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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1996
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number 0-28240
EXACTECH, INC.
(Exact name of registrant as specified in its charter)
FLORIDA 59-2603930
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4613 NW 6TH STREET
GAINESVILLE, FL
32609
(Address of principal executive offices)
(352) 377-1140
(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, $.01 par value
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 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. [ ]
As of March 3, 1997, the number of shares of the registrant's Common Stock
outstanding was 4,860,434. The aggregate market value of the Common Stock held
by non-affiliates of the registrant as of March 3, 1997 was approximately
$18,851,720, based on a closing sale price of $8.00 for the Common Stock as
reported on the NASDAQ National Market System on such date. For purposes of the
foregoing computation, all executive officers, directors and 5 percent
beneficial owners of the registrant are deemed to be affiliates. Such
determination should not be deemed to be an admission that such executive
officers, directors or 5 percent beneficial owners are, in fact, affiliates of
the registrant.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III (Items 10, 11, 12 and 13) is incorporated
by reference from the registrant's definitive proxy statement (to be filed
pursuant to Regulation 14A).
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TABLE OF CONTENTS
AND
CROSS REFERENCE SHEET
PAGE NUMBER
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PART I Item I. Business
Business Overview 4
Products 4
Marketing and Sales 7
Manufacturing and Supply 8
Patents and Proprietary Technology 9
Research and Development 11
Scientific Advisory Board 11
Competition 12
Product Liability and Insurance 12
Government Regulation 13
Employees 16
Executive Officers of the Registrant 16
Glossary 19
Item 2. Properties 22
Item 3. Legal Proceedings 22
Item 4. Submission of Matters to a Vote of Security Holders 23
PART II Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 23
Item 6. Selected Consolidated Financial Data 24
Item 7. Management's Discussion and Analysis of Results of
Operations and Financial Condition 25
Item 8. Financial Statements and Supplementary Data 31
Item 9. Changes in and Disagreements with Accountants on 47
Accounting and Financial Disclosure
PART III Item 10. Directors and Executive Officers of the Registrant 47
Item 11. Executive Compensation 47
Item 12. Security Ownership of Certain Beneficial Owners
and Management 47
Item 13. Certain Relationships and Related Transactions 47
PART IV Item 14. Exhibits, Financial Statement Schedules and Reports
on Form 8-K 48
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ITEM 1. BUSINESS
Certain terms used herein are defined in the Glossary on pages 19 to 21
hereof. Exactech, Inc. (the "Company") develops, manufactures, markets and sells
orthopaedic implant devices and related surgical instrumentation to hospitals
and physicians in the United States and overseas. Prior to 1995, the Company's
revenues were derived primarily from sales of its primary hip replacement
systems. During 1995, the Company introduced Optetrak/registered trademark/, a
total primary knee replacement system, which had been in development for three
years. The Optetrak/registered trademark/ knee system was conceived by the
Company in collaboration with members of its Scientific Advisory Board in
cooperation with the Hospital for Special Surgery, an internationally known
hospital for orthopaedic surgery. The Optetrak/registered trademark/ system
represents a highly differentiated product based on precision manufacturing
techniques and a design which reduces articular contact stress. The
Optetrak/registered trademark/ system is the most modern rendition of a series
of knee implants which were first introduced in 1974 and which are still being
marketed by certain of the Company's competitors. The Company has entered into
an agreement with the Hospital for Special Surgery which gives the Company a
non-exclusive option with respect to future knee systems developed at the
Hospital for Special Surgery.
In order to raise capital, in June 1996, the Company consummated an
underwritten initial public offering (the "IPO") of 1,840,000 shares of its
common stock, $.01 par value (the "Common Stock"), resulting in net proceeds to
the Company of $12,657,910 after deduction of underwriting, legal, accounting
and other offering related expenses. The proceeds of the IPO have been and will
be used primarily to repay indebtedness, to purchase inventory and equipment,
for research and development and for working capital and general corporate
purposes.
The Company was incorporated under the laws of the State of Florida in
November 1985.
ORTHOPAEDIC IMPLANT INDUSTRY
According to industry sources, United States sales of orthopaedic
implant products were approximately $1.6 billion in 1994, an increase of 5.6%
from 1993. During 1994, sales of knee implants were approximately $818 million,
an increase of 8.9% from 1993, while sales of hip implants were approximately
$722 million, an increase of 1.0% from 1993. The Company estimates that there
were approximately 428,000 hip and knee joint replacements in the United States
in 1994 compared to approximately 345,000 in 1990. The Company expects sales of
hip and knee joint replacements in foreign markets to grow more rapidly than in
the United States.
Management believes that the growth in the industry is due to the
increase in the number of people over age 65, an increasingly active population,
improvements in technology and increased use of implants in younger patients.
According to an industry report, the United States population over 65 years of
age continues to grow as a percentage of the population. Longer life spans and
the continuing aging of the population increases the number of individuals whose
joints will be subject to failure. Furthermore, the "baby-boomers" are
approaching the age where arthritis and osteoporosis begin to affect joints,
necessitating joint replacement. As this segment of the population continues to
age, an increasing demand for joint replacement procedures is anticipated.
Finally, the earlier generations of implanted joint replacement prostheses have
begun to reach their maximum life and are beginning to fail, resulting in an
increased demand for hip and knee revisions.
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PRODUCTS
The Company's orthopaedic implant products are used to replace joints
which have deteriorated as a result of injury or diseases such as arthritis.
Reconstructive joint surgery involves the modification of the area surrounding
the affected joint and the insertion of a set of manufactured implant components
to replace or augment the joint. During the surgery, the surgeon removes a
portion of the bones that comprise the joint, prepares the remaining bones and
surrounding tissue and then installs the implant.
Knee implants are either total or unicompartmental. Total knee
replacement systems are used to replace the entire knee joint (i.e., the
patella, upper portion of the tibia and lower portion of the femur), while
unicompartmental systems are used to replace one of the two compartments between
the femur and the tibia. Primary knee implant systems are used to replace the
natural knee joint, while knee revision systems are used to replace the
components of a previously installed primary implant system that has failed. The
components of revision systems are specially designed to fill bony voids created
by the previous implant.
Hip implants are either total or partial. In a total hip implant, the
acetabulum is replaced with an acetabular cup. The damaged head of the patient's
femur is removed and a stem is inserted into the femur on which a replacement
head is mounted. This femoral head is placed into the cup of the acetabulum to
recreate the ball and socket joint. In a partial hip implant, the damaged head
of a patient's femur is removed and replaced with a head mounted on a stem
inserted into the femur. However, the acetabulum is not replaced and the size of
the head is larger and more similar to the natural femoral head. Hip implants
are designed for either cemented or non-cemented applications. Cemented hip
implants are installed by using bone cement to attach the components to a
patient's bones, while porous coated hip implants are press-fit without cement.
Porous coated implants are designed to promote growth of the patient's remaining
bone tissue onto the implant. Primary hip implant systems are used to replace
the natural hip joint, while hip revision systems are used to replace a
previously installed primary implant system that has failed.
KNEE PRODUCTS. The Company believes that its Optetrak/registered
trademark/ knee system represents a major advance in knee implant design. The
Optetrak/registered trademark/ knee system was developed in collaboration with
the Hospital for Special Surgery in New York and a design team consisting of
physicians and biomechanists affiliated with major medical facilities and
academic institutions. The Company's Optetrak/registered trademark/ system is a
modular system designed to maximize stability, to provide increased range of
motion and improved patellar tracking and to reduce articular contact stress
that leads to implant failure. Laboratory testing performed by the Company and
clinical testing performed by the Company's design team members has demonstrated
that the system produces substantially lower articular contact stress and
improved patellar tracking than other comparable knee implant systems.
The Optetrak/registered trademark/ system includes a total primary knee
replacement system which is available with either a cruciate ligament sparing
femoral component (in both cemented and porous coated designs) or a posterior
stabilized femoral component (in both cemented and porous coated designs). These
femoral components are made of a cobalt chromium alloy. The system is also
available with several alternative tibial components, titanium backed
polyethylene tibial components with both finned keel and trapezoid keel with
stem augmentation, blocks and full or half wedges, and all polyethylene tibial
components, which are cruciate sparing and posterior stabilized. The stem, block
and wedge augmentation allow the surgeon to rebuild the ends of the patient's
bones to allow fixation of the implant system. The metal components of the
Optetrak/registered trademark/ system are fully precision machined resulting in
better congruence among components and material performance. The Company's
patellar products are made of ultra-high molecular weight polyethylene. Because
of variations in human anatomy and differing design preferences among surgeons,
knee components are manufactured by the Company in a variety of sizes and
configurations. Bone cement is used to affix the implants to the bone.
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The Optetrak/registered trademark/ system also includes a total knee
revision system which has received FDA clearance and is currently in production.
The revision system includes a constrained condylar femoral component with
enhanced stem and block augmentation and can be used with many components of the
primary system. The constrained condylar femoral component was designed to
provide greater constraint between the system components to compensate for
ligaments weakened or lost due to disease or as a result of the original
implant. The Company is currently in production of the components of this system
and has realized limited sales with Scientific Advisory Board surgeons in the
fourth quarter of 1996 and the first quarter of 1997. Full scale marketing of
this system is scheduled to commence in the second quarter of 1997. The Company
is also designing a unicompartmental knee with respect to which the Company will
be required to obtain FDA clearance to market.
HIP PRODUCTS. The Company began marketing a hip implant system in 1987.
The Company's line of hip implant products currently consists primarily of three
primary total hip implant systems, its Cemented Total Hip System, its
MCS/registered trademark/ Porous Coated Total Hip System, and the AuRA System,
and two primary partial hip implant systems, its unipolar implant and its
bipolar implant.
All total hip implants produced by the Company consist of a cup, head
and stem. Because of variations in human anatomy and differing design
preferences among surgeons, hip implants are manufactured by the Company in a
variety of head sizes, neck lengths, stem lengths, stem cross-sections and
configurations. The Company's total hip replacement systems utilize either
titanium alloy or cobalt chromium alloy femoral stem components, which can be
final machined from forgings, castings or wrought metal plate depending on the
design and material used. The Company's total hip replacement systems also
include ultra-high molecular weight polyethylene cups with and without metal
backing. The femoral heads are made of either cobalt chromium or zirconia
ceramic.
The Company's Cemented Total Hip System is intended to provide optimal
treatment for patients requiring cemented hip arthroplasty (joint reconstructive
surgery) by minimizing failure of the bone cement. The femoral stem utilizes a
cross-sectional design to reduce stress on the bone cement used to affix the
implant to the patient's remaining bone tissue. The components of the system
include a high demand forged cobalt chromium femoral stem or moderate demand
Opteon/registered trademark/ forged cobalt chromium femoral stem.
