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WMGI > SEC Filings for WMGI > Form 10-Q on 1-May-2013All Recent SEC Filings

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Form 10-Q for WRIGHT MEDICAL GROUP INC


1-May-2013

Quarterly Report


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

General
The following management's discussion and analysis of financial condition and results of operations describes the principal factors affecting the results of our operations, financial condition, and changes in financial condition for the three month period ended March 31, 2013. This discussion should be read in conjunction with the accompanying unaudited financial statements, our Annual Report on Form 10-K for the year ended December 31, 2012, which includes additional information about our critical accounting policies and practices and risk factors, and Note 1 of Part I of this Quarterly Report and Part II, Item 1A.
Executive Overview
Company Description. We are a global orthopaedic medical device company operating as two reportable business segments based on the two primary markets that we operate within: Extremities and OrthoRecon. We specialize in the design, manufacture and marketing of devices and biologic products for extremity, hip, and knee repair and reconstruction.
Our Extremities segment includes products that are used primarily in foot and ankle repair, upper extremity products, and biologics products, which are used to replace damaged or diseased bone, to stimulate bone growth and to provide other biological solutions for surgeons and their patients. Extremity hardware includes implants and other devices to replace or reconstruct injured or diseased joints and bones of the foot, ankle, hand, wrist, elbow and shoulder, which we generally refer to as either foot and ankle or upper extremity products. We are a leading provider of surgical solutions for the foot and ankle market. Our extensive foot and ankle product portfolio, our approximately 200 specialized foot and ankle sales representatives, and our increasing level of training of foot and ankle surgeons has resulted in us being a recognized leader in the foot and ankle market. Biologics are used to repair or replace damaged or diseased bone, to stimulate bone growth and to provide other biological solutions for surgeons and their patients.
Our OrthoRecon segment includes products that are used primarily to replace or repair knee, hip and bones that have deteriorated or have been damaged through disease or injury. Reconstructive devices are used to replace or repair knee, hip and other joints and bones that have deteriorated or been damaged through disease or injury.
We have been in business for over 60 years and have built a well-known and respected brand name.
Our corporate headquarters and U.S. operations are located in Arlington, Tennessee, where we conduct research and development, sales and marketing administration, manufacturing, warehousing and administrative activities. Outside the U.S., we have distribution and administrative facilities in Amsterdam, the Netherlands, and sales and distribution offices in Canada, Japan and throughout Europe. As of December 31, 2012, through a combination of our direct sales offices and approximately 80 stocking distribution partners, we have approximately 750 international sales representatives that sell our products in approximately 60 countries.
Principal Products. We primarily sell devices and biologic products for extremity, hip, and knee repair and reconstruction. We specialize in extremity and biologic products used by extremity focused surgeon specialists for the reconstruction, trauma, and arthroscopy markets. Our biologics sales encompass a broad portfolio of products designed to stimulate and augment the natural regenerative capabilities of the human body. We also sell orthopaedic products not considered to be part of our knee, hip, extremity, or biologic product lines.
Significant Quarterly Business Developments. Net sales decreased 5.0% in the first quarter of 2013 to $120.4 million, compared to net sales of $126.7 million in the first quarter of 2012 driven primarily by the impact of U.S. OrthoRecon customer losses during 2012, price decreases in Japan that were effective in the second quarter of 2012, and unfavorable currency exchange rates, partially offset by an 18% increase in global foot and ankle sales. In the first quarter of 2013, we recorded net income of $8.4 million, compared to net income of $4.6 million for the first quarter of 2012.
Items favorably impacting net income in the first quarter of 2013 as compared to the first quarter of 2012 included:
• a $0.9 million ($0.5 million net of taxes) decrease in restructuring charges;

• a $7.8 million ($7.8 million net of taxes) gain on our previously held investment in BioMimetic;

• a $19.4 million ($11.9 million net of taxes) increase in management's estimate of the Company's probable insurance recovery for previously recognized costs associated with product liability claims; and

• a $1.8 million ($0.7 million net of taxes) decrease in expenses associated with the deferred prosecution agreement and U.S. governmental inquiries.

