EXACTECH INC - FORM 10-Q - November 4, 2015

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EX-31.1 - EXHIBIT 31.1 - EXACTECH INCexac20150930exhibit311.htm
EX-31.2 - EXHIBIT 31.2 - EXACTECH INCexac20150930exhibit312.htm
EX-32.2 - EXHIBIT 32.2 - EXACTECH INCexac20150930exhibit322.htm
EX-32.1 - EXHIBIT 32.1 - EXACTECH INCexac20150930exhibit321.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_________________________________ 
FORM 10-Q
 _________________________________
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
 
For the quarterly period ended September 30, 2015
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from              to             
Commission File Number 0-28240
 _________________________________
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.)
2320 NW 66TH COURT
GAINESVILLE, FL 32653
(Address of principal executive offices)
(352) 377-1140
(Registrant’s telephone number, including area code)
_________________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x   No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes x   No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer
o
Accelerated Filer
x
Non-Accelerated Filer
o
Smaller Reporting Company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o   No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
 
Outstanding at October 30, 2015
Common Stock, $.01 par value
 
14,078,143


EXACTECH, INC.
INDEX
 
 
Page
Number
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 



Item 1. Financial Statements
EXACTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
 
(unaudited)
 
(audited)
 
September 30,
 
December 31,
 
2015
 
2014
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
17,051

 
$
10,051

Accounts receivable, net of allowances of $807 and $946
50,283

 
50,731

Prepaid expenses and other assets, net
3,692

 
2,436

Income taxes receivable
829

 
1,492

Inventories – current
72,348

 
72,827

Deferred tax assets – current
1,647

 
1,620

Total current assets
145,850

 
139,157

PROPERTY AND EQUIPMENT:
 
 
 
Land
2,692

 
2,742

Machinery and equipment
36,877

 
35,434

Surgical instruments
109,939

 
101,142

Furniture and fixtures
4,720

 
4,556

Facilities
20,247

 
19,981

Projects in process
711

 
1,166

Total property and equipment
175,186

 
165,021

Accumulated depreciation
(95,579
)
 
(84,915
)
Net property and equipment
79,607

 
80,106

OTHER ASSETS:
 
 
 
Deferred financing and deposits, net
582

 
676

Non-current inventories
18,733

 
17,465

Product licenses and designs, net
11,693

 
8,641

Patents and trademarks, net
1,492

 
1,701

Customer relationships, net
111

 
203

Goodwill
19,098

 
13,091

Total other assets
51,709

 
41,777

TOTAL ASSETS
$
277,166

 
$
261,040

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
12,642

 
$
13,615

Income taxes payable
167

 
146

Accrued expenses and other liabilities
9,113

 
9,194

Other current liabilities
1,381

 
250

Current portion of long-term debt
3,000

 
3,000

Total current liabilities
26,303

 
26,205

LONG-TERM LIABILITIES:
 
 
 
Deferred tax liabilities
3,756

 
2,794

Long-term debt, net of current portion
18,000

 
20,250

Other long-term liabilities
5,582

 
420

Total long-term liabilities
27,338

 
23,464

Total liabilities
53,641

 
49,669

SHAREHOLDERS’ EQUITY:
 
 
 
Common stock
141

 
139

Additional paid-in capital
80,347

 
76,126

Accumulated other comprehensive loss
(11,117
)
 
(8,397
)
Retained earnings
154,154

 
143,503

Total shareholders’ equity
223,525

 
211,371

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
277,166

 
$
261,040


See notes to condensed consolidated financial statements

2

EXACTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(Unaudited)
 
Three Month Periods Ended September 30,
 
Nine Month Periods Ended September 30,
 
2015
 
2014
 
2015
 
2014
NET SALES
$
56,237

 
$
57,884

 
$
179,106

 
$
185,061

COST OF GOODS SOLD
16,597

 
16,929

 
54,573

 
55,128

Gross profit
39,640

 
40,955

 
124,533

 
129,933

OPERATING EXPENSES:
 
 
 
 
 
 
 
Sales and marketing
20,587

 
21,304

 
63,901

 
67,902

General and administrative
5,180

 
5,380

 
16,803

 
16,832

Research and development
5,258

 
4,464

 
14,389

 
13,521

Depreciation and amortization
4,073

 
4,289

 
12,697

 
12,735

Total operating expenses
35,098

 
35,437

 
107,790

 
110,990

INCOME FROM OPERATIONS
4,542

 
5,518

 
16,743

 
18,943

OTHER INCOME (EXPENSE):
 
 
 
 
 
 
 
Interest income
3

 
5

 
7

 
13

Other income
26

 
3

 
91

 
53

Interest expense
(283
)
 
(253
)
 
(860
)
 
(860
)
Foreign currency loss, net
(103
)
 
(652
)
 
(862
)
 
(452
)
Total other income (expense)
(357
)
 
(897
)
 
(1,624
)
 
(1,246
)
INCOME BEFORE INCOME TAXES
4,185

 
4,621

 
15,119

 
17,697

PROVISION FOR INCOME TAXES
1,307

 
1,610

 
4,468

 
6,328

NET INCOME
$
2,878

 
$
3,011

 
$
10,651

 
$
11,369

BASIC EARNINGS PER SHARE
$
0.20

 
$
0.22

 
$
0.76

 
$
0.83

DILUTED EARNINGS PER SHARE
$
0.20

 
$
0.21

 
$
0.75

 
$
0.81

See notes to condensed consolidated financial statements




3

EXACTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
(Unaudited)
 
Three Month Periods Ended September 30,
 
Nine Month Periods Ended September 30,
 
2015
 
2014
 
2015
 
2014
Net Income
$
2,878

 
$
3,011

 
$
10,651

 
$
11,369

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Change in fair value of cash flow hedge
2

 
81

 
6

 
131

Change in currency translation
60

 
(2,546
)
 
(2,726
)
 
(3,079
)
Other comprehensive income (loss), net of tax
62

 
(2,465
)
 
(2,720
)
 
(2,948
)
Comprehensive income
$
2,940

 
$
546

 
$
7,931

 
$
8,421

See notes to condensed consolidated financial statements

4

EXACTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
Nine Month Periods Ended September 30,
 
2015
 
2014
OPERATING ACTIVITIES:
 
 
 
Net income
$
10,651

 
$
11,369

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
 
 
Provision for allowance for doubtful accounts and sales returns
(139
)
 
172

Inventory allowance
1,529

 
348

Depreciation and amortization
13,831

 
13,898

Restricted common stock issued for services
310

 
205

Compensation cost of stock awards
1,359

 
1,184

Loss on disposal of equipment
1,162

 
1,611

Loss on disposal of intangible assets
22

 
13

Foreign currency option loss (gain)
387

 
(107
)
Foreign currency exchange loss
475

 
559

Deferred income taxes
(1,551
)
 
(1,289
)
Changes in assets and liabilities, net of business combination effect, which provided (used) cash:
 
 
 
Accounts receivable
(315
)
 
10,905

Prepaids and other assets
(1,390
)
 
(923
)
Inventories
(2,558
)
 
(9,794
)
Accounts payable
(2,174
)
 
(259
)
Income taxes receivable/payable
928

 
733

Accrued expense & other liabilities
985

 
(2,347
)
Net cash provided by operating activities
23,512

 
26,278

INVESTING ACTIVITIES:
 
 
 
Purchases of property and equipment
(13,905
)
 
(13,507
)
Purchase of business, net of cash acquired
(2,005
)
 
—

Proceeds from sale of property and equipment
—

 
3

Purchase of intangible assets
—

 
(138
)
Net cash used in investing activities
(15,910
)
 
(13,642
)
FINANCING ACTIVITIES:
 
 
 
Net repayments on line of credit
—

 
(10,732
)
Principal payments on debt
(2,250
)
 
(2,250
)
Payments of contingency consideration
(676
)
 
—

Payments on capital leases
(50
)
 
(60
)
Debt issuance costs
(15
)
 
(15
)
Proceeds from issuance of common stock
2,554

 
3,766

Net cash used in financing activities
(437
)
 
(9,291
)
Effect of foreign currency translation on cash and cash equivalents
(165
)
 
(270
)
NET INCREASE IN CASH AND CASH EQUIVALENTS
7,000

 
3,075

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
10,051

 
6,011

CASH AND CASH EQUIVALENTS, END OF PERIOD
$
17,051

 
$
9,086

 
 
 
 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid during the period for:
 
 
 
Interest
$
614

 
$
846

Income taxes
5,443

 
6,872

Non-cash investing and financing activities:
 
 
 
