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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, 1997
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. [ ]
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As of February 20, 1998, the number of shares of the registrant's Common Stock
outstanding was 4,904,663. The aggregate market value of the Common Stock held
by non-affiliates of the registrant as of February 20, 1998 was approximately
$14,019,555, based on a closing sale price of $5.50 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 for its 1998
Annual Meeting of Shareholders (to be filed pursuant to Regulation 14A).
2
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 8
Research and Development 10
Scientific Advisory Board 11
Competition 11
Product Liability and Insurance 11
Government Regulation 12
Employees 14
Executive Officers of the Registrant 15
Glossary 17
Item 2. Properties 19
Item 3. Legal Proceedings 19
Item 4. Submission of Matters to a Vote of Security Holders 20
PART II Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 21
Item 6. Selected Financial Data 22
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations 23
Item 8. Financial Statements and Supplementary Data 29
Item 9. Changes in and Disagreements with Accountants on 46
Accounting and Financial Disclosure
PART III Item 10. Directors and Executive Officers of the Registrant 46
Item 11. Executive Compensation 46
Item 12. Security Ownership of Certain Beneficial Owners
and Management 46
Item 13. Certain Relationships and Related Transactions 46
PART IV Item 14. Exhibits, Financial Statement Schedules and Reports
on Form 8-K 47
3
ITEM 1. BUSINESS
Certain terms used herein are defined in the Glossary on pages 17 to 19
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 the Orthopedic Network News Volume 8 Number 3, United
States sales of orthopaedic implant products were approximately $1.8 billion in
1996, an increase of 3.5% from 1995. During 1996, sales of knee implants were
approximately $999 million, an increase of 5.3% from 1995, while sales of hip
implants were approximately $793 million, an increase of 1.4% from 1995. The
publication reports that there were 532,532 hip and knee joint replacements in
the United States in 1996 compared to 504,067 in 1995. 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.
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.
4
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.
The Optetrak/registered trademark/ system also includes a total knee
revision system with respect to which the Company commenced full scale marketing
in 1997. 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 also designing a unicompartmental knee with respect to
which the Company will be required to obtain Food and Drug Administration
("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/registered trademark/ 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.
5
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 Cemented
Total Hip System is a mature product line which the Company intends to phase out
with the AuRA/registered trademark/ Hip System over the next few years.
The Company scaled up marketing and sales of the AuRA/registered
trademark/ Hip System in 1997. AuRA/registered trademark/ is a comprehensive
system that provides solutions for a broad range of patient problems. It is
specifically designed to support the needs of a maturing generation of more
active patients. The AuRA/registered trademark/ Hip System is comprised of a new
primary total hip replacement system as well as revision components which
include calcar replacement and long stems. It can also be used for fracture and
tumor applications. All AuRA/registered trademark/ components have a common
proximal geometry which affords the surgeon reproducability of results
regardless of which stem is selected. AuRA/registered trademark/ components can
be implanted using a single set of surgical instruments which makes the system
more cost effective.
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 AuRA/registered trademark/ 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.
During 1996, the Company licensed patent technology for a modular
revision hip system. The Company commenced product development of the modular
revision hip system during 1997. The Company plans to continue product
development and to seek FDA clearance to market the system in 1998. The Company
plans to commence full scale marketing of the product in 1999.
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 AND SERVICES. The Company has designed and
received FDA clearance to market a nonmodular shoulder implant system. In 1997,
the Company temporarily halted development plans for a modular version of a
shoulder implant system. The Company currently believes that other opportunities
currently provide a more optimal use of the Company's resources.
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.
The Company has licensed certain technology for orthopaedic repairs.
This material will be supplied as a service through the Company's current sales
organization. The Company plans to commence this service in the second quarter
of 1998.
6
MARKETING AND SALES
The Company markets its orthopaedic implant products in the United
States through 32 independent agencies and two domestic distributors, 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
sales 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 two Regional Managers (West/Midwest and Northeast). The Company
has contractual arrangements with its domestic distributors which are similar to
its arrangements with its sales agencies, except the Company does not pay the
distributors commissions and the distributors purchase inventory from the
Company for use in fulfilling customer orders. The Company currently offers its
products in 30 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
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, 1996 and 1997, approximately
10%, 7% and 6%, respectively, of the Company's sales were derived from a major
customer. During the years ended December 31, 1995, 1996 and 1997 one
distributor, MBA Del Principado, S.p.A., accounted for approximately 5%, 13% 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 $193,759 in equity
to Techmed. During September 1997, the Company wrote off its investment in the
subsidiary and reserved for trade receivables deemed uncollectible.
