OrthoPediatrics Corp. — Q2 2018 Form 10-Q
Business context and period: The company designs, develops and markets orthopedic implants and instruments for children. This unaudited report covers the three and six months ended June 30, 2018; financial amounts below are in millions of dollars unless otherwise noted.
Financial performance
| Metric | Q2 2018 | Q2 2017 | First half 2018 | First half 2017 |
|---|---|---|---|---|
| Revenue | $15.1 | $11.8 | $27.2 | $21.6 |
| Gross profit / margin | $11.3 / 75% | $8.7 / 74% | $20.2 / 74% | $16.1 / 75% |
| Operating expenses | $13.4 | $9.4 | $26.7 | $17.6 |
| Operating loss | $(2.1) | $(0.7) | $(6.5) | $(1.5) |
| Net loss | $(2.7) | $(1.3) | $(7.7) | $(2.6) |
| Net loss per share | $(0.21) | $(1.56) | $(0.62) | $(3.11) |
Revenue mix: Q2 U.S. revenue was $11.5 million and international revenue was $3.6 million. Trauma and deformity revenue was $9.9 million, scoliosis $4.9 million and sports medicine/other $0.3 million. For the first half, U.S. revenue was $20.1 million and international revenue $7.1 million.
Cash flow and liquidity: First-half operating cash use was $11.7 million, versus $4.2 million a year earlier; investing cash use was $4.3 million versus $3.1 million. Cash declined $16.1 million during the half, from $42.6 million at year-end 2017 to $26.5 million at June 30, 2018. Working capital was $52.2 million. Management said cash, expected operating receipts and availability under the revolver were sufficient for anticipated needs for at least 12 months.
Debt: Total debt was $25.4 million, including a $20.0 million Squadron term loan, $3.9 million drawn on a $15.0 million revolving facility and a $1.5 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. The company reported no traditional financial covenants, but the agreement includes negative covenants and events of default.
Changes versus prior period
- Revenue increased 28% in Q2 and 26% in the first half. Management attributed most growth to higher unit volumes, particularly PediPlate/PediLoc products in trauma and deformity and RESPONSE, FIREFLY and BandLoc products in scoliosis; price changes contributed little.
- Q2 gross margin improved to 75% from 74%, while first-half margin declined to 74% from 75%. Management cited direct-country conversions as a Q2 benefit and a higher international sales mix, including sets, as a margin headwind.
- Operating costs rose faster than revenue. First-half sales and marketing expense increased 35%, G&A 69%, and R&D 72%. Management cited commissions and marketing, IPO-related restricted-stock compensation, legal costs, added personnel and product development.
- Net loss widened to $7.7 million for the first half from $2.6 million. Stock-based compensation was $2.6 million versus $0.7 million; management attributed increased G&A in part to accelerated vesting following the IPO. Per-share comparisons with 2017 are affected by preferred-stock dividend accretion and the IPO-related change in capital structure.
- Operating cash use increased, notably with first-half increases in accounts receivable of $4.2 million and inventory of $4.7 million. Capital spending was primarily for consigned instrument sets.
Outlook, risks and unusual items
- The company expects losses to continue in the near term as it expands its product portfolio, consigned sets and markets. No quantified revenue, earnings or cash-flow guidance was provided.
- Management disclosed recurring operating losses and an accumulated deficit of $110.8 million, but concluded available cash, expected cash flows and revolver capacity supported continued operations for more than 12 months after issuance of the statements.
- K2M litigation alleges patent infringement involving instruments in the RESPONSE spine system; damages sought are unspecified. The PTAB instituted inter partes review of one patent, and the district-court case was stayed pending those proceedings. The company disputes the claims but warns an adverse outcome could materially affect its business and financial condition.
- International distributor revenue recognition may depend on collectability; for certain customers, revenue is recognized when cash is received. The business also carries substantial inventory, with possible excess or obsolescence charges if demand changes.
- Squadron and its affiliates are significant related parties: Squadron is the lender, and an affiliate provides the mortgage; a Squadron-affiliated supplier received $2.3 million in payments in the first half. The company also has royalty commitments, including minimum annual royalties of $0.5 million through 2026.
- The company reported no material changes to previously disclosed risk factors. It adopted ASC 606 in 2018 without material financial-statement impact. Its deferred tax assets remain fully offset by a valuation allowance.
Important facts for investors to verify
- Whether revenue growth translates into improved operating leverage, margins and a narrowing of losses.
- Cash burn, working-capital needs and the company’s ability to fund planned inventory and instrument-set investment.
- Actual borrowing availability under the Squadron revolver, interest costs, and compliance with its covenants and default provisions.
- Developments and potential business impact of the K2M patent dispute and related PTAB proceedings.
- International sales growth, distributor collections and the effect of geographic mix on gross margin.
- Future stock-based compensation, legal expense and other costs associated with expansion.