ITEM 1. BUSINESS
Certain terms used herein are defined in the Glossary on pages 16 to 18 hereof. Exactech, Inc. (the "Company", or "Exactech") develops, manufactures, markets and sells orthopaedic implant devices and related surgical instrumentation to hospitals and physicians in the United States and overseas. The Company was founded by an orthopaedic surgeon in November 1985, and is incorporated under the laws of the State of Florida. Early in the Company's history, revenues were principally derived from sales of its primary hip replacement systems. During 1995, the Company introduced Optetrak/registered trademark/, a total primary knee replacement system, which had been in development for three years. The Optetrak/registered trademark/ knee system was conceived by the Company in collaboration with members of its Scientific Advisory Board in cooperation with the Hospital for Special Surgery, an internationally known hospital for orthopaedic surgery. The Optetrak/registered trademark/ system represents a highly differentiated product based on precision manufacturing techniques and a design which reduces articular contact stress. The Optetrak/registered trademark/ system is the most modern rendition of a series of knee implants which were first introduced in 1974 and which are still being marketed by certain of the Company's competitors. The Company has entered into an agreement with the Hospital for Special Surgery which gives the Company a non-exclusive option with respect to future knee systems developed at the Hospital for Special Surgery.
In order to raise capital, in June 1996, the Company consummated an underwritten initial public offering (the "IPO") of 1,840,000 shares of its common stock, $.01 par value (the "Common Stock"), resulting in net proceeds to the Company of $12,657,910 after deduction of underwriting, legal, accounting and other offering related expenses. The proceeds of the IPO have been and will be used primarily to repay indebtedness, to purchase inventory and equipment, for research and development and for working capital and general corporate purposes.
ORTHOPAEDIC IMPLANT INDUSTRY
According to the Orthopedic Network News Volume 9 Number 3, United States sales of orthopaedic implant products were approximately $1.9 billion in 1997, an increase of 5.3% from 1996. During 1997, sales of knee implants were approximately $1.05 billion, an increase of 6.6% from 1996, while sales of hip implants were approximately $833.9 million, an increase of 3.8% from 1996. The publication reports that there were 556,060 hip and knee joint replacements in the United States in 1997 compared to 532,532 in 1996. The Company expects sales of hip and knee joint replacements in foreign markets to grow more rapidly than in the United States.
Management believes that the growth in the industry is due to the increase in the number of people over age 65, an increasingly active population, improvements in technology and increased use of implants in younger patients. According to an industry report, the United States population over 65 years of age continues to grow as a percentage of the population. Longer life spans and the continuing aging of the population increases the number of individuals whose joints will be subject to failure. Furthermore, the "baby-boomers" are approaching the age where arthritis and osteoporosis begin to affect joints, necessitating joint replacement. As this segment of the population continues to age, an increasing demand for joint replacement procedures is anticipated. Finally, the earlier generations of implanted joint replacement prostheses have begun to reach their maximum life and are beginning to fail, resulting in an increased demand for hip and knee revisions.
PRODUCTS
The Company's orthopaedic implant products are used to replace joints which have deteriorated as a result of injury or diseases such as arthritis. Reconstructive joint surgery involves the modification of the area surrounding the affected joint and the insertion of a set of manufactured implant components to replace or augment the joint. During the surgery, the surgeon removes a portion of the bones that comprise the joint, prepares the remaining bones and surrounding tissue and then installs the implant.
Knee implants are either total or unicompartmental. Total knee replacement systems are used to replace the entire knee joint (i.e., the patella, upper portion of the tibia and lower portion of the femur), while unicompartmental systems are used to replace one of the two compartments between the femur and the tibia.
Primary knee implant systems are used to replace the natural knee joint, while knee revision systems are used to replace the components of a previously installed primary implant system that has failed. The components of revision systems are specially designed to fill bony voids created by the previous implant.
Hip implants are either total or partial. In a total hip implant, the acetabulum is replaced with an acetabular cup. The damaged head of the patient's femur is removed and a stem is inserted into the femur on which a replacement head is mounted. This femoral head is placed into the cup of the acetabulum to recreate the ball and socket joint. In a partial hip implant, the damaged head of a patient's femur is removed and replaced with a head mounted on a stem inserted into the femur. However, the acetabulum is not replaced and the size of the head is larger and more similar to the natural femoral head. Hip implants are designed for either cemented or non-cemented applications. Cemented hip implants are installed by using bone cement to attach the components to a patient's bones, while porous coated hip implants are press-fit without cement. Porous coated implants are designed to promote growth of the patient's remaining bone tissue onto the implant. Primary hip implant systems are used to replace the natural hip joint, while hip revision systems are used to replace a previously installed primary implant system that has failed.
KNEE PRODUCTS. The Company believes that its Optetrak/registered trademark/ knee system represents a major advance in knee implant design. The Optetrak/registered trademark/ knee system was developed in collaboration with the Hospital for Special Surgery in New York and a design team consisting of physicians and biomechanists affiliated with major medical facilities and academic institutions. The Company's Optetrak/registered trademark/ system is a modular system designed to maximize stability, to provide increased range of motion and improved patellar tracking and to reduce articular contact stress that leads to implant failure. Laboratory testing performed by the Company and clinical testing performed by the Company's design team members has demonstrated that the system produces substantially lower articular contact stress and improved patellar tracking than other comparable knee implant systems.
The Optetrak/registered trademark/ system includes a total primary knee replacement system which is available with either a cruciate ligament sparing femoral component (in both cemented and porous coated designs) or a posterior stabilized femoral component (in both cemented and porous coated designs). These femoral components are made of a cobalt chromium alloy. The system is also available with several alternative tibial components, titanium backed polyethylene tibial components with both finned keel and trapezoid keel with stem augmentation, blocks and full or half wedges, and all polyethylene tibial components, which are cruciate sparing and posterior stabilized. The stem, block and wedge augmentation allow the surgeon to rebuild the ends of the patient's bones to allow fixation of the implant system. The metal components of the Optetrak/registered trademark/ system are fully precision machined resulting in better congruence among components and material performance. The Company's patellar products are made of ultra-high molecular weight polyethylene. Because of variations in human anatomy and differing design preferences among surgeons, knee components are manufactured by the Company in a variety of sizes and configurations. Bone cement is used to affix the implants to the bone.
The Optetrak/registered trademark/ system also includes a total knee revision system with respect to which the Company commenced full scale marketing in 1997. The revision system includes a constrained condylar femoral component and a non-modular femoral component with enhanced stem and block augmentation and can be used with many components of the primary system. The constrained condylar femoral component was designed to provide greater constraint between the system components to compensate for ligaments weakened or lost due to disease or as a result of the original implant. The Company is also designing a unicompartmental knee with respect to which the Company will be required to obtain Food and Drug Administration ("FDA") clearance to market.
HIP PRODUCTS. The Company began marketing a hip implant system in 1987. Currently, the Company's line of hip implant products includes three total hip implant systems, its AuRA/registered trademark/Cemented Total Hip System, its MCS/registered trademark/ Porous Coated Total Hip System, and the Opteon/registered trademark/ Cemented Stem System. The AuRA/registered trademark/ system also includes revision long stems and calcar replacement stems. Additionally, the Company markets two primary partial hip implant systems, its unipolar and its bipolar implant components.
All total hip implants produced by the Company consist of a cup, head and stem. Because of variations in human anatomy and differing design preferences among surgeons, hip implants are manufactured by the Company in a variety of head sizes, neck lengths, stem lengths, stem cross-sections and configurations. The Company's total hip replacement systems utilize either titanium alloy or cobalt chromium alloy femoral stem components, which can
be final machined from forgings, castings or wrought metal plate depending on the design and material used. The Company's total hip replacement systems also include ultra-high molecular weight polyethylene cups with and without metal backing. The femoral heads are made of either cobalt chromium or zirconia ceramic.
The Company's AuRA/registered trademark/ Cemented Hip System is intended to provide optimal treatment for patients requiring cemented hip arthroplasty (joint reconstructive surgery) by minimizing failure of the bone cement. The femoral stem utilizes a cross-sectional design to reduce stress on the bone cement used to affix the implant to the patient's remaining bone tissue. The system is also designed to allow for increased range of motion in the patient. It is available in long stem and calcar replacement versions. The AuRA/registered trademark/ is a high demand forged cobalt chromium femoral stem. The Company also provides a moderate demand femoral stem, the Opteon/registered trademark/ forged cobalt chromium femoral stem. The Cemented Total Hip System is a mature product line which the Company phased out during 1998.
The Company scaled up marketing and sales of the AuRA/registered trademark/ Hip System in 1997. AuRA/registered trademark/ is a comprehensive system that provides solutions for a broad range of patient problems. It is specifically designed to support the needs of a maturing generation of more active patients. The AuRA/registered trademark/ Hip System is comprised of a new primary total hip replacement system as well as revision components which include calcar replacement and long stems. It can also be used for fracture and tumor applications. All AuRA/registered trademark/ components have a common proximal geometry which affords the surgeon reproducability of results regardless of which stem is selected. AuRA/registered trademark/ components can be implanted using a single set of surgical instruments which makes the system more cost effective.
The Company's MCS/registered trademark/ Porous Coated Total Hip System was designed to minimize thigh pain and abnormal bone remodeling resulting from bone-implant stiffness mismatch. The Company's MCS/registered trademark/ Porous Coated Total Hip System was also designed to avoid unnecessary damage to the bone and its blood supply during femoral preparation. The Company also provides instrumentation that facilitates reproducible implantation of the implant. The system consists of a modular acetabular cup and cup liner, screws for supplemental fixation of the acetabular cup, a modular head and a femoral stem. All of the Company's femoral heads are designed to be used with its femoral stems, including the Ziramic/registered trademark/ (zirconia ceramic) femoral head which was designed to further reduce friction and polyethylene wear, and is also compatible with the AuRA/registered trademark/ Hip System. The system has been cleared by FDA for use without cement.
The Company's partial hip products include a bipolar prosthesis and a unipolar prosthesis. The Company's bipolar prosthesis also utilizes one of the stems used in total hip replacements. The bipolar prosthesis is designed for use in more active patients and the unipolar prosthesis is designed for use in less active patients.
During 1996, the Company licensed patent technology for a modular revision hip system. The Company commenced product development of the modular revision hip system during 1997. The Company plans to continue product development and to seek FDA clearance to market the system in 1999. Upon receipt of FDA clearance, the Company plans to commence full scale marketing of the product in 2000.
OTHER COMPANY PRODUCTS AND SERVICES. The Company has designed and received FDA clearance to market a nonmodular shoulder implant system. In 1997, the Company temporarily halted development plans for a modular version of a shoulder implant system. The Company believes that other opportunities currently provide a more optimal use of the Company's resources.
The Company has acquired an exclusive license for an improved, and patented, surgical oscillating saw system that significantly reduces vibration, noise, and problems with control in surgery. The Company may develop this product through a separate wholly-owned subsidiary.
The Company has signed a worldwide distribution agreement with Regeneration Technology Inc., an affiliate of the University of Florida Tissue Bank, for new bone grafting material technology. This material, OpteFORM/trademark/, includes traditional allograft material components, and has the unique property of being fully formable at a temperature of 43/degrees/ to 45/degrees/C which is just above body temperature. The material becomes a resilient solid when its temperature falls to body temperature (37/degrees/C). Exactech distributes OpteFORM/trademark/ as a service through the
Company's current domestic distribution. The Company commenced this service in the fourth quarter of 1998, with full phase-in planned over the course of 1999.