Cash flow hedge gain, net of tax
6

 
131

Capitalized lease additions
8

 
—

Purchase of equipment payable
124

 
—

Business combination, contingent consideration payable
6,343

 
—

See notes to condensed consolidated financial statements

5

EXACTECH, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2015 AND 2014
(Unaudited)
1.
BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of Exactech, Inc. and its subsidiaries (the “Company” or “Exactech”), which are for interim periods, have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission relating to interim financial statements. These unaudited condensed consolidated financial statements do not include all disclosures provided in the Company's audited annual financial statements. The condensed financial statements should be read in conjunction with the audited financial statements and notes contained in Exactech's Annual Report on Form 10-K for the year ended December 31, 2014, as filed with the Securities and Exchange Commission.
In the opinion of management, all adjustments considered necessary for a fair presentation have been included, consisting of normal recurring adjustments. Our subsidiaries, Exactech Asia, Exactech UK, Exactech Japan, Exactech France, Exactech Taiwan, Exactech Deutschland, Exactech Ibérica, Exactech International Operations, Blue Ortho, and Exactech U.S., are consolidated for financial reporting purposes, and all intercompany balances and transactions have been eliminated. Results of operations for the three and nine month periods ended September 30, 2015 are not necessarily indicative of the results to be expected for the full year.
Certain amounts reported for prior periods have been reclassified to be consistent with the current period presentation.
2.
NEW ACCOUNTING PRONOUNCEMENTS AND STANDARDS
In September 2015, the Financial Accounting Standards Board, or FASB, issued guidance on business combination provisional adjustments during the measurement period. The new standard requires that an acquiror recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The guidance is effective for annual and interim periods beginning on or after December 15, 2017, and early application is permitted. We are currently assessing the impact of adopting this guidance on our financial statements, however we do not expect the adoption of this guidance to have a significant impact on our financial position or results of operations.
In July 2015, the FASB issued guidance on simplifying the measurement of inventory. The updated standard changes the current lower of cost or market test with the lower of cost or net realizable value test. Net realizable value is defined as the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. The guidance should be applied prospectively, and is effective for annual and interim periods beginning on or after December 15, 2015, with early application permitted. We are currently assessing the impact of adopting this guidance on our financial statements, however we do not expect the adoption of this guidance to have a significant impact on our financial position or results of operations.
In April 2015, the FASB issued guidance on the presentation of debt issuance costs on the balance sheet. The new standard requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The guidance is effective for annual and interim periods beginning on or after December 15, 2015, and early application is permitted. We are currently assessing the impact of adopting this guidance on our financial statements, however we do not expect the adoption of this guidance to have a significant impact on our financial position or results of operations.
In May 2014, the FASB issued new revenue recognition guidance that supersedes the existing revenue recognition guidance and most industry-specific guidance applicable to revenue recognition. The new guidance is based on the principle that revenue is recognized upon the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance will also result in enhanced disclosures about revenue, provide guidance for transactions that were not previously addressed comprehensively, and clarify guidance for multiple-element arrangements. In July 2015, the FASB delayed the effective date of this guidance by one year. The guidance is effective for the first fiscal quarter of 2018, and early application is not permitted earlier than January 1, 2015. We are currently assessing the impact of adopting this guidance on our financial statements.

6

3.
FAIR VALUE MEASURES
Our financial instruments include cash and cash equivalents, trade receivables, debt, and cash flow hedges. The carrying amounts of cash and cash equivalents, and trade receivables approximate fair value due to their short maturities. The carrying amount of debt approximates fair value due to the variable rate associated with the debt. The fair value of cash flow hedges are based on dealer quotes.
Certain financial assets and liabilities are accounted for at fair value, which is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The following fair value hierarchy prioritizes the inputs used to measure fair value:
Level 1 – Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.
Level 2 – Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using models or other valuation methodologies.
Level 3 – Pricing inputs include significant inputs that are generally less observable from objective sources. These inputs may be used with internally developed methodologies that result in management’s best estimate of fair value from the perspective of a market participant.
The table below provides information on our liabilities that are measured at fair value on a recurring basis:
 
 
 
 
 
 
 
 
 
(In Thousands)
Total Fair Value at September 30, 2015
 
Quoted Prices in Active Markets
(Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
Assets
 
 
 
 
 
 
 
 
Foreign currency forward contracts
$
124

 
$
—

 
$
124

 
$
—

 
Total:
$
124

 
$
—

 
$
124

 
$
—

 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
Contingent consideration
$
6,343

 
$
—

 
$
—

 
$
6,343

 
Interest rate swap
$
243

 
$
—

 
$
243

 
$
—

 
Total:
$
6,586

 
$
—

 
$
243

 
$
6,343

 
 
 
 
 
 
 
 
 
The fair value of our foreign currency forward contracts is based on dealer quotes and is recorded in other income (expense) of our unaudited condensed consolidated statements of income. We evaluate the effectiveness of these forward contracts on a quarterly basis, and, as of September 30, 2015, they were determined to be effective. See Note 5. Hedging Activities and Foreign Currency Translation for further discussion on the forward contracts.
The fair value of our contingent consideration liability is management's best estimate based on the present value of estimated payment scenarios, which is determined based on inputs not observable in the market. We use assumptions we believe would be made by a market participant. We evaluate our estimates on a quarterly basis, as additional data impacting the assumptions is obtained, and will recognize any changes in the unaudited condensed consolidated statements of income. See Note 12. Business Acquisition for further discussion on the contingent consideration.
The fair value of our interest rate swap agreement is based on dealer quotes and is recorded as accumulated other comprehensive loss and other long-term liabilities in the unaudited condensed consolidated balance sheets. We analyze the effectiveness of our interest rate swap on a quarterly basis, and, for the period ended September 30, 2015, we determined that the interest rate swap was effective.

7

4.
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill – The following table provides the changes to the carrying value of goodwill for the nine month period ended September 30, 2015:
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
Knee
 
Hip
 
Biologics
and Spine
 
Extremities
 
Other
 
Total
Balance as of December 31, 2014
$
3,639

 
$
597

 
$
7,553

 
$
411

 
$
891

 
$
13,091

Acquired goodwill
1,760

 
391

 
—

 
4,368

 
—

 
6,519

Foreign currency translation effects
(186
)
 
(60
)
 
—

 
(197
)
 
(69
)
 
(512
)
Balance as of September 30, 2015
$
5,213

 
$
928

 
$
7,553

 
$
4,582

 
$
822

 
$
19,098

 
 
 
 
 
 
 
 
 
 
 
 
We test goodwill for impairment annually as of the 1st of October. Our impairment analysis as of October 1, 2015 has not been completed, however we do not expect an impairment to goodwill.
Other Intangible Assets – The following table summarizes the carrying values of our other intangible assets at September 30, 2015 and December 31, 2014:
 
 
 
 
 
 
 
 
(in thousands)
Carrying Value
 
Accumulated Amortization
 
Net Carrying Value
 
Weighted Avg Amortization Period
Balance at September 30, 2015
 
 
 
 
 
 
 
Product licenses and designs
$
17,362

 
$
5,669

 
$
11,693

 
9.0
Patents and trademarks
4,677

 
3,185

 
1,492

 
14.2
Customer relationships
2,948

 
2,837

 
111

 
6.9
 
 
 
 
 
 
 
 
Balance at December 31, 2014
 
 
 
 
 
 
 
Product licenses and designs
$
15,640

 
$
6,999

 
$
8,641

 
9.8
Patents and trademarks
4,704

 
3,003

 
1,701

 
14.0
Customer relationships
3,033

 
2,830

 
203

 
6.9
 
 
 
 
 
 
 
 
5.
HEDGING ACTIVITIES AND FOREIGN CURRENCY TRANSLATION
Foreign Currency Transactions
The following table provides information on the components of our foreign currency activities recognized in the unaudited condensed consolidated statements of income:
 
 
 
 
 
 
 
 
(in thousands)
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Foreign currency transactions gain (loss)
$
23

 
$
(759
)
 
$
(475
)
 
$
(559
)
Foreign currency option (loss) gain
(126
)
 
107

 
(387
)
 
107

Foreign currency loss, net
$
(103
)
 
$
(652
)
 
$
(862
)
 
$
(452
)
 
 
 
 
 
 
 
 
Foreign Currency Transactions – Gains and losses resulting from our transactions and our subsidiaries’ transactions that are made in currencies different from our and their own are included in income as they occur and as other income (expense) in the condensed consolidated statements of income.
Foreign Currency Options – During 2015, we have entered into foreign currency forward contracts as economic hedges against the continued strengthening of the U.S. Dollar (USD) against the Euro (EUR) and the Japanese Yen (JPY). As of September 30, 2015, we had two foreign currency forward contracts with six month terms. The initial aggregate amount of the outstanding contracts is $11.6 million, with a December 31, 2015 expiration date. During the three and nine months ended September 30, 2015, we recognized losses of $0.1 million and $0.4 million, respectively, related to these instruments. The recognized losses are recorded in other income (expense) in the

8

unaudited condensed consolidated statements of income related to the fair value of these currency options based upon a dealer's quotes.
During September 2014, we entered into a foreign currency forward contract for a value of $6.4 million for a six month term, as an economic hedge against strengthening of the USD against the EUR. The foreign currency option expired on December 31, 2014. During the quarter ended September 30, 2014, we recognized a gain of $0.1 million on the condensed consolidated statements of income related to the fair value of this currency option based upon a dealer's quote.
Foreign Currency Translation
We are exposed to market risk related to changes in foreign currency exchange rates. The functional currency of substantially all of our international subsidiaries is their local currency. Transactions are translated into USD, and translation gains and losses are recognized in “Other comprehensive income (loss)”. Fluctuations in exchange rates affect our financial position and results of operations. The majority of our foreign currency exposure is to the EUR, British Pound (GBP), and JPY. During the nine months ended September 30, 2015, translation losses were $2.7 million, which were primarily due to the weakening of the JPY and the EUR against the USD. During the nine months ended September 30, 2014, translation losses were $3.1 million, which were primarily due to the weakening of the JPY against the USD, offset partially by the strengthening of the EUR and GBP against the USD. While we may experience translation gains and losses during the balance of the year ending December 31, 2015, these gains and losses are not expected to have a material adverse effect on our financial position, results of operations, or cash flows.
Other Comprehensive Income (Loss)
Other comprehensive income (loss) is composed of unrealized gains or losses from the change in fair value of certain derivative instruments that qualify for hedge accounting, and for foreign currency translation effects. The following table provides information on the components of our other comprehensive loss:
 
 
 
 
 
 
(in thousands)
Cash Flow Hedge
 
Foreign Currency Translation
 
Total
Balance December 31, 2014
$
(150
)
 
$
(8,247
)
 
$
(8,397
)
2015 adjustments, net of tax
6

 
(2,726
)
 
(2,720
)
Balance September 30, 2015
$
(144
)
 
$
(10,973
)
 
$
(11,117
)
 
 
 
 
 
