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GB > SEC Filings for GB > Form 10-Q on 6-Nov-2012All Recent SEC Filings

Show all filings for GREATBATCH, INC.

Form 10-Q for GREATBATCH, INC.


6-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Our Business

We operate our business in two reportable segments - Implantable Medical and Electrochem Solutions ("Electrochem"). The Company's customers include large multi-national original equipment manufacturers ("OEMs"). The Implantable Medical segment (formerly Greatbatch Medical) is comprised of our Greatbatch Medical and QiG Group brands and designs and manufactures medical devices and components for the cardiac rhythm management ("CRM"), neuromodulation, vascular access and orthopaedic markets. Additionally, Implantable Medical offers value-added assembly and design engineering services. As a result of the strategy put in place over three years ago, Implantable Medical now offers its customers complete medical devices including design, development, manufacturing, regulatory submission and supporting worldwide distribution. This medical device strategy is being facilitated through the QiG Group ("QiG") and leverages the component technology of Greatbatch in our core markets: cardiovascular, neuromodulation and orthopaedic. Once QiG designs and develops a medical device, it is manufactured by Greatbatch Medical. The operating expenses of QiG are included within the Implantable Medical segment.

Electrochem provides industry-leading total power solutions for rechargeable and non-rechargeable battery power systems, charging and docking stations, and power supplies, for critical applications largely in the portable medical and energy markets, where safety, reliability, quality and innovation are critical. Electrochem's product lines cover a number of highly-customized battery-powered applications in remote and demanding environments, including down hole drilling tools and in life-saving and life-enhancing applications, including automated external defibrillators, portable oxygen concentrators, ventilators and powered surgical tools, among others. Electrochem's portable medical product line sales were significantly enhanced through the Micro Power Electronics, Inc. ("Micro Power") acquisition in December 2011.

Our Acquisitions

On December 15, 2011, we acquired all of the outstanding stock of Micro Power headquartered in Beaverton, OR. Micro Power is a leading supplier of custom battery solutions, serving the portable medical, military and handheld automatic identification and data collection markets. Micro Power's commercial portfolio is highly complementary to the products and services offered by Electrochem. The results of Micro Power were included in our Electrochem segment from the date of acquisition. The aggregate purchase price of Micro Power was $71.8 million, which we funded with cash on hand and $45 million borrowed under our revolving credit facility. Total assets acquired from Micro Power were $88.2 million. Total liabilities assumed from Micro Power were $16.4 million. For the first nine months of 2012, Micro Power added approximately $62.8 million to our revenue.

On February 16, 2012, we purchased all of the outstanding common stock of NeuroNexus Technologies, Inc. ("NeuroNexus") headquartered in Ann Arbor, MI. NeuroNexus is an active implantable medical device design firm specializing in developing and commercializing neural interface technology, components and systems for neuroscience and clinical markets. NeuroNexus has an extensive intellectual property portfolio, core technologies and capabilities to support the development and manufacturing of innovative neural interface devices across a wide range of functions including neuromodulation, sensing, optical stimulation and targeted drug delivery applications. The results of NeuroNexus were included in our Implantable Medical segment from the date of acquisition. The aggregate purchase price of NeuroNexus was $13.2 million, which we funded with cash on hand and $10 million borrowed under our revolving credit facility. Total assets acquired from NeuroNexus were $14.6 million. Total liabilities assumed from NeuroNexus were $1.4 million. For the first nine months of 2012, NeuroNexus added approximately $1.7 million to our revenue.

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Our Customers

Implantable Medical customers include leading OEMs, in alphabetical order here and throughout this report, such as Biotronik, Boston Scientific, Johnson & Johnson, Medtronic, Smith & Nephew, Sorin Group, St. Jude Medical, Stryker and Zimmer. The nature and extent of our selling relationships with each OEM varies in terms of breadth of products purchased, purchased product volumes, length of contractual commitment, ordering patterns, inventory management and selling prices. During the nine months ended September 28, 2012, Boston Scientific, Johnson & Johnson, Medtronic and St. Jude Medical collectively accounted for 50% of our total Company sales.

