Summary of EXACTECH INC - Yahoo! Finance

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. Our continuing research and development projects will enable us to continue the introduction of new, advanced biologic materials and other products and services. Revenue from sales of other products, including surgical instrumentation, Cemex® bone cement, the InterSpace™ pre-formed, antibiotic cement hip, knee and shoulder spacers have contributed to revenue growth and are expected to continue to be an important part of our anticipated future revenue growth.
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 be variable in nature and related to sales growth. 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 the primary decision maker when it comes to the choice of products and services that best meet the needs of their patients, our marketing strategy is focused on meeting the needs of the orthopaedic surgeon community. In addition to surgeon's preference, hospitals and buying groups, as the economic customer, are actively participating with physicians in the choice of implants and services. Overview of the Three and Nine Months Ended September 30, 2012 During the quarter ended September 30, 2012, sales increased 8% to $51.3 million from $47.3 million in the comparable quarter ended September 30, 2011, as we continued to expand our customer base and product offerings. Gross margins increased to 70% from 68% as we experienced increased growth in our higher margin domestic operations. Operating expenses increased 4% from the quarter ended September 30, 2011, and as a percentage of sales, operating expenses decreased to 61% during the third quarter of 2012 as compared to 64% for the same quarter in 2011. This decrease, as a percentage of sales, was primarily due to the reduction in legal and compliance costs to $0.3 million in the third quarter of 2012 from $1.0 million in third quarter 2011, related to the expiration of the Deferred Prosecution Agreement, or DPA, entered into with the Department of Justice, or DOJ. Net income for the quarter ended September 30, 2012 increased 95%, and diluted earnings per share were $0.19 as compared to $0.10 last year.

During the nine months ended September 30, 2012, sales increased 8% to $165.1 million from $152.3 million in the comparable nine months ended September 30, 2011, as we continued to gain global market share. Gross margins increased to 69% from 68% as a result of our growth in our international direct distribution subsidiaries as well as growth in domestic sales. Operating expenses increased 6% from the nine months ended September 30, 2011, and, as a percentage of sales, operating expenses decreased to 60% during the first nine months of 2012 as compared to 62% for the same period in 2011. The reduction, as a percentage of sales, was primarily due to a decrease in compliance and legal costs associated with the DPA to $1.4 million in the first nine months of 2012 from $3.7 million in the first nine months of 2011. Net income for the nine months ended September 30, 2012 increased 27% to $8.9 million, and diluted earnings per share were $0.67 as compared to $0.53 last year.
During the nine months ended September 30, 2012, we acquired $13.9 million in property and equipment, including new production equipment and surgical instrumentation. Net cash flow from operations was $14.6 million for the nine months ended September 30, 2012 as compared to a net cash flow from operations of $11.0 million during the nine months ended September 30, 2011.

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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 for the three and nine month periods ended September 30, 2012 and September 30, 2011:

                                                Sales by Product Line
                                                    ($ in 000's)

                                         Three Months Ended                                   Inc (decr)
                           September 30, 2012           September 30, 2011         2012- 2011      Constant Currency
Knee                   $     18,220        35.6 %   $     17,908        37.9 %         1.7  %              4.0  %
Hip                           9,245        18.0            7,990        16.9          15.7                17.5
Biologics and Spine           5,943        11.6            5,415        11.4           9.8                11.8
Extremity                    12,215        23.8            9,780        20.7          24.9                26.3
Other                         5,647        11.0            6,185        13.1          (8.7 )              (6.0 )
Total                  $     51,270       100.0 %   $     47,278       100.0 %         8.4  %             10.5  %

                                          Nine Months Ended                                   Inc (decr)
                           September 30, 2012           September 30, 2011         2012- 2011      Constant Currency
Knee                   $     60,678        36.8 %   $     59,946        39.3 %         1.2  %              2.9  %
Hip                          30,465        18.5           24,393        16.0          24.9                25.8
Biologics and Spine          18,031        10.9           18,423        12.1          (2.1 )              (0.8 )
Extremity                    37,188        22.5           28,874        19.0          28.8                29.8
Other                        18,721        11.3           20,693        13.6          (9.5 )              (8.0 )
Total                  $    165,083       100.0 %   $    152,329       100.0 %         8.4  %              9.7  %