During June 1998, the Company purchased substantially all of the assets related to Synvasive Technology, Inc.'s ("Synvasive") Acudriver/trademark/ product line. The Acudriver/trademark/ Automated Osteotome System is an air-driven impact handpiece that aids surgeons during joint implant revision procedures by providing effective cleavage of prosthesis/bone or cement/bone interfaces. The Acudriver/trademark/ accomplishes this by providing the surgeon with precise positioning without the inconvenience and inconsistency of striking the osteotome with a mallet.
MARKETING AND SALES
The Company markets its orthopaedic implant products in the United States through 40 independent agencies and two domestic distributors, that act as the Company's sales representatives, and internationally through eight foreign distributors. The customers for the Company's products consist of hospitals, surgeons and other physicians and clinics. Traditionally, the surgeon made the ultimate decision which orthopaedic implant to use. As a result of health care reform, the rapid expansion of managed care at the expense of traditional private insurance, the advent of hospital buying groups, and various bidding procedures that have been imposed at many hospitals, sales representatives may also make presentations to hospital administrators, material management personnel, purchasing agents or review committees that may influence the final decision.
The Company generally has contractual arrangements with its independent sales agencies pursuant to which the agency is granted the exclusive right to market the Company's products in the specified territory and the agency is required to meet sales quotas to maintain its relationship with the Company. The Company's arrangements with its sales agencies typically do not preclude them from selling competitive products, although the Company believes that most of its agencies do not do so. The Company typically pays its sales agencies a commission based on net sales. The Company is highly dependent on the expertise and relationships of its sales agencies with customers. The Company's sales organization, comprised of the Company's independent sales agencies, is supervised by two Regional Managers (West and East). The Company has contractual arrangements with its domestic distributors which are similar to its arrangements with its sales agencies, except the Company does not pay the distributors commissions and the distributors purchase inventory from the Company for use in fulfilling customer orders. The Company currently offers its products in 38 states, including Florida, New York, California, Texas, Ohio, Pennsylvania and Illinois.
The Company provides inventories of its products to its United States sales agencies until sold or returned for their use in marketing its products and filling customer orders. As the size of the component to be used is frequently not known until surgery has commenced and because surgeons give little or no advance notice of surgery, a minimum of one size of each component in the system to be used must be available to each sales agency at the time of surgery. Accordingly, the Company is required to maintain substantial levels of inventory. The maintenance of relatively high levels of inventory requires the Company to incur significant expenditures of its resources. The failure by the Company to maintain required levels of inventory could have a material adverse effect on the Company's expansion. As a result of the need to maintain substantial levels of inventory, the Company is subject to the risk of inventory obsolescence. In the event that a substantial portion of the Company's inventory becomes obsolete, it would have material adverse effect on the Company.
During the years ended December 31, 1996, 1997 and 1998, approximately 7%, 6% and 7%, respectively, of the Company's sales were derived from a major customer. During the years ended December 31, 1996, 1997 and 1998 one distributor, MBA Del Principado, S.p.A., accounted for approximately 13%, 13% and 14%, respectively, of the Company's sales.
The Company generally has contractual arrangements with its foreign distributors pursuant to which the distributor is granted the exclusive right to market the Company's products in the specified territory and the distributor is required to meet sales quotas to maintain its relationship with the Company. Foreign distributors typically purchase product inventory and instruments from the Company for their use in marketing and filling customer orders.
The Company currently offers its products in twelve countries in addition to the United States: Argentina,
Australia, Belgium, Columbia, Greece, Japan, Italy, Luxembourg, Netherlands, Portugal, Spain and Turkey. For the years ended December 31, 1996, 1997 and 1998, foreign sales accounted for $2,124,856, $3,051,151, and $5,007,105 representing approximately 15.4%, 17.3%, and 20.8% respectively, of the Company's sales. For the years ended December 31, 1996, 1997, and 1998, gross profit from foreign sales accounted for $597,944, $1,127,455 and $1,871,577, respectively. The Company intends to continue to expand its sales in foreign markets in which there is increasing demand for orthopaedic implant products. In order to expand its global sales and marketing capabilities, the Company intends to assess the attractiveness of establishing local manufacturing to serve the Italian, Spanish and other EEC markets. The Company intends to continue to expand its international distribution network in 1999.
MANUFACTURING AND SUPPLY
The Company has historically utilized third-party vendors for the manufacture of all of its component parts, while performing product design, quality assurance and packaging internally. During 1998, the Company began manufacturing some of its components. The Company consults with its vendors in the early stages of the design process of its products. This strategy of using third-party vendors for some manufacturing and consulting enables the Company to efficiently source product requirements while affording it considerable flexibility. Because the Company is able to obtain competitive prices from a number of suitable suppliers with FDA-approved facilities, the Company believes it is able to offer high quality products at cost-effective prices, even more so with the increase of internal manufacturing in the coming years. In order to control its production costs, the Company continually assesses the manufacturing capabilities and cost-effectiveness of its existing and potential vendors. The Company may in the future establish manufacturing strategic alliances to assure itself of continued low-cost production. For the years ended December 31, 1996, 1997 and 1998, the Company purchased approximately 62%, 72% and 74%, respectively, of its component requirements from three manufacturers. The Company does not maintain supply contracts with any of its manufacturers and purchases components pursuant to purchase orders placed from time to time in the ordinary course of business. The Company has several alternative sources for components and does not anticipate that it will encounter problems in obtaining adequate supplies of components. Certain tooling and equipment which are unique to the Company's products are supplied by the Company to its vendors.
The Company's internal manufacturing, assembly, packaging and quality control operation are conducted at its principal offices in Gainesville, Florida. Each component received from its vendors is examined by Company personnel prior to assembly or packaging to ensure that it meets the Company's specifications. The Company began limited manufacturing of the components of its products, consisting primarily of final machining of components during 1998. The Company completed a new facility which is used for principal executive offices, research and development laboratories and manufacturing. The Company occupied the new facility in the second quarter of 1998.
PATENTS AND PROPRIETARY TECHNOLOGY; LICENSE AND CONSULTING AGREEMENTS
The Company holds United States patents covering one of its femoral stem components, its bipolar partial hip implant system, features of its Optetrak/registered trademark/ tibial components, and certain surgical instrumentation, has patent applications pending with respect to certain surgical instrumentation and certain implant components and anticipates that it will apply for additional patents it deems appropriate. In addition, the Company holds licenses from third parties to utilize certain patents, including an exclusive license to an oscillating saw technology and a non-exclusive license (described below) to certain patents, patents pending and technology utilized in the design of the Optetrak/registered trademark/ knee system. As a result of the rapid rate of development of reconstructive products, the Company believes that patents have not been a major factor in the orthopaedic industry to date. However, patents on specific designs and processes can provide a competitive advantage and management believes that patent protection of orthopaedic products will become more important as the industry matures. Although the Company believes that its patents and products do not and will not infringe patents or violate proprietary rights of others, it is possible that its existing patent rights may not be valid or that infringement of existing or future patents or proprietary rights may occur. See "Legal Proceedings" for information concerning a patent infringement claim against the Company.
In addition to patents, the Company relies on trade secrets and proprietary know-how and employs various methods to protect its proprietary information, including confidentiality agreements and proprietary information
agreements.
In connection with the development of its knee implant systems, the Company entered into consulting agreements with certain of its executive officers and design team members, including Dr. William Petty and Dr. Gary J. Miller, who are executive officers, directors and principal shareholders of the Company, and Ivan A. Gradisar, Jr., M.D., and William Murray, M.D. Pursuant to these consulting agreements, such individuals agreed to provide consulting services to the Company in connection with evaluating the design of knee implantation systems and associated instrumentation and are entitled to receive royalties during the term of the agreements aggregating 3% of the Company's net sales of such products in the United States and less than 3% of the Company's net sales of such products outside the United States. During the years ended December 31, 1996, 1997 and 1998, the Company paid royalties aggregating $187,773, $288,759 and $432,242 respectively, pursuant to these consulting agreements. The consulting agreements with Drs. Petty and Miller were superseded by their employment agreements which provide for the continuation of the royalty payments. The Company has entered into consulting agreements with two of the members of its design team in connection with the development of its AuRA/registered trademark/ hip system.
In January 1997, the Company entered into an oral consulting agreement with Albert Burstein, Ph.D., a director of the Company, to provide services regarding many facets of the orthopaedic industry including product design rationale, manufacturing and development techniques and product sales and marketing. During 1997 and 1998, the Company paid Dr. Burstein $123,750 and $135,000, respectively, as compensation under the consulting agreement.
From time to time, the Company enters into license agreements with certain unaffiliated third parties under which the Company is granted the right to utilize certain patented products, designs and processes. Pursuant to a license agreement with the Hospital for Special Surgery (the "HSS License Agreement"), the Company obtained a non-exclusive right and license to certain patents, patents pending and technology utilized in the design of the Optetrak/registered trademark/ knee implant system and to manufacture, use and sell total knee prostheses incorporating such patents and technology. The term of the HSS License Agreement continues until the earlier to occur of (i) the expiration of a period of ten years and (ii) the expiration of the licensed patents. In consideration for the grant of the license, the Company agreed to pay to the Hospital for Special Surgery royalties in an amount equal to 5% of net sales of the licensed products. Pursuant to the HSS License Agreement, the Company has the option to acquire a non-exclusive license to use any improvement or invention made or acquired by the Hospital for Special Surgery relating to the licensed products and the option to obtain an exclusive license to any such improvement or invention made jointly by the Hospital for Special Surgery and the Company. As is the case in many license agreements of this nature, the Hospital for Special Surgery did not represent to the Company that the manufacture, use or sale of the Optetrak/registered trademark/ knee implant system will not infringe the intellectual property rights of third parties. During the years ended December 31, 1996, 1997 and 1998, the Company recognized royalties to the Hospital for Special Surgery of $307,801, $474,357 and $650,548, respectively.
Pursuant to a License Agreement (the "University License Agreement") between the University of Florida (the "University") and the Company, the Company has been granted the exclusive right and license in perpetuity to make, use and sell a spinal implant device under patents owned by the University. In consideration for the right to utilize the University patents, the Company paid the University an initial license issue fee of $6,000 and, if and when the patented products or processes are utilized in devices or products sold by the Company, the Company will be required to pay the University a royalty in an amount equal to 5% of the Company's net sales of any such products in the United States, up to a maximum royalty of $500,000, and thereafter a royalty of 2% of such net sales. This royalty will be payable by the Company during the period ending 10 years from the Company's first sale of a device utilizing the University patent. In addition, the University License Agreement provides that the Company will remit to the University 75% of all royalties received by the Company for sales outside of the United States under sublicense agreements relating to the patented products or processes. In connection with the University License Agreement, the Company also has agreed to assist the University in developing certain other devices currently being researched and tested which are intended to be patented by the University. To date, the Company has only utilized the University patents in connection with product research and development and accordingly, the Company has paid no royalties to the University under the University License Agreement.