The Company's MCS/registered trademark/ Porous Coated Total Hip System
was designed to minimize thigh pain and abnormal bone remodeling resulting from
bone-implant stiffness mismatch. The Company's MCS/registered trademark/ Porous
Coated Total Hip System was also designed to avoid unnecessary damage to the
bone and its blood supply during femoral preparation. The Company also provides
instrumentation that facilitates reproducible implantation of the implant. The
system consists of a modular acetabular cup and cup liner, screws for
supplemental fixation of the acetabular cup, a modular head and a femoral stem.
All of the Company's femoral heads are designed to be used with its femoral
stems, including the Ziramic/registered trademark/ (zirconia ceramic) femoral
head which was designed to further reduce friction and polyethylene wear, and is
also compatible with the Cemented Total Hip System. The system has been cleared
by FDA for use without cement.
The Company's partial hip products include a bipolar prosthesis and a
unipolar prosthesis. The Company's bipolar prosthesis also utilizes one of the
stems used in total hip replacements. The bipolar prosthesis is designed for use
in more active patients and the unipolar prosthesis is designed for use in less
active patients.
The Company has also developed a new hip system, the AuRA System which
includes a new
6
primary total hip replacement system as well as revision components. The
Company has received FDA clearance to market the new system and the system is
currently in production. The Company plans full scale marketing of the AuRA
System in the third quarter of 1997.
During 1996, the Company licensed patent technology for a modular
revision hip system. The Company plans to commence product development of the
modular hip system in 1997 and to seek FDA clearance to market the product in
1998.
The Company provides its customers with the ACCUMATCH/registered
trademark/ Implant Selection System, a computerized matching program that
assists medical personnel in determining which of the Company's hip products is
most suitable and cost-effective for a specific patient.
OTHER COMPANY PRODUCTS. The Company has designed and received FDA
clearance to market a nonmodular shoulder implant system. The Company is
currently planning the development of a modular version of a shoulder implant
system for planned introduction in 1999. The Company plans to introduce both the
modular and nonmodular systems to the market simultaneously.
The Company has acquired an exclusive license for an improved surgical
oscillating saw system that significantly reduces vibration, noise, and problems
with control in surgery. The Company may develop this product through a separate
wholly-owned subsidiary.
MARKETING AND SALES
The Company markets its orthopaedic implant products in the United
States through 25 independent agencies, that act as the Company's sales
representatives, and internationally through eight foreign distributors,
including one distributor which is 50% owned by the Company. The customers for
the Company's products consist of hospitals, surgeons and other physicians and
clinics. Traditionally, the surgeon made the ultimate decision which orthopaedic
implant to use. As a result of health care reform, the rapid expansion of
managed care at the expense of traditional private insurance, the advent of
hospital buying groups, and various bidding procedures that have been imposed at
many hospitals, sales representatives may also make presentations to hospital
administrators, material management personnel, purchasing agents or review
committees that may influence the final decision.
The Company generally has contractual arrangements with its independent
sale agencies pursuant to which the agency is granted the exclusive right to
market the Company's products in the specified territory and the agency is
required to meet sales quotas to maintain its relationship with the Company. The
Company's arrangements with its sales agencies typically do not preclude them
from selling competitive products, although the Company believes that most of
its agents do not do so. The Company typically pays its sales agencies a
commission based on net sales. The Company is highly dependent on the expertise
and relationships of its sales agencies with customers. The Company's sales
organization, comprised of the Company's independent sales agencies, is
supervised by three Regional Managers (West/Midwest, Southeast and Northeast).
The Company currently offers its products in 33 states, including Florida, New
York, California, Texas, Ohio, Pennsylvania and Illinois.
The Company provides inventories of its products to its United States
sales agencies until sold or returned for their use in marketing its products
and filling customer orders. As the size of the component to be used is
frequently not known until surgery has commenced and because surgeons give
little or no advance notice of surgery, a minimum of one size of each component
in the system to be used must be available to each sales agency at the time of
surgery. Accordingly, the Company is required to maintain substantial levels of
inventory. The maintenance of relatively high levels of inventory requires the
7
Company to incur significant expenditures of its resources. The failure by the
Company to maintain required levels of inventory could have a material adverse
effect on the Company's expansion. As a result of the need to maintain
substantial levels of inventory, the Company is subject to the risk of inventory
obsolescence. In the event that a substantial portion of the Company's inventory
becomes obsolete, it would have material adverse effect on the Company.
During the years ended December 31, 1995 and 1996, one customer, Shands
Hospital, accounted for approximately 10% and 7%, respectively, of the Company's
sales. During the years ended December 31, 1995 and 1996 one distributor, MBA
Del Principado, S.p.A., accounted for approximately 5% and 13%, respectively, of
the Company's sales.
The Company generally has contractual arrangements with its foreign
distributors pursuant to which the distributor is granted the exclusive right to
market the Company's products in the specified territory and the distributor is
required to meet sales quotas to maintain its relationship with the Company.
Foreign distributors typically purchase product inventory and instruments from
the Company for their use in marketing and filling customer orders.
In 1993, the Company commenced foreign sales through a distributor in
Korea. In order to expand its global sales and marketing capabilities, in July
1995, the Company established Techmed, its Italian distributor, in which the
Company has a 50% ownership interest. Under the terms of the agreement pursuant
to which Techmed was established, the Company has contributed $182,485 in equity
to Techmed.
The Company currently offers its products in eight countries in
addition to the United States: Argentina, Australia, Columbia, Greece, Italy,
Korea, Spain and Turkey. For the years ended December 31, 1994, 1995 and 1996,
foreign sales accounted for $316,115, $743,700 and $2,124,856, representing
approximately 5.9%, 8.2%, and 15.4%, respectively, of the Company's sales. The
Company intends to expand its sales in foreign markets in which there is
increasing demand for orthopaedic implant products. In order to expand its
global sales and marketing capabilities, the Company intends to assess the
attractiveness of establishing local manufacturing to serve the Italian, Spanish
and other EEC markets. The Company also intends to expand its international
distribution network.
MANUFACTURING AND SUPPLY
The Company utilizes third-party vendors for the manufacture of all of
its component parts, while performing product design, quality assurance and
packaging internally. The Company consults with its vendors in the early stages
of the design process of its products. The Company believes that its strategy of
using third-party vendors for manufacturing and consulting with such vendors in
the design process enables it to efficiently source product requirements while
affording it considerable flexibility. Because the Company is able to obtain
competitive prices from a number of suitable suppliers with FDA-approved
facilities, the Company believes it is able to offer high quality products at
cost-effective prices. In order to control its production costs, the Company
continually assesses the manufacturing capabilities and cost-effectiveness of
its existing and potential vendors. The Company may in the future establish
manufacturing strategic alliances to assure itself of continued low-cost
production. For the years ended December 31, 1994, 1995 and 1996, the Company
purchased approximately 66%, 68% and 62%, respectively, of its component
requirements from three manufacturers. The Company does not maintain supply
contracts with any of its manufacturers and purchases components pursuant to
purchase orders placed from time to time in the ordinary course of business. The
Company has several alternative sources for components and does not anticipate
that it will encounter problems in obtaining adequate supplies of components.
Certain tooling and equipment which are unique to the Company's products are
8
supplied by the Company to its vendors.
The Company's assembly, packaging and quality control operation are
conducted at its principal offices in Gainesville, Florida. Each component
received from its vendors is examined by Company personnel prior to assembly or
packaging to ensure that it meets the Company's specifications. The Company
contemplates that in the future it may engage in limited manufacturing of the
components of its products, consisting primarily of final machining of
components. The Company currently is developing an architectural and engineering
plan for a new facility to be used by the Company for principal executive
offices, research and development laboratories and limited manufacturing.
PATENTS AND PROPRIETARY TECHNOLOGY; LICENSE AND CONSULTING AGREEMENTS
The Company holds United States patents covering one of its femoral
stem components and its bipolar partial hip implant system and certain surgical
instrumentation, has patent applications pending with respect to certain
surgical instrumentation and certain implant components and anticipates that it
will apply for additional patents it deems appropriate. In addition, the Company
holds licenses from third parties to utilize certain patents, including a
non-exclusive license (described below) to certain patents, patents pending and
technology utilized in the design of the Optetrak/registered trademark/ knee
system. As a result of the rapid rate of development of reconstructive products,
the Company believes that patents have not been a major factor in the
orthopaedic industry to date. However, patents on specific designs and processes
can provide a competitive advantage and management believes that patent
protection of orthopaedic products will become more important as the industry
matures. Although the Company believes that its patents and products do not and
will not infringe patents or violate proprietary rights of others, it is
possible that its existing patent rights may not be valid or that infringement
of existing or future patents or proprietary rights may occur. See "Legal
Proceedings" for information concerning a patent infringement claim against the
Company.
In addition to patents, the Company relies on trade secrets and
proprietary know-how and employs various methods to protect its proprietary
information, including confidentiality agreements and proprietary information
agreements.
In connection with the development of its knee implant systems, the
Company entered into consulting agreements with certain of its executive
officers and design team members, including Dr. William Petty and Dr. Gary J.
Miller, who are executive officers, directors and principal shareholders of the
Company, and Ivan A. Gradisar, Jr., M.D., and William Murray, M.D. Pursuant to
these consulting agreements, such individuals agreed to provide consulting
services to the Company in connection with evaluating the design of knee
implantation systems and associated instrumentation and are entitled to receive
royalties during the term of the agreements aggregating 3% of the Company's net
sales of such products in the United States and less than 3% of the Company's
net sales of such products outside the United States. During the years ended
December 31, 1994, 1995 and 1996, the Company paid royalties aggregating $1,934,
$101,393 and $187,773, respectively, pursuant to these consulting agreements.
The consulting agreements with Drs. Petty and Miller were superseded by their
employment agreements which provide for the continuation of the royalty
payments. The Company has entered into consulting agreements with two of the
members of its design team in connection with the development of its hip
revision system and is negotiating similar agreements with the remaining members
of its hip revision design team. The Company anticipates that the members of
that team will be entitled to customary royalties.