The following table includes items from the unaudited Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2012 as compared to the three and nine months ended September 30, 2011, 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,         2012 - 2011 Inc (decr)             % of Sales
                              2012                 2011               $               %           2012          2011
Net sales              $        51,270       $        47,278         3,992             8.4        100.0  %      100.0  %
Cost of goods sold              15,392                14,898           494             3.3         30.0          31.5
Gross profit                    35,878                32,380         3,498            10.8         70.0          68.5
Operating expenses:
Sales and marketing             18,713                18,041           672             3.7         36.5          38.2
General and
administrative                   4,564                 5,070          (506 )         (10.0 )        8.9          10.7
Research and
development                      4,366                 3,502           864            24.7          8.5           7.4
Depreciation and
amortization                     3,722                 3,663            59             1.6          7.3           7.7
Total operating
expenses                        31,365                30,276         1,089             3.6         61.2          64.0
Income from operations           4,513                 2,104         2,409           114.5          8.8           4.5
Other income
(expense), net                    (240 )                (299 )          59           (19.7 )       (0.5 )        (0.7 )
Income before taxes              4,273                 1,805         2,468           136.7          8.3           3.8
Provision for income

taxes 1,720 494 1,226 248.2 3.3 1.0 Net income $ 2,553 $ 1,311 1,242 94.7 5.0 2.8

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                               Nine Months Ended September
                                           30,                  2012 - 2011 Inc (decr)            % of Sales
                                  2012             2011            $               %           2012        2011
Net sales                     $  165,083       $  152,329        12,754             8.4       100.0  %     100.0 %
Cost of goods sold                50,688           48,156         2,532             5.3        30.7         31.6
Gross profit                     114,395          104,173        10,222             9.8        69.3         68.4
Operating expenses:
Sales and marketing               60,501           57,292         3,209             5.6        36.6         37.6
General and administrative        14,947           16,555        (1,608 )          (9.7 )       9.1         10.9
Research and development          12,630            9,717         2,913            30.0         7.7          6.4
Depreciation and amortization     11,327           10,642           685             6.4         6.9          7.0
Total operating expenses          99,405           94,206         5,199             5.5        60.3         61.9
Income from operations            14,990            9,967         5,023            50.4         9.0          6.5
Other income (expense), net         (897 )            100          (997 )        (997.0 )      (0.5 )        0.1
Income before taxes               14,093           10,067         4,026            40.0         8.5          6.6
Provision for income taxes         5,232            3,063         2,169            70.8         3.1          2.0
Net income                    $    8,861       $    7,004         1,857            26.5         5.4          4.6