The Company has also entered into a sublicense agreement (the "Sublicense Agreement") with Sofamor Danek Properties, Inc. ("SDP") pursuant to which the Company granted SDP the exclusive worldwide right and
sublicense to utilize the patents licensed to the Company pursuant to the University License Agreement. The term of the Sublicense Agreement continues until the last of the patents owned by the University and sublicensed to SDP terminates, unless sooner terminated in accordance with the terms of the Sublicense Agreement. Pursuant to the Sublicense Agreement, the Company received an initial sublicense fee of $250,000 and, if and when FDA approves an SDP product utilizing the University patents, the Company will receive an additional $250,000 sublicense fee. Additionally, at such time as a product utilizing the University patent is manufactured and sold by SDP, the Company will be entitled to receive a royalty from SDP in the amount of 5% of SDP's net sales of such products in the United States, up to a maximum of $500,000, and thereafter a royalty of 2% of such net sales. Under the terms of the Sublicense Agreement, the Company received an advance on anticipated royalties in the amount of $l00,000. To date, SDP has not marketed a product utilizing the University patents and, during 1996, SDP was initially denied FDA clearance to market products using the University patents. As a result, the $100,000 was recognized by the Company as sublicense income in 1996 due to the non-refundable nature of the advance.
Pursuant to a license agreement between the Company and Accumed, Inc. ("Acumed"), the Company secured a worldwide license to manufacture, use and sell products utilizing Acumed's bipolar hip prosthesis and a license to any rights under any patent that is issued covering Acumed's bipolar hip prosthesis design. The term of this license agreement continues until the expiration of the last patent comprising any part of the Accumed design, unless sooner terminated in accordance with the terms of such agreement. During the period ending on the seventh anniversary of the Company's first sale of a product utilizing the Accumed design, the Company is obligated to pay Accumed an annual royalty of 3.5% of all net receipts from the Company's worldwide sale of products incorporating an Accumed product or design patent licensed to the Company. However, if a patent is not issued within a particular country in which the Company sells products utilizing Acumed's design, the royalty payable is 2% of the Company's net sales of applicable products in such country. During the years ended December 31, 1996, 1997 and 1998, the Company paid royalties to Accumed of approximately $11,577, $11,906 and $12,764, respectively.
The Company has also entered into a patent agreement (the "Patent Agreement") with Phillip Cripe, a shareholder of the Company, under which the Company was assigned the patent rights associated with a surgical saw designed by Mr. Cripe and the concepts, techniques and processes embodied in such product. The term of this patent agreement continues until the later of ten years or the expiration of the last patent comprising any part of the surgical saw design unless sooner terminated in accordance with the terms of the Patent Agreement. In connection with the execution of the Patent Agreement, the Company granted Mr. Cripe an option to purchase 7,500 shares of the Company's Common Stock at an exercise price of $6.67 per share. The Company has also agreed to pay Mr. Cripe an annual royalty of 5% of all net receipts from the sale of products incorporating the concepts, techniques and processes embodied in the patented product (but 2% of all net receipts from the sale of associated surgical saw blades) by or on behalf of the Company. To date, the Company has not developed a product utilizing the assigned patent or know how.
During October 1996, the Company licensed certain patent technology for development of a modular hip system from Medicine Lodge, Inc. The patent license fees total $360,000, of which $275,000 was paid upon the execution of the agreement and an additional $85,000 is payable at the time of FDA clearance to market the products.
During 1997, the Company licensed certain technology. The license fees total $250,000, of which $100,000 was paid upon the execution of the agreement and an additional $150,000 is payable at such time as the licensor produces a developed product.
RESEARCH AND DEVELOPMENT
During the years ended December 31, 1996, 1997 and 1998, the Company expended $750,256, $937,988 and $1,271,825 respectively, on research and development and anticipates that research and development expenses will continue to increase. The Company's research and development efforts contributed to the introduction of the revision components of the Company's Optetrak/registered trademark/ knee implant system and the AuRA/registered trademark/ Hip System in 1997. The Company's principal research and development efforts currently relate to the production of enhanced revision components included in the Optetrak/registered trademark/ knee implant system, a new primary acetabular component, integration of the AuRA/registered trademark/ and MCS/registered trademark/ hip stem systems to allow easier interchange of surgical instrumentation, and development of the
modular hip implant system.
SCIENTIFIC ADVISORY BOARD
The Company's strategy is to utilize members of its Scientific Advisory Board, consisting of internationally known physicians and biomechanists, in the design process to facilitate the development of high quality products at cost-effective prices. The Scientific Advisory Board assists the Company in identifying new product opportunities, provides evaluation and comments on existing product development and clinical programs, and provides a direct link between the Company and the academic, medical and scientific communities which permits the Company to quickly identify and respond to the demands of orthopaedic surgeons. Members of the Scientific Advisory Board generally meet at least quarterly. In addition, from time to time, the members of the Scientific Advisory Board consult with the Company individually at the request of the Company. The Company has entered into consulting agreements with certain members of the Scientific Advisory Board pursuant to which the Company pays royalties to such members. See "Patents and Proprietary Technology; License and Consulting Agreements." The members of the Scientific Advisory Board in addition to Dr. William Petty and Dr. Gary J. Miller include: Albert H. Burstein, Ph.D., Edmund Chao, Ph.D., Ivan Gradisar, M.D., William Murray, M.D., Raymond Robinson, M.D., and Robert Trousdale, M.D.
COMPETITION
The orthopaedic implant industry is highly competitive and dominated by a number of large companies with substantially greater financial and other resources than the Company and competition is expected to intensify. From time to time, the Company and certain of its competitors have offered significant discounts as a competitive tactic, and may be expected to continue to do so. The Company believes its future operations will depend upon its ability to be responsive to the needs of its customers and to provide high quality products at cost-effective prices. The largest competitors in the orthopaedic hip implant market are Bristol-Myers Squibb Company (Zimmer Inc.), Johnson & Johnson, Osteonics, Inc., Pfizer Inc. (Howmedica, Inc.), and Biomet, Inc. who, according to an industry publication, had an estimated aggregate market share of approximately 77.1% in 1997. The largest competitors in the orthopaedic knee implant market are Bristol-Myers Squibb Company (Zimmer Inc.), Johnson & Johnson, Pfizer Inc. (Howmedica, Inc.), DePuy, Inc. and Biomet, Inc. who, according to an industry publication, had an estimated aggregate market share of approximately 67.3% in 1997.
Companies in the industry compete on the basis of product features and design, innovation, service, the ability to maintain new product flow, relationships with key orthopaedic surgeons and hospitals, the strength of their distribution network and price. While price, as opposed to surgeon preference, is becoming increasingly important in the hip market, the primary basis of competition in the knee market remains physician preference, which includes ease-of-use, clinical results, price and relationships with sales representatives. Due to health care reform, the rapid expansion of managed care at the expense of traditional private insurance and the advent of hospital buying groups, among other things, management believes that the price of the Company's orthopaedic implant products will continue to become a more important competitive factor. Manufacturers of medical devices, including orthopaedic implants, are increasingly attempting to enter into contracts with hospital chains or hospitals pursuant to which the hospital chains agree to purchase their products exclusively from such manufacturers, usually in exchange for discounted prices. If the Company's competitors are successful in securing such contracts, the Company's ability to compete may be materially adversely affected. Although to date generic products have not been a significant factor in the orthopaedic implant market, price may become even more important if suppliers of generic products enter the market on a larger scale.
PRODUCT LIABILITY AND INSURANCE
The Company is subject to potential product liability risks which are inherent in the design, marketing and sale of orthopaedic implants and surgical instrumentation. The Company has implemented strict quality control measures and currently maintains product liability insurance in amounts which it believes are typical in the industry for similar companies.
GOVERNMENT REGULATION
The Company's operations and relationships are subject to extensive, rigorous, expensive, time-consuming and uncertain regulation in the United States and certain other countries. The primary regulatory authority in the United States is the FDA. The development, testing, labeling, distribution, marketing and manufacture of medical devices, including reconstructive devices, are regulated under the Medical Device Amendments of 1976 to the Federal Food, Drug and Cosmetic Act (the "Amendments") and additional regulations promulgated by FDA. In general, these statutes and regulations require that manufacturers adhere to certain standards designed to ensure the safety and effectiveness of medical devices.
Under the Amendments, each medical device manufacturer must be a "registered device manufacturer" and must comply with regulations applicable generally to labeling, quality assurance, manufacturing practices and clinical investigations involving humans. FDA is authorized to obtain and inspect devices, their labeling and advertising, and the facilities in which they are manufactured in order to assure that a device is not improperly manufactured or labeled. The Company is registered with FDA and believes that it is in substantial compliance with all applicable material governmental regulations.
Under the Amendments, medical devices are classified into one of three classes depending on the degree of risk imparted to patients by the medical device. The Amendments define Class I devices as those for which safety and effectiveness can be guaranteed by adherence to general controls, which include compliance with Good Manufacturing Practices ("GMP"), registration and listing, reporting of adverse medical events, and appropriate truthful and non-misleading labeling. The Amendments define Class II devices as those which require pre-market demonstration of adherence to certain standards or other special controls. Such demonstration is provided through the filing of a 510(k) pre-market notification. The Amendments define a Class III product as a product which has a wholly new intended use or a product for which advances in technology cannot be assessed without clinical study. The Amendments provide that submission and approval of a pre-market application ("PMA") is required before marketing of a Class III product can proceed. The PMA process is more extensive than 510(k) process.
In practice, however, FDA has developed a three-tier regulatory approach that does not exactly parallel the classification system. PMAs are currently required of medical devices which have new intended uses and some other products classified as Class III. PMAs have only been required of "old" Class III products (i.e., which were marketed on or prior to the date of enactment of the Amendments on July 28, 1976, or which are substantially equivalent to such previously marketed devices) when FDA has published a "call" for the relevant Class III pre-Amendments device.
Generally, therefore, pre-Amendments Class III and almost all Class II products are cleared for marketing by FDA based on a demonstration that the safety and effectiveness of the product is substantially equivalent to a pre-Amendments device or a similar, already-marketed, predicate device that received 510(k) clearance. Finally, Class I products are, and a few Class II products have been exempted, from the requirement to file for 510(k) clearance.
The Company's products have been classified by FDA as Class II devices and, currently, all marketed devices hold valid cleared 510(k) pre-market notifications, including: its cemented hip implant system, including femoral stem, acetabular cup and femoral heads; bone screws; porous coated cemented femoral stem and acetabular component; bipolar partial hip implant; Zirconia/registered trademark/ (ceramic) femoral heads; Opteon/registered trademark/ femoral stem for cemented and noncemented use; MCS femoral stem and acetabular component for cemented and noncemented use; AuRA/registered trademark/ femoral stem; and the Optetrak/registered trademark/ knee replacement system.
New medical device products of the Company will likely be subject to this clearance process, although FDA has gradually enhanced the clinical data requirements applicable to many 510(k) applications over the last few years. The process of obtaining regulatory clearances is lengthy, expensive and uncertain. FDA could choose to reclassify the Company's prosthetic systems as Class III products subject to a PMA under various conditions, such as a determination that the device could not demonstrate substantial equivalence to a predicate device based on a new intended use or because a technological change or modification in the device could not be adequately evaluated for safety and effectiveness without a requirement for a PMA. Further, FDA could choose to impose strict labeling
requirements, onerous operator training requirements, post-marketing surveillance, individual patient recipient lifetime tracking, or other requirements as a condition of marketing clearance, any of which could limit the Company's ability to market its products and would have a material adverse effect on the Company's business, financial condition and results of operations.
Further, if the Company wishes to modify a product after clearance, including changes in indications, manufacturing, or other changes, additional clearance may be required. Failure to receive, or delays in receipt of, FDA clearance, including the need for additional clinical trials or data as a prerequisite, could limit the ability of the Company to market its products and could have a material adverse effect on the Company's business, financial condition and results of operations.