From time to time, the Company enters into license agreements with
certain unaffiliated third parties under which the Company is granted the right
to utilize certain patented products, designs and
9
processes. Pursuant to a license agreement with the Hospital for Special Surgery
(the "HSS License Agreement"), the Company obtained a non-exclusive right and
license to certain patents, patents pending and technology utilized in the
design of the Optetrak/registered trademark/ knee implant system and to
manufacture, use and sell total knee prostheses incorporating such patents and
technology. The term of the HSS License Agreement continues until the earlier to
occur of (i) the expiration of a period of ten years and (ii) the expiration of
the licensed patents. In consideration for the grant of the license, the Company
agreed to pay to the Hospital for Special Surgery royalties in an amount equal
to 5% of net sales of the licensed products. Pursuant to the HSS License
Agreement, the Company has the option to acquire a non-exclusive license to use
any improvement or invention made or acquired by the Hospital for Special
Surgery relating to the licensed products and the option to obtain an exclusive
license to any such improvement or invention made jointly by the Hospital for
Special Surgery and the Company. As is the case in many license agreements of
this nature, the Hospital for Special Surgery did not represent to the Company
that the manufacture, use or sale of the Optetrak/registered trademark/ knee
implant system will not infringe the intellectual property rights of third
parties. In connection with the execution of the HSS License Agreement, the
Company incurred an initial royalty to the Hospital for Special Surgery in the
amount of $133,600. During the year ended December 31, 1996, the Company paid
royalties to the Hospital for Special Surgery of $307,801.
Pursuant to a License Agreement (the "University License Agreement")
between the University of Florida (the "University") and the Company, the
Company has been granted the exclusive right and license in perpetuity to make,
use and sell a spinal implant device under patents owned by the University. In
consideration for the right to utilize the University patents, the Company paid
the University an initial license issue fee of $6,000 and, if and when the
patented products or processes are utilized in devices or products sold by the
Company, the Company will be required to pay the University a royalty in an
amount equal to 5% of the Company's net sales of any such products in the United
States, up to a maximum royalty of $500,000, and thereafter a royalty of 2% of
such net sales. This royalty will be payable by the Company during the period
ending 10 years from the Company's first sale of a device utilizing the
University patent. In addition, the University License Agreement provides that
the Company will remit to the University 75% of all royalties received by the
Company for sales outside of the United States under sublicense agreements
relating to the patented products or processes. In connection with the
University License Agreement, the Company also has agreed to assist the
University in developing certain other devices currently being researched and
tested which are intended to be patented by the University. To date, the Company
has only utilized the University patents in connection with product research and
development and accordingly, the Company has paid no royalties to the University
under the University License Agreement.
The Company has also entered into a sublicense agreement (the
"Sublicense Agreement") with Sofamor Danek Properties, Inc. ("SDP") pursuant to
which the Company granted SDP the exclusive worldwide right and sublicense to
utilize the patents licensed to the Company pursuant to the University License
Agreement. The term of the Sublicense Agreement continues until the last of the
patents owned by the University and sublicensed to SDP terminates, unless sooner
terminated in accordance with the terms of the Sublicense Agreement. Pursuant to
the Sublicense Agreement, the Company received an initial sublicense fee of
$250,000 and, if and when FDA approves an SDP product utilizing the University
patents, the Company will receive an additional $250,000 sublicense fee.
Additionally, at such time as a product utilizing the University patent is
manufactured and sold by SDP, the Company will be entitled to receive a royalty
from SDP in the amount of 5% of SDP's net sales of such products in the United
States, up to a maximum of $500,000, and thereafter a royalty of 2% of such net
sales. Under the terms of the Sublicense Agreement, the Company received an
advance on anticipated royalties in the amount of $l00,000. To date, SDP has not
marketed a product utilizing the University patents and, during 1996, SDP was
initially denied FDA clearance to market products using the University patents.
10
As a result, the $100,000 was recognized by the Company as sublicense income in
1996 due to the non-refundable nature of the advance.
Pursuant to a license agreement between the Company and Accumed, Inc.
("Accumed"), the Company secured a worldwide license to manufacture, use and
sell products utilizing Accumed's bipolar hip prosthesis and a license to any
rights under any patent that is issued covering Accumed's bipolar hip prosthesis
design. The term of this license agreement continues until the expiration of the
last patent comprising any part of the Accumed design, unless sooner terminated
in accordance with the terms of such agreement. During the period ending on the
seventh anniversary of the Company's first sale of a product utilizing the
Accumed design, the Company is obligated to pay Accumed an annual royalty of
3.5% of all net receipts from the Company's worldwide sale of products
incorporating an Accumed product or design patent licensed to the Company.
However, if a patent is not issued within a particular country in which the
Company sells products utilizing Accumed's design, the royalty payable is 2% of
the Company's net sales of applicable products in such country. During the years
ended December 31, 1994, 1995 and 1996, the Company paid royalties to Accumed of
approximately $12,524, $13,412 and $11,577, respectively.
The Company has also entered into a patent agreement (the "Patent
Agreement") with Phillip Cripe, a shareholder of the Company, under which the
Company was assigned the patent rights associated with a surgical saw designed
by Mr. Cripe and the concepts, techniques and processes embodied in such
product. The term of this patent agreement continues until the later of ten
years or the expiration of the last patent comprising any part of the surgical
saw design unless sooner terminated in accordance with the terms of the Patent
Agreement. In connection with the execution of the Patent Agreement, the Company
granted Mr. Cripe an option to purchase 7,500 shares of the Company's Common
Stock at an exercise price of $6.67 per share. The Company has also agreed to
pay Mr. Cripe an annual royalty of 5% of all net receipts from the sale of
products incorporating the concepts, techniques and processes embodied in the
patented product (but 2% of all net receipts from the sale of associated
surgical saw blades) by or on behalf of the Company. To date, the Company has
not developed a product utilizing the assigned patent or know how.
During October 1996, the Company licensed certain patent technology for
development of a modular hip system from Medicine Lodge, Inc. The patent license
fees total $360,000, of which $275,000 was paid upon the execution of the
agreement and an additional $85,000 is payable at the time of FDA clearance to
market the products.
RESEARCH AND DEVELOPMENT
During the years ended December 31, 1994, 1995 and 1996, the Company
expended $597,812, $722,118 and $750,256, respectively, on research and
development and anticipates that research and development expenses will continue
to increase. The Company's research and development efforts contributed to the
introduction in 1995 of the Company's Optetrak/registered trademark/ knee
implant system. The Company's principal research and development efforts
currently relate primarily to the production of the revision components of the
Optetrak/registered trademark/ comprehensive knee implant system and the
development of the AuRA hip implant system consisting of a new cemented primary
hip implant system and a revision hip implant system.
SCIENTIFIC ADVISORY BOARD
The Company's strategy is to utilize members of its Scientific Advisory
Board, consisting of internationally known physicians and biomechanists, in the
design process to facilitate the development
11
of high quality products at cost-effective prices. The Scientific Advisory Board
assists the Company in identifying new product opportunities, provides
evaluation and comments on existing product development and clinical programs,
and provides a direct link between the Company and the academic, medical and
scientific communities which permits the Company to quickly identify and respond
to the demands of orthopaedic surgeons. Members of the Scientific Advisory Board
generally meet at least quarterly. In addition, from time to time, the members
of the Scientific Advisory Board consult with the Company individually at the
request of the Company. The Company has entered into consulting agreements with
certain members of the Scientific Advisory Board pursuant to which the Company
pays royalties to such members. See "Patents and Proprietary Technology; License
and Consulting Agreements." The members of the Scientific Advisory Board in
addition to Dr. William Petty and Dr. Gary J. Miller include: Albert H.
Burstein, Ph.D., Edmund Chao, Ph.D., Ivan Gradisar, M.D., William Murray, M.D.,
Raymond Robinson, M.D., Franklin Sim, M.D., Robert Trousdale, M.D..
COMPETITION
The orthopaedic implant industry is highly competitive and dominated by
a number of large companies with substantially greater financial and other
resources than the Company and competition is expected to intensify. From time
to time, the Company and certain of its competitors have offered significant
discounts as a competitive tactic, and may be expected to continue to do so. The
Company believes its future operations will depend upon its ability to be
responsive to the needs of its customers and to provide high quality products at
cost-effective prices. The largest competitors in the orthopaedic hip implant
market are DePuy, Inc., Bristol-Myers Squibb Company (Zimmer Inc.), Pfizer Inc.
(Howmedica, Inc.), Stryker Corporation and Biomet, Inc. who, according to an
industry publication, had an estimated aggregate market share of approximately
82% in 1994. The largest competitors in the orthopaedic knee implant market are
Bristol-Myers Squibb Company (Zimmer Inc.), Pfizer Inc. (Howmedica, Inc.),
Johnson & Johnson, DePuy, Inc. and Sulzermedica who, according to an industry
publication, had an estimated aggregate market share of approximately 72% in
1994.
Companies in the industry compete on the basis of product features and
design, innovation, service, the ability to maintain new product flow,
relationships with key orthopaedic surgeons and hospitals, the strength of their
distribution network and price. While price, as opposed to surgeon preference,
is becoming increasingly important in the hip market, the primary basis of
competition in the knee market remains physician preference, which includes
ease-of-use, clinical results, price and relationships with sales
representatives. Due to health care reform, the rapid expansion of managed care
at the expense of traditional private insurance and the advent of hospital
buying groups, among other things, management believes that the price of the
Company's orthopaedic implant products will continue to become a more important
competitive factor. Manufacturers of medical devices, including orthopaedic
implants, are increasingly attempting to enter into contracts with hospital
chains or hospitals pursuant to which the hospital chains agree to purchase
their products exclusively from such manufacturers, usually in exchange for
discounted prices. If the Company's competitors are successful in securing such
contracts, the Company's ability to compete may be materially adversely
affected. Although to date generic products have not been a significant factor
in the orthopaedic implant market, price may become even more important if
suppliers of generic products enter the market on a larger scale.
PRODUCT LIABILITY AND INSURANCE
The Company is subject to potential product liability risks which are
inherent in the design, marketing and sale of orthopaedic implants and surgical
instrumentation. The Company has implemented strict quality control measures and
currently maintains product liability insurance in
12
amounts which it believes are typical in the industry for similar companies. See
"Legal Proceedings" for information concerning a product liability claim against
the Company.
GOVERNMENT REGULATION
The Company's operations and relationships are subject to extensive,
rigorous, expensive, time-consuming and uncertain regulation in the United
States and certain other countries. The primary regulatory authority in the
United States is the Food and Drug Administration ("FDA"). The development,
testing, labeling, distribution, marketing and manufacture of medical devices,
including reconstructive devices, are regulated under the Medical Device
Amendments of 1976 to the Federal Food, Drug and Cosmetic Act (the "Amendments")
and additional regulations promulgated by FDA. In general, these statutes and
regulations require that manufacturers adhere to certain standards designed to
ensure the safety and effectiveness of medical devices.
Under the Amendments, each medical device manufacturer must be a
"registered device manufacturer" and must comply with regulations applicable
generally to labeling, quality assurance, manufacturing practices and clinical
investigations involving humans. FDA is authorized to obtain and inspect
devices, their labeling and advertising, and the facilities in which they are
manufactured in order to assure that a device is not improperly manufactured or
labeled. The Company is registered with FDA and believes that it is in
substantial compliance with all applicable material governmental regulations.
