INTEGRA LIFESCIENCES HOLDINGS CORP annual report, FY2013

Integra LifeSciences Holdings Corporation — FY2013 Form 10-K Summary

Business context and reporting period

Integra is a global medical technology company providing products for neurosurgery, extremity reconstruction, spine surgery, wound care, regenerative medicine and surgical instruments. The filing covers the fiscal year ended December 31, 2013, with comparative results for 2012 and 2011. The company had approximately 3,300 employees and reported through five segments: U.S. Neurosurgery, U.S. Instruments, U.S. Extremities, U.S. Spine and Other, and International.

Regenerative medicine products represented approximately 23% of 2013 revenue. Management’s strategy emphasizes portfolio optimization, international expansion, acquisitions, facility consolidation, common operating systems and cost reduction.

Financial performance and key metrics

Metric	2013	2012	Change
Revenue	$836.2 million	$830.9 million	Up 1%
Gross profit	$502.1 million	$516.4 million	Down $14.3 million
Gross margin	60.0%	62.2%	Down 220 basis points
Operating income (loss)	$(3.6) million	$73.8 million	Declined $77.4 million
Net income (loss)	$(17.0) million	$41.2 million	Turned to a loss
Diluted EPS	$(0.60)	$1.44	Declined $2.04
Cash flow from operations	$53.3 million	$59.1 million	Down $5.8 million

Revenue by product category was $374.6 million for Orthopedics, $278.7 million for Neurosurgery and $182.9 million for Instruments.
Segment revenue increased 10% in U.S. Extremities to $134.7 million and 3% internationally to $189.7 million. U.S. Neurosurgery increased 1% to $172.3 million.
U.S. Instruments declined 2% to $159.6 million, while U.S. Spine and Other declined 6% to $179.9 million.
U.S. revenue was essentially flat at $642.7 million; international revenue increased approximately 3% to $193.5 million.
Operating expenses included $52.1 million of research and development, $394.3 million of selling, general and administrative expense, $12.7 million of intangible amortization and a $46.7 million goodwill impairment charge.
Operating cash flow was reduced by working-capital investment, particularly a $42.0 million increase in inventory. Capital expenditures were $47.9 million.
Cash and cash equivalents were $120.6 million at year-end, compared with $96.9 million at December 31, 2012. Working capital was $405.9 million.
Total assets were $1.196 billion and stockholders’ equity was $670.2 million at year-end.

Debt, liquidity and capital resources

Borrowings under the Senior Credit Facility were $186.9 million at December 31, 2013, with approximately $413.1 million of remaining availability. The weighted-average interest rate was 2.0%.
The company had $230.0 million principal amount of 1.625% convertible notes due December 2016; the carrying value of the liability component was $205.2 million.
The Senior Credit Facility and convertible notes mature in 2016. The company stated that it may seek to refinance or extend these obligations within the next 12 to 18 months.
In November 2013, Integra issued 4.025 million common shares for gross proceeds of $161.0 million and net proceeds of $152.5 million. The proceeds were used to repay Senior Credit Facility borrowings.
No shares were repurchased in 2013, and $75.0 million remained available under the repurchase authorization. The company has not paid cash dividends since formation.
Management stated that cash, expected operating cash flow and available credit capacity were sufficient for foreseeable working-capital, debt repayment and capital-expenditure needs for at least the next twelve months.

Material changes versus the prior comparable period

The 2013 results were materially affected by the voluntary recall of specified products manufactured at the Añasco, Puerto Rico facility. The recall reduced revenue by $3.4 million directly, created supply shortages and increased inventory reserves and quality costs.
The U.S. medical-device excise tax reduced gross margin by approximately 0.8 percentage points compared with 2012.
A $46.7 million non-cash goodwill impairment charge eliminated the goodwill balance of the U.S. Spine reporting unit. The impairment reflected lower projected revenue, operating income and cash flows, distributor turnover, delayed product introductions, operational issues and expected pricing pressure.
Operating expenses increased because of higher headcount, global ERP implementation costs and strategic consulting expenses. Total identified special charges increased to $102.6 million from $48.6 million in 2012.
Inventory increased to $213.4 million from $171.8 million, primarily reflecting supply preparations and facility-consolidation activities.
The Plainsboro, New Jersey FDA warning letter was closed effective September 24, 2013. However, the Añasco facility received six additional Form 483 observations in November 2013, and the Andover, England warning letter remained subject to remediation.
In January 2013, Integra acquired Tarsus Medical for approximately $4.7 million, including contingent consideration. The acquisition was not material to consolidated results.

Guidance, outlook, management commentary and risks

Management projected 2014 gross margin of 61% to 62%, subject to final purchase-price accounting for the Confluent Surgical acquisition.
Management expected 2014 research and development spending to be approximately 6% of revenue, selling, general and administrative expense to be 44% to 45% of revenue, and the worldwide effective tax rate to be approximately 21% to 22%.
Management planned 2014 capital expenditures of $45 million to $55 million, primarily for regenerative medicine capacity, existing facility support, ERP implementation and orthopedic instrument kits.
Facility consolidation and manufacturing-transfer activities were expected to continue in 2014, with benefits primarily expected in 2015 and beyond. Management cautioned that implementation costs, delays and execution issues could reduce the expected benefits.
On January 15, 2014, after the reporting period, Integra acquired Confluent Surgical from Covidien for $231.0 million, paid $4.0 million under a transitional supply agreement and could owe up to an additional $30.0 million subject to specified approvals and transition conditions. Integra borrowed $235.0 million under its credit facility to fund the acquisition.
Key risks include FDA and foreign regulatory compliance, remediation of the Añasco and Andover facilities, product recalls, dependence on selected suppliers and tissue banks, reimbursement and healthcare-cost pressures, competition, acquisition integration, goodwill and intangible-asset impairment, foreign currency exposure, ERP implementation and refinancing requirements.
The company was cooperating voluntarily with a U.S. Attorney’s Office inquiry concerning alleged improper billing by sales representatives in one extremities region. Management stated that the company was not a subject or target at the time of filing.
A licensor indicated that it would terminate an international extremities-product license effective October 20, 2014. Products under the agreement generated approximately $5.5 million of 2013 revenue, and the licensor was auditing Integra’s activities.
Management reported no material off-balance-sheet arrangements and stated that disclosure controls and internal control over financial reporting were effective as of December 31, 2013.

Most important facts for an investor to verify

Whether Añasco and Andover remediation has been completed to the FDA’s satisfaction and whether additional recalls, supply interruptions, penalties or export restrictions arise.
Whether the U.S. Spine business stabilizes after the $46.7 million goodwill impairment and whether further impairments or restructuring charges occur.
Whether the Confluent Surgical acquisition produces the expected growth and margin benefits without exceeding the company’s leverage and integration capacity.
How the company will refinance or repay the approximately $651.9 million of post-year-end borrowings and 2016 convertible-note obligations.
Whether gross-margin recovery, cost savings and facility-consolidation benefits meet management’s 2014 outlook.
The effect of reimbursement changes, medical-device taxes, pricing pressure and healthcare-provider consolidation on demand and profitability.
The outcome of the U.S. Attorney inquiry and the international license audit or termination.
Whether inventory levels normalize and operating cash flow improves after the 2013 recall and facility-preparation activities.