.75 $0.38
Third Quarter $2.50 $1.56 $0.44 $0.31
Fourth Quarter $2.63 $1.38 $0.44 $0.13
As of March 15, 2002, EMC had approximately 87 shareholders of record
of EMC's Common Stock. There are in excess of 1,400 beneficial owners of EMC's
Common Stock. As of March 15, 2002, EMC had approximately 12 shareholders of
record of EMC's $5 Warrants. There are in excess of 250 beneficial owners of
EMC's $5 Warrants.
On June 12, 2001, EMC issued 132,353 shares of Series A Preferred Stock
in connection with an offering at $102.00 per share for an aggregate purchase
price of $13.5 million. The 132,353 shares of Series A Preferred Stock are
immediately convertible into 13,235,300 shares of the Company's common stock.
The holders of the Series A Preferred Stock have the right to designate up to
two individuals to serve on the Company's Board of Directors. Each share of
Series A Preferred Stock is entitled, for all matters except the election of
directors, to one vote for each share of Common Stock into which such share of
-13-
Series A Preferred Stock is then convertible. Shares of Series A Preferred Stock
bear non-cumulative dividends at a rate of 8% per annum if declared by the
Company. The holders of Series A Preferred Stock are entitled to certain other
rights that are more expansive than the rights of the holders of common stock
which are detailed in the Amended and Restated Series A Preferred Stock Purchase
Agreement dated as of May 3, 2001 between EMC, the Galen Entities and the other
purchasers of the Series A Preferred Stock. Issuance costs associated with the
sale of Series A Preferred Stock amounted to $660,000. As a result of the sale
of the Series A Preferred Stock, of which 87% was acquired by the Galen Entities
(defined below), the Company now has a single stockholder who can substantially
influence the outcome of all matters voted upon by stockholders and prevent
actions that other stockholders may view favorably. The Galen Entities will be
able to substantially influence all matters requiring stockholder approval,
except for the election of directors, including the approval of significant
corporate transactions, such as acquisitions, and to block an unsolicited offer
to purchase EMC and other matters requiring a supermajority vote of
stockholders. This concentration of ownership could delay, defer or prevent a
change in control of the Company or impede a merger, consolidation, takeover or
other business combination which other stockholders may otherwise view
favorably.
On February 8, 2002, in connection with the financing necessary for the
acquisition of Chattanooga Group, Inc., EMC issued a warrant to CapitalSource
Holdings LLC (a related entity to CapitalSource Finance LLC, the entity that
provided a significant portion of the acquisition financing), pursuant to which
CapitalSource Holdings LLC has the right to acquire for a period of five years
up to an aggregate of 2,198,614 shares of common stock of the Company (the "CS
Warrants") (constituting 8.25% of the issued and outstanding common stock
(calculated on a fully diluted, as converted basis, determined using the
treasury stock method) of EMC as of February 8, 2002). The number of shares of
common stock that may be acquired under the CS Warrants is initially 2,150,000.
In the event that EMC obtains the approval of its stockholders, as is required
in order to comply with NASDAQ Marketplace Rule 4350(i)(1)(D), prior to July 1,
2002, the number of shares that may be acquired under the CS Warrant will be
increased to 2,198,614. If that approval is not obtained, then EMC would be
obligated to pay CapitalSource a fee equal to the greater of (i) $324,255.38 and
(ii) the product of 48,614 multiplied by the per share fair market value of
EMC's common stock as of July 1, 2002.
Item 6. Selected Financial Data
The following sets forth selected financial data with respect to the
Company for the periods indicated. The data as of December 31, 2001, 2000, 1999,
1998 and 1997 and for each of the five years in the period ended December 31,
2001, have been derived from EMC's audited historical consolidated financial
statements. The selected financial data should be read in conjunction with the
financial statements and related notes thereto, and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" included elsewhere in
this report.
Year Ended December 31,
----------------------
(in thousands, except per share data) 2001 2000 1999 1998 1997
---- ---- ---- ---- ----
Statement of Operations Data
Sales $ 42,721 $ 30,113 $26,095 $28,990 $24,440
Gross margin 24,869 15,130 17,902 19,408 16,504
Income (loss) from operations 1,649 (4,009) 3,015 3,201 2,500
Income (loss) before extraordinary item 548 (3,263) 1,619 1,777 1,857
Net income (loss) 548 (3,263) 1,619 1,777 1,259
Beneficial conversion feature related to
Series A Preferred Stock (3,706) - - - -
Net income attributable to common stock (3,158) (3,263) 1,619 1,777 1,259
Basic earnings (loss) per common share (0.34) (.36) 0.18 0.20 0.16
Shares used in computing basic earnings
(loss) per share 9,355 8,990 9,117 9,088 8,033
Diluted earnings (loss) per share (0.34) (.36) 0.16 0.17 0.12
Shares used in computing diluted earnings
(loss) per share 9,355 8,990 10,219 10,611 10,253
Balance Sheet Data
Working capital $ 21,861 $ 20,850 $20,680 $17,954 $14,682
Total assets 51,662 38,494 36,915 30,556 25,721
Current portion of note payable and
long-term debt 9,975 3,232 734 1,265 612
Long-term debt, less current portion 2,851 13,750 12,047 5,603 3,244
Stockholders' equity 32,177 17,820 21,074 19,824 18,024
-14-
Other Data (see fn. 9 to Financial Statements)
Basic earnings (loss) per common share
prior to beneficial conversion feature 0.06 (.36) 0.18 0.20 0.16
Shares used in computing basic earnings
(loss) per share prior to beneficial
conversion feature 9,355 8,990 9,117 9,088 8,033
Diluted earnings (loss) per share prior to
beneficial conversion feature 0.03 (.36) 0.16 0.17 0.12
Shares used in computing diluted earnings
(loss) per share prior to beneficial
conversion feature 17,517 8,990 10,219 10,611 10,253
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with the
Consolidated Financial Statements and related notes for those financial
statements as well as the other financial data included elsewhere in this Form
10-K.