Under the Amendments, medical devices are classified into one of three
classes depending on the degree of risk imparted to patients by the medical
device. The Amendments define Class I devices as those for which safety and
effectiveness can be guaranteed by adherence to general controls, which include
compliance with Good Manufacturing Practices ("GMP"), registration and listing,
reporting of adverse medical events, and appropriate truthful and non-misleading
labeling. The Amendments define Class II devices as those which require
pre-market demonstration of adherence to certain standards or other special
controls. Such demonstration is provided through the filing of a 510(k)
pre-market notification. The Amendments define a Class III product as a product
which has a wholly new intended use or a product for which advances in
technology cannot be assessed without clinical study. The Amendments provide
that submission and approval of a pre-market application ("PMA") is required
before marketing of a Class III product can proceed. The PMA process is more
extensive than 510(k) process.
In practice, however, FDA has developed a three-tier regulatory
approach that does not exactly parallel the classification system. PMAs are
currently required of medical devices which have new intended uses and some
other products classified as Class III. PMAs have only been required of "old"
Class III products (i.e., which were marketed on or prior to the date of
enactment of the Amendments on July 28, 1976, or which are substantially
equivalent to such previously marketed devices) when FDA has published a "call"
for the relevant Class III pre-Amendments device.
Generally, therefore, pre-Amendments Class III and almost all Class II
products are cleared for marketing by FDA based on a demonstration that the
safety and effectiveness of the product is substantially equivalent to a
pre-Amendments device or a similar, already-marketed, predicate device that
received 510(k) clearance. Finally, Class I products are, and a few Class II
products have been exempted, from the requirement to file for 510(k) clearance.
The Company's products have been classified by FDA as Class II devices
and, currently, all marketed devices hold valid cleared 510(k) premarket
notifications, including: its cemented hip implant system, including femoral
stem, acetabular cup and femoral heads; bone screws; porous coated cemented
13
femoral stem and acetabular component; bipolar partial hip implant; nonmodular
shoulder prostheses (humeral and glenoid); Zirconia/registered trademark/
(ceramic) femoral heads; Opteon/registered trademark/ femoral stem for cemented
and noncemented use; MCS femoral stem and acetabular component for cemented and
noncemented use; AuRA femoral stem; and the Optetrak/registered trademark/ knee
replacement system.
All new products of the Company will likely be subject to this
clearance process, although FDA has gradually enhanced the clinical data
requirements applicable to many 510(k) applications over the last few years. The
process of obtaining regulatory clearances is lengthy, expensive and uncertain.
FDA could choose to reclassify the Company's prosthetic systems as Class III
products subject to a PMA under various conditions, such as a determination that
the device could not demonstrate substantial equivalence to a predicate device
based on a new intended use or because a technological change or modification in
the device could not be adequately evaluated for safety and effectiveness
without a requirement for a PMA. Further, FDA could choose to impose strict
labeling requirements, onerous operator training requirements, post-marketing
surveillance, individual patient recipient lifetime tracking, or other
requirements as a condition of marketing clearance, any of which could limit the
Company's ability to market its products and would have a material adverse
effect on the Company's business, financial condition and results of operations.
Further, if the Company wishes to modify a product after clearance,
including changes in indications manufacturing, or other changes, additional
clearance may be required. Failure to receive, or delays in receipt of, FDA
clearance, including the need for additional clinical trials or data as a
prerequisite, could limit the ability of the Company to market its products and
could have a material adverse effect on the Company's business, financial
condition and results of operations.
The Company has licensed and sublicensed a spinal implant system which
FDA had heretofore viewed as a Class III product based on the use of pedicular
screws which FDA concluded were not substantially equivalent to any known
predicate or pre-Amendments device. On October 4, 1995, FDA promulgated proposed
regulations to reclassify spinal implant systems such as the Company's Class II
devices. The comment period closed on March 4, 1996. If these regulations do not
become final, the Company may have to develop clinical data to support a PMA
under an Investigational Device Exemption. Furthermore, the cost and results of
such a clinical study could delay or preclude the Company from receiving any
royalties with respect to this product.
The design, manufacturing, labeling, distribution and marketing of the
Company's products are subject to extensive and rigorous government regulation
in the United States well beyond that encompassed by the requirement to file a
510(k) premarket notification or a PMA application, including additional
conditions or requirements that may become a part of FDA clearance or approval.
Regulatory clearance may also include significant limitations on the indicated
uses for which the Company's products may be marketed. To that end, all
marketing materials are subject to exhaustive control. FDA enforcement policy
strictly prohibits the marketing of approved or cleared products for unapproved
uses. Furthermore, FDA does not provide an opportunity to review and approve
such materials but may take action after the production and use of such
materials.
In addition, the Company's manufacturing processes are required to
comply with GMP regulations. These regulations cover the methods of design,
testing, production, control, quality assurance, labeling, packaging, shipping,
documentation and other requirements. Enforcement of GMP regulations has
increased significantly in the last several years, and FDA has publicly stated
that compliance will be more strictly scrutinized. New regulations taking effect
in 1997 offer additional controls which parallel international standards. The
Company's facilities and manufacturing processes, as well as that of certain of
the Company's third-party suppliers, are subject to periodic inspections by
14
FDA or other agencies. To date, the Company has successfully undergone two such
inspections with only minor deficiencies cited at the exit interview and for
which appropriate corrective responses were found acceptable to FDA.
Failure to comply with applicable 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, refusals of FDA to grant future premarket
clearances or approvals, withdrawals or suspensions of current clearances or
approvals, and criminal prosecution, which could have a material adverse effect
on the Company's business, financial condition and results of operations.
The Company voluntarily initiated and satisfactorily completed two
Class III recalls. A Class III recall is defined as a situation in which the use
of a violative product is not likely to cause adverse health consequences. One
recall involved a partially mislabeled product. The second involved the
manufacturing process of a bone screw. FDA reviewed and authorized these two
recalls, and concluded that each of the two recalls was conducted and completed
properly. There were no recalls in 1996 and there have not been any recalls in
1997 to date.
Generally, the Company must obtain export certificates from FDA before
it can export any product. While the process for issuance of export certificates
has recently been expedited by FDA, and the Company has obtained export
certificates under this expedited (and its predecessor) process, there can be no
assurance that the issuance of export certificates in the future will not be
subject to new restrictions, or that the Company will continue to receive or not
be delayed in its receipt of such export certificates. Such future actions could
have a material adverse effect on the Company's business, financial condition
and results of operations.
The Company is required to obtain various licenses and permits from
foreign governments and to comply with significant regulations that vary by
country in order to market its products in foreign markets. In order to continue
marketing its products in Europe after mid-1998, the Company will be required to
obtain ISO 9001 certification and receive "CE" mark certification, an
international symbol of adherence to quality assurance standards and compliance
with applicable European medical device directives. The ISO 9001 certification
is one of the prerequisites for CE mark certification. Failure to receive the
right to affix the CE mark will prevent the Company from selling its products in
member countries of the European Union. The Company is currently in the ISO
certification process and plans on applying for both ISO 9001 and CE mark
certification.
Certain provisions of the Social Security Act, commonly referred to as
the "Anti-kickback Statute," prohibit entities, such as the Company, 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. The Anti-kickback Statute is broad in scope and has been broadly
interpreted by courts in many jurisdictions. Read literally, the statute places
at risk many business arrangements, potentially subjecting such arrangements to
lengthy, expensive investigations and prosecutions initiated by federal and
state governmental officials. Many states have adopted similar prohibitions
against payments intended to induce referrals of Medicaid and other third party
payor patients. Violation of the Anti-kickback Statute is a felony, punishable
by fines up to $25,000 per violation and imprisonment for up to five years. In
addition, the Department of Health and Human Services may impose civil penalties
excluding violators from participation in Medicare or state health programs.
15
In July 1991, in part to address concerns regarding the Anti-kickback
Statute, the federal government published regulations that provide exceptions,
or "safe harbors," for transactions that will be deemed not to violate the
Anti-kickback Statute. Proposed amendments to clarify these safe harbors were
published in July 1994 which, if adopted, would cause substantive retroactive
changes to the 1991 regulations. Certain of the Company's relationships do not
qualify for safe harbor protection. The fact that a relationship does not
qualify for safe harbor protection, however, does not mean that it is illegal,
and the Company believes that it is not in violation of the Anti-kickback
Statute. If the Company's current or future practices are found to be in
violation of the statute, such finding could have a material adverse effect on
the Company. Any state or federal regulatory review of the Company, regardless
of the outcome, would be both costly and time consuming.
Significant prohibitions against physician referrals were enacted by
Congress in the Omnibus Budget Reconciliation Act of 1993. These prohibitions,
commonly known as "Stark II," amended prior physician self-referral legislation
known as "Stark I" by dramatically enlarging the field of physician-owned or
physician-interested entities to which the referral prohibitions apply.
Effective January 1, 1995, Stark II prohibits, subject to certain exemptions, 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. The penalties for
violating Stark II include a prohibition on payment by these government programs
and civil penalties of as much as $15,000 for each violative referral and
$100,000 for participation in a "circumvention scheme." The Stark legislation is
broad and ambiguous and interpretative regulations clarifying the provisions of
Stark II as it would relate to the Company have not been issued. While the
Company believes it is in compliance with the Stark legislation, there can be no
assurance this is the case or that the government would not take a contrary
view. The violation of Stark I or II by the Company could result in significant
fines or penalties and exclusion from participation in the Medicare and Medicaid
programs.
The Company is also subject to regulation by the Occupational Safety
and Health Administration and the Environmental Protection Agency and similar
state and foreign agencies and authorities.
EMPLOYEES
As of December 31, 1996, the Company employed 36 full time employees.
The Company has no union contracts and believes that its relationship with its
employees is good.
EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of the Company are as follows:
NAME AGE POSITION
- ---- --- --------
William Petty, M.D. . . . . . . . . 54 Chairman of the Board and Chief Executive Officer
Timothy J. Seese. . . . . . . . . . 50 President, Chief Operating Officer and Director
Gary J. Miller, Ph.D. . . . . . . . 49 Vice President Research and Development and Director
16
David W. Petty. . . . . . . . . . . 30 Vice President, Marketing
Martha Miller . . . . . . . . . . . 51 Vice President, Regulatory Affairs
Marc Olarsch. . . . . . . . . . . . 35 Vice President, Sales
Joel C. Phillips. . . . . . . . . . 29 Treasurer
Betty Petty . . . . . . . . . . . . 54 Secretary
WILLIAM PETTY, M.D. was a founder and has been Chairman of the Board
and Chief Executive Officer of the Company since its inception. Dr. Petty has
been a Professor at the University of Florida College of Medicine since July
1975 and served as Chairman of the Department of Orthopaedic Surgery at the
University of Florida College of Medicine from July 1981 to January 1996. Dr.