The design, manufacturing, labeling, distribution and marketing of the Company's products are subject to extensive and rigorous government regulation in the United States well beyond that encompassed by the requirement to file a 510(k) premarket notification or a PMA application, including additional conditions or requirements that may become a part of FDA clearance or approval. Regulatory clearance may also include significant limitations on the indicated uses for which the Company's products may be marketed. To that end, all marketing materials are subject to exhaustive control. FDA enforcement policy strictly prohibits the marketing of approved or cleared products for unapproved uses. Furthermore, FDA does not provide an opportunity to review and approve such materials but may take action after the production and use of such materials.
In addition, the Company's manufacturing processes are required to comply with GMP regulations. These regulations cover the methods of design, testing, production, control, quality assurance, labeling, packaging, shipping, documentation and other requirements. Enforcement of GMP regulations has increased significantly in the last several years, and FDA has publicly stated that compliance will be more strictly scrutinized. New regulations which became effective in 1997 offer additional controls which parallel international standards. The Company's facilities and manufacturing processes, as well as that of certain of the Company's third-party suppliers, are subject to periodic inspections by FDA or other agencies. To date, the Company has successfully undergone three such inspections with only minor deficiencies cited at the exit interview and for which appropriate corrective responses were found acceptable to FDA.
Failure to comply with applicable regulatory requirements could result in, among other things, warning letters, fines, injunctions, civil penalties, repairs, replacements, refunds, recalls or seizures of products, total or partial suspensions of production, refusals of FDA to grant future premarket clearances or approvals, withdrawals or suspensions of current clearances or approvals, and criminal prosecution, which could have a material adverse effect on the Company's business, financial condition and results of operations.
Prior to 1996, the Company voluntarily initiated and satisfactorily completed two Class III recalls. A Class III recall is defined as a situation in which the use of a violative product is not likely to cause adverse health consequences. One recall involved a partially mislabeled product. The second involved the manufacturing process of a bone screw. FDA reviewed and authorized these two recalls, and concluded that each of the two recalls was conducted and completed properly. During September 1997, the Company voluntarily initiated a Class II recall as the result of the failure of an Opteon/registered trademark/ femoral hip stem. A Class II recall is defined as a situation in which the use of a violative product may cause temporary or medically reversible adverse health consequences or where the probability of serious adverse health consequences is remote.
Generally, the Company must obtain export certificates from FDA before it can export any product. While the process for issuance of export certificates has been expedited by FDA, and the Company has obtained export certificates under this expedited (and its predecessor) process, there can be no assurance that the issuance of export certificates in the future will not be subject to new restrictions, or that the Company will continue to receive or not be delayed in its receipt of such export certificates. Such future actions could have a material adverse effect on the Company's business, financial condition and results of operations.
The Company is required to obtain various licenses and permits from foreign governments and to comply with significant regulations that vary by country in order to market its products in foreign markets. In order to continue marketing its products in Europe after mid-1998, the Company was required to obtain ISO 9001 certification and receive "CE" mark certification, an international symbol of adherence to quality assurance
standards and compliance with applicable European medical device directives. The ISO 9001 certification is one of the prerequisites for CE mark certification. The Company received both ISO 9001 and CE mark certification in May 1998.
Certain provisions of the Social Security Act, commonly referred to as the "Anti-kickback Statute," prohibit entities, such as the Company, from offering, paying, soliciting or receiving any form of remuneration in return for the referral of Medicare or state health program patients or patient care opportunities, or in return for the recommendation, arrangement, purchase, lease or order of items or services that are covered by Medicare or state health programs. The Anti-kickback Statute is broad in scope and has been broadly interpreted by courts in many jurisdictions. Read literally, the statute places at risk many business arrangements, potentially subjecting such arrangements to lengthy, expensive investigations and prosecutions initiated by federal and state governmental officials. Many states have adopted similar prohibitions against payments intended to induce referrals of Medicaid and other third party payer patients. Violation of the Anti-kickback Statute is a felony, punishable by fines up to $25,000 per violation and imprisonment for up to five years. In addition, the Department of Health and Human Services may impose civil penalties excluding violators from participation in Medicare or state health programs.
In July 1991, in part to address concerns regarding the Anti-kickback Statute, the federal government published regulations that provide exceptions, or "safe harbors," for transactions that will be deemed not to violate the Anti-kickback Statute. Certain of the Company's relationships do not qualify for safe harbor protection. The fact that a relationship does not qualify for safe harbor protection, however, does not mean that it is illegal, and the Company believes that it is not in violation of the Anti-kickback Statute. If the Company's current or future practices are found to be in violation of the statute, such finding could have a material adverse effect on the Company. Any state or federal regulatory review of the Company, regardless of the outcome, would be both costly and time consuming.
Significant prohibitions against physician referrals were enacted by Congress in the Omnibus Budget Reconciliation Act of 1993. These prohibitions, commonly known as "Stark II," amended prior physician self-referral legislation known as "Stark I" by dramatically enlarging the field of physician-owned or physician-interested entities to which the referral prohibitions apply. Effective January 1, 1995, Stark II prohibits, subject to certain exemptions, a physician or a member of his immediate family from referring Medicare or Medicaid patients to an entity providing "designated health services" in which the physician has an ownership or investment interest, or with which the physician has entered into a compensation arrangement. The penalties for violating Stark II include a prohibition on payment by these government programs and civil penalties of as much as $15,000 for each violative referral and $100,000 for participation in a "circumvention scheme." The Stark legislation is broad and ambiguous and interpretative regulations clarifying the provisions of Stark II as it would relate to the Company have not been issued. While the Company believes it is in compliance with the Stark legislation, there can be no assurance this is the case or that the government would not take a contrary view. The violation of Stark I or II by the Company could result in significant fines or penalties and exclusion from participation in the Medicare and Medicaid programs.
The Company is also subject to regulation by the Occupational Safety and Health Administration and the Environmental Protection Agency and similar state and foreign agencies and authorities.
EMPLOYEES
As of December 31, 1998, the Company employed 57 full time employees. The Company has no union contracts and believes that its relationship with its employees is good.
EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of the Company are as follows:
WILLIAM PETTY, M.D. was a founder and has been Chairman of the Board and Chief Executive Officer of the Company since its inception. Dr. Petty was a Professor at the University of Florida College of Medicine from 1975 to 1998 and served as Chairman of the Department of Orthopaedic Surgery at the University of Florida College of Medicine from July 1981 to January 1996. Dr. Petty has also served as a member of the Hospital Board of Shands Hospital, Gainesville, Florida, as an examiner for the American Board of Orthopaedic Surgery, as a member of the Orthopaedic Residency Review Committee of the American Medical Association, on the Editorial Board of the JOURNAL OF BONE AND JOINT SURGERY, and on the Executive Board of the American Academy of Orthopaedic Surgeons. He holds the Kappa Delta Award for Outstanding Research from the American Academy of Orthopaedic Surgeons. His book, TOTAL JOINT REPLACEMENT, was published in 1991. Dr. Petty received his B.S., M.S., and M.D. from the University of Arkansas. He completed his residency in Orthopaedic Surgery at the Mayo Clinic in Rochester, Minnesota. Dr. Petty continues a limited practice in the surgical field of total joint arthroplasty. He devotes most (approximately 90%) of his time to the business affairs of Exactech.
TIMOTHY J. SEESE has been President and Chief Operating Officer of the Company since March 1991 and a Director since April 1991. From October 1987 to December 1990, Mr. Seese served as President and Chief Executive Officer of Meritech, Inc., a development stage company involved with infection control products. From December 1986 to October 1987, he served as President of the Critical Care Monitoring Division of Becton Dickinson and Company, a manufacturer and marketer of medical devices upon the acquisition of Deseret Medical, Inc. by Becton Dickinson and Company. From January 1983 to December 1986, he served as Business Unit Director and Director, Marketing and Sales for the Critical Care Business of Deseret Medical, Inc. Division of Warner Lambert, a medical device, pharmaceutical and consumer products company. He received his B.S. in Metallurgical Engineering from the University of Cincinnati and his M.B.A. from Harvard University.
GARY J. MILLER, PH.D. was a founder and has been the Vice President, Research and Development of the Company since October 1986 and a Director since March 1989. Dr. Miller was Associate Professor of Orthopaedic Surgery and Director of Research and Biomechanics at the University of Florida College of Medicine from July 1986 through July 1997. Dr. Miller received his B.S. from the University of Florida, his M.S. (Biomechanics) from Massachusetts Institute of Technology, and his Ph.D. in Mechanical Engineering (Biomechanics) from the University of Florida. He has held an Adjunct Associate professorship in the College of Veterinary Medicine's Small Animal Surgical Division since 1982 and was appointed as an Adjunct Associate Professor in the Department of Aerospace Engineering, Mechanics and Engineering Sciences in 1995. He was a consultant to FDA from 1989 to 1992 and has served as a consultant to such companies as Johnson & Johnson Orthopaedics, Dow-Corning Wright and Orthogenesis.
DAVID W. PETTY has been Vice President, Marketing of the Company since April 1993. He has been employed by the Company in successive capacities in the area of Operations and Sales and Marketing for the past ten years, including as Vice President, Operations from April 1991 until April 1993. Mr. Petty received his B.A. from The University of Virginia in 1988. Mr. Petty is the son of Dr. and Ms. Petty.
MARC OLARSCH has been Vice President, Sales since July 1993. From 1984 to July 1993, he was employed by Carapace, the United States subsidiary of Lohmann GmbH & Co., KB, Neuwied, Germany, a manufacturer of orthopaedic casting material, surgical wound dressings and bandages. During his tenure with Carapace, he held the positions of Regional Sales Manager and National Sales Manager. He has extensive experience with group purchasing organizations, independent manufacturers' representatives, as well as company-employed territory managers and sales representatives.
JOEL C. PHILLIPS has been Chief Financial Officer of the Company since July of 1998. Mr. Phillips has been the Treasurer of the Company since March 1996, prior to which he was Manager, Accounting and Management Information Systems since April 1993. From January 1991 to April 1993, Mr. Phillips was employed by Arthur Andersen. He is responsible for the Company's accounting and control functions. Mr. Phillips received a B.S. and a Masters in Accounting from the University of Florida and is a certified public accountant.
BETTY PETTY has been Secretary of the Company since its inception and served as Treasurer and a Director from its inception until March 1996. Ms. Petty is responsible for the development of all of the Company's literature, advertising and corporate events and also serves as Human Resources Coordinator for the Company. Ms. Petty received her B.A. from the University of Arkansas at Little Rock and her M.A. in English from Vanderbilt University. Ms. Petty is the wife of Dr. Petty.
The Company's officers are elected annually by the Board of Directors and serve at the discretion of the Board.
GLOSSARY
ACETABULAR COMPONENT-An orthopaedic implant that attaches to the pelvis replacing the diseased or damaged acetabulum in total hip arthroplasty.
ACETABULAR CUP-An orthopaedic implant which replaces the acetabulum in total hip arthroplasty.
ACETABULUM-The hip socket or cup-shaped depression on the external surface of the pelvis, in which the femoral head fits.
ALLOGRAFT-A homograft between allogenic individuals.
ARTHROPLASTY-An operation to restore as far as possible the integrity and functionality of a joint.
ARTICULAR CONTACT STRESS-A measure of force where two moving surfaces make contact; in the case of a normal human joint or an artificial joint, a measure of force between the two surfaces in contact.