Electrochem's customers are primarily companies involved in demanding markets with sophisticated total power solutions needs, such as in the portable medical and energy markets. Some of our larger OEM customers include Phillips Healthcare, Physio-Control, Covidien, Ethicon Endo-Surgery, Carefusion, Halliburton and Weatherford International.

Financial Overview

Third quarter 2012 sales increased 22% over the prior year period to $161.3 million. This increase was driven by our acquisitions, which added $21.6 million to sales, as well as growth of 13% in CRM/neuromodulation and 20% in vascular access revenue. Third quarter results also included the impact of foreign currency exchange rate fluctuations, which lowered orthopaedic sales by approximately $2 million in comparison to the prior year. On an organic constant currency basis, sales for the third quarter increased 8% versus the prior year as the benefits described above were partially offset by fewer customer product launches and development opportunities due to operational issues within our orthopaedic operations, which are aggressively being addressed through our consolidation initiatives. For the nine months ended September 28, 2012, sales increased 14% primarily due to our acquisitions, which added approximately $64.5 million to revenue, partially offset by foreign currency exchange rate fluctuations which lowered orthopaedic sales by approximately $6 million.

We prepare our consolidated financial statements in accordance with generally accepted accounting principles in the United States of America ("GAAP"). Additionally, we consistently report and discuss in our quarterly earnings releases and investor presentations adjusted operating income and margin, adjusted net income and adjusted earnings per diluted share. These adjusted amounts consist of GAAP amounts excluding the following adjustments to the extent they occur during the period: (i) facility consolidation, manufacturing transfer and system integration charges, (ii) asset write-down and disposition charges, (iii) severance charges in connection with corporate realignments or a reduction in force (iv) the impact of non-cash charges to interest expense due to the accounting change governing convertible debt, (v) unusual or infrequently occurring items, (vi) certain research and development expenditures (such as medical device design verification testing ("DVT") expenses in connection with our development of a neuromodulation platform), (vii) gain/loss on the sale of investments and (viii) the income tax (benefit) related to these adjustments. We believe that reporting these amounts provides important supplemental information to our investors and creditors seeking to understand the financial and business trends relating to our financial condition and results of operations. Additionally, certain performance-based compensation incentives provided to our executives are determined utilizing these adjusted amounts.

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A reconciliation of GAAP operating income to adjusted amounts is as follows (in thousands):

                                           Three Months Ended                                Nine Months Ended
                                  September 28,            September 30,           September 28,           September 30,
                                      2012                     2011                    2012                    2011
Operating income as
reported                        $           2,127         $        12,888         $        24,416         $        49,157
Adjustments:
Inventory step-up
amortization (COS)                             -                       -                      532                      -
Medical device DVT
expenses (RD&E)                             1,224                   1,639                   3,839                   2,863
Consolidation and
optimization costs                         14,778                     164                  20,801                     425
Integration expenses                          232                      -                    1,287                      -
Asset dispositions,
severance and other                           303                      23                   1,893                    (591 )

Adjusted operating income       $          18,664         $        14,714         $        52,768         $        51,854

Adjusted operating margin                    11.6 %                  11.2 %                  10.8 %                  12.1 %

GAAP operating income for the quarter and year-to-date periods of 2012 was $2.1 million and $24.4 million, respectively, compared to $12.9 million and $49.2 million, respectively, for the comparable 2011 periods. These decreases were primarily due to the charges recorded in connection with the consolidation of our Swiss orthopaedic operations, as well as other productivity initiatives (See Cost Savings and Consolidation Efforts section). As a result of the progress we have made on these initiatives, we now expect that our adjustments to non-GAAP operating income for 2012 will be $40 million to $45 million compared to the $20 million to $30 million estimate provided last quarter. It is important to note that, while we are increasing the 2012 estimate for these expenses, the overall estimate to complete our consolidation initiatives remains unchanged and the impact to our operating cash flows will be significantly less than the charges incurred.