Petty has also served as a member of the Hospital Board of Shands Hospital,
Gainesville, Florida, as an examiner for the American Board of Orthopaedic
Surgery, as a member of the Orthopaedic Residency Review Committee of the
American Medical Association, on the Editorial Board of the JOURNAL OF BONE AND
JOINT SURGERY, and on the Executive Board of the American Academy of Orthopaedic
Surgeons. He holds the Kappa Delta Award for Outstanding Research from the
American Academy of Orthopaedic Surgeons. His book, TOTAL JOINT REPLACEMENT, was
published in 1991. Dr. Petty received his B.S., M.S., and M.D. from the
University of Arkansas. He completed his residency in Orthopaedic Surgery at the
Mayo Clinic in Rochester, Minnesota. Dr. Petty does not devote his full business
time to the affairs of the Company and currently devotes approximately 50% of
his business time to the affairs of the Company.
TIMOTHY J. SEESE has been President and Chief Operating Officer of the
Company since March 1991 and a Director since April 1991. From October 1987 to
December 1990, Mr. Seese served as President and Chief Executive Officer of
Meritech, Inc., a development stage company involved with infection control
products. From December 1986 to October 1987, he served as President of the
Critical Care Monitoring Division of Becton Dickinson and Company, a
manufacturer and marketer of medical devices upon the acquisition of Deseret
Medical, Inc. by Becton Dickinson and Company. From January 1983 to December
1986, he served as Business Unit Director and Director, Marketing and Sales for
the Critical Care Business of Deseret Medical, Inc. Division of Warner Lambert,
a medical device, pharmaceutical and consumer products company. He received his
B.S. in Metallurgical Engineering from the University of Cincinnati and his
M.B.A. from Harvard University.
GARY J. MILLER, PH.D. was a founder and has been the Vice President,
Research and Development of the Company since October 1986 and a Director since
March 1989. Dr. Miller has been Associate Professor of Orthopaedic Surgery and
Director of Research and Biomechanics at the University of Florida College of
Medicine since July 1986. Dr. Miller received his B.S. from the University of
Florida, his M.S. (Biomechanics) from Massachusetts Institute of Technology, and
his Ph.D. in Mechanical Engineering (Biomechanics) from the University of
Florida. He has held an Adjunct Associate professorship in the College of
Veterinary Medicine's Small Animal Surgical Division since 1982 and was
appointed as an Adjunct Associate Professor in the Department of Aerospace,
Mechanics and Engineering Sciences in 1995. He was a consultant to FDA from 1989
to 1992 and has served as a consultant to such companies as Johnson & Johnson
Orthopaedics, Dow-Corning Wright and Orthogenesis. Dr. Miller does not devote
his full business time to the affairs of the Company and currently devotes
approximately 70% of his business time to the affairs of the Company.
DAVID W. PETTY has been Vice President, Marketing of the Company since
April 1993. He has been employed by the Company in successive capacities in the
area of Operations and Sales and Marketing for the past eight years, including
as Vice President, Operations from April 1991 until April 1993. Mr. Petty
received his B.A. from The University of Virginia in 1988. Mr. Petty is the son
of Dr.
17
and Ms. Petty.
MARTHA MILLER has been Vice President, Regulatory Affairs of the
Company since March 1996 and served as Director of Regulatory Affairs from April
1994 until March 1996. Ms. Miller joined the Company after fifteen years at
Smith & Nephew and Bristol-Myers Squibb, where she specialized in FDA compliance
and other governmental regulations. Ms. Miller received her degree in nursing
from Methodist Hospital School of Nursing.
MARC OLARSCH has been Vice President, Sales since July 1993. From 1984
to July 1993, he was employed by Carapace, the United States subsidiary of
Lohmann GmbH & Co., KB, Neuwied, Germany, a manufacturer of orthopaedic casting
material, surgical wound dressings and bandages. During his tenure with
Carapace, he held the positions of Regional Sales Manager and National Sales
Manager. He has extensive experience with group purchasing organizations,
independent manufacturers' representatives, as well as company-employed
territory managers and sales representatives.
JOEL C. PHILLIPS has been Treasurer of the Company since March 1996 and
Manager, Accounting and Management Information Systems since April 1993. From
January 1991 to April 1993, Mr. Phillips was employed by Arthur Andersen &
Company. He is responsible for the Company's accounting and control function, as
well as the computer-based operating and management information systems. Mr.
Phillips received a B.S. and a Masters in Accounting from the University of
Florida and is a certified public accountant.
BETTY PETTY has been Secretary of the Company since its inception and
served as Treasurer and a Director from its inception until March 1996. Ms.
Petty is responsible for the development of all of the Company's literature,
advertising and corporate events and also serves as Human Resources Coordinator
for the Company. Ms. Petty received her B.A. from the University of Arkansas at
Little Rock and her M.A. in English from Vanderbilt University. Ms. Petty is the
wife of Dr. Petty.
The Company's officers are elected annually by the Board of Directors and
serve at the discretion of the Board.
18
GLOSSARY
ACETABULAR COMPONENT-An orthopaedic implant that attaches to the pelvis
replacing the diseased or damaged acetabulum in total hip arthroplasty
ACETABULAR CUP-An orthopaedic implant which replaces the acetabulum in total hip
arthroplasty.
ACETABULUM-The hip socket or cup-shaped depression on the external surface of
the pelvis, in which the femoral head fits.
ARTHROPLASTY-An operation to restore as far as possible the integrity and
functionality of a joint.
ARTICULAR CONTACT STRESS-A measure of force where two moving surfaces make
contact; in the case of a normal human joint or an artificial joint, a measure
of force between the two surfaces in contact.
BIPOLAR COMPONENT/BIPOLAR PROSTHESIS-An orthopaedic hip implant used with a
femoral stem and a femoral head to repair fractures of the neck of the femoral
stem when the acetabulum and acetabular cartilage are in good condition.
BONE REMODELING-Reshaping of the bone as a result of stresses applied, sometimes
from stresses transferred to the bone by an orthopaedic implant.
BONE SCREWS-Screws used to affix an orthopaedic implant to a bone.
CEMENT-A nonmetallic material used for filling a cavity and attaching implants
to bone in joint arthroplasty.
CERAMIC-A glass like material made from metallic oxides used as an alternative
to metal in the ball of a ball and socket joint in hip and other large joint
orthopaedic implants.
COBALT CHROMIUM ALLAY-A substance primarily composed of a mixture of cobalt and
chromium used for orthopaedic implants.
CONSTRAINED CONDYLAR FEMORAL COMPONENT-A type of knee replacement component
typically used in revision surgery which compensates for lack of ligamentous
stability in the knee joint.
CRUCIATE LIGAMENT SPARING FEMORAL COMPONENT-A total knee replacement component
designed specifically for use in situations where the surgeon chooses to
maintain a functional or partially functional posterior cruciate ligament (one
of the major ligaments in the knee joint). Also called a cruciate retaining
femoral component.
EXTRAMEDULLARY ALIGNMENT-A method used in setting the alignment for bone
preparation in knee arthroplasty.
FEMORAL-Pertaining to the femur (large bone in the thigh).
FEMORAL HEAD-The ball of the ball and socket hip joint. The artificial ball used
to replace the natural ball of a diseased or damaged hip joint.
19
FEMORAL STEM-An orthopaedic implant placed into the femur or thigh bone in total
hip arthroplasty.
FEMUR-The bone located between the hip and the knee (large bone in the thigh).
FINNED KEEL-A shape or geometry of part of a specific design of a tibial
component which is implanted into the bone in knee arthroplasty.
FIXATION METHODS-Various methods of fixating implant components of artificial
joints to human bone.
FORGING-A fabrication process whereby a metal is heated and hammered into a
final shape resulting in a strong, dense part.
HIP ARTHROPLASTY-An operation to restore as far as possible the integrity and
functionality of the hip joint.
IMPLANT-A device employed in arthroplasty.
JOINT REPLACEMENT-An arthroplasty procedure where joint functionality is
restored as far as possible by totally substituting an artificial joint
orthopaedic implant system for a diseased or damaged joint.
KNEE ARTHROPLASTY-An operation to restore as far as possible the integrity and
functionality of the knee joint.
MODULAR-Made up of interchangeable parts which, when joined together, comprise
an entire orthopaedic implant.
NON-CEMENT-Description of a total orthopaedic implant component or procedure in
which bone cement is not used and the metal of the component is placed directly
against the bone.
ORTHOPAEDICS-The medical specialty concerned with the preservation, restoration
and development of form and function of the musculoskeletal system, extremities,
spine and associated structures by medical, surgical and physical methods.
OSTEOARTHRITIS-Degenerative joint disease occurring chiefly in older persons,
characterized by degeneration of the cartilage and bone and changes in the
synovial membrane. It is accompanied by pain and stiffness, particularly after
prolonged activity.
PATELLA-A triangular sesamoid bone situated at the front of the knee (knee cap).
PATELLA TRACKING-The action of the knee cap or patella gliding over the surface
of the end of the femur or thighbone when the knee bends and straightens. Also
the action of a patellar component gliding over the surface of a femoral
component in a knee with a total knee arthroplasty.
POLYETHYLENE-A plastic polymer in the thermoplastic group compatible with tissue
in the body.
POLYETHYLENE CUP LINER-An ultra-high molecular weight polyethylene insert which
provides the articular surface inside an acetabular cup.
POROUS COATING-A coating made of metal beads applied by heat and pressure to the
metal surface of an orthopaedic implant that promotes bony ingrowth in order to
hold the orthopaedic implant in place.
20
POSTERIOR STABILIZED FEMORAL COMPONENT-A knee component which fits on the end of
the femur and is used in situations where the surgeon chooses to eliminate the
posterior cruciate ligament, one of the major ligaments in the knee joint. The
component replaces to some degree the function of the posterior cruciate
ligament.
PRESS FIT-A method of fixation using a wedge-fit, rather than cement.
PRIMARY SYSTEMS-Orthopaedic implants which are designed to replace the natural
joint.
RECONSTRUCTIVE IMPLANT DEVICES-Orthopaedic implants which are implanted to
reconstruct major joints which have been damaged by degenerative bone disease or
accident.
REVISION SYSTEMS-Orthopaedic implants, which are designed to replace a failed
orthopaedic implant.
TIBIA-The inner and larger bone of the leg below the knee (shin bone).
TITANIUM-A metal used primarily in non-cemented applications in joint
arthroplasty.
TOTAL JOINT ARTHROPLASTY-An operation to replace a diseased or damaged joint of
the body with artificial implants usually to reduce pain and restore function in
the joint.
TOTAL JOINT IMPLANTS-Implants used in total joint arthroplasty.