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, 1995, 1996 and
7
1997, foreign sales accounted for $743,700, $2,124,856 and $3,051,151,
representing approximately 8.2%, 15.4%, and 17.3%, respectively, of the
Company's sales. For the years ended December 31, 1995, 1996 and 1997, gross
profit from foreign sales accounted for $257,083, $597,944 and $1,127,455,
respectively. 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 intends to continue to
expand its international distribution network in 1998.
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, 1995, 1996 and 1997, the Company
purchased approximately 68%, 62% and 72%, 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
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
plans to engage in limited manufacturing of the components of its products,
consisting primarily of final machining of components during 1998. The Company
is in the process of completing a new facility to be used by the Company for
principal executive offices, research and development laboratories and
manufacturing. The Company expects to occupy the new facility in the third
quarter of 1998.
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
8
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, 1995, 1996 and
1997, the Company paid royalties aggregating $101,393, $187,773 and $288,759
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.
In January 1997, the Company entered into an oral consulting agreement
with Albert Burstein, Ph.D., a director of the Company, to provide services
regarding many facets of the orthopaedic industry including product design
rationale, manufacturing and development techniques and product sales and
marketing. During 1997, the Company paid Dr. Burstein $123,750 as compensation
under the consulting agreement.
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 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.
During the years ended December 31, 1996 and 1997, the Company recognized
royalties to the Hospital for Special Surgery of $307,801 and $474,357,
respectively.
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
9
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. 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, 1995, 1996 and 1997, the Company paid royalties to Accumed of
approximately $13,412, $11,577 and $11,906, 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.
During 1997, the Company licensed certain technology. The license fees
total $250,000, of which $100,000 was paid upon the execution of the agreement
and an additional $150,000 is payable at such time as the licensor produces a
developed product.
RESEARCH AND DEVELOPMENT
During the years ended December 31, 1995, 1996 and 1997, the Company
expended $722,118, $750,256 and $937,988 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 of the revision components of the Company's Optetrak/registered
trademark/ knee implant system and the AuRA/registered trademark/ Hip System in
1997. The Company's principal research and development efforts currently relate
primarily to the production of enhanced revision components of the
Optetrak/registered trademark/ comprehensive knee implant system and the
development of the modular hip implant system.
10
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 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.), Osteonics, Inc. and Biomet, Inc. who, according to an
industry publication, had an estimated aggregate market share of approximately
79% in 1996. 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 Osteonics, Inc. who, according to an industry
publication, had an estimated aggregate market share of approximately 69% in
1996.
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 amounts which it believes are
typical in the industry for similar companies.
11
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 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
femoral stem and acetabular component; bipolar partial hip implant;
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/registered
trademark/ femoral stem; and the Optetrak/registered trademark/ knee replacement
system.
New medical device 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
12
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 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 which became
effective 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 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.
Prior to 1996, 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. During September 1997, the Company voluntarily initiated a
Class II recall as the result of the failure of an Opteon/registered trademark/
femoral hip stem. A Class II recall is defined as a situation in which the use
of a violative product may cause temporary or medically reversible adverse
health consequences or where the probability of serious adverse health
consequences is remote.
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
13
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 during the second quarter of 1998.
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
payer 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.
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. 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, 1997, the Company employed 45 full time employees.
The Company has no union contracts and believes that its relationship with its
employees is good.
14
EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of the Company are as follows:
NAME AGE POSITION
- ---- --- --------
William Petty, M.D. . . . . . . 55 Chairman of the Board and Chief Executive Officer
Timothy J. Seese. . . . . . . . 51 President, Chief Operating Officer and Director
Gary J. Miller, Ph.D. . . . . . 50 Vice President Research and Development and Director
David W. Petty. . . . . . . . . 31 Vice President, Marketing
Marc Olarsch. . . . . . . . . . 35 Vice President, Sales
Joel C. Phillips . . . . . . . 30 Treasurer
Betty Petty . . . . . . . . . . 55 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 was Associate Professor of Orthopaedic Surgery and
Director of Research and Biomechanics at the University of Florida College of
Medicine from July 1986 through July 1997. 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
Engineering, 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.
