OrthoPediatrics Corp. — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Unaudited results; financial amounts below are in millions of dollars unless stated otherwise.
Business context
OrthoPediatrics designs and sells orthopedic implants and instruments for children. It sells primarily through independent sales agencies in the U.S. and distributors internationally, while expanding direct-to-hospital agency operations. The company began direct sales in Canada in September 2018. Its model requires substantial investment in consigned implant and instrument sets before related sales are realized.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $15.8 | $12.4 | $43.0 | $33.9 |
| Gross profit | $12.0 | $9.5 | $32.2 | $25.6 |
| Gross margin | 76% | 77% | 75% | 75% |
| Operating loss | $(1.2) | $(0.8) | $(7.7) | $(2.3) |
| Net loss | $(1.9) | $(1.5) | $(9.6) | $(4.1) |
| Operating cash flow | Not presented quarterly | Not presented quarterly | $(12.9) | $(3.9) |
Q3 revenue grew 28%; nine-month revenue grew 27%. Growth was mainly volume-driven, led by trauma and deformity and scoliosis products. U.S. revenue was $12.4 million for Q3 and $32.5 million year to date; international revenue was $3.4 million and $10.5 million, respectively. Sports medicine/other sales declined in both comparisons.
Q3 gross margin eased to 76% from 77%, which management attributed primarily to a higher share of international sales, including instrument sets. Nine-month gross margin was 75% in both years. Operating expenses increased faster than nine-month revenue: sales and marketing rose 32%, general and administrative rose 59%, and research and development rose 39%. G&A growth included higher stock compensation, legal expense, and staffing. Nine-month stock-based compensation was $2.9 million versus $1.1 million.
Liquidity, cash flow and debt
Cash was $24.5 million at September 30, 2018, down $18.1 million from $42.6 million at December 31, 2017. Nine-month operating cash use was $12.9 million, including working-capital use of $8.4 million, principally from increases in inventory ($6.1 million) and receivables ($4.1 million). Investing cash use was $5.5 million, primarily for instrument sets and equipment. Financing provided $0.2 million.
Current assets were $61.8 million and current liabilities $10.9 million. Total debt was $25.4 million, including $20.0 million term debt and $3.9 million drawn on a $15.0 million revolving facility with affiliate Squadron, plus a $1.4 million mortgage. The Squadron facilities bear interest at the greater of three-month LIBOR plus 8.61% or 10%, are secured by substantially all company assets, and mature in January 2023. Management stated that cash, expected operating receipts, and revolver availability should fund current and essential planned operations for more than 12 months. The company continues to report operating losses and had an accumulated deficit of $112.6 million.
Outlook, risks and other notable matters
- No specific revenue or earnings guidance was provided. Management expects near-term losses as it expands its product portfolio, sales infrastructure, and consigned sets.
- Revenue is typically higher during summer months and holiday periods; pediatric surgery timing can vary.
- International distributor collectability and product returns affect revenue recognition for certain customers. Inventory demand and product obsolescence are additional operating risks.
- K2M litigation alleges patent infringement involving instruments in the RESPONSE spine system. The district court case was stayed pending patent review proceedings; trials on two petitions were set for February 20, 2019. The company warned an adverse outcome could materially affect its business and financial condition.
- Royalties include commitments ranging from 0.5% to 20% of sales and minimum annual royalties of $0.5 million through 2026. Certain product-development milestone payments could not be quantified.
- The company adopted ASC 606 on January 1, 2018; it reported no material impact. Deferred tax assets remain fully offset by a valuation allowance, with no income tax benefit recognized.
Important facts for investors to verify
- Whether revenue growth and the stated volume gains continue, particularly in trauma and deformity, scoliosis, and newer direct-sales markets.
- Whether cash burn, inventory and receivables growth, and capital spending remain consistent with management’s greater-than-12-month liquidity assessment.
- Debt terms, interest expense, available revolver capacity, and the company’s reliance on its affiliate lender.
- Developments and potential financial or commercial effects of the K2M patent proceedings.
- Future gross-margin trends, stock-compensation expense, and other drivers of operating expense growth.