Items unfavorably impacting net income in the first quarter of 2013 included:


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• charges of $7.5 million ($6.1 million net of taxes) for due diligence and transaction costs associated with our acquisition of BioMimetic;

• charges of $1.6 million ($1.0 million net of taxes) associated with transitioning a major portion of our U.S. independent distributor foot and ankle territories to direct employee sales representation;

• non-cash interest expense of $2.1 million ($1.3 million net of taxes) associated with the our 2017 Convertible Notes;

• an unrealized loss of $2.0 million ($1.2 million net of taxes) associated with the mark-to-market adjustment on our derivative assets and liabilities;

• decreased profitability in our OrthoRecon segment, primarily driven by sales declines; and

• decreased profitability in our Extremities business, primarily driven by investments in our direct U.S. foot and ankle sales force and a $1.6 million operating loss associated with the acquired BioMimetic business.

Our Extremities segment sales increased 6% in the first quarter of 2013, as an 18% increase in foot and ankle sales, driven by the continued success of our CLAW® II Polyaxial Compression Plating System and our ORTHOLOCTM 3Di Reconstruction Plating System, both launched in the first and second quarters of 2012, respectively, was partially offset by a 10% decline in our biologics business and a 7% decline in upper extremity sales.
Our OrthoRecon segment sales decreased 13% in the first quarter of 2013, driven primarily by U.S. customer losses during the latter part of 2012, unfavorable pricing in Japan that went into effect in the second quarter of 2012, and unfavorable currency exchange rates.
Geographically, our first quarter domestic sales were down 3%, as a 17% increase in foot and ankle sales was offset by a 7% decline in hip sales, 14% decline in biologics sales, a 19% decline in knee sales and a 7% decline in upper extremity sales.
Our international sales decreased 7% to $52.6 million in the first quarter of 2013, compared to $56.6 million in the first quarter of 2012, primarily due to a 17% decline in Japan as well as a $2.1 million unfavorable impact from currency exchange rates.
During the quarter ended March 31, 2013, we became subject to a 2.3% excise tax on U.S. sales of medical devices, as prescribed in the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act. This tax had a negative impact on our profitability.
On March 1, 2013, we completed our acquisition of BioMimetic Therapeutics, Inc. (BioMimetic). The transaction combines BioMimetic's biologics platform and pipeline with our established sales force and product portfolio, to further accelerate growth opportunities in our Extremities business. We previously announced plans on November 19, 2012 to acquire BioMimetic Therapeutics, Inc. for an upfront purchase price of approximately $190 million in cash and stock plus additional milestone payments of up to approximately $190 million in cash, which are payable upon receipt of FDA approval of Augment® Bone Graft and upon achieving certain revenue milestones.
In conjunction with the closing of the transaction, we paid $33.2 million in cash, net of cash acquired, and approximately 7.0 million shares of Wright common stock and 28.1 million contingent value rights (CVRs) were issued. See Note 2 to our condensed consolidated financial statements for further information regarding this acquisition.
Opportunities and Challenges. We believe that we have an opportunity to transform our business to increase our foot and ankle revenue growth rates and increase our cash generation through significant reduction of our inventories. We have made changes to attempt to realize these opportunities, including aggressively converting a portion of our U.S. independent distributor foot and ankle territories to direct employee sales representation, substantially increasing our investment in foot and ankle medical education to drive market adoption of new products and technologies, and implementing steps to significantly reduce inventories over the next several years. With the acquisition of BioMimetic, we have an opportunity to transform our biologics business and further accelerate growth in our Extremities segment. These transformational changes for our business have required significant investment; however, we believe these investments will improve the performance of our business in the longer term.
Our U.S. OrthoRecon business has been unfavorably affected by the 2011 distributor transitions and challenges associated with implementing enhancements to our compliance processes announced in the third quarter of 2011, and our U.S. sales force conversion in 2012. Further, we expect that our U.S. and international businesses will continue to be unfavorably affected by the market conditions and conditions affecting European healthcare systems being experienced throughout the hip and knee industry, including procedural growth rates below historical levels and pricing declines.
Significant Industry Factors. Our industry is affected by numerous competitive, regulatory, and other significant factors. The growth of our business relies on our ability to continue to develop new products and innovative technologies, obtain regulatory clearance and compliance for our products, protect the proprietary technology of our products and our manufacturing processes, manufacture our products cost-effectively, respond to competitive pressures specific to each of our geographic markets, including our ability to enforce non-compete agreements, and successfully market and distribute our products in a profitable manner. We,