BIPOLAR COMPONENT/BIPOLAR PROSTHESIS-An orthopaedic hip implant used with a femoral stem and a femoral head to repair fractures of the neck of the femoral stem when the acetabulum and acetabular cartilage are in good condition.
BONE REMODELING-Reshaping of the bone as a result of stresses applied, sometimes from stresses transferred to the bone by an orthopaedic implant.
BONE SCREWS-Screws used to affix an orthopaedic implant to a bone.
CALCAR REPLACEMENT STEM-A femoral hip implant component used when there is bone loss or destruction in the proximal medial area of the femur.
CEMENT-A nonmetallic material used for filling a cavity and attaching implants to bone in joint arthroplasty.
CERAMIC-A glass like material made from metallic oxides used as an alternative to metal in the ball of a ball and socket joint in hip and other large joint orthopaedic implants.
COBALT CHROMIUM ALLAY-A substance primarily composed of a mixture of cobalt and chromium used for orthopaedic implants.
CONSTRAINED CONDYLAR FEMORAL COMPONENT-A type of knee replacement component typically used in revision surgery which compensates for lack of ligamentous stability in the knee joint.
CRUCIATE LIGAMENT SPARING FEMORAL COMPONENT-A total knee replacement component designed specifically for use in situations where the surgeon chooses to maintain a functional or partially functional posterior cruciate ligament (one of the major ligaments in the knee joint). Also called a cruciate retaining femoral component.
EXTRAMEDULLARY ALIGNMENT-A method used in setting the alignment for bone preparation in knee arthroplasty.
FEMORAL-Pertaining to the femur (large bone in the thigh).
FEMORAL HEAD-The ball of the ball and socket hip joint. The artificial ball used to replace the natural ball of a diseased or damaged hip joint.
FEMORAL STEM-An orthopaedic implant placed into the femur or thigh bone in total hip arthroplasty.
FEMUR-The bone located between the hip and the knee (large bone in the thigh).
FINNED KEEL-A shape or geometry of part of a specific design of a tibial component which is implanted into the bone in knee arthroplasty.
FIXATION METHODS-Various methods of fixating implant components of artificial joints to human bone.
FORGING-A fabrication process whereby a metal is heated and hammered into a final shape resulting in a strong, dense part.
HIP ARTHROPLASTY-An operation to restore as far as possible the integrity and functionality of the hip joint.
HOMOGRAFT- A graft of tissue from the donor of the same species as the recipient
IMPLANT-A device employed in arthroplasty.
JOINT REPLACEMENT-An arthroplasty procedure where joint functionality is restored as far as possible by totally substituting an artificial joint orthopaedic implant system for a diseased or damaged joint.
KNEE ARTHROPLASTY-An operation to restore as far as possible the integrity and functionality of the knee joint.
LONG STEM-A femoral hip implant component used when the length of the primary component does not meet the fixation needs of the surgical situation.
MODULAR-Made up of interchangeable parts which, when joined together, comprise an entire orthopaedic implant.
NON-CEMENT-Description of a total orthopaedic implant component or procedure in which bone cement is not used and the metal of the component is placed directly against the bone.
ORTHOPAEDICS-The medical specialty concerned with the preservation, restoration and development of form and function of the musculoskeletal system, extremities, spine and associated structures by medical, surgical and physical methods.
OSTEOARTHRITIS-Degenerative joint disease occurring chiefly in older persons, characterized by degeneration of the cartilage and bone and changes in the synovial membrane. It is accompanied by pain and stiffness, particularly after prolonged activity.
PATELLA-A triangular sesamoid bone situated at the front of the knee (knee cap).
PATELLA TRACKING-The action of the knee cap or patella gliding over the surface of the end of the femur or thighbone when the knee bends and straightens. Also the action of a patellar component gliding over the surface of a femoral component in a knee with a total knee arthroplasty.
POLYETHYLENE-A plastic polymer in the thermoplastic group compatible with tissue in the body.
POLYETHYLENE CUP LINER-An ultra-high molecular weight polyethylene insert which provides the articular surface inside an acetabular cup.
POROUS COATING-A coating made of metal beads applied by heat and pressure to the metal surface of an orthopaedic implant that promotes bony ingrowth in order to hold the orthopaedic implant in place.
POSTERIOR STABILIZED FEMORAL COMPONENT-A knee component which fits on the end of the femur and is used in situations where the surgeon chooses to eliminate the posterior cruciate ligament, one of the major ligaments in the knee joint. The component replaces to some degree the function of the posterior cruciate ligament.
PRESS FIT-A method of fixation using a wedge-fit, rather than cement.
PRIMARY SYSTEMS-Orthopaedic implants which are designed to replace the natural joint.
RECONSTRUCTIVE IMPLANT DEVICES-Orthopaedic implants which are implanted to reconstruct major joints which have been damaged by degenerative bone disease or accident.
REVISION SYSTEMS-Orthopaedic implants which are designed to replace a failed orthopaedic implant.
TIBIA-The inner and larger bone of the leg below the knee (shin bone).
TITANIUM-A metal used primarily in non-cemented applications in joint arthroplasty.
TOTAL JOINT ARTHROPLASTY-An operation to replace a diseased or damaged joint of the body with artificial implants usually to reduce pain and restore function in the joint.
TOTAL JOINT IMPLANTS-Implants used in total joint arthroplasty.
TRAPEZOID KEEL WITH STEM AUGMENTATION-A geometry of a specific design of tibial component that allows for attaching space-filling metal blocks and stems to fill bone defects in the tibia in knee arthroplasty.
UNICOMPARTMENTAL IMPLANTS-Implants designed to resurface only one compartment of a human knee.
UNIPOLAR PROSTHESIS-A large hemispherical implant component which is attached to a femoral stem in a partial hip arthroplasty.
ITEM 2.
ITEM 2. PROPERTIES
In June 1998, the Company completed construction of a new 38,000 square foot facility on approximately eight acres of land owned by it in Gainesville, Florida to be used by the Company for principal executive offices, research and development laboratories and manufacturing. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources".
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In the ordinary course of business, the Company is, from time to time, a party to pending and threatened legal proceedings, primarily involving claims for product liability. The Company believes that the outcome of such legal actions and proceedings will not have a material adverse effect on the Company.
On April 3, 1995, Joint Medical Products, Inc. ("Joint Medical") commenced an action (the "Action") against the Company, and many of its competitors, alleging the infringement of a United States patent held by Joint Medical entitled "Ball and Socket Bearing for Artificial Joint" (the "Ball and Socket Patent"). As part of the Action, Joint Medical alleged that the Company's manufacture and sale of certain orthopaedic implants was an infringement of the Ball and Socket Patent. The Company and Joint Medical entered into a Tolling Agreement, effective as of April 3, 1995, pursuant to which the parties agreed that the Action would be dismissed without prejudice as to the Company. The Tolling Agreement further provided that neither the Company nor Joint Medical would commence any further action regarding the Company's alleged infringement of the Ball and Socket Patent until the rendering of a decision by the Board of Patent Appeals and Interferences regarding such alleged patent infringement. In accordance with the Tolling Agreement, the Action was dismissed as against the Company, among others, as of July 28, 1995. During 1996, the Board of Patent Appeals and Interferences ruled in Joint Medical's favor and allowed the filing of claims to continue. On January 28, 1997, Joint Medical filed a complaint in the U.S. District Court for the District of Connecticut against the Company seeking injunctive relief and unspecified monetary damages. The Company believes, based upon a reasoned opinion of patent counsel, Fish and Richardson P.C., that Joint Medical's claims are without merit and that its orthopaedic implants do not infringe upon the Ball and Socket Patent. In December 1997, the complaint was dismissed without prejudice. The product line claimed to be in violation of the patent is the MCS/registered trademark/ Porous Acetabular Shell which represented approximately 7%, 6% and 7% of the Company's revenues for the years ended December 31, 1996, 1997 and 1998, respectively. A finding that such product line infringes upon the Ball and Socket Patent could materially and adversely affect the Company's business operations,
as well as expose the Company to significant monetary damages.
On August 21, 1997, a competitor of the Company filed a complaint in the United States District Court in New Jersey alleging that the Company induced several of the competitor's sales agents to breach their employment agreements when the Company contracted with these agents to sell the Company's products. The plaintiff was seeking an unspecified monetary award and punitive damages in the amount to be determined at trial. The plaintiff also sought to enjoin the Company from soliciting plaintiff's employees, interfering with their customer relationships and selling products to their former customers. At a hearing in the Superior Court of New Jersey on October 8, 1997, the judge denied the plaintiff's request for injuctive relief. On December 23, 1998, the Company settled the lawsuit by agreeing to pay the competitor an unspecified sum for the release of all claims raised in the lawsuit.
In December 1997, a competitor of the Company filed a complaint against one of the competitor's former sales agents in the United States District Court in Oregon. The competitor petitioned the court to include the Company in the complaint alleging liability for actions of the sales agent and interference by the Company with a contract between the competitor and the sales agent. The court refused to allow the Company to be included in the complaint, but affirmed that the competitor could name the Company in a separate complaint. Without admitting any wrongdoing, the Company and the agent settled the dispute through mediation in February 1998, and obtained a release of all claims. As part of the settlement, the Company agreed to pay $20,000 to the agent for legal expenses and an additional $55,000 in enhanced sales commissions to the agent over an indeterminate period of time if the commissions are earned. The Company also agreed not to hire as a new sales agent any of the competitor's exclusive distributors or sales representatives whose territory is west of the Mississippi River in the continental United States for a period of four months.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's security holders during the fourth quarter of the fiscal year ended December 31, 1998.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock has traded on the Nasdaq National Market under the symbol "EXAC" since May 30, 1996, the date of the initial public offering (IPO). The following table sets forth, for the periods indicated, the high and low sales price of the Common Stock, as reported on the Nasdaq National Market:
High Low ------------ ------------- - ----------------------------------------- Second Quarter (beginning May 30, 1996) $ 11.00 $ 8.00 Third Quarter 8.13 5.00 Fourth Quarter 12.25 7.00
- ----------------------------------------- First Quarter $ 10.00 $ 6.50 Second Quarter 7.75 6.00 Third Quarter 7.00 5.56 Fourth Quarter 6.88 3.88
- ----------------------------------------- First Quarter $ 7.13 $ 5.13 Second Quarter 8.25 6.75 Third Quarter 8.19 5.88 Fourth Quarter 13.00 5.88
- ----------------------------------------- First Quarter (through February 19, 1999) $ 13.50 $ 10.00
No cash dividends have been paid to date by the Company on its Common Stock. The Company intends to retain all future earnings for the operation and expansion of its business and does not anticipate the payment of dividends in the foreseeable future. Any future determination as to the payment of cash dividends will depend upon a number of factors, including future earnings, results of operations, capital requirements, the Company's financial condition and any restrictions under credit agreements existing from time to time, as well as such other factors as the Board of Directors may deem relevant.
As of February 19, 1999, the Company had approximately 226 stockholders of record. There are in excess of 2,500 beneficial owners of the Company's Common Stock.
After deducting expenses of $2,062,090 of the IPO, the Company received $12,657,910 in net proceeds from the IPO. Set forth below is information concerning the actual use of such proceeds.