Basis of Presentation
This Form 10-K is dated as of March 15, 2002 and will, except for the
audited financial statements and the notes which are an integral part of such
financial statements, reflect the status of EMC as of that date. The audited
financial statements and accompanying notes will reflect the status of EMC as of
December 31, 2001. Therefore, the narrative portion of the Form 10-K will
include the recently acquired business, assets, liabilities and operations of
Chattanooga Group, Inc.
In connection with the acquisition of Chattanooga Group, Inc., and for
purposes of efficiency and state tax minimization, Encore Orthopedics, Inc. was
converted on February 7, 2002, from a Delaware corporation to a Delaware limited
partnership. It has two partners, Encore Medical GP, Inc. ("EGP") and Encore
Medical Asset Corporation ("EMAC"), the general partner and limited partner,
respectively. Both of these corporations are wholly owned subsidiaries of Encore
Medical Corporation. All of the assets, liabilities, operations and financial
results will be consolidated in the financial statements of EMC. Prior to
February 7, 2002, neither EGP or EMAC has any operations. On March 1, 2002,
Chattanooga Group, Inc. was merged into and with Encore Medical, L.P. Encore
Medical, L.P. being the surviving entity.
Critical Accounting Policies and Estimates
Management's discussion and analysis of financial condition and results
of operations is based upon the financial statements, which have been prepared
in accordance with accounting principles generally accepted in the United States
of America. The preparation of these financial statements requires the Company
to make estimates and judgments that affect the reported amounts of assets,
liabilities and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, management evaluates estimates, including
those related to inventory, accounts receivable, deferred taxes, and
contingencies and litigation. EMC bases its estimates on historical experience
and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates.
Financial Reporting Release No. 60, which was recently released by the
Securities and Exchange Commission, proposes a new requirement that all public
companies include a discussion of critical accounting policies or methods used
in the preparation of financial statements. Note 1 to the Consolidated Financial
Statements included elsewhere in this report includes a summary of the
significant accounting policies and methods used in the preparation of our
financial statements. The following is a brief discussion of the more
significant accounting policies and methods used by the Company.
In addition, the Securities and Exchange Commission recently released
Financial Reporting Release No. 61, which requires all companies to include a
discussion to address, among other things, liquidity, off-balance sheet
arrangements, contractual obligations and commercial commitments.
We apply the following critical accounting policies in the preparation
of our financial statements:
Inventory Reserves
- ------------------
The nature of EMC's implant business requires it to maintain sufficient
inventory on hand at all times to meet the requirements of its customers. EMC
records inventory at the lower of cost or market, with cost based upon average
actual cost. General inventory reserves are maintained for the possible
impairment of the inventory for such issues as slow moving, excess,
-15-
product obsolescence and valuation. In determining the adequacy of its reserves,
at each reporting period EMC analyzes the following, among other things:
1. Current inventory quantities on hand;
2. Product acceptance in the marketplace;
3. Customer demand;
4. Historical sales;
5. Forecasted sales;
6. Product obsolescence; and
7. Technological innovations.
Any modifications to EMC's estimates of its reserves are reflected in
cost of goods sold within the statement of operations during the period in which
such modifications are determined necessary by management.
Revenue Recognition
- -------------------
The Company's products are sold through (i) a network of sales
representatives and foreign implants distributors, and (ii) through large
medical/surgical product distributors. Revenues from sales made by
representatives, who are paid commissions upon the ultimate sale of the
products, are recorded at the time the product is utilized in a surgical
procedure and a purchase order is received. Revenues from sales to foreign
customers are recorded when the product is shipped to the customer. The foreign
implant distributors, who sell the products to other customers, take title to
the products, have no special rights of return, and assume the risk for credit
and obsolescence. For the OSG Products, sales are recorded at the time the
product is shipped to the customer.