 
We do not enter into or hold derivative instruments for trading or speculative purposes. We entered into our interest rate swap to eliminate variability in future cash flows by converting LIBOR-based variable-rate interest payments into fixed-rate interest payments. The fair value of our interest rate swap agreement is based on dealer quotes, and the change in fair value is recorded as accumulated other comprehensive loss in the consolidated balance sheets. We do not expect the change in fair value of our interest rate swap to have a material impact on our results of operations, financial position or cash flows.
6.
INVENTORIES
Inventories are valued at the lower of cost or market and include implants consigned to customers and agents. We also loan a significant amount of implant inventory to non-distributor customers. The consigned or loaned inventory remains our inventory until we are notified of the implantation. We are also required to maintain substantial levels of inventory, as it is necessary to maintain all sizes of each component to fill customer orders. The size of the component to be used for a specific patient is typically not known with certainty until the time of surgery. Due to this uncertainty, a minimum of one of each size of each component in the system to be used must be available to each sales representative at the time of surgery. As a result of this need to maintain substantial levels of inventory, we are subject to the risk of inventory obsolescence. In the event that a substantial portion of our inventory becomes obsolete, it would have a material adverse effect on the Company. Allowance charges for obsolete and slow moving inventories are recorded based upon an analysis of specific identification of obsolete inventory items and quantification of slow moving inventory items. For slow moving inventory, this analysis compares the quantity of inventory on hand to the historical sales of such inventory items. As a result of this analysis, we record an estimated allowance for slow moving inventory. Due to the nature of the slow moving inventory, this allowance may fluctuate up or down, as a charge or recovery. Allowance charges for the three and nine months ended September 30, 2015 were $1.0 million and $1.5 million, respectively. Allowance charges for the three and nine months ended September 30, 2014 were $0.4 million and $0.3

9

million, respectively. We also test our inventory levels for the amount of inventory that we expect to sell within one year. At certain times, such as when we stock new subsidiaries, add consignment locations, and launch new products, the level of inventory can exceed the forecasted level of cost of goods expected to be sold for the next twelve months. We classify such inventory as non-current.
The following table summarizes our classifications of inventory as of September 30, 2015 and December 31, 2014:
 
 
 
 
(in thousands)
September 30,
2015
 
December 31,
2014
Raw materials
$
17,786

 
$
21,091

Work in process
1,219

 
1,283

Finished goods on hand
32,390

 
31,105

Finished goods on loan/consignment
39,686

 
36,813

Inventory total
91,081

 
90,292

Non-current inventories
18,733

 
17,465

Inventories, current
$
72,348

 
$
72,827

 
 
 
 
7.
INCOME TAX
At September 30, 2015, net operating loss carry forwards of our foreign and domestic subsidiaries totaled $27.6 million, some of which begin to expire in 2020. For accounting purposes, the estimated tax effect of this net operating loss carry forward results in a deferred tax asset. The deferred tax asset associated with these losses was $8.7 million with a valuation allowance of $4.8 million charged against this deferred tax asset assuming these losses will not be fully realized. At December 31, 2014, these net operating loss carry forwards totaled $26.7 million, and the deferred tax asset was $8.5 million with a valuation allowance of $5.1 million charged against this deferred tax asset assuming these losses will not be fully realized.
Our income tax returns are subject to examination in numerous state, federal and foreign jurisdictions due to the multiple income tax jurisdictions in which we operate. We are not currently aware of any open examinations by the various government jurisdictions. As of September 30, 2015, we had no liability recorded as an uncertain tax benefit. The Credit for Increasing Research Activities expired for the year ending December 31, 2014, and for the nine months ended September 30, 2015, we did not record a research credit benefit.
8.
DEBT
Debt consisted of the following at September 30, 2015 and December 31, 2014:
 
 
 
 
(in thousands)
September 30,
2015
 
December 31,
2014
Term loan payable in quarterly principal installments of $750, from June 2013 to December 2016. Interest based on adjustable rate as determined by three month LIBOR (1.83% as of 9/30/2015)
$
21,000

 
$
23,250

Less current portion
(3,000
)
 
(3,000
)
 
$
18,000

 
$
20,250

 
 
 
 
The following is a schedule of future debt maturities as of September 30, 2015, for the years ending December 31 (in thousands):
 
 
2015
$
750

2016
3,000

2017
17,250

2018
—

2019
—

Thereafter
—

 
$
21,000

 
 

10

9.
COMMITMENTS AND CONTINGENCIES
Litigation
There are various claims, lawsuits, and disputes with third parties and pending actions involving various allegations against us incident to the operation of our business, principally product liability cases. While we believe that the various claims are without merit, we are unable to predict the ultimate outcome of such litigation. We therefore maintain insurance, subject to self-insured retention limits, for all such claims, and establish accruals for product liability and other claims based upon our experience with similar past claims, advice of counsel and the best information reasonably available. At September 30, 2015 and December 31, 2014, we had $75,000 and $135,000 accrued, respectively, for product liability claims. These product liability claims are subject to various uncertainties, and it is possible that they may be resolved unfavorably to us. While it is not possible to predict with certainty the outcome of the various cases, it is the opinion of management that, upon ultimate resolution, the cases will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.
Our insurance policies covering product liability claims must be renewed annually. Although we have been able to obtain insurance coverage for product liability claims at a cost and on other terms and conditions that have been acceptable to us, we may not be able to procure acceptable policies in the future.
Purchase Commitments
At September 30, 2015, we had outstanding commitments for the purchase of inventory, raw materials and supplies of $15.7 million and outstanding commitments for the purchase of capital equipment of $4.3 million. Purchases under our distribution agreements were $2.6 million during the nine months ended September 30, 2015.
Our Taiwanese subsidiary, Exactech Taiwan, has entered into a license agreement with the Industrial Technology Research Institute (ITRI) and the National Taiwan University Hospital (NTUH) for the rights to technology and patents related to the repair of cartilage lesions. As of September 30, 2015, we have paid approximately $2.1 million for the licenses, patents, and equipment related to this license agreement, and we will make royalty payments when the technology becomes marketable. Using the technology, we plan to launch a cartilage repair program that will include a device and method for the treatment and repair of cartilage in the knee joint. It is expected that the project will require us to complete human clinical trials under the guidance of the Food & Drug Administration in order to obtain pre-market approval for the device in the United States. The agreement terms include a license fee based on the achievement of specific, regulatory milestones and a royalty arrangement based on sales once regulatory clearances are established.
10.
SEGMENT INFORMATION
We evaluate our operating segments by our major product lines: knee implants, hip implants, biologics and spine, extremity implants and other products. The “other products” segment includes miscellaneous sales categories, such as surgical instruments held for sale, bone cement, instrument rental fees, shipping charges, and other implant product lines. Evaluation of the performance of operating segments is based on their respective incomes from operations before taxes, interest income and expense, and nonrecurring items. Intersegment sales and transfers are not significant. The accounting policies of the reportable segments are the same as those described in Note 2 of the notes to our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2014.
Total assets not identified with a specific segment are listed as “corporate” and include cash and cash equivalents, accounts receivable, income taxes receivable, deposits and prepaid expenses, deferred tax assets, land, facilities, office furniture and computer equipment, notes receivable, and other investments. Depreciation and amortization on corporate assets is allocated to the product segments for purposes of evaluating the income (loss) from operations, and capitalized surgical instruments are allocated to the appropriate product line supported by those assets.

11

Summarized information concerning our reportable segments is shown in the following table (in thousands):
 
 
 
 
 
 
 
 
Three Months Ended September 30,
Knee
Hip
Biologics & Spine
Extremity
Other
Corporate
Total
2015
 
 
 
 
 
 
 
Net sales
$
15,313

$
9,925

$
5,663

$
19,974

$
5,362

$
—

$
56,237

Segment profit (loss)
767

222

163

4,087

(697
)
(357
)
4,185

Total assets, net
67,479

34,014

22,442

37,033

13,220

102,978

277,166

Capital expenditures
1,380

1,243

70

1,237

8

661

4,599

Depreciation and Amortization
1,729

629

255

620

140

1,029

4,402

2014
 
 
 
 
 
 
 
Net sales
$
18,148

$
10,160

$
5,415

$
18,601

$
5,560

$
—

$
57,884

Segment profit (loss)
981

372

93

4,253

(181
)
(897
)
4,621

Total assets, net
67,528

33,233

24,848

27,920

15,002

89,352

257,883

Capital expenditures
1,101

1,794

356

1,250

574

324

5,399

Depreciation and Amortization
2,049

702

317

609

155

852

4,684

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30,
Knee
Hip
Biologics & Spine
Extremity
Other
Corporate
Total
2015
 
 
 
 
 
 
 
Net sales
$
52,708

$
31,820

$
16,676

$
61,533

$
16,369

$
—

$
179,106

Segment profit (loss)
3,590

1,662

693

13,598

(2,800
)
(1,624
)
15,119

Total assets, net
67,479

34,014

22,442

37,033

13,220

102,978

277,166

Capital expenditures
4,576

2,921

1,195

3,146

668

1,530

14,036

Depreciation and Amortization
5,437

2,074

814

2,193

406

2,907

13,831

2014
 
 
 
 
 
 
 
Net sales
$
59,762

$
32,160

$
17,707

$
57,278

$
18,154

$
—

$
185,061

Segment profit (loss)
4,820

2,483

497

13,399

(2,256
)
(1,246
)
17,697

Total assets, net
67,528

33,233

24,848

27,920

15,002

89,352

257,883

Capital expenditures
3,215

3,306

871

3,228

1,119

1,906

13,645

Depreciation and Amortization
5,943

2,107

920

1,660

487

2,781

13,898

 
 
 
 
 
 
 
 
Geographic distribution of our long-lived assets and inventory is shown in the following table (in thousands):
 
 
 
 
 
 
 
 
As of:
September 30, 2015
 
December 31, 2014
 
Domestic
 
International
 
Domestic
 
International
Long lived assets, gross
$
146,087

 
$
54,087

 
$
144,750

 
$
43,648

Accumulated depreciation and amortization
(88,605
)
 
(18,666
)
 
(82,167
)
 
(15,580
)
Long lived assets, net
57,482

 
35,421

 
62,583

 
28,068

 
 