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. and Ms. Petty.
15
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.
16
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.
ALLOGRAFT- a homograft between allogenic individuals
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.
CALCAR REPLACEMENT STEM-A femoral hip implant component used when there is bone
loss or destruction in the proximal medial area of the femur.
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.
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).
17
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.
HOMOGRAFT- a graft of tissue from the donor of the same species as the recipient
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.
LONG STEM-A femoral hip implant component used when the length of the primary
component does not meet the fixation needs of the surgical situation.
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.
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.
18
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
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 constructing a new facility on the land to be used by the Company
for principal executive offices, research and development laboratories and
manufacturing. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations - Liquidity and Capital Resources".
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 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
19
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, Fish and
Richardson P.C., that Joint Medical's claims are without merit and that its
orthopaedic implants do not infringe upon the Ball and Socket Patent. In
December 1997, the complaint was dismissed without prejudice. The product line
claimed to be in violation of the patent is the MCS/registered trademark/ Porous
Acetabular Shell which represented approximately 11%, 7% and 6% of the Company's
revenues for the years ended December 31, 1995, 1996 and 1997, respectively. A
finding that such product line infringes upon the Ball and Socket Patent could
materially and adversely affect the Company's business operations, as well as
expose the Company to significant monetary damages.
On August 21, 1997, Oxford Medical, Inc., a competitor of the Company,
filed a complaint in the United States District Court in New Jersey alleging
that the Company induced several of the competitor's sales agents to breach
their employment agreements when the Company contracted with these agents to
sell the Company's products. The plaintiff is seeking an unspecified monetary
award and punitive damages in the amount to be determined at trial. The
plaintiff also sought to enjoin the Company from soliciting plaintiff's
employees, interfering with their customer relationships and selling products to
their former customers. The Company believes that the allegations are without
merit. At a hearing in the Superior Court of New Jersey on October 8, 1997, the
judge denied the plaintiff's request for injuctive relief. Litigation is
currently proceeding.
In December 1997, Biomet, Inc., a competitor of the Company, filed a
complaint against one of the competitor's former sales agents in the United
States District Court in Oregon. The competitor petitioned the court to include
the Company in the complaint alleging liability for actions of the sales agent
and interference by the Company with a contract between the competitor and the
sales agent. The court refused to allow the Company to be included in the
complaint, but affirmed that the competitor could name the Company in a separate
complaint. Without admitting any wrongdoing, the Company and the agent settled
the dispute through mediation in February 1998, and obtained a release of all
claims. As part of the settlement, the Company agreed to pay $20,000 to the
agent for legal expenses and an additional $55,000 in enhanced sales commissions
to the agent over an indeterminate period of time if the commissions are earned.
The Company also agreed not to hire as a new sales agent any of the competitor's
exclusive distributors or sales representatives whose territory is west of the
Mississippi in the continental United States for a period of four months.
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, 1997.
20
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 $10.00 $6.50
Second Quarter 7.75 6.00
Third Quarter 7.00 5.56
Fourth Quarter 6.88 3.88
1998
- ----
First Quarter (through February 20, 1998) $ 6.00 $5.00
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 February 20, 1998, the Company had approximately 231 stockholders
of record. There are in excess of 2,000 beneficial owners of the Company's
Common Stock.
After deducting expenses of $2,062,090 of the IPO, the Company received
$12,657,910 in net proceeds from the IPO. Set forth below is information
concerning the actual use of such proceeds.
DIRECT OR INDIRECT PAYMENTS DIRECT OR INDIRECT PAYMENTS
TO RELATED PARTIES (1) TO OTHERS
--------------------------- ---------------------------
Purchase and installation of machinery
and equipment $ - $2,896,048
Repayment of indebtedness $ - $4,942,268
Temporary Investments (2) $ - $2,044,961
Other Purposes (3) $ - $2,774,633
1 - Includes direct or indirect payments to directors, officers, general
partners of the Company, or their associates; to persons owning ten percent
or more of any class of equity securities of the Company; and to affiliates
of the Company.
2 - Includes daily maturing fund investments and overnight repurchase agreements
totaling $2,044,961.