EMC must make estimates of potential future product returns and rebates
related to current period product revenue. To do so, management analyzes
historical returns, current economic trends, and changes in customer demand and
acceptance of EMC's products when evaluating the adequacy of the sales returns
and other allowances. Significant management judgments and estimates must be
made and used in connection with establishing the sales returns, rebates and
other allowances in any accounting period.
Allowance for Doubtful Accounts
- -------------------------------
EMC must make estimates of the uncollectibility of accounts
receivables. In doing so, management analyzes accounts receivable and historical
bad debts, customer concentrations, customer credit-worthiness, current economic
trends and changes in customer payment patterns when evaluating the adequacy of
the allowance for doubtful accounts.
Deferred Tax Asset Valuation Allowance
- --------------------------------------
In assessing the potential realization of deferred tax assets,
management considers whether it is more likely than not that some portion or all
of the deferred tax assets will be realized. The ultimate realization of
deferred tax assets is dependent upon EMC attaining future taxable income during
the periods in which those temporary differences become deductible. Based upon
management's projections of future taxable income and the periods and manner in
which EMC's deferred tax assets will be available, management estimates that it
is more likely than not that all of EMC's deferred tax assets will be available
to offset future taxable income. As such, no valuation allowance has been
provided against the deferred tax asset balance at December 31, 2001.
General
EMC is expanding to be a broad based, diversified medical products
company that designs, manufactures and markets high quality medical products
around the world. From its roots as an orthopedic implant company, it is
broadening its focus into additional areas of orthopedic patient care and
surgical products. It will accomplish this through internal growth and
acquisitions targeted at profitable, well positioned companies that can allow it
to build several platforms in the medical products industry. This strategy
commenced during the last half of 2001 and has continued into 2002.
EMC has only a single operating subsidiary. This company designs,
markets and distributes orthopedic products and supplies. Its products are used
primarily by orthopedic medical specialists to treat patients with
musculoskeletal conditions resulting from degenerative diseases, deformities,
traumatic events and participation in sporting events. Encore's implant products
cover a broad variety of orthopedic needs and include hip, knee and shoulder
implants to reconstruct damaged joints, trauma products to reconstruct bone
fractures, and spinal implants to aid in the repair of the spinal column. The
Company has one of the broadest lines of orthopedic soft goods in the
marketplace for non-surgical products that repair, regenerate and
-16-
rehabilitate soft tissue and bone, and protect against injury. The Chattanooga
Group division of Encore has a complete line of all items necessary for
rehabilitation of orthopedic injuries, serving the needs of physical therapists,
chiropractors and sports medicine professionals.
On July 2, 2001, EMC purchased the OSG Products. On February 8, 2002,
EMC purchased Chattanooga Group, Inc., a privately-held, Tennessee based
provider of orthopedic rehabilitation equipment. CGI designs, manufactures and
distributes around the world a wide range of rehabilitation products making it
capable of providing turn-key clinics for orthopedic professionals.
As a result of these activities, EMC offers three broad platforms of
orthopedic products - implants, soft goods and rehabilitation equipment. These
products provide solutions for patients and orthopedic professionals throughout
the patient's continuum of care.
Encore has invested in building a flexible infrastructure consisting of
experienced personnel, business and management information systems, and floor
space to provide the highest level of customer responsiveness at the lowest
possible cost. The most current technology is employed to provide the visibility
required throughout the Company to plan for and manage rapid growth.
Results of Operations
Year Ended December 31, 2001 Compared to Year Ended December 31, 2000.
Overall, 2001 was a positive year for EMC. The core business of implant
sales grew, while the first acquisition, of the OSG Products, was accomplished.
Total sales increased 42% over 2000 to $42,721,000 from $30,113,000. Implant
product sales increased to $33,837,000 or 12% over the prior year. The Company
focused on building its domestic sales force and, as a result, domestic implant
sales increased 28% with every product line experiencing double-digit growth.
Particularly strong was the increase in spinal product sales. Agents that were
with Encore for the entire year showed strong increases over the prior year's
sales. The OSG Products contributed $8,884,000 or 70% of the total increase.
International sales decreased by 16.6%, which reflected the fall off of the
European distributors as the change from the PLUS organization sales force to a
different set of distributors was instigated.
Gross margin increased by $9,739,000 or 64% compared to 2000. This
increase was due, in part, to there being no additional charges for product
rationalization, which in 2000 amounted to $4,203,000. OSG Products contributed
$2,950,000 to gross margin and the gross margin for implants increased by
$2,586,000, excluding the additional charge in 2000, or 13%. Gross margin as a
percent of sales for 2000 without the inventory charge for product
rationalization was 64%. Gross margin as a percent of sales declined from 64% in
2000 to 58% in 2001 due to sales mix, both geographical and product. Gross
margin as a percent of sales for implants and soft goods were 65% and 33%
respectively, for a consolidated 58%.
Research and development expenses decreased by $46,000, or 3%,
primarily due to the approval of products in late 2000 and early 2001, such as
the Keystone(R) Modular Hip System and the Metal/Metal Acetabular Hip System.