1 - Includes direct or indirect payments to directors, officers, general partners of the Company, or their associates; to persons owning ten percent or more of any class of equity securities of the Company; and to affiliates of the Company. 2 - Includes increase of inventory held for sale of $3,464,276.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below has been derived from the audited financial statements of the Company. This data should be read in conjunction with the financial statements, the notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations included elsewhere herein.
* Earnings per share for years prior to 1997 have been restated in accordance with Statement of Financial Accounting Standards No.128 "Earnings Per Share".
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The following discussion should be read in conjunction with the financial statements and related notes appearing elsewhere herein.
Exactech, Inc. was founded by an orthopaedic surgeon in November 1985 to develop, manufacture, market and sell orthopaedic implant devices and related surgical instrumentation to hospitals and physicians in the United States and overseas. Exactech's high quality devices respond to the cost-conscious demands of the hospital and surgical community in replacing joints which have deteriorated as a result of injury or diseases, such as arthritis.
Early in our history, the Company's revenues were principally derived from sales of its primary hip replacement systems. Currently, the principal products in Exactech's line of hip implant devices consist of three primary total hip implant systems, the Opteon/registered trademark/ Cemented Hip System, the MCS/registered trademark/ Porous Coated Total Hip System, and the AuRA/registered trademark/ System, and several partial hip implant systems, the AuRA/registered trademark/ Revision hip implant, the unipolar implant, and the bipolar implant.
Exactech scaled up marketing and sales of the AuRA/registered trademark/ Hip System in 1997. AuRA/registered trademark/ is a comprehensive system that provides solutions for a broad range of patient problems. It is specifically designed to support the needs of a maturing generation of more active patients. The AuRA/registered trademark/ Hip System is comprised of a new primary total hip replacement system as well as revision components which include calcar replacement and long stems. It can also be used for fracture and tumor applications. All AuRA/registered trademark/ components have a common proximal geometry which affords the surgeon reproducibility of results regardless of which stem is selected. AuRA/registered trademark/ components can be implanted using a single set of surgical instruments which makes the system more cost effective.
During 1995, the Company introduced Optetrak/registered trademark/, a total primary knee replacement system, which had been in development for three years. The Optetrak/registered trademark/ knee system was conceived by Exactech in collaboration with members of its Scientific Advisory Board in cooperation with the Hospital for Special Surgery, an internationally known hospital for orthopaedic surgery. The Optetrak/registered trademark/ system represents a highly differentiated product based on precision manufacturing techniques and a design which reduces articular contact stress. The Optetrak/registered trademark/ system is the most modern rendition of a series of knee implants which were first introduced in 1974 and which are still being marketed by certain of the Company's competitors.
OpteFORM/trademark/, a newly developed biologic material for grafting and repairing bone defects, supplied by Regeneration Technologies, Inc., was introduced in 1998. OpteFORM/trademark/ is expected to become increasingly important in Exactech's product line as production increases.
During June 1998, the Company began offering the Acudriver/trademark/ Automated Osteotome System, which is an air-driven impact handpiece that aids surgeons during joint implant revision procedures by providing effective cleavage of prosthesis/bone or cement/bone interfaces. The Acudriver/trademark/ accomplishes this by providing the surgeon with precise positioning without the inconvenience and inconsistency of striking the osteotome with a mallet.
To market our orthopaedic implant products in the United States, Exactech utilizes a network of independent agencies and domestic distributors, that act as the Company's sales representatives. Internationally, the Company's products are marketed through distributors.
Exactech, its directors, officers, employees, and Scientific Advisory Board are committed to the continuing process of product design and development to meet the exacting demands of orthopaedic surgeons and their patients.
The following table sets forth for the periods indicated information with respect to the number of units of the Company's products sold and the dollar amount and percentages of revenues derived from such sales (dollars in thousands):
SALES AND EARNINGS
Net sales increased by $6,376,296, or 36%, to $24,024,356 in the year ended December 31, 1998, from $17,648,060 in the year ended December 31, 1997. Net sales for the year ended December 31, 1997 increased $3,808,084, or 28%, from $13,839,976 in the year ended December 31, 1996. Domestic sales increased 30%, to $19,017,251 in the year ended December 31, 1998, from $14,596,909 in the year ended December 31, 1997. During the year ended December 31, 1997, domestic sales increased 25%, from $11,715,120 in the year ended December 31, 1996. International sales increased 64%, to $5,007,105 in the year ended December 31, 1998, from $3,051,151 in the year ended December 31, 1997. For the year ended December 31, 1997, international sales increased 44%, from $2,124,856 in the year ended December 31, 1996. As a percentage of sales, international sales increased to 21% for the year ended December 31, 1998 from 17% for the year ended December 31, 1997 and 15% for the year ended December 31, 1996. The increase in net sales, in both 1998 and 1997, resulted primarily from increased unit volume of the Company's knee implant products. Sales of knee implant products for the year ended December 31, 1998, increased by 38%, on a unit basis and by 39% on a dollar basis when compared to the year ended December 31, 1997, which had increased by 66% on a unit basis and by 50% on a dollar basis from the year ended December 31, 1996. These increases represented a continued expansion of the Company's sales and marketing distribution network. Sales of hip implant products for the year ended December 31, 1998 increased by 9% on a unit basis and by 7% on a dollar basis when compared to the year ended December 31, 1997. The increase in hip sales is primarily due to increased market acceptance of the AuRA/registered trademark/ primary and revision cemented hip system. During 1997, hip implant sales had decreased by 8% on a unit basis and by 4% on a dollar basis from the year ended December 31, 1996. Hip and knee instrument sales and rentals increased 58% to $952,909 in the year ended December 31, 1998 from $602,082 in the year ended December 31, 1997, compared to a 22% decrease from $772,554 in the year ended December 31, 1996 as international knee instrument sales decreased.
Gross profit increased by $3,681,208, or 31%, to $15,433,965 in the year ended December 31, 1998, from $11,752,758 in the year ended December 31, 1997, as compared to a 28% increase in 1997 of $2,596,657, from $9,156,101 in the year ended December 31, 1996. As a percentage of sales, gross profit decreased to 64% in the year ended December 31, 1998 compared to 67% in the year ended December 31, 1997 and 66% in the year ended
December 31, 1996. The decrease in the year ended December 31, 1998 was primarily due to the increase in international sales, as a percentage of total sales, which are at lower margins. The increase in the year ended December 31, 1997, was primarily the result of a reduction in the unit costs of the Company's knee products as production volumes increased.
Total operating expenses increased by $2,646,570, or 29%, to $11,842,956 in the year ended December 31, 1998, after an increase of $2,492,950, or 37%, to $9,196,387 in the year ended December 31, 1997, from $6,703,437 in the year ended December 31, 1996. Operating expenses decreased as a percentage of sales for the year ended December 31, 1998, to 49%, from 52% for the year ended December 31, 1997. Operating expenses increased as a percentage of sales in the year ended December 31, 1997, to 52% from 48% in the year ended December 31, 1996. Sales and marketing expenses increased by $1,056,705, or 22%, to $5,968,611 in the year ended December 31, 1998, from $4,911,906 in the year ended December 31, 1997, as compared to an increase of 39% from 1996 to 1997. As a percentage of sales, sales and marketing expenses in 1998 decreased to 25% as compared to 28% in 1997, which represented an increase from 25% in 1996. The Company's sales and marketing expenses are largely variable costs based on sales levels, with the largest component being commissions. During 1998, sales and marketing expenses decreased, as a percentage of sales, in large part due to the increased percentage of international sales, with their lower commission structure.
General and administrative expenses increased by $506,686, or 30%, to $2,184,564, in the year ended December 31, 1998, from $1,677,878 in the year ended December 31, 1997, as compared to a 25% increase during 1997 from $1,346,304 in 1996. For the year ended December 31, 1998, as a percentage of sales, general and administrative expenses decreased slightly to 9% after remaining relatively constant at 10% during 1996 and 1997. Total general and administrative expenses increased on a dollar basis during 1998 as compared to 1997 primarily as a result of additional costs associated with litigation that was settled during December 1998.
Research and development expenses increased by $333,837, or 36%, to $1,271,825 in the year ended December 31, 1998, from $937,988 in the year ended December 31, 1997, as compared to an increase of 25% during 1997 from 1996, as product development expenses for an integrated primary hip and modular hip systems increased. As a percentage of sales, research and development expenses remained relatively constant at 5% in the years ended December 31, 1996, 1997 and 1998.
Depreciation and amortization expenses increased 48% to $1,202,000 in the year ended December 31, 1998, from $813,200 in the year ended December 31, 1997, and $509,236 in the year ended December 31, 1996. Depreciation and amortization expenses increased in 1998 primarily due to the completion of the Company's new facility and the installation of furniture, fixtures, and equipment associated with the facility. During 1998, $4,199,634 of facility, furniture, fixtures, equipment, and instruments were placed in service.
Royalty expenses increased by $360,541, or 42%, to $1,215,956 in the year ended December 31, 1998, from $855,415 in the year ended December 31, 1997 as compared to a 50% increase in 1997 from $571,807 in 1996. The increase in royalty expenses was primarily the result of growth in sales of knee implant products which incur a higher royalty rate. During 1998, the Company recognized royalty expenses of $650,548 as compared to $474,357 in 1997 and $307,801 in 1996 in connection with the license agreement with the Hospital for Special Surgery and $565,408 compared to $381,058 in 1997 and $187,773 in 1996 in connection with other consulting and license agreements. As a percentage of sales, royalty expenses were flat at 5% for the years ended December 31, 1998 and 1997, and 4% in the year ended December 31, 1996.
The Company's income from operations increased by $1,034,638, or 41%, to $3,591,009 in the year ended December 31, 1998, from $2,556,371 in the year ended December 31, 1997, which represented an increase of $103,707, or 4%, from $2,452,664 in the year ended December 31, 1996. For the year ended December 31, 1998, the increase was principally due to an increase in sales combined with a reduction in operating expenses, as a percentage of sales, partially offset by an increase in cost of sales.
The Company recognized net interest expense of $70,686 in the year ended December 31, 1998 as compared to net interest income of $200,720 in the year ended December 31, 1997. The recognition of expense as compared to income was the result of a reduction of short-term investments while there was increased borrowing associated with construction of the new facility. Interest expense of $233,099 for the year ended December 31,
1998 was partially offset by $162,413 of interest income. Previously, the COMPANY recognized net interest income of $200,720 in the year ended December 31, 1997, as compared to $12,336 in the year ended December 31, 1996. Interest income of $275,112 for the year ended December 31, 1997, was offset by $74,392 of interest expense as the proceeds of the Company's IPO consummated in June 1996 were invested in short-term commercial paper and government backed securities. The outstanding principal balance of the Company's debt averaged approximately $3,914,156, $510,325 and $1,427,000 during 1998, 1997 and 1996, respectively. The average outstanding balance increased in 1998 because approximately $3,900,000 was outstanding on the industrial revenue bond (IRB) loan for the full year, whereas $3,900,000 was outstanding for only a month and a half in 1997. The weighted average interest rate on such debt was 4.37%, 4.32% and 8.56% for 1998, 1997 and 1996, respectively.
In July 1995, the Company purchased a 50% interest in Techmed S.p.A., its Italian distributor. Prior to September 1997, the investment in the subsidiary was accounted for using the equity method with the Company's share of the subsidiary's net earnings (loss) included as a separate item in the statement of income. During September 1997, the Company wrote off its investment in the subsidiary and reserved for trade receivables deemed uncollectible. In April 1998, the Company sold its interest in Techmed S.p.A. As a result, the Company recognized $13,778 in gain associated with the sale.