3 - Includes increase of inventory held for sale of $2,774,663.
21
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,
---------------------------------------------------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
STATEMENT OF OPERATIONS DATA:
Net sales $ 4,675,505 $ 5,355,804 $ 9,118,075 $13,839,976 $17,648,060
Cost of goods sold 1,360,025 1,586,633 2,995,955 4,683,875 5,895,302
Gross profit 3,315,480 3,769,171 6,122,120 9,156,101 11,752,758
Operating expenses
Sales and marketing 1,405,043 1,500,514 2,326,286 3,525,834 4,911,906
General and administrative 594,645 750,669 1,033,319 1,346,304 1,677,878
Research and development 488,029 597,812 722,118 750,256 937,988
Royalties 11,686 14,767 210,127 571,807 855,415
Depreciation and amortization 142,481 224,624 350,612 509,236 813,200
Total operating expenses 2,641,884 3,088,386 4,642,462 6,703,437 9,196,387
Income from operations 673,596 680,785 1,479,658 2,452,664 2,556,371
Other income (expense):
Interest income
(expense), net (137,448) (158,288) (273,110) 12,336 200,720
Income from sub-license
agreement, net - - 170,534 100,000 -
Equity in net loss of
subsidiary - - (22,361) (59,486) (183,909)
Income before provision for
income taxes 536,148 522,497 1,354,721 2,505,514 2,573,182
Provision for income taxes 182,709 176,369 527,793 950,906 997,188
Net income 353,439 346,128 826,928 1,554,608 1,575,994
Preferred stock dividends 8,194 19,298 22,798 10,154 -
Net income available to
common shareholders 345,245 326,830 804,130 1,544,454 1,575,994
Basic earnings per common share * $0.12 $0.11 $0.27 $0.38 $0.32
Diluted earnings per common share * $0.12 $0.11 $0.27 $0.37 $0.32
AS OF DECEMBER 31,
------------------------------------------------------------------
BALANCE SHEET DATA: 1993 1994 1995 1996 1997
---- ---- ---- ---- ----
Total current assets $4,128,169 $4,781,430 $ 8,411,133 $17,358,859 $20,334,332
Total assets 5,035,368 6,296,745 10,620,750 1,107,072 27,154,836
Total current liabilities 1,940,097 1,896,488 4,476,374 2,182,278 2,464,461
Total long-term debt, net of current portion 10,928 684,903 1,002,309 18,144 3,912,835
Total liabilities 2,509,605 3,210,993 6,452,479 2,527,297 6,811,244
Total preferred stock 241,220 241,220 291,220 - -
Total common shareholders' equity 2,284,543 2,844,532 3,877,051 18,579,775 20,343,592
* Earnings per share for years prior to 1997 have been restated per SFAS 128 "Earnings Per Share"
22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The following discussion should be read in conjunction with the
financial statements and related notes appearing elsewhere herein.
The Company develops, manufactures, markets and sells orthopaedic
implant devices and related surgical instrumentation to hospitals and
physicians. Sales of hip implant products historically accounted for most of the
Company's revenues and profits; however, since 1995, sales of knee implant
products have accounted for an increasing portion of its revenues and profits.
The Company anticipates that sales of knee implant products will continue to
account for an increasing portion of its revenues and profits. Furthermore, the
Company anticipates that overall profit margins in the hip implant market may
decline as a result of increasing price competition.
The following table sets forth for the periods indicated information
with respect to the number of units of the Company's products sold and the
dollar amount and percentages of revenues derived from such sales (dollars in
thousands):
EXACTECH, INC.