 
 
 
 
 
 
Inventory
$
55,418

 
$
35,663

 
$
57,361

 
$
32,931

 
 
 
 
 
 
 
 
Geographic distribution of our sales is summarized in the following table (in thousands):
 
 
 
 
 
 
Three Months Ended September 30,
2015
 
2014
 
% Inc/Decr
Domestic sales
$
40,719

 
$
40,019

 
1.7

International sales
15,518

 
17,865

 
(13.1
)
Total sales
$
56,237

 
$
57,884

 
(2.8
)
 
 
 
 
 
 
Nine Months Ended September 30,
2015
 
2014
 
% Inc/Decr
Domestic sales
$
123,262

 
$
123,826

 
(0.5
)
International sales
55,844

 
61,235

 
(8.8
)
Total sales
$
179,106

 
$
185,061

 
(3.2
)
 
 
 
 
 
 

12

11.
SHAREHOLDERS’ EQUITY
The following is a reconciliation of the numerators and denominators of the basic and diluted EPS computations for net income and net income available to common shareholders:
 
 
 
 
 
 
 
 
 
Income (Numerator)
Shares (Denominator)
Per Share
 
Income (Numerator)
Shares (Denominator)
Per Share
 
Three Months Ended
 
Three Months Ended
(in thousands, except per share amounts)
September 30, 2015
 
September 30, 2014
Net income
$
2,878

 
 
 
$
3,011

 
 
Basic EPS:
 
 
 
 
 
 
 
Net income available to common shareholders
$
2,878

14,058

$
0.20

 
$
3,011

13,766

$
0.22

Effect of dilutive securities:
 
 
 
 
 
 
 
Stock options
 
143

 
 
 
298

 
Diluted EPS:
 
 
 
 
 
 
 
Net income available to common shareholders plus assumed conversions
$
2,878

14,201

$
0.20

 
$
3,011

14,064

$
0.21

 
 
 
 
 
 
 
 
 
Nine Months Ended
 
Nine Months Ended
(in thousands, except per share amounts)
September 30, 2015
 
September 30, 2014
Net income
$
10,651

 
 
 
$
11,369

 
 
Basic EPS:
 
 
 
 
 
 
 
Net income available to common shareholders
$
10,651

13,996

$
0.76

 
$
11,369

13,690

$
0.83

Effect of dilutive securities:
 
 
 
 
 
 
 
Stock options
 
205

 
 
 
299

 
Diluted EPS:
 
 
 
 
 
 
 
Net income available to common shareholders plus assumed conversions
$
10,651

14,201

$
0.75

 
$
11,369

13,989

$
0.81

 
 
 
 
 
 
 
 
For the three months ended September 30, 2015, weighted average options to purchase 446,088 shares of common stock were outstanding but were not included in the computation of diluted EPS because the options were antidilutive under the treasury stock method. For the three months ended September 30, 2014, weighted average options to purchase 206,150 shares of common stock were not included in the computation of diluted EPS because the options were antidilutive under the treasury stock method.
For the nine months ended September 30, 2015, weighted average options to purchase 308,680 shares of common stock were outstanding but were not included in the computation of diluted EPS because the options were antidilutive under the treasury stock method. For the nine months ended September 30, 2014, weighted average options to purchase 119,710 shares of common stock were not included in the computation of diluted EPS because the options were antidilutive under the treasury stock method.

13

Changes in Shareholders’ Equity:
The following is a summary of the changes in shareholders’ equity for the nine months ended September 30, 2015: 
 
 
 
 
 
 
 
 
 
 
 
 
 
Common Stock
 
Additional Paid-In Capital
 
Retained Earnings
 
Accumulated Other Comprehensive Income (Loss)
 
Total
(in thousands)
Shares
 
Amount
 
Balance December 31, 2014
13,891

 
$
139

 
$
76,126

 
$
143,503

 
$
(8,397
)
 
$
211,371

Net income
—

 
—

 
—

 
10,651

 
—

 
10,651

Other comprehensive income (loss), net of tax
—

 
—

 
—

 
—

 
(2,720
)
 
(2,720
)
Exercise of stock options
138

 
2

 
1,979

 
—

 
—

 
1,981

Issuance of restricted common stock for services
14

 
—

 
310

 
—

 
—

 
310

Issuance of common stock under Employee Stock Purchase Plan
34

 
—

 
573

 
—

 
—

 
573

Compensation cost of stock options
—

 
—

 
1,359

 
—

 
—

 
1,359

Balance September 30, 2015
14,077

 
$
141

 
$
80,347

 
$
154,154

 
$
(11,117
)
 
$
223,525

 
 
 
 
 
 
 
 
 
 
 
 
Stock-based Compensation Awards:
We sponsor an Executive Incentive Compensation Plan, which provides for the award of stock-based compensation, including options, stock appreciation rights, restricted stock and other stock-based incentive compensation awards to key employees, directors and independent agents and consultants. We implemented a comprehensive, consolidated incentive compensation plan upon shareholder approval at our Annual Meeting of Shareholders on May 7, 2009, referred to as the 2009 Plan, which was amended and restated at our 2014 Annual Meeting of Shareholders, held on May 8, 2014, to increase the maximum number of shares issuable under the 2009 Plan by 500,000. The maximum number of common shares issuable under the amended and restated 2009 Plan is 1,500,000 plus (a) the number of shares with respect to awards previously granted under our preexisting plans that terminate without being exercised, expire, are forfeited or canceled, plus (b) the number of shares that remain available for future issuance under our preexisting plans plus (c) the number of shares that are surrendered in payment of any awards or any tax withholding with respect thereto. Common stock issued upon exercise of stock options is settled with authorized but unissued shares available. Under the 2009 Plan, the exercise price of option awards equals the market price of our common stock on the date of grant, and each award has a maximum term of ten years. As of September 30, 2015, there were 309,973 total shares remaining issuable under the 2009 Plan.
The aggregate compensation cost charged against income with respect to awards issued under the 2009 Plan and the 2009 Employee Stock Purchase Plan, referred to as the 2009 ESPP, was $1.4 million and $1.2 million for the nine months ended September 30, 2015 and 2014, respectively. Income tax benefit on exercises of non-qualified stock options was $0.4 million and $0.3 million for the nine months ended September 30, 2015 and 2014, respectively. As of September 30, 2015, total unrecognized compensation cost related to unvested awards was $2.3 million and is expected to be recognized over a weighted-average period of 1.85 years.

14

Stock Options:
A summary of the status of stock option activity under our stock-based compensation plans as of September 30, 2015 and changes during the year to date is presented below:
 
 
 
 
 
 
 
 
 
2015
 
Options    
 
Weighted Avg Exercise Price
 
Weighted Avg Remaining Contractual Term
 
Aggregate Intrinsic Value (In thousands)
Outstanding - January 1
1,244,166

 
$
17.49

 
 
 
 
Granted
176,125

 
23.28

 
 
 
 
Exercised
(137,703
)
 
14.39

 
 
 
$
1,044

Forfeited or Expired
(4,401
)
 
19.52

 
 
 
 
Outstanding - September 30
1,278,187

 
$
18.62

 
3.50
 
$
590

Exercisable - September 30
692,507

 
$
17.30

 
2.07
 
$
466

 
 
 
 
 
 
 
 
Outstanding options, consisting of five-year to ten-year incentive and non-qualified stock options, vest and become exercisable ratably over a three to five year period from the date of grant. The outstanding options expire from five to ten years from the date of grant or upon termination of employment with Exactech, and are contingent upon continued employment during the applicable option term. Certain non-qualified stock options are granted to non-employee sales agents and consultants, and they typically vest ratably over a period of three to four years from the date of grant and expire in five years or less from the date of grant, or upon termination of the agent's or consultant’s contract with Exactech. Stock options for the purchase of 176,125 shares of common stock were granted during the nine months ended September 30, 2015, compared to stock options for the purchase of 201,217 shares of common stock granted during the same period in 2014.
Restricted Stock Awards:
Under the 2009 Plan, we may grant restricted stock awards to eligible employees, directors, and independent agents and consultants. Restrictions on transferability, risk of forfeiture and other restrictions are determined by the Compensation Committee of the Board of Directors, or the Committee, at the time of the award. During February 2015, the Committee approved equity compensation to the outside members of the Board of Directors for their service on the Board of Directors. The annual compensation for each director consists of the grant of stock awards with an aggregate market value of $77,500, payable in four equal quarterly grants of common stock based on the market prices of our common stock on the respective dates of grant. The summary information of the restricted stock grants for the first nine months of 2015 is presented below: 
 
 
 
 
Grant date
February 27, 2015

May 29, 2015

August 31, 2015

Aggregate shares of restricted stock granted
4,974

4,530

4,940

Grant date fair value
$
116,000

$
97,000

$
97,000

Weighted average fair value per share
$
23.35

$
21.38

$
19.61

 
 
 
 
During February 2014, the Committee approved equity compensation to the outside members of the Board of Directors for their service on the Board of Directors. The annual compensation for each director consisted of the grant of stock awards with an aggregate market value of $75,000, payable in four equal quarterly grants of common stock based on the market prices of our common stock on the respective dates of grant. The summary information of the restricted stock grants for the first nine months of 2014 is presented below:
 
 
 
 
Grant date
February 28, 2014

May 31, 2014

August 29, 2014

Aggregate shares of restricted stock granted
4,020

4,502

4,710

Grant date fair value
$
94,000

$
105,000

$
112,000

Weighted average fair value per share
$
23.30

$
23.29

$
23.88

 
 
 
 
 
All of the restricted stock awards in 2015 and 2014 were fully vested at each of the grant dates. The restricted stock awards require no service period and thus contain no risk of, or provision for, forfeiture.