Three and Nine Months Ended September 30, 2012 Compared to Three and Nine Months Ended September 30, 2011
Sales
For the quarter ended September 30, 2012, sales increased 8% to $51.3 million from $47.3 million in the quarter ended September 30, 2011, as a result of market share gains and partially offset by general pricing pressures. Sales of knee implant products increased 2% to $18.2 million for the quarter ended September 30, 2012 compared to $17.9 million for the quarter ended September 30, 2011, as sales of our Logic knee systems continued to grow. The sales return from our former independent distributor in Spain, as well as currency fluctuations partially offset the market growth, as the knee product growth, excluding the impact of those two offsetting items, reflected a 6% growth. Sales of our extremity products were up 25% to $12.2 million as compared to $9.8 million for the same period in 2011, as we continued to see increasing market acceptance of our Equinoxe® reverse shoulder system. Hip implant sales of $9.2 million during the quarter ended September 30, 2012 increased 16% over the $8.0 million in sales during the quarter ended September 30, 2011, as we continued growth in our Novation Element™ hip system. Sales from biologics and spine increased 10% during the quarter ended September 30, 2012 to $5.9 million, from $5.4 million in the comparable quarter in 2011. Sales of all other products decreased to $5.6 million as compared to $6.2 million in the same quarter last year. Domestically, sales increased 12% to $35.3 million, or 69% of total sales, during the quarter ended September 30, 2012, up from $31.5 million, which represented 67% of total sales, in the comparable quarter last year. Internationally, sales increased 1% to $16.0 million, representing 31% of total sales, for the quarter ended September 30, 2012, as compared to $15.8 million, which was 33% of total sales, for the same quarter in 2011. On a constant currency basis international sales grew approximately 7% during the quarter ended September 30, 2012, compared to the same quarter in 2011. For the nine months ended September 30, 2012, sales increased 8% to $165.1 million from $152.3 million in the comparable nine months ended September 30, 2011. Sales of knee implant products increased 1% to $60.7 million for the nine months ended September 30, 2012 compared to $59.9 million for the same nine month period in 2011. Sales of our extremity products were up 29% to $37.2 million as compared to $28.9 million for the same period in 2011, as the acceptance of our Equinoxe reverse shoulder system continued. Hip implant sales of $30.5 million during the nine months ended September 30, 2012 increased 25% over the $24.4 million in sales during the nine months ended September 30, 2011, as we continued to experience market penetration with our Novation Element hip system. Sales from biologics and spine decreased 2% during the nine months ended September 30, 2012 to $18.0 million, from $18.4 million in the comparable nine months in 2011. Sales of all other products decreased to $18.7 million as compared to $20.7 million in the same nine months in 2011. Domestically, sales increased 8% to $107.3 million, or 65% of total sales, during the nine months ended September 30, 2012, up from $99.0 million, which also represented 65% of total sales, in the comparable period in 2011. Internationally, sales increased 8% to $57.8 million, representing 35% of total sales, for the nine months ended September 30, 2012, as compared to $53.3 million, which was also 35%

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of total sales, for the same nine months in 2011. The international sales increase was primarily attributable to market growth in our direct sales operations.
Gross Profit
Gross profit increased 11% to $35.9 million in the quarter ended September 30, 2012 from $32.4 million in the quarter ended September 30, 2011. As a percentage of sales, gross profit increased to 70% during the quarter ended September 30, 2012 as compared to 68% in the quarter ended September 30, 2011, as a direct result of our domestic sales growth, which generally carries higher margins, as well as continued growth in our international sales from our direct distribution operations, which also carry higher margins. Looking forward to the remainder of the fiscal year, we expect gross profit, as a percentage of sales, to be flat to 0.5% higher than prior year quarters on a comparative quarter basis. Gross profit increased 10% to $114.4 million in the nine months ended September 30, 2012 from $104.2 million in the nine months ended September 30, 2011. As a percentage of sales, gross profit increased to 69% during the nine months ended September 30, 2012 as compared to 68% in the same nine month period in 2011, also as a result of growth in our domestic market and international direct markets, which generally result in higher margin sales. Operating Expenses
Total operating expenses increased 4% to $31.4 million in the quarter ended September 30, 2012 from $30.3 million in the quarter ended September 30, 2011, primarily due to increases in research and development and sales and marketing expenses, offset partially by a reduction in general and administrative expenses. As a percentage of sales, total operating expenses decreased to 61% for the quarter ended September 30, 2012, as compared to 64% for the quarter ended September 30, 2011. The decrease in operating expenses, as a percentage of sales, is primarily due to the decrease in compliance expenses related to the expiration of the DPA from $1.0 million in the third quarter of 2011 to $0.3 million in the third quarter of 2012. Total operating expenses increased 6% to $99.4 million in the nine months ended September 30, 2012 from $94.2 million in the nine months ended September 30, 2011. As a percentage of sales, total operating expenses decreased to 60% for the nine months ended September 30, 2012, as compared to 62% for the same period in 2011. Included in operating expenses for the first nine months in 2012 is $1.4 million in compliance costs, compared to $3.7 million in the first nine months in 2011.
Sales and marketing expenses, the largest component of total operating expenses, increased 4% for the quarter ended September 30, 2012 to $18.7 million from $18.0 million in the same quarter last year. The increase was primarily related to variable selling costs as a result of our sales growth. Sales and marketing expenses, as a percentage of sales decreased to 36% for the quarter ended September 30, 2012, from 38% for the quarter ended September 30, 2011. Sales and marketing expenses increased 6% for the nine months ended September 30, 2012 to $60.5 million from $57.3 million in the nine months ended September 30, 2011. Sales and marketing expenses, as a percentage of sales, decreased slightly to 37% for the nine months ended September 30, 2012, from 38% for the nine months ended September 30, 2011. Looking forward, sales and marketing expenditures, as a percentage of sales, are expected to be in the range of 36% to 37% for the fourth quarter of 2012.
General and administrative expenses decreased to $4.6 million in the quarter ended September 30, 2012 from $5.1 million in the same quarter in 2011, as we reduced compliance expenses related to the OIG monitorship during the third quarter of 2012. As a percentage of sales, general and administrative expenses decreased to 9% for the quarter ended September 30, 2012, as compared to 11% in the quarter ended September 30, 2011. General and administrative expenses decreased 10% to $14.9 million in the nine months ended September 30, 2012 from $16.6 million in the nine months ended September 30, 2011, which included the $1.4 million and $3.7 million in expenses related to the DPA and OIG monitorships for each of the periods, respectively. As a percentage of sales, general and administrative expenses decreased to 9% for the nine months ended September 30, 2012, as compared to 11% in the nine months ended September 30, 2011. General and administrative expenses for the balance of the year ending December 31, 2012 are expected to be in the range of 9% to 10% of sales the fourth quarter of 2012.
Research and development expenses increased 25% for the quarter ended September 30, 2012 to $4.4 million from $3.5 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, 2012 from 7% for the comparable quarter last year. The increase was due primarily to increased design and development activities, including our cartilage repair development project. Research and development expenses increased 30% for the nine months ended September 30, 2012 to $12.6 million from $9.7 million in the first nine months of 2011. As a percentage of sales, research and development expenses increased to 8% for the nine months ended September 30, 2012 from 6% for the comparable nine months last year. We anticipate growth in research and development expenditures, as a percent of sales, to continue to outpace sales growth as