SALES SUMMARY BY PRODUCT LINE ($'000'S)
YEAR ENDED
----------------------------------------------------------------------------------------
DECEMBER 31, 1995 DECEMBER 31, 1996 DECEMBER 31, 1997
HIP PRODUCTS UNITS$ $ % UNITS $ % UNITS $ %
- ------------ ------ - - ----- - - ----- - -
Cemented 5,207 2,567 28.2% 5,370 2,339 16.9% 5,117 2,288 13.0%
Porous Coated 4,321 1,931 21.2% 5,354 1,932 14.0% 4,589 1,735 9.8%
Bipolar Prosthesis 846 460 5.0% 835 459 3.3% 890 417 2.4%
Revision - - - 4 9 0.1% 54 126 0.7%
--------------------------- --------------------------- ----------------------------
Total Hip Products 10,374 4,958 54.4% 11,563 4,739 34.3% 10,650 4,566 25.9%
KNEE PRODUCTS
Cemented Cruciate Sparing 3,220 1,932 21.2$ 9,174 4,515 32.6% 12,550 5,652 32.0%
Cemented Posterior Stabilized 1,233 726 7.9% 3,536 1,969 14.2% 7,045 4,411 25.0%
Porous Coated 571 811 8.9% 1,315 1,775 12.8% 1,428 1,502 8.5%
Revision - - - - - - 2,313 847 4.8%
--------------------------- --------------------------- ----------------------------
Total Knee Products 5,024 3,469 38.0% 14,025 8,259 59.6% 23,336 12,412 70.3%
Instrument Sales and Rental 644 7.1% 773 5.6% 602 3.4%
Miscellaneous 47 0.5% 69 0.5% 68 0.4%
=================== ==================== ===================
TOTAL 9,118 100.0% 13,840 100.0% 17,648 100.0%
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Net sales increased by $3,808,084, or 28%, to $17,648,060 in the year
ended december 31, 1997, from $13,839,976 in the year ended December 31, 1996.
Domestic sales increased 25%, to $14,596,909 in the year ended December 31,
1997, from $11,715,120 in the year ended December 31, 1996. International sales
increased 44%, to $3,051,151 in the year ended December 31, 1997, from
$2,124,856 in the year ended December 31, 1996. As a percentage of sales,
international sales increased from 15% in the year ended December 31, 1996, to
17% in the year ended December 31, 1997. 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, 1997, increased
by 66% on a unit basis and by 50% on a dollar basis from the year ended december
31, 1996, as a result of the continued full-scale marketing of the Optetrak
knee system and the release of the revision knee components. Sales of hip
implant products for the year ended december 31, 1997 decreased by 8% on a unit
basis and by 4% on a dollar basis from the year ended december 31, 1996. The
modest average selling price increases in
23
the hip implant products are the result of sales of the higher priced AuRA hip
system revision components. Hip and knee instrument sales and rentals decreased
to $602,082 in the year ended December 31, 1997, from $772,554 in the year ended
December 31, 1996 as international knee instrument sales decreased.
Gross profit increased by $2,596,657, or 28%, to $11,752,758 in the
year ended December 31, 1997, from $9,156,101 in the year ended December 31,
1996. As a percentage of sales, gross profit increased to 67% in the year ended
December 31, 1997, from 66% in the year ended December 31, 1996. The increase
was primarily the result of a reduction in the unit costs of the company's knee
products as production volumes increased.
Total operating expenses increased by $2,492,950, or 37%, to $9,196,387
in the year ended December 31, 1997, from $6,703,437 in the year ended December
31, 1996. Operating expenses increased as a percentage of sales in the year
ended December 31, 1997, to 52% from 48% in the year ended December 31, 1996.
Sales and marketing expenses increased by $1,386,072, or 39%, to $4,911,906 in
the year ended December 31, 1997, from $3,525,834 in the year ended December 31,
1996. As a percentage of sales, sales and marketing expenses increased to 28% in
the year ended December 31, 1997 as compared to 26% in the year ended December
31, 1996. Sales and marketing expenses increased as a percentage of sales
largely due to enhanced commission programs used to maintain existing and
attract new agents. 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 $331,574, or 25%, to
$1,677,878 in the year ended December 31, 1997, from $1,346,304 in the year
ended December 31, 1996. As a percentage of sales, general and administrative
expenses remained relatively constant at 10% in the years ended December 31,
1996 and 1997. 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 increased legal expenses associated with ongoing legal proceedings.
See "Item 3. Legal Proceedings."
Research and development expenses increased by $187,732, or 25%, to
$937,988 in the year ended December 31, 1997 from $750,256 in the year ended
December 31, 1996, as product development expenses for the revision and modular
hip systems increased. As a percentage of sales, research and development
expenses remained relatively constant at 5% in the years ended December 31, 1996
and 1997.
Depreciation and amortization expenses increased to $813,200 in the
year ended December 31, 1997, from $509,236 in the year ended December 31, 1996.