The decline is also due to the timing of expenditures for current projects.
Current activities include the design of a new revision shoulder, a universal
hip stem, and a new total knee system. Clinical studies are continuing on a
mobile bearing knee product, the ceramic/ceramic acetabular hip system and a
ceramic femoral knee component.
Selling, general, and administrative expenses increased $4,505,000 or
29% compared to 2000. This was due in part to commissions and royalties paid on
increased implant sales, incentive, amortization of intangibles, professional
fees, relocation expense and contract services. Additionally, expenses related
to the OSG Products also contributed to the total increase. However, as a
percent of sales, selling, general and administrative expenses decreased to 46%
compared to 51% of sales in 2000.
Additional charges of $1,623,000 and $2,001,000 were taken in the
second quarter of 2001 and the fourth quarter of 2000, respectively, which
related to specific items that are not part of the normal selling, general and
administrative, or research and development expenses, the components of which
are summarized as follows:
For the Year Ended December 31,
2001 2000
---- ----
Impairment of intangibles $ - $ 700
Post retirement benefits for former employees - 439
Provision for doubtful accounts - 383
-17-
Legal settlement charges 535 -
Compensation expense associated with stock
option exchange program 917 -
Other 171 479
------- -------
Total $ 1,623 $ 2,001
======= =======
The most significant charge in 2001 related to an exchange of certain
outstanding options for stock. Approximately 1.9 million options were cancelled
and approximately 600,000 shares were issued to the senior management of EMC.
The total charge taken for this exchange approximated $917,000, the cash impact
of which was $419,000. The $535,000 in legal settlement charges in 2001 related
to the settlement of the lawsuit brought by one of EMC's stockholders in an
attempt to stop the issuance of the Series A Preferred Stock. $125,000 of this
expense was a cash expense. Finally, there was a $171,000 charge for
compensation expense associated with a cashless exercise of options by a former
employee.
Operating income increased from a loss of $4,009,000 to income from
operations of $1,649,000. Prior to the effect of the additional charges in 2001
and 2000, as well as the additional inventory reserves of $4,203,000 taken in
2000, operating income in 2001 increased 49% from $2,195,000 in 2000 to
$3,272,000 in 2001.
Interest expense decreased $47,000 in 2001 to $1,299,000 as compared to
2000. This decrease reflects both lower interest rates on the revolving credit
facility of EMC and a decreasing amount outstanding on that revolving credit
facility. As a result of the increases in sales, and the lower spending levels,
overall, net income for 2001 was $548,000 as compared to a net loss in 2000 of
$3,263,000.
On June 12, 2001, the stockholders of the Company approved the issuance
of 132,353 shares of Series A Preferred Stock at $102.00 per share for an
aggregate purchase price of $13.5 million. The 132,353 shares of Series A
Preferred Stock are immediately convertible into 13,235,300 shares of the
Company's common stock. Issuance costs associated with the sale of Series A
Stock amounted to $660,000. In connection with the issuance of Series A
Preferred Stock in June 2001, because the stock is immediately convertible into
common stock of Encore at the holder's option at a conversion price of $1.02 per
share, which was below the per share closing price of the Company's common stock
on the date of the issuance of the Series A Preferred Stock, EMC recorded a
charge to net income available to common stockholders of $3,706,000 representing
the fair value of the beneficial conversion feature of the Series A Preferred
Stock.
Year Ended December 31, 2000 Compared to Year Ended December 31, 1999.
Sales were $30,113,000 for the year ended December 31, 2000,
representing an increase of $4,018,000 or 15% compared to total sales of
$26,095,000 for the year ended December 31, 1999. Both international and U.S.
sales increased during the year. International sales increased 42% in the year
ended December 31, 2000 when compared to the year ended December 31, 1999. This
was due to the rebuilding of the international sales force, primarily in Japan,
as well as the addition of sales forces in certain countries in the Middle East
and France. In the United States, sales increased 5% for the year when compared
to the prior year. While agents that were with Encore for the entire year showed
strong increases over the prior year's sales, Encore was not as successful as it
anticipated in increasing the number of sales agents or representatives actively
selling Encore products. In an effort to focus the sales force on productive
agents, there were a number of sales representatives whose agreements with
Encore were terminated during 2000.
Sales of reconstructive devices, knees, hips, and shoulders, each
showed a significant increase in sales in 2000 when compared to 1999. Knee sales
increased 10% over the prior year, hip sales increased 20% over the prior year,
and shoulder sales increased 11% over the prior year. This was a result of
several agents showing stronger sales year over year and the introduction of
revision hips products.
However, trauma sales showed an overall decrease of 10% from the prior
year. This was primarily due to the fact that there had been a large order
during 1999 for the Japanese customer of the Ultimax(TM) line of trauma products
which was not repeated during 2000.
Spinal product sales increased to over $500,000 during the year of
2000, which was a result of obtaining the necessary FDA approvals for the
Scient'x product lines during the first quarter of 2000 and beginning to sell
the Medicrea product lines during the second half of 2000.
