INTEGRA LIFESCIENCES HOLDINGS CORP annual report, FY2012

Integra LifeSciences Holdings Corporation: FY2012 Form 10-K Summary

Business Context and Reporting Period

Integra is a global medical technology company focused on neurosurgery, extremity reconstruction, spine, orthobiologics, regenerative medicine, surgical instruments and related products. The filing covers the fiscal year ended December 31, 2012, and was filed February 26, 2013. Beginning in 2012, management reported five segments: U.S. Neurosurgery, U.S. Instruments, U.S. Extremities, U.S. Spine and Other, and International.

Approximately 3,500 employees supported operations across the United States and international markets. Approximately 24% of 2012 revenue came from collagen-based regenerative medicine products. The company notes that fourth-quarter revenue is typically stronger because hospitals often purchase products near the end of their budget cycles.

Financial Performance and Key Metrics

Metric	2012	2011	Change
Revenue	$830.9 million	$780.1 million	+6.5%
Gross profit	$516.4 million	$480.9 million	+7.4%
Gross margin	62.2%	61.7%	+0.5 percentage points
Operating income	$73.8 million	$54.9 million	+34.4%
Income before taxes	$52.0 million	$28.5 million	+82.6%
Net income	$41.2 million	$28.0 million	+47.2%
Diluted earnings per share	$1.44	$0.95	+51.6%
Operating cash flow	$58.7 million	$104.3 million	-43.7%

Revenue by product category was $369.3 million for Orthopedics, $277.5 million for Neurosurgery and $184.0 million for Instruments. U.S. revenue increased 9% to $642.8 million, while international revenue was essentially flat at approximately $188.1 million, including a $6.8 million negative foreign-exchange effect.

Segment revenue was $171.3 million for U.S. Neurosurgery, $162.3 million for U.S. Instruments, $122.8 million for U.S. Extremities, $190.5 million for U.S. Spine and Other, and $183.9 million for International. U.S. Extremities was the fastest-growing segment, increasing 25%, while International revenue declined 1% as European hospital capital spending remained pressured.

Operating expenses included $51.0 million of research and development, $373.1 million of selling, general and administrative expense, and $18.5 million of intangible amortization. The effective tax rate was 20.8%, compared with 1.8% in 2011, when discrete tax benefits and other tax adjustments materially reduced the rate.

Liquidity, Debt and Cash Flow

• Cash and cash equivalents were $96.9 million at December 31, 2012, compared with $100.8 million at year-end 2011.
• Operating cash flow was $58.7 million. Investing cash flow was negative $79.3 million, including $69.0 million of capital expenditures. Financing cash flow was positive $12.1 million.
• The company borrowed $155.0 million under its senior credit facility and repaid the $165.0 million 2012 convertible notes at maturity, including $134.4 million classified as repayment of the liability component and approximately $30.6 million of accreted interest paid through operating cash flow.
• Revolver borrowings were $321.9 million at a weighted-average interest rate of 1.8%, with approximately $278.1 million of remaining borrowing capacity under the $600 million facility.
• The company had $230.0 million principal amount of 1.625% convertible senior notes due December 2016; the carrying value of the liability component was $197.7 million.
• Total contractual obligations were reported at $638.1 million, including convertible securities, revolver borrowings, interest, leases and purchase obligations.
• Working capital was $346.1 million at year-end 2012. Management stated that cash, expected operating cash flow and available revolver capacity should satisfy foreseeable requirements for at least the next twelve months.

Material Changes Versus the Prior Comparable Period

• Revenue growth was driven principally by U.S. operations, acquisitions, strong Extremities and Orthobiologics demand, and growth in spine hardware. The Ascension and SeaSpine acquisitions contributed to the year-over-year comparison.
• Gross margin improved from 61.7% to 62.2%, primarily because of favorable product mix and lower amortization, partially offset by quality-process and FDA remediation spending.
• Operating income and net income improved substantially, partly because 2011 included $13.3 million of incremental stock-based compensation related to executive changes.
• Operating cash flow declined materially because of the repayment of accreted interest on the 2012 notes and a $29.8 million tax-withholding payment related to the settlement of deferred equity compensation for former CEO Stuart Essig.
• Total special charges declined to $48.6 million from $65.5 million in 2011. Major 2012 items included $16.4 million for global ERP implementation, $10.1 million for facility optimization, $7.9 million for Plainsboro remediation and related underutilization, and $8.5 million of non-cash convertible debt interest.
• Management changed the reporting structure to five segments and implemented a revised goodwill testing date. No goodwill impairment was identified, although U.S. Spine goodwill had only approximately 13% excess fair value over carrying value in the annual test.

Guidance, Outlook, Risks and Unusual Items

• Management expected 2013 gross margin to remain approximately 63%, research and development spending to be 6.5% to 7% of revenue, and the effective tax rate to be approximately 17%.
• 2013 capital expenditures were expected to be $55 million to $65 million, primarily for regenerative medicine manufacturing capacity, plant maintenance, ERP implementation and orthopedic instrument kits.
• The company expected to pay approximately $9 million to $12 million of U.S. medical device excise tax in 2013. Management expected the tax to be capitalized in inventory and recognized in cost of goods sold as products were sold.
• Plainsboro remediation was expected to be completed by the end of the second quarter of 2013, with additional spending of approximately $1.5 million to $2.0 million. Remediation expenses affected 2012 revenue and gross margin.
• The FDA issued warning letters relating to quality-system issues at the Plainsboro, New Jersey facility, the Andover, England facility and, after year-end, the Anasco, Puerto Rico facility. Distribution of collagen products from Anasco was briefly suspended in February 2013 and resumed after a third-party validation review.
• The company faces risks from FDA and international regulatory compliance, product approvals, reimbursement changes, healthcare reform, competition, foreign exchange, acquisition integration, supplier concentration, human- and animal-derived materials, product liability and potential impairment of goodwill and intangible assets.
• The United States Attorney’s Office contacted the company regarding alleged creation of invoices for products not sold or surgeries that did not occur by two sales representatives in one Extremities region. The company stated that it was cooperating voluntarily and was not a subject or target of the investigation as of the filing.
• A fourth-quarter out-of-period adjustment reduced interest expense by $3.3 million for previously uncapitalized interest on construction-in-progress balances. Management concluded the correction was immaterial to previously issued periods and to full-year 2012 earnings.
• On January 24, 2013, the company acquired Tarsus Medical for $3.0 million, subject to working-capital adjustments, with potential additional consideration of $1.5 million and up to $14.5 million tied to sales milestones.

Important Facts for Investors to Verify

• Progress and final resolution of all FDA warning letters, including whether exportation certificates, manufacturing activities or product distribution remain restricted.
• Whether the expected 2013 gross margin, research and development spending, tax rate and capital expenditure ranges are achieved.
• Cash conversion and operating cash flow after the one-time 2012 debt-interest and deferred-equity tax payments, as well as the effect of the medical device excise tax.
• Leverage, covenant compliance and refinancing capacity as the $321.9 million revolver balance and $230.0 million convertible notes approach their 2016 maturity.
• Performance of U.S. Spine and Other, including the risk of goodwill impairment if forecasts, growth assumptions or discount rates deteriorate.
• Potential financial or reputational consequences of the U.S. Attorney’s inquiry and any product liability, regulatory, reimbursement or litigation contingencies.
• Integration and return on investment from acquisitions, including SeaSpine, Ascension and the post-year-end Tarsus Medical acquisition.