Income before provision for income taxes increased by $960,919, or 37%, to $3,534,101 in the year ended December 31, 1998, from $2,573,182 in the year ended December 31, 1997, as compared to an increase in 1997 of $67,668, or 3%, from $2,505,514 in the year ended December 31, 1996. The provision for income taxes increased 41% to $1,406,671 in the year ended December 31, 1998, from $997,188 in the year ended December 31, 1997, and $950,906 in the year ended December 31, 1996. The Company realized net income of $2,127,430 in the year ended December 31, 1998, a 35% increase, as compared to $1,575,994 in the year ended December 31, 1997. Net income for the year ended December 31, 1997 increased 2% from $1,544,454 in the year ended December 31, 1996.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, the Company has financed its operations through borrowings, the sale of equity securities and cash flow from operations. At December 31, 1998, the Company had working capital of $15,867,747 as compared to $14,402,799 at December 31, 1997, and $15,176,581 at December 31, 1996. As a result of operating, investing and financing activities, cash and cash equivalents at December 31, 1998 decreased $46,569 to $662,652. For the year ended December 31, 1997, cash and cash equivalents decreased to $709,221 from $3,992,442 at December 31, 1996. The decrease in working capital was primarily the result of costs associated with completing, furnishing, and equipping the new facility. During 1998, the Company expended $2,044,045 in costs on the completion of the new facility. The Company is committed to approximately $27,000 in remaining construction costs associated with the completion of the new facility as of December 31, 1998. During July 1998, the Company's line of credit facility with Merrill Lynch Business Financial Services, Inc. was renewed and increased to $6,000,000. The credit facility, which is collateralized by accounts receivable and inventory, expires in June 2000. At December 31, 1998, there was no amount outstanding under the line of credit. The Company believes that funds from operations and borrowings under its existing credit facilities will be sufficient to satisfy its contemplated cash requirements for the following twelve months.
OPERATING ACTIVITIES
Operating activities provided net cash of $854,614 in the year ended December 31, 1998 and used net cash of $1,625,239 in the year ended December 31, 1997 as compared to providing net cash of $8,951 in the year ended December 31, 1996. Operating activities provided cash due to the increase in net income, which increased to $2,127,430 in the year ended December 31, 1998, from $1,575,994 in the year ended December 31, 1997 and from $1,544,454 in 1996, as well as a smaller increase in total inventories of $834,682 during 1998 as compared to $3,072,123 during 1997 and $1,303,401 in 1996. Cash required as a result of the increase in trade receivables was $1,877,814 during 1998, as compared to $1,298,132 during 1997 and $660,735 in 1996.
FINANCING ACTIVITIES
For the year ended December 31, 1998, financing activities provided net cash to the Company of $7,561,
as compared to $3,892,522 in the year ended December 31, 1997 and $9,017,468 in the year ended December 31, 1996.
In November 1997, the Company entered into a $3,900,000 industrial revenue bond financing with the City of Gainesville, Florida (the "City"), pursuant to which the City issued its industrial revenue bonds and loaned the proceeds to the Company. The bonds are secured by an irrevocable letter of credit issued by a bank. The $3,900,000 credit facility requires the payment by the Company of principal installments as follows: $300,000 per year from 2000 through 2006; $200,000 per year from 2007 through 2013; and $100,000 per year from 2014 through 2017. Monthly interest payments are based on an adjustable rate as determined by the bonds remarketing agent based on market rate fluctuations (4.1% as of December 31, 1998). The proceeds of the credit facility were used to finance construction of the new facility. The Company's obligations to the bank issuing the letter of credit are secured by the land and improvements comprising the facility.
Net cash provided by financing activities for the year ended December 31, 1997 reflects the proceeds from the $3,900,000 industrial revenue bond financing with the City. In 1997, the Company also paid $118,935 of debt issuance costs associated with the industrial revenue bond financing which will be recognized as expense over the term of the loan. Cash provided by financing activities for the year ended December 31, 1996 reflects the net proceeds of $12,657,910 from the Company's IPO consummated in June 1996.
INVESTING ACTIVITIES
The Company invested the remaining proceeds of the industrial revenue bond financing and the IPO in daily maturing investments as of December 31, 1998. At December 31, 1997, $3,467,072 was invested in commercial paper and discount notes yielding approximately 5%. During 1998, these investments were liquidated to provide funds for the construction of the Company's new facility. As of December 31, 1998, $284,794 was invested in Merrill Lynch's Treasury Fund and Institutional Fund comprised of commercial paper and government backed securities yielding a return of approximately 4.5%, as compared to $1,763,996 at December 31, 1997. During the year ended December 31, 1998, net cash used in investing activities decreased to $908,744 as compared to $5,550,504 during the year ended December 31, 1997, which was an increase from $5,235,956 in the year ended December 31, 1996. The decrease in 1998 was primarily due to the change in unexpended IRB proceeds that were utilized to purchase property and equipment, including the Company's new facility, manufacturing equipment, product licenses and instrumentation.
YEAR 2000
The inability of computers, software and other equipment utilizing microprocessors to recognize and properly process data fields containing a 2 digit year is commonly referred to as the Year 2000 Compliance issue. As the year 2000 approaches, such systems may be unable to accurately process certain date-based information.
The Company has identified all significant applications that will require modification to ensure Year 2000 Compliance. Internal and external resources are being used to make the required modifications and test Year 2000 Compliance. The modification process of all significant applications is substantially complete. The Company plans on completing the testing process of all significant applications by June 30, 1999.
In addition, the Company has communicated with suppliers with whom it does significant business to determine their Year 2000 Compliance readiness and the extent to which the Company is vulnerable to any third party Year 2000 issues. The Company received acceptable responses from these suppliers as to their readiness; however, there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have a material adverse effect on the Company.
The total cost to the Company of these Year 2000 Compliance activities has not been and is not anticipated to be material to its financial position or results of operations in any given year. These costs and the date on which the Company plans to complete the Year 2000 modification and testing processes are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability
of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ from those plans.
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 2 of Notes to Financial Statements for information concerning recent accounting pronouncements.
CAUTIONARY STATEMENT RELATING TO FORWARD LOOKING STATEMENTS
The foregoing Management's Discussion and Analysis contains various "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 which represent the Company's expectations or beliefs concerning future events, including, but not limited to, statements regarding growth in sales of the Company's products, profit margins, the adequacy of the Company's year 2000 compliance program, and the sufficiency of the Company's cash flow for its future liquidity and capital resource needs. These forward looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward looking statements. These factors include, without limitation, the effect of competitive pricing, the Company's dependence on the ability of its third-party manufacturers to produce components on a basis which is cost-effective to the Company, market acceptance of the Company's products and the effects of governmental regulation. Results actually achieved may differ materially from expected results included in these statements as a result of these or other factors.
ITEM 7.A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk from changes in interest rates. For its cash and cash equivalents, a change in interest rates effects the amount of interest income that can be earned. For its debt instruments, changes in interest rates effect the amount of interest expense incurred.
The following table provides information about the Company's financial instruments that are sensitive to changes in interests rates.
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Exactech, Inc. Gainesville, Florida
We have audited the accompanying balance sheets of Exactech, Inc. (the "Company") as of December 31, 1997 and 1998, and the related statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of Exactech, Inc. as of December 31, 1997 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
February 12, 1999
SEE NOTES TO FINANCIAL STATEMENTS
SEE NOTES TO FINANCIAL STATEMENTS
SEE NOTES TO FINANCIAL STATEMENTS
SEE NOTES TO FINANCIAL STATEMENTS
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 - --------------------------------------------------------------------------------
1. ORGANIZATION
Exactech, Inc. (the "Company") was organized in 1985 to develop and market orthopaedic implant devices. In 1988, the Company began marketing its first product, a total hip replacement system. In 1994, the Company began marketing a knee system. The Company's principal market is the United States; however, international markets represent approximately twenty-one percent of the Company's business.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CASH AND CASH EQUIVALENTS - Cash and cash equivalents consist of cash on deposit in financial institutions, including a money market account, institutional money funds, overnight repurchase agreements, and other short-term investments with a maturity of 90 days or less at the time of purchase.
CONCENTRATION OF CREDIT RISK - The Company's accounts receivable consist primarily of amounts due from hospitals. The Company performs credit evaluations on its customers and generally does not require collateral.
SHORT TERM INVESTMENTS - The Company invests its excess funds in various high-quality and low-risk investment securities. Debt securities for which the Company has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Securities are classified as trading securities if bought and held principally for the purpose of selling them in the near future. Securities not classified as held to maturity or trading are classified as available for sale, and reported at fair value with unrealized gains and losses excluded from earnings and reported net of tax as a separate component of shareholders' equity until realized. The fair values of the investments are estimated based on quoted market prices. Short-term investments held at December 31, 1997, were classified as held to maturity, and consisted of short-term, government backed securities. The amortized cost of such short-term investments approximates fair value. No such short-term investments were held at December 31, 1998.
INVENTORIES - Inventories are valued at the lower of cost (first-in, first-out method) or market and include implants provided to customers and agents. The Company provides significant loaned implant inventory to non-distributor customers. The Company recognizes an inventory reserve based on obsolescence and slow-moving inventory.
PROPERTY AND EQUIPMENT - Property and equipment is stated at cost less accumulated depreciation. Depreciation expense is computed using the straight-line method over estimated useful lives of the related assets ranging from five to thirty-nine years. Maintenance and repairs are charged to expense. Certain instruments utilized in the surgical implant procedures are loaned to customers and are amortized over an estimated useful life of seven years. Periodically, management reviews property and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment is measured by comparing the carrying amount of the asset to the sum of expected future cash flows (undiscounted and without interest charges) resulting from use of the asset and its eventual disposition.
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (CONTINUED) - --------------------------------------------------------------------------------
REVENUE RECOGNITION - The Company provides inventories of its products to its United States sales agencies until sold or returned for use in marketing its products and filling customer orders. In the case of sales through such sales agencies, sales revenues are generally recognized when the product is implanted. Distributors typically purchase product inventory and instruments from the Company for their use in marketing and filling customer orders. Sales to such distributors are recognized upon shipment of the product. Estimated costs of returns and allowances on sales to foreign distributors are accrued at the time products are shipped.
INVESTMENT IN SUBSIDIARY - In July 1995, the Company purchased a 50% interest in Techmed, its Italian distributor. Prior to September of 1997, the investment in the subsidiary was accounted for using the equity method with the Company's share of the subsidiary's net earnings (loss) included as a separate item in the statement of income. During September 1997, the Company wrote off its investment in the subsidiary. During 1998, a gain of $13,778 was recognized on the final disposition of this investment.
DEFERRED FINANCING COSTS - Deferred financing costs are stated net of accumulated amortization of $29,217. These costs are amortized to interest expense over the expected life of the underlying debt.
PATENTS AND TRADEMARKS - Patents and trademarks are amortized on a straight-line basis over their estimated useful lives ranging from five to seventeen years.
INCOME TAXES - Deferred income taxes are provided on temporary differences which arise from certain transactions being reported for financial statement purposes in different periods than for income tax purposes. Deferred tax assets and liabilities are recognized using an asset and liability approach and are based on differences between financial statement and tax basis of assets and liabilities using presently enacted tax rates.
ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during each reporting period. Actual results could differ from those estimates.