Gross margin during 2000 was negatively impacted by two different
items. First, with the increased percentage of international sales, as compared
to U.S. sales, gross margin decreased because U.S. sales generate a greater
gross margin than sales outside the United States. Secondly, during the fourth
quarter of 2000, Encore conducted an extensive evaluation of its product lines
and decided to rationalize the products it was offering for sale. As a result of
this product rationalization, there
-18-
was $4,203,000 of additional reserves added to the inventory reserve for slow
moving, discontinued and obsolete items. Gross margin, as a percentage of sales,
was 50% when the inventory charge is included, and 64% without the inventory
charge. This compares to a gross margin of 69% of sales for 1999.
Selling, general and administrative expenses increased by $2,104,000 or
16% over 1999. A portion of this increase came from an increase of commission
and royalty expenses related to higher sales. Additional increases in selling
expenses related to national sales meeting and surgeon meetings which had not
been held in prior years.
Research and development expenses increased by $147,000 over the amount
spent in 1999. This represents an increase of 9%. Significant activities
undertaken during the year resulted in the Keystone(R) Modular Hip System being
approved by the FDA during 2000, as well as a number of IDE clinical studies
being conducted. Additionally, several products are in the process of being
developed.
An additional charge of $2,001,000 was taken in the fourth quarter of
2000 which relates to specific items that are not part of the normal selling,
general and administrative, or research and development expenses. The most
significant was a charge of $700,000 related to impairment of intangible assets.
Additional components of this charge include $439,000 which relates to post
retirement obligations for former employees and $383,000 which relates to
doubtful accounts connected to a French customer.
As a result of these other charges and the increase in the inventory
reserve taken in 2000, operating income showed a loss of $4,009,000. However,
absent these charges, operating income would have been $2,195,000. This amount
is $820,000 or 27% less than operating income for 1999.
Interest expense increased by $369,000 in 2000 compared to 1999. This
was due to a full year of interest expense related to the notes incurred in the
acquisition of BTI, whereas only nine months of interest expense was incurred
during 1999 related to these notes. In addition, the average amount outstanding
on the line of credit during 2000 was greater than the average amount
outstanding during 1999.
The total effect of the increase in sales, offset by the increase in
expenses as well as the charges to inventory reserves and other charges outlined
above resulted in EMC having a net loss for the year of $3,263,000.
Capital Expenditures
Encore has spent a significant amount of its resources over the past
several years on building a state-of-the-art, fully integrated orthopedic
implant company. These expenditures have included the investment in surgical
instrumentation, machine tools to increase manufacturing capacity, computer
hardware and software, and equipment required to support a growing organization.
Over the last several years, Encore has acquired machine tools primarily through
capital leases. Encore has made significant investments in surgical implant
instrumentation; which is necessary to implant Encore reconstructive products.
Also, the size of the sales force and the increases in the product lines has
necessitated increases in the need for additional surgical implant instruments.
In the United States, these instruments are capitalized and depreciated. They
are used by the sales force to aid in sales. Internationally, these instruments
are sold or leased to international customers. The amounts of surgical implant
instruments capitalized in 2001, 2000 and 1999 were $1,934,000, $1,280,000 and
$1,373,000, respectively. Other capital expenditures during those periods were
$114,000, $414,000 and $731,000, respectively. Additionally, Encore acquired
$1,266,000 of equipment in connection with the acquisition of the OSG Products
on July 2, 2001. Encore has capitalized $657,000 primarily in warehouse
equipment and computer equipment and software to set up information systems,
network and warehousing capabilities related to OSG Products.
As a growing organization, Encore has devoted significant capital
resources to expanding and improving its management information systems through
additions of hardware and software. The expenditures for these computer
expansions and improvements were approximately $619,000 in 2001, $194,000 in
2000, and $249,000 in 1999.
Liquidity
Since inception, EMC has financed its operations through the sale of
equity securities, borrowings and cash flow from operations. As of December 31,
2001, the Company had available to it a $10.5 million revolving credit facility
(the "Prior Credit Facility"). As of December 31, 2001, the Company had drawn
approximately $6.6 million and the Company was in compliance with all of the
financial covenants of the Prior Credit Facility.
During 2001, operating activities provided cash and cash equivalents of
$8.8 million primarily due to a decrease in inventory, an increase in accounts
payable and accrued liabilities, and net income adjusted for depreciation and
amortization.
-19-
This compares favorably to 2000 when operating activities used cash and cash
equivalents of $2.9 million. EMC's continued growth has resulted in an increase
in its capital requirements. This growth has been primarily funded by the Prior
Credit Facility, the Credit Agreement (as defined below), cash generated from
operations to meet its working capital needs and the sale of equity. As of
December 31, 2001, EMC had net working capital of approximately $22 million.