Depreciation and amortization expenses increased in 1997 as a result of the
increased investment in hip and knee instrumentation. During the year ended
December 31, 1997, $1,951,104 of such instruments were placed in service and
capitalized, resulting in the increase in depreciation and amortization
expenses.
Royalty expenses increased by $283,608, or 50%, to $855,415 in the year
ended December 31, 1997, from $571,807 in the year ended December 31, 1996,
primarily as a result of growth in sales of knee implant products which incur a
higher royalty rate. In 1997, the Company recognized royalty expenses of
$474,357 in connection with the license agreement with the Hospital for Special
Surgery and $381,058 in connection with other consulting and license agreements.
As a percentage of sales, royalty expenses were 5% and 4% in the years ended
December 31, 1997 and 1996, respectively.
The Company's income from operations increased by $103,707, or 4%, to
$2,556,371 in the year ended December 31, 1997, from $2,452,664 in the year
ended December 31, 1996. 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 $200,720 in the year
ended December 31, 1997, as compared to $12,336 in the year ended December 31,
1996. Interest income of $275,112 for the year ended December 31, 1997, was
offset by $74,392 of interest expense 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 $510,325 and $1,427,000 during 1997 and 1996,
respectively. The average outstanding balance decreased in 1997 because
approximately $3,900,000 was outstanding on the IRB loan only for a period of a
month and a half, whereas, the Company averaged approximately $3,000,000 in
outstanding debt for the first five months of 1996. The weighted average
interest
24
rate on such debt was 4.32% and 8.56% for 1997 and 1996, respectively.
In July 1995, the Company purchased a 50% interest in Techmed, its
Italian distributor. Prior to September 1997, the investment in the subsidiary
was accounted for using the equity method with the Company's share of the
subsidiary's net earnings (loss) included as a separate item in the statement of
income. During September 1997, the Company wrote off its investment in the
subsidiary and reserved for trade receivables deemed uncollectible.
Income before provision for income taxes increased by $67,668, or 3%,
to $2,573,182 in the year ended December 31, 1997, from $2,505,514 in the year
ended December 31, 1996. The provision for income taxes was $997,188 in the year
ended December 31, 1997, compared to $950,906 in the year ended December 31,
1996.
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, there were no preferred stock dividends for the year ended December 31,
1997, as compared to $10,154 in the year ended December 31, 1996. As a result,
the Company had net income of $1,575,994 in the year ended December 31, 1997,
compared to $1,544,454 in the year ended December 31, 1996, a 2% increase.
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.
Domestic 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 138% on a dollar basis from the year ended December 31, 1995,
as a result of the continued full-scale marketing of the Optetrak 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
MCS screw and the Opteon medium demand stem. Specifically, the MCS 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
25
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 expenses 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 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 1995 were invested in short-term
commercial paper and government backed securities. The outstanding principal
balance of the Company's debt averaged approximately $1,427,000 and $2,900,000
during 1996 and 1995, respectively. The weighted average interest rate on such
debt was 8.56% and 9.87% for 1996 and 1995, respectively.
In July 1995, the Company purchased a 50% interest in Techmed, its
Italian distributor. The investment has been 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.
26
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, 1997, the Company had working capital of $17,869,871 compared to
$15,176,581 at December 31, 1996. As a result of operating, investing and
financing activities, cash and cash equivalents at December 31, 1997 increased
to $4,176,293 from $3,992,442 at December 31, 1996. The increase in working
capital is primarily the result of the proceeds from an industrial revenue bond
financing discussed below, the proceeds of which are being used to finance the
Company's new facility. As of December 31, 1997, the Company had expended
$1,371,545 in costs associated with the construction of the facility. The
Company is committed to approximately $2,028,000 in remaining construction costs
associated with the completion of the new facility as of December 31, 1997. The
Company maintains a $3,000,000 credit facility with Merrill Lynch Business
Financial Services, Inc. which is secured by accounts receivable and inventory
and expires in July 1998. At December 31, 1997, there was no amount outstanding
under the line of credit. The Company believes that funds from operations, the
remaining proceeds of the IPO and borrowings under its existing credit
facilities will be sufficient to satisfy its contemplated cash requirements for
the following twelve months.