15

Employee Stock Purchase Plan:
On February 18, 2009, our board of directors adopted the 2009 ESPP, and our shareholders approved the 2009 ESPP at our Annual Meeting of Shareholders on May 7, 2009. Under the 2009 ESPP, employees are able to purchase shares of our common stock at a fifteen percent (15%) discount via payroll deduction, up to a maximum number of shares issuable under the 2009 ESPP of 300,000. There are four offering periods during an annual period. As of September 30, 2015, 50,776 shares remained available for purchase under this 2009 ESPP. The fair value of the employees' purchase rights is estimated using the Black-Scholes model. Purchase information and fair value assumptions are presented in the following table:
 
 
 
 
Nine Months Ended September 30,
2015
 
2014
Shares purchased
33,800
 
26,258
Dividend yield
—
 
—
Expected life
1 year
 
1 year
Expected volatility
32%
 
27%
Risk free interest rates
0.3%
 
0.1%
Weighted average per share fair value
$4.87
 
$4.92
 
 
 
 
12.
BUSINESS ACQUISITION
On January 15, 2015, we completed the acquisition of all of the outstanding capital stock of Blue Ortho SAS, a France-based company. Blue Ortho is the computer-assisted surgical technology development and manufacturing firm that partnered with the Company to develop the ExactechGPS® Guided Personalized Surgery system. We acquired Blue Ortho to further the partnership between us and the team at Blue Ortho and expand the development of ExactechGPS to other segments of our portfolio.
The aggregate purchase price for Blue Ortho is a maximum of €10.0 million, of which €2.0 million, or $2.3 million at a 1.16 USD exchange rate at closing, was paid to the Blue Ortho shareholders in cash at the closing of the acquisition, and the remainder will be paid to such shareholders contingent on the achievement of certain future surgical case milestones. During the second quarter ended June 30, 2015, we revised our preliminary valuation of the contingent consideration, and reduced the fair value of the consideration by approximately $1.1 million. The estimated fair value of the contingent consideration was determined using the following assumptions: discount rates of 4.5-6.5%, probability levels of milestone range of outcomes, and expected timing of achievement of contingent consideration earn-out amounts. We expect the contingent consideration to be paid over the next five to ten years. We financed the acquisition from our operating cash flows.
Upon completion of the acquisition, we effectively settled a pre-existing development agreement for the development of the ExactechGPS. Blue Ortho's results of operations for the fiscal year ending December 31, 2014 and through January 15, 2015 were finalized during the second quarter ended June 30, 2015, which resulted in an increase in our net assets acquired, compared to our previous estimation. Preliminary valuation assessment of the acquired assets, including valuation and useful lives of the acquired identifiable intangible assets was revised during the second quarter of 2015, and we recognized an adjustment to the identifiable intangible assets acquired. The accounting for our acquisition of Blue Ortho is preliminary, pending final valuation and deferred tax liability determination. The preliminary goodwill is determined as the excess of the consideration over the fair value of the net assets acquired, and allocated to the knee, extremity and hip segments based on such valuation. Pro forma revenue and earnings for the business combination have not been presented because the effects, both individually and in the aggregate, were not material to our results of operations.

16

The following table summarizes the preliminary purchase price allocation and determination of goodwill, which is not deductible for tax purposes, as of January 2015 (in thousands):
 
 
Amounts at Acquisition
Measurement Period Adjustment
Amounts at Acquisition (as adjusted)
 
Consideration:
 
 
 
 
 
Cash
 
$
2,329


$
2,329

 
Fair value of contingent consideration
 
8,243

$
(1,095
)
7,148

 
Total Purchase Price
 
10,572

(1,095
)
9,477

 
Settlement of pre-existing agreement
 
3,080


3,080

 
 
 
13,652

(1,095
)
12,557

 
 
 
 
 
 
 
Acquisition related expenses - incurred as of September 30, 2015
 
 
 
$
278

 
 
 
 
 
 
 
Preliminary identifiable assets acquired and liabilities assumed:
 
 
 
 
 
Current assets acquired
 
1,024

291

1,316

 
Property and equipment
 
127

37

164

 
Current liabilities assumed
 
(389
)
(27
)
(417
)
 
Deferred tax liability assumed
 
(2,400
)
(86
)
(2,486
)
 
Identifiable intangible assets
 
7,201

259

7,460

 
 
 
5,563

474

6,037

 
Goodwill
 
8,089

(1,569
)
6,520

 
Net assets acquired
 
$
13,652

$
(1,095
)
$
12,557

 
 
 
 
 
 
 
The identifiable intangible assets are being amortized using the straight-line method using estimated ten year useful lives, and are recorded net of accumulated amortization in Product licenses and designs on the unaudited condensed consolidated balance sheet.
The following table summarizes the contingent consideration balance and activity for the nine months ended September 30, 2015 (in thousands):
 
 
 
Beginning fair value of contingent liability
 
$
7,148

Period change in valuation
 
139

Payments
 
(676
)
Foreign currency translation effects
 
(268
)
Contingent liability balance, September 30, 2015
 
6,343

Current liability
 
1,120

Non-current liability
 
$
5,223

 
 
 
Due to our expected timing of earn-out payments, a portion of the contingent consideration is classified in other current liabilities on our unaudited condensed consolidated balance sheets. The remainder is classified as other non-current liabilities. The period change in the contingent consideration during the nine months ended September 30, 2015 was recognized as interest expense in the unaudited condensed consolidated statements of income.


17

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and related notes appearing elsewhere in this report.
Overview of the Company
We develop, manufacture, market and sell orthopaedic implant devices, related surgical instrumentation, supplies and biologic materials to hospitals and physicians in the United States and internationally. Our revenues are principally derived from sales of knee, hip, and extremity joint replacement systems and spinal fusion products. We believe that our continuing research and development projects will enable us to continue the introduction of new joint replacement systems, product line extensions, and other products and services.
Our operating expenses consist of sales and marketing expenses, general and administrative expenses, research and development expenses, and depreciation expenses. The largest component of operating expenses, sales and marketing expenses, primarily consists of payments made to independent sales representatives for their services to hospitals and surgical facilities on our behalf. These expenses tend to vary and generally relate to our sales volume. Research and development expenses primarily consist of expenditures on projects concerning knee, extremities, spine and hip implant product lines and biologic materials and services.
In marketing our products, we use a combination of traditional targeted media marketing together with our primary marketing focus, direct customer contact and service to orthopaedic surgeons. Because surgeons are important decision makers when it comes to the choice of products and services that best meet the needs of their patients, we focus our marketing strategy on meeting the needs of the orthopaedic surgeon community. In addition to surgeon’s preference, hospitals and buying groups, as the economic customers, actively participate with physicians in the choice of implants and services.
Overview of the Three and Nine Months Ended September 30, 2015
During the quarter ended September 30, 2015, sales decreased 3% to $56.2 million from $57.9 million in the quarter ended September 30, 2014, partially as a result of the foreign currency impact on our international operations, which resulted in a 13% decrease in our international sales. Our domestic sales increased 2%, and worldwide gross margins decreased to 70.5% in the third quarter of 2015 from 70.7% for the same quarter in 2014. Operating expenses decreased 1% when compared to the quarter ended September 30, 2014, and as a percentage of sales, increased to 62% during the third quarter of 2015 compared to 61% during the third quarter of 2014. Net income for the quarter ended September 30, 2015 decreased 4%, and diluted earnings per share was $0.20 as compared to $0.21 in the same quarter last year, which was primarily a result of the decrease in our sales and the impact of the strengthening of the U.S. Dollar (USD) against the Euro (EUR) and Japanese Yen (JPY).
During the nine months ended September 30, 2015, sales decreased 3% to $179.1 million from $185.1 million in the nine months ended September 30, 2014, partially as a result of the foreign currency impact on our international operations, which resulted in a 9% decrease in our international sales. Our domestic sales were unchanged, as we have seen modest results of the improvements in our sales organization take effect, although they were partially offset by continued pricing pressures. Gross margins decreased to 69.5% in the first nine months of 2015 from 70.2% for the first nine months in 2014, from pricing pressures and foreign currency fluctuations. Operating expenses decreased 3% when compared to the nine months ended September 30, 2014, and as a percentage of sales remained stable at 60% during the first nine months of 2015 and 2014. Net income for the nine months ended September 30, 2015 decreased 6%, and diluted earnings per share was $0.75 as compared to $0.81 in the same nine months last year, primarily as a result of the foregoing sales decrease and the impact of a strengthening USD.
During the nine months ended September 30, 2015, we acquired $14.0 million in property and equipment, including new production equipment and surgical instrumentation. As of September 30, 2015, cash outlays for our January 2015 acquisition of Blue Ortho, our partner in the development of the ExactechGPS®, were $2.9 million. Net cash flow from operations was $23.5 million for the nine months ended September 30, 2015, as compared to net cash flow from operations of $26.3 million during the nine months ended September 30, 2014. The decrease was primarily due to lower receivable collections and higher accounts payable payments in the first nine months of 2015, as compared to the first nine months of 2014.