In June 2001, EMC raised $12.8 million, net of issuance costs of
$660,000, in connection with the sale of Series A Preferred Stock. The purpose
of raising this money was to fund acquisitions EMC had previously announced it
was pursuing. The first of these acquisitions was completed on July 2, 2001,
with the purchase of the OSG Products from Kimberly-Clark Corporation.
In order to finance the acquisition of Chattanooga Group, Inc., EMC and
its subsidiaries entered into a new Credit Agreement (the "Credit Agreement")
dated as of February 8, 2002 with Bank of America, National Association, as
agent, and the lenders signatory thereto, for a maximum borrowing capacity of up
to $30,000,000, subject to limitations based upon EMC's Borrowing Base, as
defined (the "Senior Credit Facility"), pursuant to the Credit Agreement. EMC
and its subsidiaries executed various security documents in order to secure the
financing under the Credit Agreement, including security agreements, a mortgage,
guaranty agreements, a copyright security agreement, patent security agreements,
trademark security agreements and various Uniform Commercial Code financing
statements. As of February 8, 2002, EMC had borrowed approximately $18,000,000
under the Credit Agreement, with the availability (based upon the current
Borrowing Base) of approximately an additional $2,700,000 to borrow for working
capital and general corporate purposes.
Further, in order to finance the acquisition of Chattanooga Group,
Inc., EMC and its subsidiaries entered into a Note and Equity Purchase Agreement
(the "Note Agreement") dated as of February 8, 2002 with CapitalSource Finance
LLC, as agent and purchaser ("CapitalSource"), pursuant to which EMC sold
$24,000,000 in senior subordinated notes (the "Senior Subordinated Notes") to
CapitalSource. EMC and its subsidiaries executed various security documents in
order to secure the financing under the Note Agreement, including security
agreements, a mortgage, guaranty agreements, a copyright security agreement,
patent security agreements, trademark security agreements and various Uniform
Commercial Code financing statements. The security interests created by the
security documents executed pursuant to the Note Agreement are junior and
subordinate to the security interests created by the security documents executed
pursuant to the Credit Agreement.
In connection with the Note Agreement, EMC granted CapitalSource a
warrant to purchase up to an aggregate of 2,198,614 shares of common stock of
the Company (the "CS Warrants") (constituting 8.25% of the issued and
outstanding common stock (calculated on a fully diluted, as converted basis,
determined using the treasury stock method) of EMC as of February 8, 2002). The
number of shares of common stock that may be acquired under the CS Warrant is
initially 2,150,000. In the event that EMC obtains the approval of its
stockholders, as is required in order to comply with NASDAQ Marketplace Rule
4350(i)(1)(D), prior to July 1, 2002, the number of shares that may be acquired
under the CS Warrant will be increased to 2,198,614. If that approval is not
obtained, then EMC would be obligated to pay CapitalSource a fee equal to the
greater of (i) $324,255.38 and (ii) the product of 48,614 multiplied by the per
share fair market value of EMC's common stock as of July 1, 2002.
These debt arrangements contain operating and financial restrictions
which may restrict EMC's business and financing activities. These debt
agreements restrict EMC's ability to (i) incur additional indebtedness; (ii)
issue redeemable equity interests and preferred equity interests; (iii) pay
dividends or make distributions, repurchase equity interests or make other
restricted payments; (iv) make capital expenditures; (v) create liens; (vi)
enter into transactions with our affiliates; (vii) make investments; (viii) sell
assets; or (ix) enter into mergers or consolidations.
Under the Note Agreement, if EMC generates less than certain amounts of
earnings before interest, taxes, depreciation and amortization, then EMC would
have the right, commencing on March 31, 2003 and ending on August 15, 2003, to
prepay without penalty up to $6,000,000 aggregate principal amount of the senior
subordinated notes. If EMC exercises this right, then a pro-rata portion of the
CS Warrants (the "Conveyed Warrants") would be conveyed by CapitalSource to the
Galen Entities (as defined below). In the event EMC does not choose to exercise
this right, then three related entities, Galen Partners III, L.P., Galen
Partners International III, L.P. and Galen Employee Fund III, L.P.
(collectively, the "Galen Entities"), have agreed to purchase the amount of
senior subordinated notes that EMC has the right to prepay. The Galen Entities
beneficially own approximately 51% of the outstanding shares of common stock (on
an as-converted basis) of EMC. In the event the Galen Entities purchase any
senior subordinated notes from CapitalSource, then upon such purchase, (a) those
notes will automatically convert into additional shares of EMC's Series A
Preferred Stock at a conversion price equal to the lower of (i) $150 per share
or (ii) 50 times the greater of $1 or the trailing ten-day average closing price
of the Company's common stock on the date of conversion, and (b) a pro-rata
portion of the Warrants will also be conveyed by CapitalSource Holdings LLC to
the Galen Entities. As an inducement for the Galen Entities to enter into the
CapitalSource/Galen Agreement, EMC granted the Galen Entities options dated as
of February 8, 2002 (the "Option Agreements") to acquire up to that number of
shares of EMC common stock with a value equal to $6,000,000 at an exercise price
equal to the greater of $3.50 per share or one-half of
-20-
the trailing ten-day average closing price of EMC's common stock on the date of
exercise. If the Galen Entities choose to exercise their rights under the Option
Agreements, then any Conveyed Warrants will automatically be terminated.