Adjusted operating income was $18.7 million in the third quarter of 2012, compared to $14.7 million for the comparable 2011 period. This 27% increase was primarily a result of our increased revenue as well as the initiatives we began to implement in the second quarter to leverage our operating infrastructure, and optimize our net research, development and engineering ("RD&E") investments. This included the reallocation of RD&E resources to higher priority projects, the postponement of some RD&E projects, as well as the decision to pursue various alternatives to monetize some of our existing intellectual property that are outside our core business. As a result of these decisions, we expect RD&E for the second half of 2012 to be slightly lower than the first half. In comparison to the second quarter of 2012, net RD&E declined $0.9 million. For the first nine months of 2012, adjusted operating income was $52.8 million compared to $51.9 million for the 2011 period as the benefits described above were offset by the operational issues at our Swiss orthopaedic facilities.

Based upon our results for the first nine months of 2012, we still expect that revenue will be in line with our original guidance as the weakness we are seeing in our orthopaedics revenue is being offset by stronger than expected performance from our CRM and portable medical product lines. Consistent with last quarter, we expect that our full year 2012 adjusted operating income as a percentage of sales and adjusted diluted EPS will be at the lower end of our guidance provided at the beginning of the year due to lower than expected profitability from our Swiss operations. Overall, we estimate that the operational issues at our Swiss orthopaedic facilities decreased our adjusted diluted EPS for the first nine months of 2012 by approximately $0.13 per share versus the first nine months of 2011.

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GAAP and adjusted diluted EPS for the third quarter of 2012 were a loss of $0.32 and income of $0.46 per share, respectively, compared to $0.30 and $0.41 per share, respectively, for the third quarter of 2011. For the first nine months of 2012, GAAP and adjusted diluted EPS were $0.03 and $1.25 per share, respectively, compared to $1.16 and $1.29 per share, respectively, for the same period of 2011.

A reconciliation of GAAP net income (loss) and diluted EPS to adjusted amounts is as follows (in thousands, except per share amounts):

                                                          Three Months Ended                                      Nine Months Ended
                                              September 28,                September 30,              September 28,               September 30,
                                                   2012                         2011                       2012                        2011
                                                          Impact                     Impact                      Impact                      Impact
                                            Net            Per           Net           Per          Net           Per           Net           Per
                                           Income        Diluted        Income       Diluted       Income       Diluted        Income       Diluted
                                           (Loss)         Share         (Loss)        Share        (Loss)        Share         (Loss)        Share
Net income (loss) as reported              $(7,561)      $  (0.32 )    $  6,989     $    0.30     $    757      $   0.03      $ 27,483      $   1.16
Adjustments:
Inventory step-up amortization (COS)             -             -             -             -           346          0.01            -             -
Medical device DVT expenses (RD&E)              796          0.03         1,065          0.05        2,495          0.10         1,861          0.08
Consolidation and optimization
costs(a)                                     11,119          0.46           107            -        15,034          0.63           276          0.01
Integration expenses                            151          0.01            -             -           837          0.03            -             -
Asset dispositions, severance and
other                                           197          0.01            15            -         1,230          0.05          (384 )       (0.02 )
Gain on cost method investments,
net(b)                                         (228 )       (0.01 )          -             -          (228 )       (0.01 )      (2,751 )       (0.12 )
CSN conversion option discount
amortization(c)                               1,498          0.06         1,391          0.06        4,413          0.18         4,097          0.17
Swiss tax impact(d)                           5,008          0.21            -             -         5,008          0.21            -             -

Adjusted net income and diluted EPS(e)     $10,980       $   0.46      $  9,567     $    0.41     $ 29,892      $   1.25      $ 30,582      $   1.29

Adjusted diluted weighted average
shares(f)                                    24,011                      23,611                     23,924                      23,663

(a) Net of tax amounts computed using U.S. and foreign statutory tax rates of 35% and 22.5%, respectively, for items incurred in those geographic locations.

(b) Pre-tax amount is $350 thousand for both the quarter and year-to-date periods for 2012 and $4.2 million for the year-to-date period of 2011.

(c) Pre-tax amount is $2.3 million and $6.8 million for the 2012 quarter and year-to-date periods, respectively, and $2.1 million and $6.3 million for the 2011 quarter and year-to-date periods, respectively.

(d) Relates to the loss of our Swiss tax holiday due to our decision to discontinue manufacturing in Switzerland, as well as the establishment of a valuation allowance on our Swiss deferred tax assets as it is more likely than not that they will not be fully realized.

