INTEGRA LIFESCIENCES HOLDINGS CORP quarterly report, Q2 FY2013

Integra LifeSciences Holdings Corporation — 2013 Q2 Form 10-Q

Reporting period: Three and six months ended June 30, 2013; filed August 1, 2013. Integra is a global medical-device company serving neurosurgery, orthopedics, regenerative medicine, spine, extremities, surgical instruments and related markets through five reportable segments.

Financial performance and liquidity

Metric	Q2 2013	Q2 2012	Six months 2013	Six months 2012
Revenue	$205.5 million	$210.2 million	$402.2 million	$406.4 million
Gross margin	59.6%	62.8%	59.4%	62.4%
Operating income	$8.0 million	$18.0 million	$7.9 million	$35.5 million
Operating margin	3.9%	8.6%	2.0%	8.7%
Net income (loss)	$3.4 million	$8.5 million	$(0.6) million	$15.2 million
Diluted EPS	$0.12	$0.30	$(0.02)	$0.53
Operating cash flow	Not separately provided	Not separately provided	$10.8 million	$34.6 million

Revenue declined 2.2% in the quarter and 1.0% year to date. Gross margin was pressured by product mix, recall-related inventory reserves, quality-system remediation and the 2.3% U.S. medical-device excise tax. Selling, general and administrative expense increased to $99.6 million in Q2 and $199.8 million year to date, driven by higher headcount, consulting, ERP implementation and strategic-project costs.

Cash and cash equivalents were $98.6 million at June 30, 2013, compared with $96.9 million at December 31, 2012. Working capital was $368.4 million, compared with $346.1 million at year-end. Inventory increased to $195.5 million from $171.8 million, contributing to the decline in operating cash flow.

Capital expenditures were $24.5 million in the first six months, and cash used in investing activities was $26.8 million. Financing activities provided $19.3 million, primarily from $20.0 million of new borrowings. The company reported no material off-balance-sheet arrangements.

Debt and capital resources

Senior Credit Facility borrowings were $341.9 million at a weighted-average rate of 2.0%, up from $321.9 million at December 31, 2012; approximately $258.1 million remained available.
The June 21, 2013 credit amendment increased the maximum consolidated total leverage ratio to 4.25 through June 30, 2014, stepping down to 4.00 through March 31, 2015 and 3.75 thereafter. The company was in compliance with its covenants at quarter-end.
The 2016 Convertible Senior Notes had $230.0 million principal outstanding and a $201.4 million carrying amount; they bear 1.625% interest and mature in December 2016.
The company had $98.6 million of cash, including $82.4 million held by non-U.S. subsidiaries. Potential U.S. tax consequences could arise if foreign cash were repatriated.
No shares were repurchased under the $75.0 million authorization; the full authorization remained available at June 30, 2013. The company has not paid cash dividends since formation.

Material changes versus the prior comparable period

Recall and supply disruption: A voluntary recall of specified collagen products manufactured in Añasco, Puerto Rico reduced six-month revenue by $3.1 million and caused backorders and product shortages. Management expected lower revenue in the third quarter than previously forecast.
Segment performance: Q2 revenue increased 5% in U.S. Extremities and 4% internationally, but declined 1% in U.S. Neurosurgery, 3% in U.S. Instruments and 12% in U.S. Spine and Other. Year-to-date revenue changes were +11%, +1%, -2%, -3% and -8%, respectively.
Profitability: Q2 operating income fell 56%; six-month operating income fell 78%. The six-month net loss reflected lower gross profit, higher operating expenses and other expenses, partly offset by lower interest expense.
Interest expense: Q2 interest expense decreased to $5.0 million from $7.1 million, and six-month expense decreased to $9.8 million from $15.0 million, primarily because the 2012 convertible notes were repaid in June 2012. This benefit was partly offset by increased revolving-credit borrowings.
Acquisition: The company acquired Tarsus Medical, Inc. in January 2013 for approximately $4.7 million, including contingent consideration. Management stated that the acquisition was not material to consolidated operating results.
ERP and special charges: Reported special charges totaled $14.9 million in Q2 and $29.9 million year to date, including ERP implementation, facility optimization, remediation, recall, acquisition-related and non-cash convertible-debt costs.

Guidance, outlook and management commentary

Management expected full-year 2013 gross margin of approximately 60% to 61%, below 2012 levels.
Management targeted research and development expense of approximately 6.0% of full-year revenue.
The expected full-year effective tax rate was approximately 4.5%, subject to changes in tax jurisdiction mix, research credits and tax-contingency releases.
Management expected approximately $7.0 million of 2013 quality-system remediation spending and expected the activities to be completed in the second half of 2013.
Planned 2013 capital expenditures were $55 million to $65 million, primarily for regenerative-medicine manufacturing capacity, existing-facility maintenance, ERP implementation and orthopedic instrument kits. Medical-device excise-tax payments were expected to be $9 million to $12 million.
Management expected most recall-related supply disruptions to be resolved by year-end and orthobiologics supply to return to normal by the end of the third quarter, but cautioned that customer losses and elevated backorders could persist.

Risks, contingencies and unusual items

FDA warning letters and remediation activities affected facilities in Plainsboro, New Jersey; Andover, England; and Añasco, Puerto Rico. An FDA inspection of the Plainsboro facility began July 16, 2013 and remained in progress at the time of filing.
The recall involved specific collagen-product lots that may have had process deviations and potentially elevated endotoxin levels. The company reported no patient injuries or adverse events attributable to the recalled products, but further supply, regulatory, litigation or financial effects remain possible.
Goodwill was $292.9 million at June 30, 2013. Management noted that continued deterioration in the U.S. Spine and Private Label reporting units, or revised forecasts, could result in a future impairment.
The U.S. Attorney’s Office for the District of New Jersey was investigating alleged improper billing activities involving three sales representatives in an Extremities Reconstruction region. The company stated that it was cooperating voluntarily and was not a subject or target at the filing date.
The company faces ordinary-course product liability, regulatory, employment and commercial claims. Management did not expect them to have a material adverse effect, although a particular period could be materially affected.
Interest-rate, foreign-currency, reimbursement, competitive, healthcare-cost-containment and medical-device regulatory risks remain significant. The interest-rate swap had a $120.0 million notional amount and a $3.0 million net liability at quarter-end.
On July 1, 2013, the company entered into a 20-year Plainsboro lease ending June 30, 2033, with annual rent of approximately $0.6 million plus approximately $0.3 million of taxes and operating expenses.

Key facts for investors to verify

Whether Añasco recall-related supply constraints, backorders and customer retention improved as projected in the second half of 2013.
The outcome of FDA inspections and warning-letter remediation at Plainsboro, Andover and Añasco, including any restrictions on manufacturing, exports or product distribution.
Whether U.S. Spine and Other performance returned to market levels and whether U.S. Spine and Private Label goodwill remained recoverable.
Actual cash generation relative to planned $55 million to $65 million of capital expenditures and $9 million to $12 million of medical-device excise-tax payments.
Compliance with the amended credit-facility leverage covenants as profitability and debt levels evolve.
The resolution and financial exposure, if any, associated with the U.S. Attorney’s investigation and other product, regulatory or litigation contingencies.