18

The following table includes the net sales and percentage of net sales, as well as a comparison of net sales change to net sales change calculated on a constant currency basis, for each of our product lines, which are also our reportable segments, for the three and nine month periods ended September 30, 2015 and September 30, 2014:
Sales by Product Line
($ in 000’s)
 
Three Months Ended
 
Inc (decr)
 
September 30, 2015
 
September 30, 2014
 
2015 - 2014
 
Constant Currency
Extremity
$
19,974

 
35.5
%
 
$
18,601

 
32.1
%
 
7.4
 %
 
8.7
 %
Knee
15,313

 
27.2

 
18,148

 
31.4

 
(15.6
)
 
(12.5
)
Hip
9,925

 
17.7

 
10,160

 
17.5

 
(2.3
)
 
3.5

Biologics and Spine
5,663

 
10.1

 
5,415

 
9.4

 
4.6

 
7.9

Other
5,362

 
9.5

 
5,560

 
9.6

 
(3.6
)
 
(3.0
)
Total
$
56,237

 
100.0
%
 
$
57,884

 
100.0
%
 
(2.8
)%
 
(0.1
)%
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended
 
Inc (decr)
 
September 30, 2015
 
September 30, 2014
 
2015 - 2014
 
Constant Currency
Extremity
$
61,533

 
34.4
%
 
$
57,278

 
30.9
%
 
7.4
 %
 
8.9
 %
Knee
52,708

 
29.4

 
59,762

 
32.3

 
(11.8
)
 
(7.4
)
Hip
31,820

 
17.8

 
32,160

 
17.4

 
(1.1
)
 
4.0

Biologics and Spine
16,676

 
9.3

 
17,707

 
9.6

 
(5.8
)
 
(1.7
)
Other
16,369

 
9.1

 
18,154

 
9.8

 
(9.8
)
 
(8.5
)
Total
$
179,106

 
100.0
%
 
$
185,061

 
100.0
%
 
(3.2
)%
 
—
 %
 
 
 
 
 
 
 
 
 
 
 
 
The following table includes the net sales, percentage of net sales, net sales change, and net sales change calculated on a constant currency basis, for our geographic distribution for the three and nine month periods ended September 30, 2015 and September 30, 2014:
Sales by Geographic Distribution
($ in 000’s)
 
Three Months Ended
 
Inc (decr)
 
September 30, 2015
 
September 30, 2014
 
2015- 2014
 
Constant Currency
Domestic Sales
$
40,719

 
72.4
%
 
$
40,019

 
69.1
%
 
1.7
 %
 
1.7
 %
International Sales
15,518

 
27.6
%
 
17,865

 
30.9
%
 
(13.1
)%
 
(4.1
)%
Total
$
56,237

 
100.0
%
 
$
57,884

 
100.0
%
 
(2.8
)%
 
(0.1
)%
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended
 
Inc (decr)
 
September 30, 2015
 
September 30, 2014
 
2015- 2014
 
Constant Currency
Domestic Sales
$
123,262

 
68.8
%
 
$
123,826

 
66.9
%
 
(0.5
)%
 
(0.5
)%
International Sales
55,844

 
31.2
%
 
61,235

 
33.1
%
 
(8.8
)%
 
1.0
 %
Total
$
179,106

 
100.0
%
 
$
185,061

 
100.0
%
 
(3.2
)%
 
—
 %
 
 
 
 
 
 
 
 
 
 
 
 

19

The following table includes items from the unaudited condensed consolidated statements of income for the three and nine months ended September 30, 2015 as compared to the three and nine months ended September 30, 2014, the dollar and percentage change from period to period and the percentage relationship to net sales (dollars in thousands):
Comparative Statement of Income Data
 
Three Months Ended September 30,
 
2015 – 2014 Inc (decr)
 
% of Sales
 
2015
 
2014
 
$
 
%
 
2015
 
2014
Net sales
$
56,237

 
$
57,884

 
(1,647
)
 
(2.8
)
 
100.0
 %
 
100.0
 %
Cost of goods sold
16,597

 
16,929

 
(332
)
 
(2.0
)
 
29.5

 
29.3

Gross profit
39,640

 
40,955

 
(1,315
)
 
(3.2
)
 
70.5

 
70.7

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
20,587

 
21,304

 
(717
)
 
(3.4
)
 
36.6

 
36.8

General and administrative
5,180

 
5,380

 
(200
)
 
(3.7
)
 
9.2

 
9.3

Research and development
5,258

 
4,464

 
794

 
17.8

 
9.4

 
7.7

Depreciation and amortization
4,073

 
4,289

 
(216
)
 
(5.0
)
 
7.2

 
7.4

Total operating expenses
35,098

 
35,437

 
(339
)
 
(1.0
)
 
62.4

 
61.2

Income from operations
4,542

 
5,518

 
(976
)
 
(17.7
)
 
8.1

 
9.5

Other income (expense), net
(357
)
 
(897
)
 
540

 
60.2

 
(0.7
)
 
(1.5
)
Income before taxes
4,185

 
4,621

 
(436
)
 
(9.4
)
 
7.4

 
8.0

Provision for income taxes
1,307

 
1,610

 
(303
)
 
(18.8
)
 
2.3

 
2.8

Net income
$
2,878

 
$
3,011

 
(133
)
 
(4.4
)
 
5.1

 
5.2

 
 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30,
 
2015 – 2014 Inc (decr)
 
% of Sales
 
2015
 
2014
 
$
 
%
 
2015
 
2014
Net sales
$
179,106

 
$
185,061

 
(5,955
)
 
(3.2
)
 
100.0
 %
 
100.0
 %
Cost of goods sold
54,573

 
55,128

 
(555
)
 
(1.0
)
 
30.5

 
29.8

Gross profit
124,533

 
129,933

 
(5,400
)
 
(4.2
)
 
69.5

 
70.2

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
63,901

 
67,902

 
(4,001
)
 
(5.9
)
 
35.7

 
36.7

General and administrative
16,803

 
16,832

 
(29
)
 
(0.2
)
 
9.4

 
9.1

Research and development
14,389

 
13,521

 
868

 
6.4

 
8.0

 
7.3

Depreciation and amortization
12,697

 
12,735

 
(38
)
 
(0.3
)
 
7.1

 
6.9

Total operating expenses
107,790

 
110,990

 
(3,200
)
 
(2.9
)
 
60.2

 
60.0

Income from operations
16,743

 
18,943

 
(2,200
)
 
(11.6
)
 
9.3

 
10.2

Other income (expense), net
(1,624
)
 
(1,246
)
 
(378
)
 
(30.3
)
 
(0.9
)
 
(0.7
)
Income before taxes
15,119

 
17,697

 
(2,578
)
 
(14.6
)
 
8.4

 
9.5

Provision for income taxes
4,468

 
6,328

 
(1,860
)
 
(29.4
)
 
2.5

 
3.4

Net income
$
10,651

 
$
11,369

 
(718
)
 
(6.3
)
 
5.9

 
6.1

Three and Nine Months Ended September 30, 2015 Compared to Three and Nine Months Ended September 30, 2014
Sales
For the quarter ended September 30, 2015, sales decreased 3% to $56.2 million from $57.9 million in the quarter ended September 30, 2014, partially as a result of the foreign currency impact from the weakening of the EUR and JPY, which resulted in a constant currency impact of $1.6 million. International sales for the quarter also decreased as a result of a decline of approximately $1.7 million in sales to certain emerging markets related to currency challenges between the USD and their local currencies. Domestic sales increased slightly as our sales organization changes took effect. Sales of our extremity products increased 7% to $20.0 million as compared to $18.6 million for the same period

20

in 2014. Sales of knee implant products decreased 16% to $15.3 million for the quarter ended September 30, 2015, compared to $18.1 million for the same quarter in 2014, as a result of continued pricing pressures in the worldwide knee market, coupled with the foreign currency impact and economic challenges in certain international markets. Hip implant sales of $9.9 million during the quarter ended September 30, 2015 decreased 2% from $10.2 million during the quarter ended September 30, 2014, as a result of foreign currency impact on international sales and pricing pressures in the United States. Sales from biologics and spine increased 5% during the quarter ended September 30, 2015 to $5.7 million from $5.4 million in the comparable quarter in 2014, primarily as a result of pricing stabilization in the domestic biologics market, as well as contributions from new spine implant system launches. Sales of all other products decreased to $5.4 million as compared to $5.6 million in the same quarter last year.
For the nine months ended September 30, 2015, sales decreased 3% to $179.1 million from $185.1 million in the nine months ended September 30, 2014 partially as a result of the foreign currency impact on our international sales and the loss of business experienced in the first half of 2015 due to our sales organization changes domestically. Sales of our extremity products increased 7% to $61.5 million as compared to $57.3 million for the same period in 2014. Sales of knee implant products decreased 12% to $52.7 million for the nine months ended September 30, 2015, compared to $59.8 million for the same nine months in 2014, as a result of the pricing pressures and the foreign currency impact in international markets. Hip implant sales decreased 1% to $31.8 million during the nine months ended September 30, 2015 from $32.2 million during the nine months ended September 30, 2014. Sales from biologics and spine decreased 6% during the nine months ended September 30, 2015 to $16.7 million from $17.7 million in the comparable nine months in 2014, as a result of the continued competitive pressures in the domestic biologics market and foreign currency impact to the international market. Sales of all other products decreased to $16.4 million as compared to $18.2 million in the same nine month period last year.
Gross Profit
Gross profit decreased to $39.6 million in the quarter ended September 30, 2015 from $41.0 million in the quarter ended September 30, 2014. As a percentage of sales, gross profit decreased slightly to 70.5% during the quarter ended September 30, 2015 from 70.7% for the quarter ended September 30, 2014. Gross profit decreased to $124.5 million in the nine months ended September 30, 2015 from $129.9 million in the nine months ended September 30, 2014. As a percentage of sales, gross profit decreased to 69.5% during the nine months ended September 30, 2015 from 70.2% for the nine months ended September 30, 2014. The decrease in the three and nine month periods was primarily a result of continued pricing pressures in both domestic and international markets. Looking forward to the fourth quarter of 2015, we expect gross profit, as a percentage of sales, to decrease approximately 0.5-0.75% on a comparative quarter basis.
Operating Expenses
Total operating expenses decreased 1% to $35.1 million in the quarter ended September 30, 2015 from $35.4 million in the quarter ended September 30, 2014. As a percentage of sales, total operating expenses increased to 62% for the quarter ended September 30, 2015, as compared to 61% for the same quarter in 2014, as a result of our increased research and development spending. Total operating expenses decreased 3% to $107.8 million in the nine months ended September 30, 2015 from $111.0 million in the nine months ended September 30, 2014. As a percentage of sales, total operating expenses remained at 60% for each of the nine months ended September 30, 2015 and 2014. The decrease in operating expenses was a result of our continued focus on controlling general operating expenses, as well as the impact of foreign currency exchange rates on our international cost structure.
Sales and marketing expenses, the largest component of total operating expenses, decreased 3% for the quarter ended September 30, 2015 to $20.6 million from $21.3 million in the same quarter last year. Sales and marketing expenses, as a percentage of sales, remained relatively constant at 37% for each of the quarters ended September 30, 2015 and 2014. Sales and marketing expenses decreased 6% for the nine months ended September 30, 2015 to $63.9 million from $67.9 million in the same nine months last year. Sales and marketing expenses, as a percentage of sales, were 36% for the nine months ended September 30, 2015, compared to 37% for the nine months ended September 30, 2014. The decrease for both the three and nine months ended September 30, 2015 was primarily related to reduced variable selling costs and lower USD costs in our international operations as a result of the strong USD exchange rate. Looking forward, sales and marketing expenditures, as a percentage of sales, are expected to be in the range of 35.5% to 36.5% for the fourth quarter of 2015.
General and administrative expenses decreased 4% to $5.2 million for the quarter ended September 30, 2015. As a percentage of sales, general and administrative expenses remained at 9% for each of the quarters ended September 30, 2015 and 2014. General and administrative expenses remained at $16.8 million for each of the nine months ended