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increases in product development activities through the fourth quarter of 2012 are expected, with total research and development expenses ranging from 7% to 8% of sales.
Depreciation and amortization increased only slightly, remaining at approximately $3.7 million for each of the quarters ended September 30, 2012 and 2011, which reflected a 2% increase from the prior year. As a percentage of sales, depreciation and amortization decreased to 7% during the quarter ended September 30, 2012 from 8% during the quarter ended September 30, 2011. Depreciation and amortization increased 6% to $11.3 million during the nine months ended September 30, 2012 from $10.6 million in the nine months ended September 30, 2011, as a result of continuing investment in our operations and expanding surgical instrumentation deployment. As a percentage of sales, depreciation and amortization remained flat at 7% for the nine month periods ended September 30, 2012 and 2011. We placed $11.8 million of surgical instrumentation in service and spent approximately $0.8 million for patents and trademarks during the first nine months of 2012. Income from Operations
Our income from operations increased 114% to $4.5 million, or 9% of sales in the quarter ended September 30, 2012 from $2.1 million, or 4% of sales in the quarter ended September 30, 2011. Our income from operations increased 50% to $15.0 million, or 9% of sales in the nine months ended September 30, 2012 from $10.0 million, or 7% of sales in the nine month period ended September 30, 2011. The increase in our income from operations was a result of the increase in sales combined with our efforts to reduce our growth in expenses. Looking forward, we expect operating expenses for the fourth quarter to increase slower than sales growth and, therefore, we anticipate income from operations to be in the range of 8% to 10% for the fourth quarter of 2012. Other Income and Expenses
We had other expenses, net of other income, of $0.2 million during the quarter ended September 30, 2012, as compared to other expenses, net of other income, of $0.3 million in the quarter ended September 30, 2011, due to net foreign currency gains of $60,000, compared to foreign currency transaction losses of $48,000 for the same quarter of 2011. Net interest expense remained relatively unchanged at $0.3 million for each of the quarters ended September 30, 2012 and 2011. We had other expenses, net of other income, of $0.9 million during the nine months ended September 30, 2012, as compared to other income, net of other expenses of $0.1 million in the nine months ended September 30, 2011. The decrease to net other income was primarily due to the reduction in net foreign currency gains of $0.2 million for the first nine months of 2012 from $0.8 million for the first nine months of 2011. Net foreign currency activities during the nine months ended September 30, 2012 consisted of $0.2 million in foreign currency transaction gains, offset by the realized loss of $0.3 million from our forward currency option hedge. Also contributing to the decrease was net interest expense, which increased for the nine months ended September 30, 2012 to $1.1 million from $0.8 million during the nine months ended September 30, 2011 due to increased borrowing under our line of credit facility. Taxes and Net Income
Income before provision for income taxes increased 137% to $4.3 million in the quarter ended September 30, 2012 from $1.8 million in the quarter ended September 30, 2011. The effective tax rate, as a percentage of income before taxes, was 40% for the quarter ended September 30, 2012 as compared to 27% for the quarter ended September 30, 2011. The increase in the effective tax rate for the third quarter of 2012 was primarily due to to non-deductible losses in certain European operations and a higher percentage of our income from operations from the U.S. which incurs a higher effective tax rate. As a result of the foregoing, we realized net income of $2.6 million in the quarter ended September 30, 2012, an increase of 95% from $1.3 million in the quarter ended September 30, 2011. As a percentage of sales, net income increased to 5% for the quarter ended September 30, 2012 from 3% for the quarter ended September 30, 2011. Earnings per share, on a diluted basis, increased to $0.19 for quarter ended September 30, 2012, from $0.10 for the quarter ended September 30, 2011. Income before provision for income taxes increased 40% to $14.1 million in the nine months ended September 30, 2012 from $10.1 million in the same period in 2011. The effective tax rate, as a percentage of income before taxes, was 37% for the nine months ended September 30, 2012 and 30% for the same nine month periods in 2011. The increase in the effective tax rate for the first nine months was primarily due to the tax impact of the research and development tax credit that was effective in the first nine months of 2011 as opposed to having expired during the first nine months of 2012, and the change in estimate of the non-deductible portion of the 2010 DOJ settlement. Formerly, we anticipated that $0.6 million of this settlement was non-deductible and, as a result of IRS discussions with the DOJ in the third quarter of 2012, it was clarified that $1.3 million of this settlement was non-deductible resulting in $0.3 million of additional tax liability. We expect our effective tax rates to range from 35% to 37% for the fourth quarter of 2012, assuming non-renewal of the research and development tax