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and the entire industry, are subject to extensive governmental regulation, primarily by the FDA. Failure to comply with regulatory requirements could have a material adverse effect on our business. Additionally, our industry is highly competitive and has recently experienced increased pricing pressures, specifically in the areas of reconstructive joint devices.
In December 2007, we received a subpoena from the United States Department of Justice (DOJ) through the United States Attorney's Office for the District of New Jersey (USAO) requesting documents for the period January 1998 through the present related to any consulting and professional service agreements with orthopaedic surgeons in connection with hip or knee joint replacement procedures or products. This subpoena was served shortly after several of our knee and hip competitors agreed with the DOJ to resolutions of similar investigations. On September 29, 2010, WMT, entered into a 12-month Deferred Prosecution Agreement (DPA) with the USAO and a Civil Settlement Agreement (CSA) with the United States. Under the DPA, the USAO filed a criminal complaint in the United States District Court for the District of New Jersey (Court) charging WMT with conspiracy to commit violations of the Anti-Kickback Statute (42 U.S.C. § 1320a-7b) during the years 2002 through 2007. The Court deferred prosecution of the criminal complaint during the term of the DPA and the USAO agreed that if WMT complied with the DPA's provisions, the USAO would seek dismissal of the criminal complaint.
Pursuant to the CSA, WMT settled civil and administrative claims relating to the matter for a payment of $7.9 million without any admission by WMT. In conjunction with the CSA, WMT also entered into a five year Corporate Integrity Agreement (CIA) with the Office of the Inspector General of the United States Department of Health and Human Services (OIG-HHS). Pursuant to the DPA, an independent monitor reviewed and evaluated WMT's compliance with its obligations under the DPA. The DPA and the CIA were filed as Exhibits 10.3 and 10.2, respectively, to our current report on Form 8-K filed on September 30, 2010. The DPA was also posted to our website. Each of the DPA and the CIA could be modified by mutual consent of the parties thereto.
On September 15, 2011, WMT reached an agreement with the USAO and the OIG-HHS under which WMT voluntarily agreed to extend the term of its DPA for 12 months, to September 29, 2012. On September 15, 2011, WMT also agreed with the OIG-HHS to an amendment to the CIA under which certain of WMT's substantive obligations under the CIA would begin on September 29, 2012, when the amended DPA monitoring period expired. The term of the CIA has not changed, and will expire as previously provided on September 29, 2015.
On October 4, 2012, the USAO issued a press release announcing that the amended DPA had expired on September 29, 2012, that it had moved to dismiss the criminal complaint against WMT because WMT had fully complied with the terms of the DPA, and that the Court had ordered dismissal of the complaint on October 4, 2012. The DPA imposed, and the CIA continues to impose, certain obligations on WMT to maintain compliance with U.S. healthcare laws, regulations and other requirements. Our failure to do so could expose us to significant liability including, but not limited to, exclusion from federal healthcare program participation, including Medicaid and Medicare, which would have a material adverse effect on our financial condition, results of operations and cash flows, potential prosecution, civil and criminal fines or penalties, and additional litigation cost and expense.
In addition to the USAO and OIG-HHS, other governmental agencies, including state authorities, could conduct investigations or institute proceedings that are not precluded by the terms of the settlements reflected in the DPA and the CIA. In addition, the settlement with the USAO and OIG-HHS could increase our exposure to lawsuits by potential whistleblowers, including under the federal false claims acts, based on new theories or allegations arising from the allegations made by the USAO. The costs of defending or resolving any such investigations or proceedings could have a material adverse effect on our financial condition, results of operations and cash flows.
The successful implementation of our enhanced compliance program requires the full and sustained cooperation of our employees, distributors, and sales agents as well as the healthcare professionals with whom they interact. These efforts may require increased expenses and additional investments. We may also encounter inefficiencies in the implementation of our new compliance enhancements, including delays in medical education, research and development projects, and clinical studies, which may unfavorably impact our business and our relationships with customers.
A detailed discussion of these and other factors is provided in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2012 and elsewhere in this Quarterly report.
We market metal-on-metal hip (MoM) arthroplasty systems. On June 27 and June 28, 2012, FDA's Orthopaedic and Rehabilitation Devices Panel of the Medical Devices Advisory Committee met and discussed the safety and effectiveness of MoM hip arthroplasty systems. FDA sought expert scientific and clinical opinion on the risks and benefits of MoM hip arthroplasty systems from the Committee and the public. In January 2013, the FDA proposed a new regulation requiring that all MoM hip implants undergo the full PMA process, with supportive clinical data. This regulation applies to currently marketed devices, as well as those entering the market for the first time. FDA has not provided a date for final implementation and enforcement of this new requirement.