TRAPEZOID KEEL WITH STEM AUGMENTATION-A geometry of a specific design of tibial
component that allows for attaching space-filling metal blocks and stems to fill
bone defects in the tibia in knee arthroplasty.
UNICOMPARTMENTAL IMPLANTS-Implants designed to resurface only one compartment of
a human knee.
UNIPOLAR PROSTHESIS-A large hemispherical implant component which is attached to
a femoral stem in a partial hip arthroplasty
21
ITEM 2. PROPERTIES
The Company maintains its corporate headquarters and a warehouse for
its business operations, consisting of approximately 12,000 square feet, located
in Gainesville, Florida, under a two-year lease which commenced on July 1, 1996.
The lease does not provide for any renewal of the term thereof. The Company's
monthly lease payments are approximately $5,523, for an annual lease payment of
approximately $66,276, which amounts do not include the Company's share of
applicable sales taxes related to rental payments, county real estate taxes and
public utility charges. The Company also owns a total of approximately eight
acres of land in Gainesville, Florida. The Company anticipates that it will
require more space in connection with the expansion of its business. The Company
is currently in development of an architectural and engineering plan for a new
facility to be built on a portion of such land and to be used by the Company for
principal executive offices, research and development laboratories and
manufacturing.
ITEM 3. LEGAL PROCEEDINGS
In the ordinary course of business, the Company is, from time to time,
a party to pending and threatened legal proceedings, primarily involving claims
for product liability. The Company believes that the outcome of such legal
actions and proceedings will not have a material adverse effect on the Company.
On December 13, 1994, a products liability action was commenced by
Marilyn Evans and Phillips Evans against the Company in the Circuit Court for
Pinellas County, Florida regarding the acetabular components of the Company's
total hip replacement system. As part of this action, the plaintiffs alleged
that following total hip replacement surgery the plaintiff suffered personal
injury as a result of the deterioration of the Company's implanted acetabular
components. The plaintiffs were seeking unspecified monetary damages against the
Company as a result of its alleged breach of warranty respecting the total hip
replacement system. The Company was represented by its insurance carrier in the
action. Although the Company believed that the action was without merit, the
insurance carrier settled with the plaintiffs in 1996 for $80,000. The Company's
liability was the $10,000 deductible associated with the insurance policy.
On April 3, 1995, Joint Medical Products, Inc. ("Joint Medical")
commenced an action (the "Action") against the Company, and many of its
competitors, alleging the infringement of a United States patent held by Joint
Medical entitled "Ball and Socket Bearing for Artificial Joint" (the "Ball and
Socket Patent"). As part of the Action, Joint Medical alleged that the Company's
manufacture and sale of certain orthopaedic implants was an infringement of the
Ball and Socket Patent. The Company and Joint Medical entered into a Tolling
Agreement, effective as of April 3, 1995, pursuant to which the parties agreed
that the Action would be dismissed without prejudice as to the Company. The
Tolling Agreement further provided that neither the Company nor Joint Medical
would commence any further action regarding the Company's alleged infringement
of the Ball and Socket Patent until the rendering of a decision by the Board of
Patent Appeals and Interferences regarding such alleged patent infringement. In
accordance with the Tolling Agreement, the Action was dismissed as against the
Company, among others, as of July 28, 1995. During 1996, the Board of Patent
Appeals and Interferences ruled in Joint Medical's favor and allowed the filing
of claims to continue. On January 28, 1997, Joint Medical filed a complaint in
the U.S. District Court for the District of Connecticut against the Company
seeking injunctive relief and unspecified monetary damages. The Company
believes, based upon a reasoned opinion of patent counsel, Spensley Horn Jubas &
Lubitz, that Joint Medical's claims are without merit and that its orthopaedic
implants do not infringe upon the Ball and Socket Patent.
22
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's security holders
during the fourth quarter of the fiscal year ended December 31, 1996.
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock has traded on the Nasdaq National Market
under the symbol "EXAC" since May 30, 1996, the date of the IPO. The following
table sets forth, for the periods indicated, the high and low sales price of the
Common Stock, as reported on the Nasdaq National Market:
HIGH LOW
---- ---
1996
Second Quarter (beginning May 30, 1996) $11.00 $8.00
Third Quarter 8.13 5.00
Fourth Quarter 12.25 7.00
1997
First Quarter (through February 28, 1997) $10.00 $7.75
No cash dividends have been paid to date by the Company on its Common
Stock. The Company intends to retain all future earnings for the operation and
expansion of its business and does not anticipate the payment of dividends in
the foreseeable future. Any future determination as to the payment of cash
dividends will depend upon a number of factors, including future earnings,
results of operations, capital requirements, the Company's financial condition
and any restrictions under credit agreements existing from time to time, as well
as such other factors as the Board of Directors may deem relevant.
As of March 3, 1997, the Company had approximately 228 stockholders of
record. There are in excess of 400 beneficial owners of the Company's Common
Stock.
23
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below has been derived from the
audited financial statements of the Company. This data should be read in
conjunction with the financial statements, the notes thereto and Management's
Discussion and Analysis of Results of Operations and Financial Condition
included elsewhere herein.
YEAR ENDED DECEMBER 31,
---------------------------------------------------------------
1992 1993 1994 1995 1996
------------ ---------- ---------- ---------- -----------
STATEMENT OF OPERATIONS DATA:
Net Sales $3,722,478 $4,675,505 $5,355,804 $9,118,075 $13,839,976
Cost of goods sold 941,528 1,360,025 1,586,633 2,995,955 4,683,875
Gross Profit 2,780,950 3,315,480 3,769,171 6,122,120 9,156,101
Operating Expenses
Sales and marketing 1,101,678 1,405,043 1,500,514 2,326,286 3,525,834
General and administrative 589,369 594,645 750,669 1,033,319 1,346,304
Research and development 258,738 488,029 597,812 722,118 750,256
Royalties 3,189 11,686 14,767 210,127 571,807
Depreciation and amortization 89,456 142,481 224,624 350,612 509,236
Total operating expenses 2,042,430 2,641,884 3,088,386 4,642,462 6,703,437
Income from operations 738,520 673,596 680,785 1,479,658 2,452,664
Other income (expense):
Interest income
(expense), net (95,274) (137,448) (158,288) (273,110) 12,336
Income from sub-license
agreement, net - - - 170,534 100,000
Equity in net loss of
subsidiary - - - (22,361) (59,486)
Income before provision for
income taxes 643,246 536,148 522,497 1,354,721 2,505,514
Provision for income taxes 225,586 182,709 176,369 527,793 950,906
Net Income 417,660 353,439 346,128 826,928 1,554,608
Preferred stock dividends - 8,194 19,298 22,798 10,154
Net income available to
common shareholders 417,660 345,245 326,830 804,130 1,544,454
Net income per common and
common equivalent share $0.15 $0.12 $0.11 $0.27 $0.37
BALANCE SHEET DATA:
Total current assets $4,029,368 $4,128,169 $4,781,430 $8,411,133 $17,358,859
Total assets 4,423,050 5,035,368 6,296,745 10,620,750 21,107,072
Total current liabilities 1,926,356 1,940,097 1,896,488 4,476,374 2,182,278
Total liabilities 2,485,352 2,509,605 3,210,993 6,452,479 2,527,297
Total preferred stock - 241,220 241,220 291,220 -
Total common shareholders' equity 1,937,698 2,284,543 2,844,532 3,877,051 18,579,775
24
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The following discussion should be read in conjunction with the
financial statements and related notes appearing elsewhere herein.
The Company develops, manufactures, markets and sells orthopaedic
implant devices and related surgical instrumentation to hospitals and
physicians. Sales of hip implant products historically accounted for most of the
Company's revenues and profits; however, since 1995, sales of knee implant
products have accounted for an increasing portion of its revenues and profits.
The Company anticipates that sales of knee implant products will continue to
account for an increasing portion of its revenues and profits. Furthermore, the
Company anticipates that overall profit margins in the hip implant market may
decline as a result of increasing price competition.
The following table sets forth for the periods indicated information
with respect to the number of units of the Company's products sold and the
dollar amount and percentages of revenues derived from such sales (dollars in
thousands):
EXACTECH, INC.
SALES SUMMARY BY PRODUCT LINE
YEAR ENDED
-------------------------------------------------------------------------------------
DECEMBER 31, 1994 DECEMBER 31, 1995 DECEMBER 31, 1996
HIP PRODUCTS UNITS $ % UNITS $ % UNITS $ %
----- ----- ------ ------ ----- ------ ------ ------ ------
Cemented 4,669 2,554 47.7% 5,207 2,567 28.2% 5,370 2,339 16.9%
Porous Coated 4,367 1,988 37.1% 4,321 1,931 21.2% 5,354 1,932 14.0%
Revision - - - - - - 4 9 0.1%
Bipolar 814 394 7.4% 846 460 5.0% 835 459 3.3%
----- ----- ------ ------ ----- ------ ------ ------ ------
Total Hip Products 9,850 4,936 92.2% 10,374 4,958 54.4% 11,563 4,739 34.3%
KNEE PRODUCTS
Cemented Cruciate Sparing 272 212 3.9% 3,220 1,932 21.2% 9,174 4,515 32.6%
Cemented Posterior Stabilized - - 0.0% 1,233 726 7.9% 3,536 1,969 14.2%
Porous Coated 30 52 1.0% 571 811 8.9% 1,315 1,775 12.8%
----- ----- ------ ----- ----- ------ ------ ------ ------
Total Knee Products 302 264 4.9% 5,024 3,469 38.0% 14,025 8,259 59.6%
Instrument Sales and Rental 122 2.3% 644 7.1% 773 5.6%
Miscellaneous 34 0.6% 47 0.5% 69 0.5%
===== ====== ===== ====== ====== ======
Total 5,356 100.0% 9,118 100.0% 13,840 100.0%
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
Net sales increased by $4,721,901, or 52%, to $13,839,976 in the year
ended December 31, 1996, from $9,118,075 in the year ended December 31, 1995.
U.S. sales increased 40%, to $11,715,120 in the year ended December 31, 1996,
from $8,374,375 in the year ended December 31, 1995. International sales
increased 186%, to $2,124,856 in the year ended December 31, 1996, from $743,700
in the year ended December 31, 1995. As a percentage of sales, international
sales increased from 8% in the year ended December 31, 1995, to 15% in the year
ended December 31, 1996. The increase in net sales resulted primarily from
increased unit volume of the Company's knee implant products. Sales of knee
implant products for the year ended December 31, 1996, increased by 179% on a
unit basis and by
25
138% on a dollar basis from the year ended December 31, 1995, as a result of the
continued full-scale marketing of the Optetrak7 knee system. Sales of hip
implant products for the year ended December 31, 1996 increased by 11.5% on a
unit basis and decreased by 4.4% on a dollar basis from the year ended December
31, 1995. The average selling price reductions in the hip system are the result
of increased unit sales of lower priced products including the MCS7 screw and
the Opteon7 medium demand stem. Specifically, the MCS7 screw system accounted
for 901 units of the 1,189 hip units increase in 1996 sales while providing only
3% of hip system sales. Hip and knee instrument sales and rentals increased to
$772,554 in the year ended December 31, 1996, from $644,316 in the year ended
December 31, 1995 as international knee instrument sales increased.