OPTIONS AND STOCK AWARDS - The Company has elected to account for its employee stock compensation plans under the intrinsic value based method with pro forma disclosures of net earnings and earnings per share, as if the fair value based method of accounting defined in SFAS No. 123 "Accounting for Stock Based Compensation" had been applied (Note 11). Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date or other measurement date over the amount an employee must pay to acquire the stock. Under the fair value based method, compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period.
RECLASSIFICATIONS - Certain items in the prior year financial statements have been reclassified to conform to the 1998 presentation.
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (CONTINUED) - --------------------------------------------------------------------------------
NEW ACCOUNTING STANDARDS - In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"), effective for fiscal years beginning after December 15, 1997. SFAS No. 130 requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. The Company adopted this accounting standard on January 1, 1998, as required. Adoption of SFAS No. 130 did not have a material effect on the Company's disclosures.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131") effective for fiscal years beginning after December 15, 1997. SFAS No. 131 establishes standards for reporting information about operating segments in annual financial statements and requires selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Statement of comparative information for earlier periods presented is required in the initial year of application. Interim information is not required until the second year of application, at which time comparative information is required. The Company adopted this accounting standard on January 1, 1998, as required (Note 7).
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (CONTINUED) - --------------------------------------------------------------------------------
3. INCOME TAXES
A reconciliation between the amount of reported income tax provision and the amount computed at the statutory Federal income tax rate for the years ended December 31, 1996, 1997 and 1998 follows:
The types of temporary differences and their related tax effects that give rise to deferred tax assets and liabilities at December 31, 1997 and 1998 are as follows:
During the year ended December 31, 1998, the Company generated a capital loss carryover of $294,399 which is available to offset future taxable capital gains. The capital loss carryover will expire in 2003.
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998(CONTINUED) - -------------------------------------------------------------------------------
The following is a schedule of debt maturities and future minimum lease payments under the capital leases, together with the present value of minimum lease payments as of December 31, 1998:
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (CONTINUED) - --------------------------------------------------------------------------------
INDUSTRIAL REVENUE BOND NOTE PAYABLE
In November 1997, the Company entered into a $3,900,000 industrial revenue bond financing with the City of Gainesville, Florida (the "City"), pursuant to which the City issued its industrial revenue bonds and loaned the proceeds to the Company. The bonds are secured by an irrevocable letter of credit issued by a bank. Due to the variable nature of the note, the balance of the note payable approximates fair value.
At December 31, 1998, the unexpended portion of the IRB proceeds, $856,992 remained invested in short-term investments and cash equivalents.
LINE OF CREDIT
During July 1998, the Company renewed and increased a $6,000,000 line of credit with Merrill Lynch Business Financial Services, Inc. There are no amounts outstanding under this line of credit at December 31, 1998.
5. RELATED PARTY TRANSACTIONS
The Company has entered into a purchase agreement with Brighton Partners, Inc. to purchase raw materials used in the ongoing production of its products. The agreement requires the purchase of tooling dies in the amount of $159,000 and provides for special purchasing terms for the Company. Some of the Company's officers and directors maintain ownership in Brighton Partners Inc. During 1998, purchases associated with this agreement totaled $116,058.
The Company has entered into consulting agreements with certain of its executive officers, directors and principal shareholders in connection with product design which entitles them to royalty payments aggregating 3% of the Company's net sales of such products in the United States and less than 3% of the Company's net sales of such products outside the United States. During the years ended December 31, 1996, 1997 and 1998, the Company paid royalties aggregating $187,773, $288,759 and $436,242, respectively, pursuant to these consulting agreements.
6. COMMITMENTS AND CONTINGENCIES
The Company is committed to approximately $27,000 in remaining construction costs associated with the completion of the new facility as of December 31, 1998.
The Company, in the normal course of business, is subject to claims and litigation in the areas of product and general liability. Management does not believe any of such claims will have a material impact on the Company's financial position.
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (CONTINUED) - --------------------------------------------------------------------------------
7. SEGMENT INFORMATION
Segment information is reported by the major product lines of the Company: knee implants, hip implants, and tissue services. The "other" category is for minor sales categories, such as instrument rental fees and shipping charges. The accounting policies of the reportable segments are the same as those described in Note 2. The Company evaluates the performance of its operating segments based on income from operations before taxes, interest income and expense, and nonrecurring items. Intersegment sales and transfers are not significant.
Total assets not identified with a specific segment (in thousands of dollars) are $10,444, $11,932, and $12,557 for the years ended December 31, 1996, 1997, and 1998, respectively. Assets not identified with a specific segment include cash and cash equivalents, accounts receivable, refundable income taxes, prepaid expenses, land, facilities, office furniture and computer equipment, and other assets.
Summarized financial information concerning the Company's reportable segments is shown in the following table.
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (CONTINUED) - --------------------------------------------------------------------------------
MAJOR CUSTOMER AND FOREIGN OPERATIONS
During the years ended December 31, 1996, 1997, and 1998, approximately 7%, 6% and 7% respectively, of the Company's sales were derived from a major customer. During the years ended December 31, 1996, 1997, and 1998, approximately 13%, 13% and 14%, respectively, of the Company's sales were derived from an international distributor of its products. Revenue and gross profits for the Company's foreign operations for the three years ended December 31, 1998 were as follows:
1996 1997 1998 ---- ---- ---- Revenues $2,124,856 $3,051,151 $5,007,105
Gross profit $597,944 $1,127,455 $1,871,577
8. PENSION PLAN
The Company currently sponsors a defined contribution 401(k) plan for its employees. The Company provides matching contributions of 25% on the first 3% of salary deferral by employees. The Company's total contribution to this plan during 1998 was $12,896.
9. LICENSE AND SUBLICENSE AGREEMENTS
During October 1996, the Company licensed patent technology for development of a modular hip system. The patent license fees total $360,000 with $275,000 being paid at time of agreement and an additional $85,000 being payable at time of FDA clearance to market the products.
During 1997, the Company licensed certain technology. The license fees total $250,000, of which $100,000 was paid upon the execution of the agreement and an additional $150,000 is payable at such time as the licensor produces a developed product. The cost of the license agreement will be amortized over the period of its estimated economic benefit.
10. ASSET PURCHASES
During June 1998, the Company purchased substantially all of the assets related to Synvasive Technology, Inc.'s ("Synvasive") AcuDriver/trademark/ product line for $375,000. The assets included inventory, tooling, fixtures, designs, trademark and future patent rights.
11. COMMON STOCKHOLDERS' EQUITY
COMMON STOCK:
In June 1996, the Company completed an underwritten initial public offering ("IPO") of 1,840,000 shares of its common stock at an initial offering price of $8.00 per share, yielding gross proceeds of $14,720,000. Net proceeds to the Company as a result of the IPO were $12,657,910 after deduction of underwriting, legal, accounting and other offering related expenses in the aggregate of $2,062,090. Upon consummation of the IPO, $50,000 of 10% debentures were converted to 6,250 shares of common stock.
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (CONTINUED) - --------------------------------------------------------------------------------
EARNINGS PER SHARE: The following is a reconciliation of the numerators and denominators of the basic and diluted EPS computations for net income and net income available to common shareholders:
For the year ended December 31, 1996, options to purchase 336,200 shares of common stock at prices ranging from $8.00 to $8.80 per share were outstanding but were not included in the computation of diluted EPS because the options' exercise prices were greater than the average market price of the common shares.
For the year ended December 31, 1997, options to purchase 348,900 shares of common stock at prices ranging from $7.50 to $9.00 per share were outstanding but were not included in the computation of diluted EPS because the options' exercise prices were greater than the average market price of the common shares.
For the year ended December 31, 1998, options to purchase 376,700 shares of common stock at prices ranging from $7.50 to $9.00 per share were outstanding but were not included in the computation of diluted EPS because the options' exercise prices were greater than the average market price of the common shares.
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998(CONTINUED) - --------------------------------------------------------------------------------
OPTIONS AND STOCK AWARDS:
The Company sponsors an Employee Stock Option and Incentive Plan which provides for the issuance of stock options and restricted stock awards to key employees and a Director's Stock Option Plan which provides for the issuance of stock options to non-employee directors (collectively the "Plans"). The Company also issues stock options to sales agents and other individuals. The maximum number of common shares issuable under the Plans is 600,000 shares.
If compensation cost for stock option grants had been determined based on the fair value at the grant dates for 1996, 1997 and 1998 consistent with the method prescribed by SFAS No. 123, the Company's net earnings and earnings per share on a diluted basis would have been adjusted to the pro forma amounts indicated below:
Outstanding options, consisting of ten-year non-qualified stock options, vest and become exercisable over a five year period from date of grant. The outstanding options expire ten years from the date of grant or upon retirement from the Company, and are contingent upon continued employment during the applicable ten-year period.
Under SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1996, 1997 and 1998, respectively: dividend yield of 0, 0 and 0 percent, expected volatility of 43, 70 and 41 percent, risk-free interest rates of 6.8, 6.0 and 5.1 percent, and expected lives of 5, 5 and 5 years.
EXACTECH, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998(CONTINUED) - --------------------------------------------------------------------------------
A summary of the status of fixed stock option grants under the Company's stock-based compensation plans as of December 31, 1996, 1997 and 1998, and changes during the years ending on those dates is presented below:
The following table summarizes information about fixed stock options outstanding at December 31, 1998:
Exercise Options Options Weighted Average Price Range Outstanding Exercisable Remaining Life ----------------- -------------- ------------- ---------------- $ 2.30 - 6.67 167,245 139,481 5.38 7.13 - 8.00 289,700 136,120 7.82 8.06 - 9.00 101,000 43,000 7.53 =============== ============= =========== Total 557,945 318,601 7.04 =============== ============= ===========
Remaining non-exercisable options as of December 31, 1998 become exercisable as follows:
1999 87,322 2000 87,022 2001 49,290 2002 8,930 2003 6,780 ================== 239,344 ==================
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information set forth under the caption "Management" in the Company's definitive Proxy Statement for its 1999 Annual Meeting of Shareholders (the "Proxy Statement") is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information set forth under the caption "Executive Compensation" in the Company's Proxy Statement is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth under the caption "Security Ownership" in the Company's Proxy Statement is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth under the caption "Certain Transactions" in the Company's Proxy Statement is incorporated herein by reference.
PART IV. OTHER INFORMATION
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) Financial Statements
The financial statements filed as part of this report are listed under Item 8.
Item 8.
(b) Reports on Form 8-K
None
(c) Exhibits:
Copies of the exhibits filed with this Annual Report on Form 10-K or incorporated herein by reference do not accompany copies hereof for distribution to shareholders of the Company. The Company will furnish a copy of any of such exhibits to any shareholder requesting the same.
(1) Incorporated by reference to the exhibit of the same number filed with the Registrant's Registration Statement on Form S-1 (File No. 333-02980). (2) Management contract or compensation plan. (3) Incorporated by reference to exhibit 10 filed with the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996. (4) Incorporated by reference to the exhibit of the same number filed with the Registrant's Annual Report on Form 10-K for the year ended December 31, 1997. (5) Incorporated by reference to exhibit 10 filed with the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998.
(d) Financial Statement Schedules:
Schedule II-Valuation and Qualifying Accounts
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
March 5, 1999 EXACTECH, INC. By: /S/ WILLIAM PETTY -------------------------- William Petty Chairman of the Board and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXACTECH, INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1998
EXHIBIT INDEX
EXHIBIT DESCRIPTION - ------- -----------
11.1 Computation of Earnings Per Share
27.1 Financial Data Schedule