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credit. As a result of the foregoing, we realized net income of $8.9 million in the nine months ended September 30, 2012, an increase of 27% from $7.0 million in the nine months ended September 30, 2011. As a percentage of sales, net income increased to 5.4% from 4.6% during the nine months ended September 30, 2012. Earnings per share, on a diluted basis, increased to $0.67 for nine months ended September 30, 2012, from $0.53 for the nine months ended September 30, 2011.
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, 2012, we had working capital of $96.2 million, an increase of 4% from $92.2 million at the end of 2011. Working capital in 2012 increased primarily as a result of an increase in our current inventory balance, and was partially offset by increases in our accounts payable and accrued expenses associated with our expansion. We experienced overall increases in our current assets and liabilities due to our continued growth. We project that cash flows from operating activities, borrowing under our new line of credit, and the issuance of equity securities, in connection with both stock purchases under the 2009 ESPP and stock option exercises will be sufficient to meet our commitments and cash requirements in the next twelve months. If not, we will seek additional funding options with any number of possible combinations of additional debt, additional equity or convertible debt.
Operating Activities - Operating activities provided net cash of $14.6 million in the nine months ended September 30, 2012, as compared to net cash from operations of $11.0 million during the nine months ended September 30, 2011. A primary contributor to this change related to the decreases in accounts receivable, which provided cash of $2.6 million for the nine months ended September 30, 2012, in contrast to using net cash $3.4 million for the nine months ended September 30, 2011. A major contributor to the collection effort is our sales distribution office in Spain, which during the second quarter of 2012, received approximately 8.2 million EUR for substantially all of its accounts receivable aged six months or older. Our allowance for doubtful accounts and sales returns decreased to $0.8 million at September 30, 2012 from $3.2 million . . .