(e) The per share data in this table has been rounded to the nearest $0.01 and therefore may not sum to the total.

(f) Weighted average diluted shares for the third quarter of 2012 includes 365 thousand shares of dilution related to outstanding stock incentive awards that were not dilutive for GAAP EPS purposes.

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Our CEO's View

We continue to drive growth in our core business and benefited from favorable market trends and new product introductions within our portable medical product line. During the quarter, we continued to deepen our relationship with our larger OEM customers and successfully negotiated several long-term agreements which secured existing revenue streams, as well as expanded those relationships into other product lines. As we move forward, our goal is to continue to drive core growth through an increased focus on and investment in sales and marketing and the commercialization of our medical device pipeline. Additionally, we are focused on further improving profitability by leveraging our infrastructure and optimizing our research and development investment.

Key points about the third quarter of 2012 are as follows:

We have a high-growth portable medical product line.

We have added sales and marketing resources to our Implantable Medical segment focused on growing our revenues faster than the market.

We are aggressively addressing our Swiss orthopaedic issues with a consolidation plan that is on track to deliver improved operating results starting in early 2013.

We have reviewed and prioritized our RD&E investment with a goal of improving our return on invested capital both near-term and long term.

We will continue our on-going productivity efforts with suppliers, lean manufacturing processes and focused cost reductions.

We are aware of the large difference between our GAAP EPS and Adjusted EPS because of the expenses incurred for our productivity and consolidation initiatives. We expect the difference between GAAP and Adjusted EPS to be much smaller next year and to realize the productivity from our investments we are making this year.

We are confirming our adjusted diluted EPS guidance at the low end of the range and are cautiously optimistic for the fourth quarter given the continued challenges surrounding key CRM players.

Our cash flow from operations remains strong and continues to provide the funding needed to execute on all of our strategic objectives.

I am pleased with the progress we have made on our strategic objectives and remain confident that these initiatives will improve the long-term growth and profitability of our Company.

Product Development

Implantable Medical - As part of the natural evolution of our Company, in 2008, we reassigned 40 Greatbatch Medical engineers to create the QiG Group in order to help facilitate the development of complete medical devices for our customers. In creating QiG, we pooled and focused the tremendous talent, resources and capacity for innovation within our organization. Today, QiG encompasses approximately 120 research and development professionals working in facilities in six states and focused on three compelling therapeutic areas:
cardiovascular, neuromodulation and, longer-term, orthopaedics. Additionally, QiG has established partnerships with nearly a dozen key physicians who are highly specialized in these areas. These partnerships are helping us to design medical devices from the ground up with features that will meet the needs of today's practicing clinicians.

As a result of the investments we have made, we are now able to provide our customers with complete medical devices. This includes development and regulatory submissions, as well as manufacturing and supporting worldwide distribution. These medical devices are full product solutions that complement our OEM customers' products and utilize the component expertise and capabilities residing within Greatbatch. The benefits to our OEM customers include shortening the time to market for these devices by accelerating the velocity of innovation, optimizing their supply chain and ultimately providing them with cost efficiencies.

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Within QiG, we are utilizing a disciplined and diversified portfolio approach with three investment modes: strategic equity investments; OEM initiated medical device projects; and independent market driven medical device developments each to be sold by an OEM or distribution partner. The QiG Group employs a disciplined and thorough process for evaluating these opportunities. A scorecard process is utilized to review and select the most strategically valuable ideas to pursue, taking into account a host of variables, including the market opportunity, regulatory pathway and reimbursement, market need and market potential, intellectual property and projected financial return.

Today we have six strategic equity investments and have developed or are in the process of developing nearly a dozen medical devices in conjunction with our OEM partners, which are beginning to provide a return on the investment we have made. Additionally, we have four new medical devices that we are independently working on that are in various stages of development. While we do not intend to discuss each of these projects individually each quarter, we will discuss significant milestones as they occur. Some of the medical device projects that we currently are working on include:

Cardiovascular portfolio - Venous and arterial introducers, anti-microbial coatings, steerable delivery systems, and MRI conditional brady, gastric stimulation and sleep apnea leads. During 2012, we received U.S. Food and Drug Administration ("FDA") 510(k) clearance on our transradial catheter sheath introducer and steerable delivery sheath for atrial fibrillation ablation and received the CE mark for distribution of our transseptal needle that supports access and delivery of ablation therapies for atrial fibrillation.

