Business Context and Reporting Period
Integra LifeSciences Holdings Corporation filed this unaudited Form 10-Q for the three and nine months ended September 30, 2011. Integra develops, manufactures and distributes medical devices in orthopedics, neurosurgery and instruments, with one reportable segment. The company operates globally, although the United States generated approximately 78% of third-quarter revenue and 76% of nine-month revenue.
Financial Performance and Liquidity
| Metric | Q3 2011 | Q3 2010 | 9M 2011 | 9M 2010 |
|---|---|---|---|---|
| Revenue | $202.2 million | $186.6 million | $576.6 million | $537.9 million |
| Gross margin | 61.1% | 62.9% | 62.5% | 63.4% |
| Operating income | $18.3 million | $27.3 million | $47.2 million | $74.5 million |
| Operating margin | 9.0% | 14.6% | 8.2% | 13.9% |
| Net income | $11.2 million | $16.5 million | $23.4 million | $46.9 million |
| Diluted EPS | $0.39 | $0.55 | $0.79 | $1.54 |
| Operating cash flow | Not separately provided | Not separately provided | $69.6 million | $77.1 million |
Revenue increased 8% in the quarter and 7% year to date. Orthopedics revenue increased 18% in the quarter and 11% year to date, primarily reflecting SeaSpine and orthobiologics growth. Neurosurgery revenue increased 4% in the quarter and 6% year to date. Instruments revenue declined slightly in the quarter but increased 3% year to date.
Gross margin declined because of higher orthopedic inventory write-offs and reserves, higher manufacturing costs, acquisition-related inventory amortization, product discontinuance costs and expenses associated with remediation at the Plainsboro, New Jersey facility. Selling, general and administrative expense increased 16% in the quarter and 18% year to date, while interest expense increased to $7.6 million in the quarter and $19.8 million year to date.
Cash and cash equivalents were $111.0 million at September 30, 2011, compared with $128.8 million at December 31, 2010. Working capital was $371.9 million, compared with $243.0 million at year-end 2010. Cash used in investing activities was $174.8 million, including $149.4 million for acquisitions and $25.4 million of capital expenditures. Financing activities provided $87.2 million, principally from convertible debt and warrant proceeds, partially offset by debt repayments, debt issuance costs and $69.0 million of treasury-stock purchases.
Borrowings under the revolving Senior Credit Facility were $192.5 million at a weighted-average rate of 1.7%, with approximately $407.5 million available. Long-term convertible securities had a carrying value of $349.1 million, including the $165.0 million 2012 Notes and the $230.0 million principal amount of 2016 Notes. Management stated that available cash and borrowing capacity should be sufficient for near-term operations, capital expenditures and potential acquisition payments.
Material Changes Versus the Prior Comparable Period
- Net income declined 32% in the quarter and 50% year to date, despite revenue growth.
- Operating margin fell approximately 5.6 percentage points in the quarter and 5.7 percentage points year to date.
- Interest expense increased $3.2 million in the quarter and $6.5 million year to date due to additional borrowings, the 2016 Notes, the interest-rate swap and related non-cash convertible-debt interest.
- SeaSpine was acquired in May 2011 for approximately $89.0 million, and Ascension Orthopedics was acquired in September 2011 for approximately $66.5 million. These acquisitions increased goodwill and identifiable intangible assets.
- The company issued $230.0 million of 1.625% convertible senior notes due 2016, received $28.5 million from related warrant transactions and repurchased $37.6 million of common stock in connection with the offering.
- Shares outstanding declined as a result of $69.0 million of share repurchases, including approximately 1.5 million shares during the first nine months.
Guidance, Outlook, Risks and Unusual Items
- Management expected full-year 2011 gross margin to be below 2010 levels because of acquisition-related inventory amortization and continued Plainsboro remediation, idle-time and underutilization costs.
- Management targeted 2011 research and development expense at approximately 6.5% to 7% of revenue and selling, general and administrative expense, excluding special charges, at 40% to 42% of revenue.
- Management expected a full-year 2011 effective tax rate of approximately 8.5%, versus 20.0% in 2010. The third-quarter rate was unusually low at 0.4%, partly due to a $0.8 million reversal of uncertain-tax-position accruals and a reduced full-year income projection.
- Special charges totaled $13.7 million in the quarter and $43.8 million year to date. They included ERP implementation costs, acquisition-related charges, CEO employment-contract stock compensation of $8.4 million, manufacturing remediation and idle-time costs, product discontinuance costs, intangible impairments and non-cash convertible-debt interest.
- The FDA issued Form 483 observations identifying quality-system violations at the Plainsboro collagen-device facility and the Burlington facility. Remediation was expected to continue through the fourth quarter and into early 2012. The FDA indicated it would not grant certain export certificates until identified violations were corrected; delays could restrict production, sales and international distribution.
- Management reported softness in extremity reconstruction, particularly foot and ankle and skin products. European healthcare austerity measures continued to pressure demand.
- Goodwill impairment testing in the second quarter resulted in no impairment, but the company recorded $1.6 million of technology-asset impairment, $0.9 million of brand-name impairment and $0.2 million of additional brand-name impairment or related charges during the year-to-date period.
- The company settled a Theken acquisition earnout dispute for $4.6 million in August 2011. A significant product-liability matter was also settled for approximately $4.6 million and was covered by insurance without a net income effect.
- Management stated that ordinary-course claims and proceedings were not expected to have a material adverse effect, but acknowledged that contingencies could materially affect a particular reporting period.
Important Facts for Investors to Verify
- Whether FDA remediation is completed on schedule and whether export certificates, production capacity or product availability are affected.
- The sustainability of revenue growth after separating SeaSpine and Ascension acquisition effects from organic growth.
- Whether gross-margin pressure from inventory amortization, manufacturing remediation, excess inventory and product discontinuances persists into 2012.
- The company’s ability to refinance or repay the $165.0 million 2012 Notes, which management classified as long term based on expected use of the Senior Credit Facility.
- The effect of higher leverage, convertible-note interest, warrant dilution and the $407.5 million of remaining credit availability on liquidity and earnings per share.
- The recurrence and cash impact of ERP implementation, acquisition integration, restructuring, rebranding and other special charges.
- Exposure to foreign exchange movements, European healthcare austerity, regulatory approvals, reimbursement requirements and product-liability claims.