Conversely, if the Galen Entities choose to exercise any Conveyed Warrants, then
the Option Agreements will automatically be terminated. The Option Agreements
will otherwise automatically terminate on the earlier of (i) the 30th day
following the date the Galen Entities are no longer obligated to purchase any
senior subordinated notes under the CapitalSource/Galen Agreement, (ii) the date
the Galen Entities acquire any senior subordinated notes or (iii) August 15,
2003.
While EMC's current forecast shows that the Company will be able to
meet the financial covenants during 2002 and will be able to keep the need for
outstanding debt under the maximum ceilings for amounts outstanding, there is no
assurance that the forecasts will prove accurate or that the bank's requirements
will be able to be met. There exists the possibility that EMC will need to
obtain additional equity financing, although there is no assurance as to the
amount, availability or cost of such financing.
In addition to the current restrictions and requirements contained in
the current credit arrangements, EMC's significant debt level may limit its
flexibility in obtaining additional financing and in pursuing other business
opportunities. EMC's high degree of leverage could have negative consequences
for it, including the following: (i) the ability to obtain additional financing,
if necessary, for working capital, capital expenditures, acquisitions or other
purposes may be impaired, or financing may not be available to it on favorable
terms; (ii) EMC will need a substantial portion of its cash flow to pay the
principal and interest on its indebtedness, including indebtedness that it may
incur in the future; (iii) payments on the EMC's indebtedness will reduce the
funds that would otherwise be available for operations and future business
opportunities; (iv) a substantial decrease in net operating cash flows could
make it difficult for EMC to meet its debt service requirements and force it to
modify its operations; (v) EMC's debt level may make it more vulnerable than its
competitors to a downturn in either its business or the economy generally; and
(vi) since some of the debt has a variable rate of interest, it exposes EMC to
the risk of increased interest rates.
EMC began actively purchasing its equity securities, both common stock
and $5 Warrants, in connection with the buyback program it announced at the
beginning of 1998. This program was initiated because EMC management and the
Board of Directors felt that EMC's equity was undervalued. EMC repurchased
43,500 and 185,200 shares of common stock in 2000 and 1999, respectively. EMC
repurchased 81,500 $5 Warrants during 1999. Unrelated to the buyback program, in
2001 EMC acquired 180,000 shares of common stock of EMC from an entity related
to the former Chairman of the Board of EMC and approximately 134,000 shares of
common stock resulting from a cashless exercise of stock options. EMC did not
repurchase any $5 Warrants during 2000 or 2001.
EMC is exposed to certain market risk as part of its ongoing business
operations. Primary exposure includes changing in interest rates. EMC is exposed
to interest rate risk in connection with the term loans and borrowings under the
Credit Agreement, which bears interest at floating rates based on the London
Interbank Offered Rate ("LIBOR") or the prime rate plus an applicable borrowing
margin. EMC manages its interest rate risk by balancing the amount of fixed and
variable debt. For fixed rate debt, interest rate changes affect the market
value, but do not impact earnings or cash flow. Conversely, for variable rate
debt, interest rate changes generally do not affect the fair market value, but
do impact future earnings and cash flows, assuming other factors are held
constant. As of December 31, 2001, all of the debt on the Prior Credit Facility
was a variable rate debt, while certain other debt of the Company was fixed rate
debt. With the new financing incurred in connection with the acquisition of
Chattanooga Group, Inc., all of the Senior Credit Facility is variable rate
debt, while the Senior Subordinated Notes, while having the possibility for
interest rate fluctuation, are structured so as to remain at no less than 13%
interest and no more than 15% interest. EMC may use derivative financial
instruments where appropriate to manage its interest rate risk. However, as a
matter of policy, it does not enter into derivative or other financial
investments for trading or speculative purposes. To date, it has entered into no
derivate financial instruments. Currently and historically, all of the Company's
sales have historically been denominated in U.S. dollars, and therefore the
Company has not been subject to foreign currency exchange risks. However, as the
Company begins to directly distribute its products in selected foreign markets,
it is expected that future sales of these products in these markets will be
denominated in the applicable foreign currencies, which would cause currency
fluctuations to more directly impact its operating results.