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Results of Operations
Comparison of three months ended March 31, 2013 to three months ended March 31,
2012
The following table sets forth, for the periods indicated, our results of
operations expressed as dollar amounts (in thousands) and as percentages of net
sales:
                                                  Three Months Ended March 31,
                                                2013                        2012
                                        Amount      % of Sales      Amount     % of Sales
Net sales                             $ 120,355        100.0 %    $ 126,656        100.0 %
Cost of sales 1                          38,275         31.8 %       36,806         29.1 %
Cost of sales - restructuring                 -            - %          435          0.3 %
Gross profit                             82,080         68.2 %       89,415         70.6 %
Operating expenses:
Selling, general and administrative 1    64,993         54.0 %       72,348         57.1 %
Research and development 1                6,756          5.6 %        6,221          4.9 %
Amortization of intangible assets         2,097          1.7 %          742          0.6 %
Restructuring charges                         -            - %          443          0.3 %
Total operating expenses                 73,846         61.4 %       79,754         63.0 %
Operating income                          8,234          6.8 %        9,661          7.6 %
Interest expense, net                     3,945          3.3 %        1,807          1.4 %
Other (income) expense, net              (5,751 )       (4.8 %)         161          0.1 %
Income before income taxes               10,040          8.3 %        7,693          6.1 %
Provision for income taxes                1,605          1.3 %        3,132          2.5 %
Net income                            $   8,435          7.0 %    $   4,561          3.6 %


__________________________


1 These line items include the following amounts of non-cash, stock-based compensation expense for the periods indicated:

                                                        Three Months Ended March 31,
                                              2013        % of Sales        2012        % of Sales
Cost of sales                             $      333          0.3 %     $      346          0.3 %
Selling, general and administrative            4,103          3.4 %          1,886          1.5 %
Research and development                         182          0.2 %            151          0.1 %

The following table sets forth our net sales by product line for the periods indicated (in thousands) and the percentage of year-over-year change:

Three Months Ended March 31,
                       2013            2012      % Change
OrthoRecon
Hips              $    35,497       $  41,500     (14.5 %)
Knees                  27,812          31,082     (10.5 %)
Other                     753           1,201     (37.3 %)
Total OrthoRecon       64,062          73,783     (13.2 %)

Extremities
Foot and Ankle         35,077          29,627      18.4 %
Upper Extremity         6,062           6,545      (7.4 %)
Biologics              13,657          15,187     (10.1 %)
Other                   1,497           1,514      (1.1 %)
Total Extremities      56,293          52,873       6.5 %

Total Sales       $   120,355       $ 126,656      (5.0 %)


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The following table presents net sales by geographic area (in thousands):

Three Months Ended March 31,
                      2013             2012      % Change
Geographic
Domestic        $     67,805        $  70,062      (3.2 %)
International         52,550           56,594      (7.1 %)
Total net sales $    120,355        $ 126,656      (5.0 %)