Neuromodulation portfolio - With regards to Algostim, our spinal cord stimulator for the treatment of chronic pain in the trunk and limbs, during the second quarter of 2012, we provided an update on the timing of our premarket approval application ("PMA") submission given the extension of our DVT testing timeline. We continue to make strong technical progress on the development of this device and continue to retire critical milestones needed for program completion and the ultimate submission to regulatory authorities, which we still expect in the second half of 2013.

Additionally, we continue to receive strong interest from numerous world-class medical device companies, who appreciate the unique opportunity to market and distribute Algostim to interventional pain physicians, neurosurgeons and orthopaedic spine surgeons around the world. We believe Algostim's unique features and benefits will allow the right commercial partner to capture significant market share in today's $1.3 billion spinal cord stimulation market, which continues to see double digit market growth. We look forward to sharing more details regarding Algostim and our commercial partner progress as well as our other three devices that we are independently developing at our next investor day conference which will be scheduled early next year.

Approximately $0.5 million of the NeuroNexus purchase price in February 2012 was allocated to the estimated fair value of acquired IPR&D projects that expect to generate cash flows but have not yet reached technological feasibility, and thus were classified as an indefinite-lived intangible asset until the completion or abandonment of the associated projects. The value assigned to IPR&D related to the development of micro-electrodes for deep brain mapping and electrocorticography, and is expected to be commercialized by 2014. There have been no significant changes from our original estimates with regards to these projects.

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Electrochem - Electrochem continues to win new customers, new applications and next generation products. Our core competencies enable us to be well-positioned to win existing share and additional new product introductions based on our experience in packaging solutions, our customer relationships, our investment in technology and facilities, our capacity to service our customers, and our legacy of delivering highly reliable and innovative solutions to the medical marketplace.

The 2012 growth in Electrochem is being driven by successful product launches into the higher growth, higher value portable medical market. Gaining better access to this attractive market was one of the main drivers behind our acquisition of Micro Power as it provides us with a significant opportunity for growth given its $400 million market size.

Additionally, this market is benefiting from favorable market trends as patient care shifts from clinical settings to the home and as an aging population drives the need for lightweight and portable devices for patients and caregivers. These favorable trends are expected to allow this market to grow faster than our legacy markets over the next several years. Finally, this market is also attractive to us given that it has long product life cycles that should provide stability and diversification to our revenue base.

Cost Savings and Consolidation Efforts

In 2012 and 2011, we recorded charges in Other Operating (Income) Expense, Net in the Condensed Consolidated Statements of Operations related to cost savings and consolidation efforts. These initiatives were undertaken to improve our operational efficiencies and profitability. Additional information regarding the timing, cash flow and amount of future expenditures is set forth in Note 9 "Other Operating (Income) Expense, Net" of the Notes to the Condensed Consolidated Financial Statements contained in Item 1 of this report, as well as the "Liquidity and Capital Resources" section of this Item.

Over the last two years, we have been implementing a multi-faceted plan to further enhance, optimize and leverage our orthopaedics operations. This plan includes the construction of an orthopaedic manufacturing facility in Fort Wayne, IN, updating our Indianapolis, IN facility to streamline operations, increase capacity, and further expand capabilities, and in the third quarter of 2012, we finalized and initiated plans to transfer most major functions currently performed at our facilities in Orvin and Corgemont, Switzerland into our Fort Wayne, IN and Tijuana, Mexico facilities. The total capital investment expected for these initiatives is between $25 million and $35 million, of which $21 million has been expended to date. Total expense expected to be incurred for these initiatives is between $30 million and $36 million, of which $15.4 million has been incurred to date.

Near the end of 2011, we initiated plans to optimize and expand our manufacturing infrastructure in order to support our medical device strategy. This will include the transfer of certain product lines to lower cost . . .

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