Contractual Obligations and Commercial Commitments
At December 31, 2001, the aggregate amount of annual principal maturities of
long-term debt (excluding capital lease obligations) of EMC is as follows (in
thousands):
Year Ended December 31,
2002 $ 9,786
2003 1,727
-21-
2004 789
2005 208
---------
$ 12,510
---------
Leases
The Company leases building space, manufacturing facilities and equipment under
non-cancelable lease agreements that expire at various dates. At December 31,
2001, future minimum lease payments are as follows (in thousands):
Capital Operating
Leases Leases
---------------- ----------------
Year Ending December 31,
2002 $ 209 $ 701
2003 97 657
2004 38 660
2005 - 691
2006 and thereafter - 186
---------------- ----------------
Total minimum lease payments 344 $ 2,895
----------------
Less - amounts representing interest (28)
----------------
Net minimum lease payments 316
Less - current portion of obligations under capital leases (189)
----------------
$ 127
----------------
Related Party Transactions
On February 1, 2001, EMC purchased from an entity related to the former
Chairman of the Board of EMC 180,000 shares of common stock of EMC. These shares
were purchased at a price approximately equal to the then current trade price of
the stock on the NASDAQ. The consideration for these shares was given in the
form of a promissory note with an original principal amount of $409,000, bearing
interest at 6.5%, payable bi-weekly over a three year period. Simultaneously
with this transaction, the former Chairman of the Board agreed to relinquish
109,767 options to purchase common stock in EMC that were in his possession. The
exercise prices of these options ranged from $1.69 to $5.16.
Forward Looking Statements
The foregoing Management's Discussion and Analysis contains various
"forward looking statements" within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that
represent EMC's expectations or beliefs concerning future events, including, but
not limited to, statements regarding growth in sales of Encore's products,
profit margins and the sufficiency of Encore's cash flow for its future
liquidity and capital resource needs. These forward looking statements are
further qualified by important factors that could cause actual results to differ
materially from those in the forward looking statements. These factors include,
without limitation, the effect of competitive pricing, Encore's dependence on
the ability of its third-party manufacturers to produce components on a basis
that is cost-effective to Encore, market acceptance of Encore's products, the
ability to attract and retain competent employees, technological obsolescence of
one or more products, changes in product strategies, the availability to locate
acceptable acquisition candidates and then finance and integrate those
acquisitions, and effects of government regulation. Results actually achieved
may differ materially from expected results included in these statements as a
result of these or other factors.
Recently Issued Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board issued SFAS No.
141, "Business Combinations" (SFAS No. 141). SFAS 141 is effective as follows:
a) use of the pooling-of-interest method is prohibited for business combinations
initiated after June 30, 2001; and b) the provisions of SFAS 141 also apply to
all business combinations accounted for by the purchase method that are
completed after June 30, 2001 (that is, the date of the acquisition is July 2001
or later). There are also transition provisions that apply to business
combinations completed before July 1, 2001, that were accounted for by the
purchase method. We do not expect the adoption of SFAS No. 141 to have a
significant impact on our financial condition or results of operation.
-22-
In June 2001, the Financial Accounting Standards Board issued SFAS No.
142, "Goodwill and Other Intangible Assets," (SFAS No. 142) which changes how
goodwill and other intangible assets are accounted for subsequent to their
initial recognition. Under this standard, goodwill and other intangible assets
having identifiable useful lives are no longer amortized, but are subjected to
periodic assessments of impairment. SFAS No. 142 is effective for fiscal years
beginning after December 15, 2001. We are currently in the process of evaluating
SFAS No. 142 and the effect it may have on our financial statements. As of this
date, we have not determined whether SFAS No. 142 will have a material impact on
our financial statements or results of operations.
In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations," which addresses financial accounting and reporting for
obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. This statement applies to all entities that
have legal obligations associated with the retirement of long-lived assets that
result from the acquisition, construction, development or normal use of the
asset. SFAS 143 is effective for fiscal years beginning after June 15, 2002. We
do not expect the adoption of SFAS 143 to have a significant impact on our
financial condition or results of operations.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," which addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
While SFAS No. 144 supersedes SFAS Statement No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," it
retains many of the fundamental provisions of that statement. SFAS 144 also
supersedes the accounting and reporting provisions of APB Opinion No. 30,
"Reporting the Results of Operations-Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions," for the disposal of a segment of a business. SFAS 144
is effective for fiscal years beginning after December 15, 2001 and interim
periods within those fiscal years. We do not expect the adoption of SFAS 144 to
have a significant impact on our financial condition or results of operations.
In the fourth quarter of 2000, EMC adopted Staff Accounting Bulletin
("SAB") No. 101, Revenue Recognition in Financial Statements, which provides
guidance in applying generally accepted accounting principles to certain revenue
recognition issues. The adoption of SAB 101 did not have a material impact on
EMC's financial position or overall trends in results of operations.
Item 7A. Market Risk Disclosure
Not Applicable
Item 8. Financial Statements and Supplementary Data
Page
----
Report of KPMG LLP Independent Accountants 24
Report of PricewaterhouseCoopers LLP Independent Accountants 25
Consolidated Balance Sheets at December 31, 2001 and 2000 26
Consolidated Statements of Operations for the Three Years Ended December 31, 2001 27
Consolidated Statements of Changes in Stockholders' Equity for the Three Years Ended
December 31, 2001 28
Consolidated Statements of Cash Flows for the Three Years Ended December 31, 2001 29
Notes to Consolidated Financial Statements 30
-23-