Orthofix Medical Inc. annual report, FY2015

Business context and reporting period

Orthofix International N.V. (the filing identifies the registrant as Orthofix International N.V., not Orthofix Medical Inc.) filed this Form 10-K for the fiscal year ended December 31, 2015. The global medical-device company operates BioStim, Biologics, Extremity Fixation and Spine Fixation businesses. Revenue comes from product sales and marketing fees, including fees associated with tissue products marketed with the Musculoskeletal Transplant Foundation.

Financial performance and liquidity

• Reported sales declined 1.4%; excluding currency effects, sales increased 2.4%. Foreign exchange reduced 2015 sales by $15.3 million.
• Sales by SBU: BioStim $165.0 million (+6.6% reported), Biologics $59.8 million (+7.1%), Extremity Fixation $96.0 million (-12.4% reported; +1.0% constant currency), and Spine Fixation $75.7 million (-7.8%).
• Sales and marketing expense rose 6.9% to $178.1 million; general and administrative expense rose 10.2% to $87.2 million. Research and development expense was $26.4 million, versus $25.0 million.
• Income-tax expense was $10.8 million despite $8.5 million of pretax income, producing a 127.5% effective tax rate. The filing attributes the elevated rate principally to losses in jurisdictions where tax benefits could not be recognized and valuation allowances.
• Cash and cash equivalents were $63.7 million at year-end, versus $36.8 million; current assets were $212.3 million and current liabilities $82.0 million. Total assets were $400.2 million and shareholders’ equity $290.3 million.
• No borrowings were outstanding under the new $125 million secured revolving facility at year-end; the company reported no long-term debt. The facility matures in August 2020 and carries leverage and interest-coverage covenants.
• Investing cash outflow was $38.3 million, including the $15.3 million eNeura note investment and $27.9 million of capital expenditures. Financing cash inflow was $25.1 million, including release of restricted cash; the company repurchased $11.6 million of shares.
• Fourth-quarter 2015 sales were $104.6 million, operating income $7.4 million and net income $3.4 million. In Q4 2014, sales were $100.3 million, operating income $4.0 million and net loss $5.8 million.

Changes, outlook and significant matters

• Gross margin improved by 2.8 percentage points, reflecting mix shift toward BioStim and Biologics, improved inventory management and operating efficiencies. Operating income nevertheless declined as operating expenses increased.
• Management reported a 20% expansion of the U.S. sales team and six significant product launches plus four line extensions in 2015. For 2016, it aimed to grow each SBU faster than its market, introduce new products, improve operating leverage and reduce SG&A as a proportion of sales. No specific revenue or earnings guidance was provided.
• Project Bluecore, a systems, processes and controls initiative, was expected to continue through 2016; the U.S. ERP rollout was planned for Q2 2016. The filing gives approximately $6 million as the 2016 Bluecore budget and expects about 85% of the investment to be capitalized. Management also planned approximately $15–18 million of 2016 capital expenditures overall.
• Accounting reviews led to two multi-year restatements, completed in March 2014 and March 2015. The SEC investigation remained ongoing. A securities class-action settlement had preliminary court approval, with final approval then scheduled for April 28, 2016; insurers had undertaken to cover the settlement payment, subject to approval.
• The DOJ extended the company’s deferred prosecution agreement through July 17, 2016, citing insufficient compliance efforts during the first 18 months, while investigating allegations of potential improper payments involving the Brazil subsidiary. The company also remained subject to a five-year healthcare Corporate Integrity Agreement.
• The company accrued a $4.0 million settlement with Mexico’s IMSS, reached in February 2016, consisting of $1.0 million cash and $3.0 million in products and training. Certain former Breg product-liability matters remain unresolved; a $5.7 million accrual covers specified cold-therapy liabilities, while possible losses on other claims could not be estimated.
• The eNeura convertible note had $15.0 million principal and 8% interest, with an exclusive acquisition option through September 2016. Its year-end fair value was $12.7 million, including a $3.3 million unrealized loss recorded in other comprehensive income. Management cautioned that repayment or acquisition success was uncertain.
• Management and the auditor concluded internal control over financial reporting was effective as of December 31, 2015; the auditor issued unqualified opinions on the financial statements and internal controls. Key risks also include reimbursement pressure, foreign exchange, Puerto Rico receivables, regulatory compliance, litigation and reliance on MTF for key tissue products.

Investor verification priorities

• Confirm subsequent outcomes of the SEC investigation, class-action settlement approval and Brazil-related DOJ review, including any financial or compliance consequences.
• Track constant-currency sales and the recovery of Extremity Fixation and Spine Fixation, alongside the sustainability of BioStim and Biologics growth and margin improvement.
• Verify cash generation, working-capital trends, capital spending, share repurchases and compliance with the secured facility’s covenants.
• Assess recoverability and developments in the eNeura note and acquisition option, and the status and potential cost of Breg indemnified claims.
• Review progress of Bluecore and the planned product launches, as well as the effect of reimbursement, currency and Puerto Rico credit conditions.