Net Sales
Extremities Segment. Net sales in our Extremities segment totaled $56.3 million in the first quarter of 2013, as compared to $52.9 million in the first quarter of 2012. The 6% increase in our Extremities segment was driven by 18% growth in our foot and ankle business, offset by a 10% decline in our biologics business and a 7% decline in upper extremities.
Our foot and ankle net sales increased to $35.1 million in the first quarter of 2013, representing growth of 18% over the first quarter of 2012. Domestically, foot and ankle product sales increased 17% over the first quarter of 2012, due to the continued success of our ORTHOLOCTM 3Di Reconstruction Plating System and our CLAW® II Polyaxial Compression Plating System, launched in the second and first quarters of 2012, respectively, as well as continued growth of our INBONETM Total Ankle Arthroplasty products. Our international foot and ankle sales grew 27% as a result of increased sales in Europe primarily driven by the acquisition of a foot and ankle business in the first quarter of 2013. Upper extremity net sales decreased to $6.1 million in the first quarter of 2013, representing a decline of 7% over the first quarter of 2012, driven by a 7% decline in the U.S.
Net sales of our biologics products totaled $13.7 million in the first quarter of 2013, representing a 10% decrease from the first quarter of 2012. In the U.S., our biologics sales decreased 14% in 2013, due to lower sales volume. OrthoRecon Segment. Net sales in our OrthoRecon segment totaled $64.1 million in the first quarter of 2013, as compared to $73.8 million in the first quarter of 2012, a 13% decline.
Our hip product net sales totaled $35.5 million during the first quarter of 2013, representing a 14% decrease from the prior year. Our domestic hip sales decreased 7% over prior year primarily due to a 6% decrease in volume as the result of customer losses during 2012. Internationally, hip sales declined 18% from the prior year, driven primarily by a 9% price decline in Japan as a result of lower governmental reimbursement rates and the conversion of our Belgium subsidiary to a stocking distributor in the second quarter of 2012, as well as the negative impact of $1.6 million of unfavorable currency exchange rates. Our knee product net sales decreased 11% to $27.8 million in the first quarter of 2013 from $31.1 million during the same period in 2012. Domestically, knee sales decreased 19% from prior year, primarily attributable to a 16% decrease in sales volume as the result of lost customers during 2012 and sales dis-synergies related to the U.S. sales force conversion initiative during 2012. International knee sales decreased 2% over prior year as increased sales to stocking distributors were more than offset by a 10% price decline in Japan and $0.4 million of unfavorable currency exchange rates. Cost of Sales
Our cost of sales as a percentage of net sales increased to 31.8% in the first quarter of 2013, as compared to 29.1% in the first quarter of 2012, primarily due to unfavorable geographic and product mix, and unfavorable currency exchange rates. Our cost of sales and corresponding gross profit percentages can be expected to fluctuate in future periods depending upon changes in our product sales mix and prices, distribution channels and geographies, manufacturing yields, period expenses, levels of production volume, cost of raw materials, and currency exchange rates.
Selling, General and Administrative
Our selling, general and administrative expenses as a percentage of net sales totaled 54.0% in the first quarter of 2013, compared to 57.1% in the first quarter of 2012. Selling, general and administrative expense for the first quarter of 2013 included a benefit of $19.4 million related to a change to management's estimate of our probable insurance recovery for previously recognized costs associated with product liability claims (16.1% of net sales) (see Note 10 to our condensed consolidated financial statement for further discussion), and $1.1 million of U.S. governmental inquires costs (0.9% of net sales), $2.3 million (1.9% of net sales) of non-cash stock-based compensation expense related to the conversion of fully vested BioMimetic options into Wright options, $7.5 million of due diligence and transaction and transition costs related to our acquisition of BioMimetic (6.2% of net sales), and $0.4 million of cost related to distributor transition agreements (0.3% of net sales). Selling, general and administrative expense for the first quarter of 2012 included $2.9 million of U.S. government inquiries/DPA related costs (2.3% of net sales). The remaining


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increase is the result of increased sales and marketing costs as a result of our initiative to convert a substantial portion of our U.S. foot and ankle sales force to direct employees, expenses associated with the acquired BioMimetic business, the impact of the enacted 2.3% excise tax on U.S. sales of medical devices, and the impact of fixed general and administrative expenses in relation to a lower level of sales.
Research and Development
Our investment in research and development activities represented approximately 5.6% of net sales in the first quarter of 2013, as compared to 4.9% of net sales in the first quarter of 2012. Our research and development expenses include $0.2 million (0.2% of net sales) of non-cash, stock-based compensation expense in the first quarter of 2013 and $0.2 million (0.1% of net sales) of non-cash, stock-based compensation expense in the first quarter of 2012. The increase in research and development costs as a percentage of net sales is attributable to spending associated with the acquired BioMimetic business and relatively flat spending in relation to lower sales.
Amortization of Intangible Assets
Charges associated with the amortization of intangible assets totaled $2.1 million (1.7% of net sales) in the first quarter of 2013, as compared to $0.7 million (0.6% of net sales) in the first quarter of 2012. $1.4 million of the increase is attributable to amortization expense associated with distributor non-compete agreements entered into during the second and third quarters of 2012. Based on the intangible assets held as of March 31, 2013, we expect to recognize amortization expense of approximately $7.7 million for the full year of 2013, $5.3 million in 2014, $2.9 million in 2015, $2.2 million in 2016, and $2.0 million in 2017. Based upon our preliminary value of IPR&D, we anticipate an increase in amortization expense of approximately $10 million per year upon approval of Augment® Bone Graft.
Interest Expense, Net
Interest expense, net, consists of interest expense of $4.0 million during the first quarter of 2013 and $1.9 million during the first quarter of 2012, offset by interest income of $0.1 million during the first quarter of 2013 and 2012. Our interest expense during the first quarter of 2013 relates primarily to $1.5 million of interest expense on our 2017 Notes and $2.1 million of non-cash interest expense associated with the amortization of the discount on our 2017 Notes. Our interest income is generated by our invested cash balances and investments in marketable securities. The amounts of interest income we expect to realize in 2013 and beyond are subject to variability, dependent upon both . . .

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