Gross profit increased by $3,033,981, or 50%, to $9,156,101 in the year
ended December 31, 1996, from $6,122,120 in the year ended December 31, 1995. As
a percentage of sales, gross profit decreased to 66% in the year ended December
31, 1996, from 67% in the year ended December 31, 1995. The decrease was
primarily the result of an increased mix of international sales. International
sales are typically at lower gross profit margins. However, the Company does not
incur commission expense on such sales.
Total operating expenses increased by $2,060,975, or 44%, to $6,703,437
in the year ended December 31, 1996, from $4,642,462 in the year ended December
31, 1995. Operating expenses decreased as a percentage of sales in the year
ended December 31, 1996, to 48% from 51% in the year ended December 31, 1995.
Sales and marketing expenses increased by $1,199,548, or 52%, to $3,525,834 in
the year ended December 31, 1996, from $2,326,286 in the year ended December 31,
1995. As a percentage of sales, sales and marketing expenses remained relatively
constant between the year ended December 31, 1996 and the year ended December
31, 1995 at 26% and 25%, respectively. The Company's sales and marketing
expenses are largely variable costs based on sales levels, with the largest
component being commissions.
General and administrative expenses increased by $312,985, or 30%, to
$1,346,304 in the year ended December 31, 1996, from $1,033,319 in the year
ended December 31, 1995. As a percentage of sales, general and administrative
expenses decreased to 10% in the year ended December 31, 1996, from 11% in the
year ended December 31, 1995. Total general and administrative expenses
increased on a dollar basis during the most recent year as compared to the prior
year primarily as a result of additional product liability insurance expense
resulting from increased sales and the hiring of additional staff.
Research and development expenses increased by $28,138, or 4%, to
$750,256 in the year ended December 31, 1996 from $722,118 in the year ended
December 31, 1995, as product development expenses for the revision knee and hip
systems increased while product development expenses for the primary knee
systems decreased. Research and development expenses were 5% and 8% of sales for
1996 and 1995, respectively.
Depreciation and amortization increased to $509,236 in the year ended
December 31, 1996, from $350,612 in the year ended December 31, 1995.
Depreciation and amortization expenses increased in the most recent year as a
result of the increased investment in hip and knee instrumentation. During the
year ended December 31, 1996, $1,332,759 of such instruments were placed in
service and capitalized, resulting in the increase in depreciation and
amortization expenses.
Royalty expenses increased by $361,680, to $571,807 in the year ended
December 31, 1996, from $210,127 in the year ended December 31, 1995, primarily
as a result of growth in sales of knee implant products which incur a higher
royalty rate. In 1996, the Company accrued royalty expenses of $307,801 in
connection with the license agreement with the Hospital for Special Surgery and
$187,773 in
26
connection with consulting agreements. As a percentage of sales, royalty
expenses were 4.1% and 2.3% in the years ended December 31, 1996 and 1995,
respectively.
The Company's income from operations increased by $973,006, or 66%, to
$2,452,664 in the year ended December 31, 1996, from $1,479,658 in the year
ended December 31, 1995. The increase was primarily attributable to the increase
in sales and gross profits, partially offset by the increase in operating
expenses.
The Company recognized net interest income of $12,336 in the year ended
December 31, 1996, as compared to net interest expense of $273,110 in the year
ended December 31, 1995. Interest expense of $239,623 for the year ended
December 31, 1996, was offset by $251,959 of interest income as the proceeds of
the Company's IPO consummated in June 1996 were invested in short-term
commercial paper and government backed securities. The outstanding principal
balance of the Company's debt averaged approximately $2,900,000 and $1,427,000
during 1995 and 1996, respectively. The weighted average interest rate on such
debt was 9.87% and 8.56% for 1995 and 1996, respectively.
In July 1995, the Company purchased a 50% interest in Techmed, its
Italian distributor. The investment is accounted for by the equity method.
Included in other income and expenses for the year ended December 31, 1996, are
$59,486, the Company's equity share in the net loss of Techmed and the
recognition of sublicense income of $100,000.
The Company entered into a sublicense agreement (the "Sublicense
Agreement") with SDP pursuant to which the Company received a $250,000 license
fee in 1995. Under the terms of the sublicense agreement, an advance on
potential royalties in the amount of $100,000 was paid to the Company. The
$100,000 advance is non-refundable to the extent that the sub-licensee does not
receive FDA clearance to market the product. During 1996, the Company was
notified by the sublicensee that initial applications for FDA clearance to
market had been denied. Accordingly, the $100,000 was recognized as sublicense
income because the $100,000 was fully earned by the Company.
Income before provision for income taxes increased by $1,150,793, or
85%, to $2,505,514 in the year ended December 31, 1996, from $1,354,721 in the
year ended December 31, 1995. The provision for income taxes was $950,906 in the
year ended December 31, 1996, compared to $527,793 in the year ended December
31, 1995.
All outstanding shares of the Company's preferred stock were either
converted to Common Stock or redeemed in the year ended December 31, 1996. As a
result, preferred stock dividends for the year ended December 31, 1996,
decreased to $10,154 from $22,798 in the year ended December 31, 1995. As a
result, the Company had net income of $1,544,454 in the year ended December 31,
1996, compared to $804,130 in the year ended December 31, 1995, a 92% increase.
YEAR ENDED DECEMBER 31, 1995 COMPARED TO YEAR ENDED DECEMBER 31, 1994
Net sales increased by $3,762,271, or 70%, to $9,118,075 in 1995 from
$5,355,804 in 1994. The increase in net sales resulted primarily from increased
unit volume of the Company's knee implant products. Sales of cemented hip
implant products increased by 11.5% on a unit basis and by 0.5% on a dollar
basis from 1994 to 1995. Cemented hip implants increased on a unit basis largely
due to increased sales of the Opteon/registered trademark/ moderate demand
femoral stem. While overall unit volume of cemented implants increased, the
Opteon/registered trademark/ stem was substituted by some customers for the
Company's high demand cemented stem. The list price for the Opteon/registered
trademark/ stem is $999 and the list price for the high demand
27
cemented stem is $1,695. Therefore, the average price of total cemented hip
implant sales declined. The Company expects that this shift in product mix will
continue in the future but at a somewhat slower rate. Sales of porous coated hip
implants decreased by 1.1% on a unit basis and by 2.9% on a dollar basis. The
price reductions typically were granted in response to competitive quotes. Sales
of instruments and revenue from rental charges for instruments are included in
net sales and also increased from 1994 to 1995.
Gross profit increased by $2,352,949, or 62%, to $6,122,120 in 1995
from $3,769,171 in 1994. As a percentage of sales, gross profit decreased to 67%
in 1995 from 70% in 1994. The decrease was primarily due to the increased
proportional sales of cemented hip implants, which have a lower gross profit
margin, and a corresponding decrease in sales of porous coated hip products,
which have a higher gross profit margin. The decrease was also due to decreased
selling prices of porous coated implant products and increased international
sales. The decrease in gross profits from sales of hip implants was partially
offset by increased sales of knee implants, from which the Company typically
realizes higher gross profit margins.
Total operating expenses increased by $1,554,076, or 50%, to $4,642,462
in 1995 from $3,088,386 in 1994. Sales and marketing expenses, the largest
component of total operating expenses, increased by $825,772, or 55%, to
$2,326,286 in 1995 from $1,500,514 in 1994. Sales and marketing expenses
declined as a percentage of sales to 26% in 1995 from 28% in 1994. The Company's
sales and marketing expenses are largely variable costs based on sales levels,
with the largest component being commissions. The remaining fixed component of
these expenses was spread over a larger sales volume in 1995, resulting in sales
and marketing expenses constituting a lower percentage of sales.
General and administrative expenses increased by $282,650, or 38%, to
$1,033,319 in 1995 from $750,669 in 1994. Total general and administrative
expenses increased primarily as a result of the hiring of additional staff and
increases in administrative expenses associated with the expansion of the
Company. As a percentage of sales, general and administrative expenses decreased
to 11% in 1995 from 14% in 1994.
Research and development expenses increased by $124,306, or 21%, to
$722,118 in 1995 from $597,812 in 1994, primarily as a result of an increase in
project expenses and the addition of a designer-draftsman to support the
expanded number of hip and knee development programs. Research and development
expenses were 8% and 11% of sales for 1995 and 1994, respectively.
Depreciation and amortization increased to $350,612 in 1995 from
$224,624 in 1994, as a result of the addition of fixed assets.
Royalty expenses increased by $195,360, to $210,127 in 1995 from
$14,767 in 1994 primarily as a result of sales of knee implant products. In
1995, the Company accrued royalty expenses of $89,274 in connection with the
license agreement with the Hospital for Special Surgery and $108,853 in
connection with consulting agreements. As a percentage of sales, royalty
expenses were 2.3% and 0.3% in 1995 and 1994, respectively.
The Company's income from operations increased by $798,873, or 117%, to
$1,479,658 in 1995 from $680,785 in 1994. The increase was attributable to the
increase in sales and gross profits, partially offset by the increase in
operating expenses.
Net interest expense increased to $273,110 in 1995 from $158,288 in
1994 as outstanding indebtedness increased from 1994 to 1995. The outstanding
principal balance of the Company's debt averaged approximately $2,059,000 and
$2,900,000 during 1994 and 1995, respectively. The weighted average interest
rate on such debt was 8.25% and 9.87% for 1994 and 1995, respectively.
28
The Company entered into the Sublicense Agreement with SDP pursuant to
which the Company received a $250,000 license fee in 1995. The Company realized
income of $170,534 in 1995 from the Sublicense Agreement, representing the
$250,000 license fee net of expenses incurred under the license agreement
pursuant to which the Company obtained the rights to the sublicensed technology.
Included in other expense in 1995 is equity in the net loss of the Techmed
subsidiary of $22,361.
