Orthofix Medical Inc. annual report, FY2018

Orthofix Medical Inc. — FY 2018 Form 10-K

Reporting period: Fiscal year ended December 31, 2018; the filing also provides unaudited fourth-quarter results. Orthofix is a global musculoskeletal medical-device company with four reporting segments: Bone Growth Therapies, Spinal Implants, Biologics, and Orthofix Extremities. The company completed its change of domicile from Curaçao to Delaware on July 31, 2018.

Financial performance and position

Metric	FY 2018	FY 2017
Net sales	$453.0 million	$433.8 million
Gross profit / gross margin	$356.4 million / 78.7%	$340.8 million / 78.6%
Operating income / margin	$30.1 million / 6.6%	$40.8 million / 9.4%
Net income from continuing operations	$13.8 million	$7.3 million
Net income per diluted share	$0.72	$0.39
Net cash from operating activities	$49.9 million	$39.0 million
Free cash flow	$34.7 million	$22.0 million

Sales increased 4.4% reported and 3.9% at constant currency. Management’s non-GAAP net margin, defined as gross profit less sales and marketing expense, was $150.9 million, up 5.9%; it is not equivalent to GAAP operating profit.

FY 2018 segment sales were Bone Growth Therapies $195.3 million (+5.0%), Spinal Implants $91.7 million (+11.8%), Biologics $59.7 million (-4.8%), and Orthofix Extremities $106.4 million (+3.1%).

Unaudited Q4: Sales were $121.1 million versus $116.9 million in Q4 2017; operating income was $12.4 million versus $17.9 million; net income was $8.9 million versus $1.6 million. The filing does not provide Q4 cash-flow figures.

At year-end, cash and cash equivalents were $69.6 million and restricted cash was $2.6 million, compared with $81.2 million of cash and cash equivalents in 2017. Total assets were $466.6 million and shareholders’ equity was $335.4 million. There was no borrowing outstanding on the $125 million secured revolving credit facility; long-term debt was reported as zero. The Italian line of credit was also undrawn.

Material changes versus prior period

• Operating income fell $10.7 million despite higher sales and a slightly improved gross margin. General and administrative expense rose 17.5% to $84.5 million, including acquisition and domestication costs, higher share-based compensation, and legal-related costs; the company also recorded $3.1 million of expense from increased fair value of Spinal Kinetics contingent consideration.
• Net income from continuing operations rose 89.4%, helped in part by income tax expense declining to $9.1 million from $29.1 million. The 2017 tax expense included an $8.3 million charge related to U.S. tax reform; the 2018 effective tax rate was 39.7% versus 80.0%.
• Operating cash flow increased $10.9 million, primarily reflecting improved working-capital movements, including inventory. Investing cash outflow rose to $61.0 million, mainly due to the Spinal Kinetics acquisition.
• Biologics sales declined following a contractual reduction in MTF marketing fees, despite 3.3% growth in Trinity tissue volume. Spinal Implants growth included M6 disc sales following the acquisition, while legacy international sales faced distribution disruption.
• Adoption of the new revenue standard increased reported FY 2018 sales by $7.7 million and continuing-operations net income by $4.8 million compared with the company’s historical accounting method. Prior-year figures were not restated; the accounting change also increased opening retained earnings by $4.8 million.

Outlook, commentary, risks and unusual items

• No quantified company-wide revenue or earnings guidance is provided in the supplied filing text. Management described continued product launches, sales-force and market development, and investment in research and development as priorities. The company spent $33.2 million on R&D in 2018.
• Orthofix acquired Spinal Kinetics on April 30, 2018 for approximately $51.1 million cash at closing, plus potential milestone payments of up to $60 million. FDA approval of the M6-C artificial cervical disc followed on February 6, 2019, triggering a $15 million payment, paid February 14, 2019. The company planned a controlled, limited U.S. launch in 2019. Up to $45 million of additional revenue-based milestones may be payable.
• The company reported it did not expect to collect the complete principal and interest on its $15 million eNeura note, which matured March 4, 2019, and was negotiating a possible extension or modification. The note’s year-end fair value was $17.8 million; collection and valuation remain uncertain.
• Approximately $2.6 million of cash remained restricted following a Brazilian court order connected with an investigation into tender irregularities involving more than 30 companies. The company contested the order and stated it did not expect a material loss based on information then available.
• Other exposures include reimbursement and pricing pressure, device regulation and product liability, reliance on distributors and third-party tissue supplier MTF, foreign exchange, and potential changes to the Italian medical-device payback measure. The company accrued $3.7 million for that Italian measure, while noting the ultimate liability could differ.
• The company disclosed prior SEC/FCPA matters and a 2017 settlement, including $14.4 million of U.S. Government resolution charges recorded in 2016. The independent compliance consultant’s engagement concluded in March 2018. Management reported effective disclosure controls and internal control over financial reporting; the acquired Spinal Kinetics business was excluded from the 2018 internal-control assessment.
• CEO Bradley Mason entered a transition and retirement arrangement on February 25, 2019; he was to remain in role until a successor began and then provide transition consulting.

Important facts for investors to verify

• Track sales and profitability by segment, particularly whether Biologics fee reductions and Spinal Implants international distribution issues persist.
• Verify the commercial uptake and economics of the M6-C launch, including remaining revenue-based milestone obligations of up to $45 million.
• Follow collection, extension, conversion, or impairment outcomes for the eNeura note and the release of Brazil-restricted cash.
• Assess cash conversion and working-capital quality, including the rise in days sales outstanding to 63 days from 53 days; the filing attributes much of this increase to the revenue-standard adoption.
• Review the full audited financial statements and notes for legal contingencies, tax uncertainties, and acquisition accounting. Ernst & Young issued an unqualified opinion on the financial statements and internal control, with Spinal Kinetics excluded from the internal-control audit.