21

September 30, 2015 and 2014. As a percentage of sales, general and administrative expenses remained at 9% for each of the nine months ended September 30, 2015 and 2014. General and administrative expenses for the fourth quarter of 2015 are expected to be in the range of 8.5% to 9.5% of sales.
Research and development expenses increased 18% for the quarter ended September 30, 2015 to $5.3 million from $4.5 million in the same quarter last year. As a percentage of sales, research and development expenses increased to 9% for the quarter ended September 30, 2015 as compared to 8% for the quarter ended September 30, 2014. Research and development expenses increased 6% to $14.4 million for the nine months ended September 30, 2015 from $13.5 million for the same period in 2014. The integration of the Blue Ortho acquisition as well as continuing product development costs to support new product launches increased research and development expenses for the reported periods. As a percentage of sales, research and development expenses increased to 8% for the nine months ended September 30, 2015 from 7% for the same period in 2014. We expect research and development expenses ranging from 7.5% to 8.5% of sales for the fourth quarter of 2015.
Depreciation and amortization decreased 5% to $4.1 million for the quarter ended September 30, 2015 from $4.3 million during the same quarter in 2014. As a percentage of sales, depreciation and amortization remained relatively flat at 7% during each of the quarters ended September 30, 2015 and 2014. Depreciation and amortization remained at $12.7 million for each of the nine months ended September 30, 2015 and 2014. As a percentage of sales, depreciation and amortization remained constant at 7% during each of the nine months ended September 30, 2015 and 2014. We placed $12.4 million of surgical instrumentation and $1.1 million of equipment in service during the first nine month periods of 2015.
Income from Operations
Our income from operations decreased 18% to $4.5 million, or 8% of sales, in the quarter ended September 30, 2015 from $5.5 million, or 10% of sales, in the quarter ended September 30, 2014. Our income from operations decreased 12% to $16.7 million, or 9% of sales, in the nine months ended September 30, 2015 from $18.9 million, or 10% of sales, in the nine months ended September 30, 2014. The decrease in our income from operations for the three and nine months ended September 30, 2015 was primarily a result of our sales decrease, partially offset by the decrease in operating expenses. Looking forward, we expect operating expenses for the fourth quarter to remain approximately flat, and together with an anticipated decrease in revenue of 1-2%, we anticipate income from operations, as a percentage of sales, to decrease by 1-1.5% for the fourth quarter of 2015.
Other Income and Expenses
We had other expenses, net of other income, of $0.4 million during the quarter ended September 30, 2015, compared to other expenses, net of other income of $0.9 million in the quarter ended September 30, 2014. The change for the quarter was primarily a result of net foreign currency losses of $0.1 million for the quarter ended September 30, 2015, as compared to net foreign currency losses of $0.7 million for the same quarter of 2014. The decrease in currency loss in the quarter ended September 30, 2015 was primarily due to effective hedging instruments that offset the strengthening of the JPY against the USD on intercompany debt late in the quarter ended September 30, 2015, compared to the strengthening of the USD against the EUR and JPY during the quarter ended September 30, 2014. Net interest expense was $0.3 million for the quarter ended September 30, 2015, and $0.2 million for the quarter ended September 30, 2014.
We had other expenses, net of other income, of $1.6 million during the nine months ended September 30, 2015, compared to other expenses, net of other income of $1.2 million in the nine months ended September 30, 2014. The change for the nine months was a result of net foreign currency losses of $0.9 million for the nine months ended September 30, 2015, compared to net foreign currency losses of $0.5 million for the same nine months of 2014. The currency loss in the nine months ended September 30, 2015 was primarily due to the premiums paid on foreign currency forward options we entered into during January and June 2015, and was partially offset by gains on the value of the forward options during the first nine months of 2015. Net interest expense was $0.9 million for the nine months ended September 30, 2015, and $0.8 million for the same period in 2014.
Taxes and Net Income
Income before provision for income taxes decreased 9% to $4.2 million in the quarter ended September 30, 2015 from $4.6 million in the quarter ended September 30, 2014, primarily due to the impact of sales and foreign currency losses. The effective tax rate, as a percentage of income before taxes, was 31% for the quarter ended September 30, 2015, compared to 35% for the same quarter in 2014, primarily as a result of the favorable change in the mix of income in the different tax jurisdictions. As a result of the foregoing, we realized net income of $2.9 million in the quarter ended

22

September 30, 2015, a decrease of 4% from $3.0 million in the quarter ended September 30, 2014. As a percentage of sales, net income decreased slightly to 5.1% for the quarter ended September 30, 2015 from 5.2% for the same quarter in 2014. Earnings per share, on a diluted basis, decreased to $0.20 for the quarter ended September 30, 2015, from $0.21 for the quarter ended September 30, 2014.
Income before provision for income taxes decreased 15% to $15.1 million in the nine months ended September 30, 2015 from $17.7 million in the nine months ended September 30, 2014, also primarily due to lower sales and gross margins. The effective tax rate, as a percentage of income before taxes, was 30% for the nine months ended September 30, 2015, compared to 36% for the same period in 2014, as a result of the reduction of the valuation allowance related to the net operating losses of certain of our international subsidiaries due to their improved financial performance and the mix of income in the different tax jurisdictions. As a result of the foregoing, we realized net income of $10.7 million in the nine months ended September 30, 2015, a decrease of 6% from $11.4 million in the nine months ended September 30, 2014. As a percentage of sales, net income decreased to 5.9% for the nine months ended September 30, 2015 from 6.1% for the same nine months in 2014. Earnings per share, on a diluted basis, decreased to $0.75 for the nine months ended September 30, 2015, from $0.81 for the nine months ended September 30, 2014.
Liquidity and Capital Resources
We have financed our operations primarily through a combination of commercial debt financing and cash flows from our operating activities. At September 30, 2015, we had working capital of $119.5 million, a 5.8% increase from $113.0 million at the end of 2014. Working capital in 2015 increased as a result of the increase in our cash and accounts receivable balances.
We expect that cash flows from operating activities, borrowings under our line of credit, and the issuance of equity securities in connection with both stock purchases under the 2009 ESPP and the exercise of stock option awards under the 2009 Plan will be sufficient to meet our commitments and cash requirements in the next twelve months. If not, we will seek additional funding through any number of possible combinations of additional debt, additional issuance of equity or convertible debt. As of September 30, 2015, $4.8 million of our cash balance was held outside the U.S. Our foreign cash holdings vary depending on operating cash needs of our foreign subsidiaries and the timing of reimbursements to the U.S. There are currently no restrictions against repatriation of this cash.
Operating Activities – Operating activities provided net cash of $23.5 million in the nine months ended September 30, 2015, as compared to net cash from operations of $26.3 million during the nine months ended September 30, 2014. This decrease was primarily related to the increase in accounts receivable experienced in the first nine months of 2015, which used cash of $0.3 million for the nine months ended September 30, 2015, in contrast to a decrease in accounts receivable providing net cash of $10.9 million for the nine months ended September 30, 2014. A major contributor to the change in total accounts receivable was the large payment of government receivables in Spain during the first quarter of 2014, which did not occur in 2015, as the Spanish government has maintained relatively stable payments since then. Our allowance for doubtful accounts and sales returns decreased to $0.8 million at September 30, 2015 from $0.9 million at December 31, 2014. The total days sales outstanding (DSO) ratio, based on average accounts receivable balances, was 76 for the nine month period ended September 30, 2015, as compared to 77 for the nine month period ended September 30, 2014, as we continued to see improvement in accounts receivable payment terms in the United States. However, as we continue to expand our operations internationally, our DSO ratio could increase because credit terms outside of the United States tend to be relatively longer than those in the United States. Inventory cash outlay decreased to $2.6 million during the nine months ended September 30, 2015, as compared to an outlay of $9.8 million during the same period in 2014, as we continued to see positive impact on our supply chain improvements.
Investing Activities - Investing activities used net cash of $15.9 million in the nine months ended September 30, 2015, as compared to $13.6 million in the nine months ended September 30, 2014. A contributor to the increase was our increased cash outlays for surgical instrumentation and manufacturing equipment, which were $13.4 million during the nine month period ended September 30, 2015, as compared to cash outlays of $12.8 million for purchases of surgical instrumentation and manufacturing equipment during the same period of 2014.
In January 2015, we acquired Blue Ortho and paid cash consideration of $2.3 million at closing and recognized a preliminary contingent consideration of $7.1 million, which we expect to be paid over the next five to ten years. We funded our acquisition from cash flow from operations. We acquired $1.3 million in current assets, $0.2 million in property and equipment, $7.5 million in identifiable intangible assets, assumed $0.4 million in current liabilities and assumed preliminary deferred taxes of $2.5 million. We have recognized a preliminary goodwill amount of $6.5 million. Our accounting for the acquisition is preliminary and pending final asset valuations.