Income before provision for income taxes increased by $832,224, or
159%, to $1,354,721 in 1995 from $522,497 in 1994. The provision for income
taxes was $527,793 in 1995 compared to $176,369 in 1994. The increase resulted
from the increase in income before provision for income taxes and an increase in
the tax rate to 39% in 1995 compared to 33.8% in 1994. Preferred stock dividends
increased in 1995 to $22,798 from $19,298 in 1994. As a result, the Company had
net income of $804,130 in 1995 compared to $326,830 in 1994.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, the Company financed its operations through borrowings,
the sale of equity securities and cash flow from operations. At December 31,
1996, the Company had working capital of $15,176,581 compared to $3,934,759 at
December 31, 1995. As a result of operating, investing and financing activities,
cash and cash equivalents at December 31, 1996 increased to $3,992,442 from
$201,979 at December 31, 1995. In June 1996, the Company consummated the IPO
resulting in net proceeds to the Company of $12,657,910 after deduction of
underwriting, legal, accounting and other offering related expenses. The
significant increase in working capital is primarily the result of the proceeds
from the IPO. The proceeds of the IPO have been and will be used primarily to
repay outstanding debt, to purchase inventory and equipment, for research and
development and for working capital and general corporate purposes. The Company
projects that the current working capital will be sufficient to fund operations
and expand the business for at least the next twelve months.
OPERATING ACTIVITIES
Operating activities provided net cash of $8,951 in the year ended
December 31, 1996 compared to using net cash of $956,834 in the year ended
December 31, 1995. The primary reason for the change was a lower increase in
inventory during 1996 of $1,303,401 as compared to the $2,636,627 increase in
inventory that occurred during 1995. Another factor resulting in less cash being
used in operating activities for the year ended December 31, 1996, was reduced
growth in trade receivables. Cash required as a result of the increase in trade
receivables was $660,735 during 1996, as compared to $1,107,845 during 1995.
FINANCING ACTIVITIES
The Company had entered into a loan agreement with Merrill Lynch Business
Financial Services, Inc. (the "Lender") which provided for a term loan in the
amount of $1,250,000 and a $3,000,000 line of credit which expired in June 1996.
In June 1996, the Company used a portion of the net proceeds of the IPO to repay
the $1,047,825 outstanding under the term loan and the $2,826,712 outstanding
balance under the line of credit. William Petty and Betty Petty, executive
officers and principal shareholders of the Company, had personally guaranteed
the repayment of the Company's obligations under the loan agreement with the
Lender. The Company has negotiated a new loan agreement with the Lender
providing for a $3,000,000 line of credit and the elimination of the personal
guarantees of William Petty and Betty Petty.
29
The Company had a term loan secured by real property. In August 1996, the
Company repaid the term loan, which was secured by certain of the Company's real
property, with a portion of the net proceeds of the IPO.
The Company had issued an aggregate of $500,000 in principal amount of its
8% Subordinated Debentures (the "8% Debentures") to Michael M. Kearney, a
shareholder of the Company, and R. Wynn Kearney, a director and shareholder of
the Company. Interest on the 8% Debentures accrued at the rate of 8% per annum
and was payable quarterly. The Company redeemed $50,000 of the 8% Debentures in
1995 and redeemed the outstanding $450,000 of 8% Debentures in full on June 19,
1996; with a portion of the net proceeds of the IPO, at a redemption price equal
to the outstanding principal amount thereof. In connection with the issuance of
the 8% Debentures, the Company issued to the holders thereof warrants (the
"Debenture Warrants") to purchase 32,194 shares of Common Stock at an exercise
price per share equal to $6.00 (75% of the initial public offering price of the
Common Stock-$8.00). The Debenture Warrants are exercisable during the
three-year period commencing on the date of the IPO (June 4, 1996). In addition,
in April and May 1995, the Company issued an aggregate of $310,000 in principal
amount of its 10% Subordinated Convertible Debentures (the "10% Debentures"), of
which $100,000 was issued to Alan Chervitz, a shareholder of the Company.
Interest on the 10% Debentures accrued at the rate of 10% per annum and was
payable quarterly. As a result of the IPO, $280,000 of the 10% Debentures was
converted to Common Stock. The remaining $30,000 of the 10% Debentures was
redeemed as provided in the original agreement.
Net cash provided by financing activities increased from $1,866,169
during 1995, to $9,017,468 during 1996. The primary reason for the increase in
cash provided by financing activities was the net proceeds derived from the
Company's IPO.
INVESTING ACTIVITIES
The Company has invested the remaining proceeds of the IPO in
short-term investments. As of December 31, 1996, $3,083,788 was invested in
United States Treasury Notes with maturities ranging from June 30, 1997 through
July 31, 1997 and yielding from 5.57% to 5.75%, and $3,600,894 was invested in
Merrill Lynch=s Institutional Investment Fund and Money Market Fund comprised of
commercial paper and government backed securities yielding a return of
approximately 5%. During 1996, net cash used in investing activities increased
to $5,235,956 as compared to $974,772 in 1995. This increase was primarily due
to the increase in short term investments and an increase in purchases of
property and equipment during 1996.
CAUTIONARY STATEMENT RELATING TO FORWARD LOOKING STATEMENTS
The foregoing Management's Discussion and Analysis contains various
"forward looking statements" within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934 which
represent the Company's expectations or beliefs concerning future events,
including, but not limited to, statements regarding growth in sales of the
Company's products, profit margins and the sufficiency of the Company'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, the
Company's dependence on the ability of its third-party manufacturers to produce
components on a basis which is cost-effective to the Company, market acceptance
of the Company's products and the effects of governmental regulation. Results
actually achieved may differ materially from expected results included in these
statements as a result of these or other factors.
30
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
TABLE OF CONTENTS
PAGE
----
Independent Auditors' Report 32
Balance Sheets as of December 31, 1995 and December 31, 1996 33
Statements of Income for the Years Ended December 31, 1994, 1995 and 1996 35
Statement of Changes in Common Shareholders' Equity for the
Years Ended December 31, 1994, 1995 and 1996 36
Statements of Cash Flows for the Years Ended 37
December 31, 1994, 1995 and 1996
Notes to Financial Statements for the Years Ended 38
December 31, 1994, 1995 and 1996
31
Deloitte & Touche LLP
Certified Public Accountants
One Independent Drive Suite 2801
Jacksonville, FL 32202
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders
of Exactech, Inc.
Gainesville, Florida
We have audited the accompanying balance sheets of Exactech, Inc. (the
"Company") as of December 31, 1995 and 1996, and the related statements of
income, shareholders' equity, and cash flows for each of the three years in the
period ended December 31, 1996. Our audits also included the financial statement
schedule listed in the Index at Item 14. These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on the financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of Exactech, Inc. as of December 31, 1995 and
1996, and the results of its operations and its cash flows for each of the three
years in the period ended December 31, 1996 in conformity with generally
accepted accounting principles. Also, in our opinion, such financial statement
schedule, when considered in relation to the basic financial statements taken as
a whole, presents fairly in all material respects the information set forth
therein.
DELOITTE & TOUCHE LLP
February 7, 1997
32
EXACTECH, INC.
BALANCE SHEETS
DECEMBER 31, 1995 AND 1996
- ---------------------------------------------------------------------------------------------------
ASSETS 1995 1996
------------ --------------
CURRENT ASSETS:
Cash and cash equivalents $ 201,979 $ 3,992,442
Short-term investments - 3,083,788
Trade receivables (net of allowance of $13,500 and $37,164) 1,802,129 2,462,864
Prepaid expenses and other assets 84,670 194,009
Inventories 6,322,355 7,625,756
------------- --------------
Total current assets 8,411,133 17,358,859
PROPERTY AND EQUIPMENT:
Machinery and equipment 2,504,130 4,174,394
Furniture and fixtures 101,137 115,089
------------- --------------
Total 2,605,267 4,289,483
Accumulated depreciation (881,747) (1,322,392)
------------- --------------
Net property and equipment 1,723,520 2,967,091
OTHER ASSETS:
Land held for future use 263,301 263,301
Investment in subsidiary 67,987 100,638
Deferred financing costs, net 56,152 21,296
Deferred stock issuance costs 10,000 -
Advances and deposits 2,442 2,442
Patents and trademarks, net of accumulated amortization 86,215 393,445
------------- --------------
Total other assets 486,097 781,122
------------- --------------
TOTAL ASSETS $ 10,620,750 $ 21,107,072
============= ==============
See notes to audited financial statements
33
EXACTECH, INC.
BALANCE SHEETS
DECEMBER 31, 1995 AND 1996
- -----------------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY 1995 1996
----------- -----------
CURRENT LIABILITIES:
Accounts payable $ 1,439,598 $ 1,430,321
Borrowings under line of credit 1,844,266 --
Income taxes payable 275,991 40,986
Current portion of long-term debt and capital lease obligations 266,389 32,861
Commissions payable 351,431 373,900
Royalties payable 232,735 168,387
Other liabilities 65,964 135,823
----------- -----------
Total current liabilities 4,476,374 2,182,278
DEFERRED INCOME TAXES 213,796 326,875
LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS 1,002,309 18,144
NET OF CURRENT PORTION
SUBORDINATED DEBENTURES-RELATED PARTIES 550,000 -
SUBORDINATED DEBENTURES-OTHER 210,000 -
----------- -----------
Total liabilities 6,452,479 2,527,297
CONTINGENCIES (Note 6)
MANDATORILY REDEEMABLE PREFERRED STOCK:
Series A Preferred Stock, $.01 par value; 13,622 shares 136,220 -
authorized, issued and outstanding; liquidation value $ 136,220
Series C Preferred Stock, $.01 par value; 5,000 shares 50,000 -
authorized, issued and outstanding; liquidation value $ 50,000
NONREDEEMABLE PREFERRED STOCK:
Series B Preferred Stock, $.01 par value; 20,000 shares 105,000 -
authorized; 10,500 shares issued and outstanding ;
liquidation value $105,000
COMMON SHAREHOLDERS' EQUITY:
Common stock, $.01 par value; 15,000,000 shares authorized 29,539 48,604
2,953,903 and 4,860,434 shares issued and outstanding
Additional paid-in capital 1,676,383 14,815,588
Retained earnings 2,171,129 3,715,583
----------- -----------
Total common shareholders' equity 3,877,051 18,579,775
----------- -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $10,620,750 $21,107,072
=========== ===========
See notes to audited financial statements
34
EXACTECH, INC.
STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
- ---------------------------------------------------------------------------------------------------------
1994 1995 1996
-------------- --------------- --------------
NET SALES $ 5,355,804 $ 9,118,075 $ 13,839,976
COST OF GOODS SOLD 1,586,633 2,995,955 4,683,875
-------------- --------------- --------------
Gross profit 3,769,171 6,122,120 9,156,101
OPERATING EXPENSES:
Sales and marketing 1,500,514 2,326,286 3,525,834
General and administrative 750,669 1,033,319 1,346,304
Research and development 597,812 722,118 750,256
Depreciation and amortization 224,624 350,612 509,236
Royalties 14,767 210,127 571,807
-------------- --------------- --------------
Total operating expenses 3,088,386 4,642,462 6,703,4