OPERATING ACTIVITIES
Operating activities used net cash of $1,625,239 in the year ended
December 31, 1997 as compared to providing net cash of $8,951 in the year ended
December 31, 1996. The primary reason for the change was the larger increase in
inventory during 1997 of $3,072,123 as compared to the $1,303,401 increase in
inventory that occurred during 1996. Another factor resulting in more cash being
used in operating activities for the year ended December 31, 1997, was the
growth in trade receivables. Cash required as a result of the increase in trade
receivables was $1,298,132 during 1997, as compared to $660,735 during 1996.
FINANCING ACTIVITIES
In November 1997, the Company entered into a $3,900,000 industrial
revenue bond financing with the City of Gainesville, Florida (the "City"),
pursuant to which the City issued its industrial revenue bonds and loaned the
proceeds to the Company. The bonds are secured by an irrevocable letter of
credit issued by a bank. The $3,900,000 credit facility requires the payment by
the Company of principal installments as follows: $300,000 per year from 2000
through 2006; $200,000 per year from 2007 through 2013; and $100,000 per year
from 2014 through 2017. Monthly interest payments are based on an adjustable
rate as determined by the bonds remarketing agent based on market rate
fluctuations (4.3% as of December 31, 1997). The proceeds of the credit facility
are being used to finance construction of the new facility. The Company's
obligations to the bank issuing the letter of credit are secured by the land and
improvements comprising the facility.
Net cash provided by financing activities decreased from $9,017,468
during the year ended December 31, 1996, to $3,892,522 in the year ended
December 31, 1997. Net Cash provided by financing activities for the year ended
December 31, 1997 reflects the proceeds of from the $3,900,000 industrial
revenue bond financing with the City while net cash provided by financing
activities for the year ended December 31, 1996 reflects the net proceeds of
$12,657,910 from the Company's IPO consummated in June 1996. In 1997, the
Company also paid $118,935 of debt issuance costs associated with the industrial
revenue bond financing which will be recognized as expense over the term of the
loan.
INVESTING ACTIVITIES
The Company invested the remaining proceeds of the industrial revenue
bond financing and the IPO in short-term investments and government backed
securities. As of December 31, 1997, $3,467,072 was invested in commercial paper
and discount notes yielding approximately 5% and $1,763,996 was invested in
Merrill Lynch's Treasury Fund and Money Market Fund comprised of commercial
paper and government backed securities yielding a return of approximately 5%.
During the year ended December 31, 1997, net cash used in investing activities
decreased to $2,083,432 as compared to $5,235,956 in the year ended December 31,
1996. This decrease was primarily due to the maturity of $3,083,788 of short
term investments in 1997 and reduced purchases of short term investments of
$1,335,740 in 1997 as compared to $3,083,788 in 1996.
27
RECENT ACCOUNTING PRONOUNCEMENTS
- --------------------------------
See Note 2 of Notes to Financial Statements for information concerning
recent accounting pronouncements.
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.
28
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
TABLE OF CONTENTS
PAGE
Independent Auditors' Report 30
Balance Sheets as of December 31, 1996 and 1997 31
Statements of Income for the Years Ended December 31, 1995, 1996 and 1997 32
Statement of Changes in Shareholders' Equity for the Years Ended
December 31, 1995, 1996 and 1997 33
Statements of Cash Flows for the Years Ended 34
December 31, 1995, 1996 and 1997
Notes to Financial Statements for the Years Ended 35
December 31, 1995, 1996 and 1997
29
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, 1996 and 1997, and the related statements of
income, shareholders' equity, and cash flows for each of the three years in the
period ended December 31, 1997. 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, 1996 and
1997, and the results of its operations and its cash flows for each of the three
years in the period ended December 31, 1997 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.
February 13, 1998
30
EXACTECH, INC.
BALANCE SHEETS
DECEMBER 31, 1996 AND 1997
- ----------------------------------------------------------------------------------------------------------------
ASSETS 1996 1997
---- ----
CURRENT ASSETS:
Cash and cash equivalents $ 3,992,442 $ 4,176,293
Short-term investments 3,083,788 1,335,740
Trade receivables (net of allowance of $37,164 and $161,046) 2,462,864 3,760,996
Refundable income taxes 259,778
Prepaid expenses and other assets 194,009 103,646
Inventories 7,625,756 10,697,879
------------ ------------
Total current assets 17,358,859 20,334,332
PROPERTY AND EQUIPMENT:
Land 263,301 263,301
Machinery and equ