23

Financing Activities - Financing activities used net cash of $0.4 million in the nine months ended September 30, 2015, as compared to $9.3 million in net cash used for the nine months ended September 30, 2014. In the first nine months of 2015, we had net debt repayments of $2.3 million, as compared to net repayments of $13.0 million in the first nine months of 2014, due to the repayment of our revolving line of credit balance. Proceeds from the exercise of stock options provided cash of $2.6 million during the nine months ended September 30, 2015, as compared to $3.8 million during the nine months ended September 30, 2014, and we used the proceeds to fund general working capital.
During the first nine months of 2015, we paid contingent consideration payments to the former shareholders of Blue Ortho of €0.6 million, or $0.7 million. As of September 30, 2015 we had $6.3 million of contingent consideration liability in our unaudited condensed consolidated balance sheets, of which $1.1 million is classified in other current liabilities, due to our expected timing of earn-out payments. The remaining $5.2 million preliminary contingent liability is classified as other non-current liabilities.
Long-term Debt
On February 24, 2012, we entered into a revolving credit and term loan agreement for a maximum aggregate principal amount of $100.0 million, referred to as the Credit Agreement, with SunTrust Bank, as Administrative Agent, issuing bank and swingline lender, and a syndicate of other lenders. The Credit Agreement is composed of a $30.0 million term loan facility and revolving credit line in an aggregate principal amount of up to $70.0 million, of which, a portion is a $5.0 million swingline facility. Interest on loans outstanding under the Credit Agreement is based, at our election, on a base rate, a Eurodollar Rate or an index rate, in each case plus an applicable margin. The Credit Agreement expires on February 24, 2017. Additionally, the Credit Agreement contains financial covenants requiring that we maintain a leverage ratio of not greater than 2.50 to 1.00 and a fixed charge coverage ratio (as defined in the Credit Agreement) of not less than 2.00 to 1.00. As of September 30, 2015, we were in compliance with all financial covenants. For additional information regarding the Credit Agreement, please see note 6 - Debt to our audited consolidated financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2014.
Other Commitments and Contingencies
At September 30, 2015, we had outstanding commitments for the purchase of inventory, raw materials and supplies of $15.7 million and outstanding commitments for the purchase of capital equipment of $4.3 million. Purchases under our distribution agreements were $2.6 million during the nine months ended September 30, 2015.


24

CAUTIONARY STATEMENT RELATING TO FORWARD LOOKING STATEMENTS
This report contains various “forward looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), 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. When used in this report, the terms “anticipate,” “believe,” “estimate,” “expect” and “intend” and words or phrases of similar import, as they relate to the Company or its subsidiaries or its management, are intended to identify forward-looking statements. 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 suppliers to produce components on a cost-effective basis to the Company, significant expenditures of resources to maintain high levels of inventory, market acceptance of the Company’s products, the impact of the medical device excise tax, the outcome of litigation, the effects of governmental regulation, potential product liability risks and risks of securing adequate levels of product liability insurance coverage, and the availability of reimbursement to patients from health care payers for procedures in which the Company’s products are used. Results actually achieved may differ materially from expected results included in these statements as a result of these or other factors, including those factors discussed under “Risk Factors” in our annual report on Form 10-K for the year ended December 31, 2014 and each quarterly report on Form 10-Q we filed after this annual report. Exactech undertakes no obligation to update, and the Company does not have a policy of updating or revising, these forward-looking statements. Except where the context otherwise requires, the terms, “we”, “us”, “our”, “the Company,” or “Exactech” refer to the business of Exactech, Inc. and its consolidated subsidiaries.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk
We are exposed to market risk from interest rates. For our cash and cash equivalents, a change in interest rates affects the amount of interest income that can be earned. For our debt instruments, changes in interest rates affect the amount of interest expense incurred. If our variable rates of interest increased by 1%, our debt service would increase by approximately $0.1 million for the remainder of 2015.
At September 30, 2015, we had one interest-rate swap agreement outstanding that converts variable-rate interest to fixed-rate interest based on three-month LIBOR. We entered into our interest rate swap to eliminate variability in future cash flows by converting LIBOR-based variable-rate interest payments into fixed-rate interest payments. We do not expect our interest rate swap will have a material impact on our results of operations, financial position or cash flows.
The table that follows provides information about our financial instruments that are sensitive to changes in interest rates, including debt obligations and the interest rate swap. The table presents principal cash flow by expected maturity dates and weighted average interest rates for our debt obligations and interest rate swap. We believe that the amounts presented reasonably approximate the financial instrument's respective fair market value as of September 30, 2015, and the weighted average interest rate is that experienced during the nine months ended September 30, 2015:
 
 
 
 
 
 
 
(in thousands, except percentages)
2015
2016
2017
2018
Thereafter
Total
Liabilities
 
 
 
 
 
 
Term loan at variable interest rate
$
750

$
3,000

$
17,250

$
—

$
—

$
21,000

Weighted average interest rate
1.8
%
 
 
 
 
 
 
 
 
 
 
 
 
Interest Rate Swap
 
 
 
 
 
 
Notional amount
 
 
 
27,000

 
 
Fixed rate interest
 
 
 
1.5
%
 
 
 
 
 
 
 
 
 
Foreign Currency Risk
Foreign Currency Translations – We are exposed to market risk related to changes in foreign currency exchange rates. The functional currency of substantially all of our international subsidiaries is their local currency. Transactions are translated into U.S. Dollars (USD), and exchange gains and losses arising from translation are recognized in “Other comprehensive income (loss)”. Fluctuations in exchange rates affect our financial position and results of operations. The majority of our foreign currency exposure is to the Euro (EUR), British Pound (GBP), and Japanese Yen (JPY). During the nine months ended September 30, 2015, translation losses were $2.7 million, which were primarily due to the weakening of the JPY, EUR and GBP against the USD. During the nine months ended September 30, 2014, translation losses were $3.1 million.
Foreign Currency Transactions – The USD is our primary currency, and transactions that are completed in a foreign currency are translated into USD and recorded in the financial statements. We recognized currency transaction losses of $0.5 million for the nine months ended September 30, 2015, due to the weakening of the JPY and EUR as compared to the USD, and currency transaction losses of $0.6 million during the same period in 2014. We currently believe that our exchange rate risk exposure is not material to our operations.
Foreign Currency Options – During 2015, we entered into foreign currency forward contracts as economic hedges against the continued strengthening of the USD against the EUR and the JPY. As of September 30, 2015, we had two foreign currency forward contracts in effect with six month terms. The initial aggregate amount of the outstanding contracts is $11.6 million, with a December 31, 2015 expiration date. During the three and nine months ended September 30, 2015, we recognized losses of $0.1 million and $0.4 million, respectively, related to these instruments. The recognized losses are recorded in other income (expense) in the condensed consolidated statements of income related to the fair value of these currency options based upon a dealer's quotes.
During September 2014, we entered into a foreign currency forward contract for a value of $6.4 million for a six month term, as an economic hedge against strengthening of the USD against the EUR. The foreign currency option expired on December 31, 2014. During the quarter ended September 30, 2014, we recognized a gain of $0.1 million on the condensed consolidated statements of income related to the fair value of this currency option based upon a dealer's quote.

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Item 4. Controls and Procedures
Disclosure Controls and Procedures
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer ("CEO") and our Chief Financial Officer ("CFO"), of the effectiveness of the design and operation of our disclosure controls and procedures, or “disclosure controls,” pursuant to Exchange Act Rule 13a-15(b). Disclosure controls are controls and procedures designed to reasonably ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this quarterly report, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure controls include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to our management, including our CEO and CFO, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure. Our disclosure controls include some, but not all, components of our internal control over financial reporting. Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of September 30, 2015.
Changes in Internal Control over Financial Reporting
There have not been any changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 during the three months ended September 30, 2015, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II.
OTHER INFORMATION
Item 1. Legal Proceedings
There are various claims, lawsuits, and disputes with third parties and pending actions involving various allegations against us incident to the operation of our business, principally product liability cases. While we believe that the various claims are without merit, we are unable to predict the ultimate outcome of such litigation. We therefore maintain insurance, subject to self-insured retention limits, for all such claims, and establish accruals for product liability and other claims based upon our experience with similar past claims, advice of counsel and the best information reasonably available. At September 30, 2015 and December 31, 2014, we had $75,000 and $135,000 accrued, respectively, for product liability claims. These product liability claims are subject to various uncertainties, and it is possible that they may be resolved unfavorably to us. While it is not possible to predict with certainty the outcome of the various cases, it is the opinion of management that, upon ultimate resolution, the cases will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.
Our insurance policies covering product liability claims must be renewed annually. Although we have been able to obtain insurance coverage for product liability claims at a cost and on other terms and conditions that have been acceptable to us, we may not be able to procure acceptable policies in the future.
Item 1A. Risk Factors
There have been no material changes to the risk factors set forth in Part I, Item 1A, of our Annual Report on Form 10-K for the year ended December 31, 2014.

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Item 6. Exhibits
(a) Exhibit
 
Description
31.1
 
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
 
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
 
Certification of Chief Executive Officer pursuant to 18 USC Section 1350.
32.2
 
Certification of Chief Financial Officer pursuant to 18 USC Section 1350.
101.INS
 
XBRL Instance Document
101.SCH
 
XBRL Taxonomy Extension Schema
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase
101.LAB
 
XBRL Taxonomy Extension Label Linkbase
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase


29

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
  
 
Exactech, Inc.
 
 
 
 
Date:
November 4, 2015
By:
/s/ David Petty                                               
 
 
 
David Petty
 
 
 
Chief Executive Officer (principal executive officer) and President
 
 
 
 
Date:
November 4, 2015
By:
/s/ Joel C. Phillips                                             
 
 
 
Joel C. Phillips
 
 
 
EVP, Chief Financial Officer (principal financial officer and principal accounting officer) and
 
 
 
Treasurer

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