ITEM 1. BUSINESS
OVERVIEW
Encore Medical Corporation ("EMC") through its primary operating subsidiary, Encore Orthopedics, Inc. ("Encore" or the "Company"), designs, markets and distributes orthopedic products and supplies. Its products are used primarily by orthopedic medical specialists to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and participation in sporting events. Encore's products cover a broad variety of orthopedic needs and include hip, knee and shoulder implants to reconstruct damaged joints and trauma products to reconstruct bone fractures.
Encore was formed in April 1992, when several executives with significant experience in the orthopedics industry joined with a small original equipment manufacturer of orthopedic implants and related instruments. Encore's first product, the Foundation(R) Knee System, was introduced in Europe in late 1992 and in the United States in February 1993 after receiving Food and Drug Administration ("FDA") 510(k) approval. Encore also obtained registration for this product in Japan, where sales began in late 1994. Since that time Encore has developed and obtained regulatory approval for over 50 additional orthopedic total joint products, trauma products, biologic products, spinal products, and product improvements. Encore is also awaiting 510(k) and IDE/PMA approval on several other products.
By October 1997, Encore moved up to number 145 on the Inc. 500 listing, compared to being ranked number 398 in the 1996 Inc. 500 list of the fastest growing private companies. In May 1996, Encore completed its first acquisition when it acquired the assets and liabilities of Applied Osteo Systems, Inc. ("AOS"). The acquisition expanded Encore's product line into trauma products. This expansion into trauma products was furthered by the acquisition of Biodynamic Technologies, Inc. ("BTI") in March 1999.
On March 25, 1997, the stockholders of Encore approved the merger of Encore with and into Healthcare Acquisition, Inc., a wholly owned subsidiary of Healthcare Acquisition Corp., ("HCAC"), with Encore being the surviving entity. As part of the transaction, HCAC became known as Encore Medical Corporation. HCAC was formed in 1995 to invest in a healthcare business and completed its initial public offering in March 1996. Encore currently employs approximately 100 people worldwide.
The Company continues its growth by being present in the newest fields of the orthopedic industry. Encore completed a distribution agreement with Biocomposites, Ltd. of England that provided entry into the bone graft substitute market. The Company also gained FDA approval of an expedited clinical trial methodology for a low friction, ceramic-on-ceramic total hip replacement product. Rapid growth and high margins characterize these innovative markets. Encore's latest venture is in the spinal implant marketplace, which had growth rates in 1996 and 1997 exceeding 30% per year. This new market anticipates growth rates in excess of 20% per year for the next several years. Encore gained access to its first spinal products through an exclusive United States distribution agreement with SCIENT'X, a Paris-based spinal products manufacturer.
INDUSTRY BACKGROUND
Certain of the information contained in this Form 10-K, generally, and in this section concerning the definition, size and development of the various product markets in which Encore participates, and Encore's general expectations concerning the development of such product markets, both domestically and internationally, are based on estimates prepared by Encore using data from various sources (primarily Medical Data International, Inc., Dain Raucher Wessel, US Bancorp, Piper Jaffray and Knowledge Enterprises, as well as data from Encore's internal research), which data Encore has no reason to believe are unreliable, and on assumptions made by Encore, based on such data, and Encore's knowledge of the orthopedic product industry, which Encore believes to be reasonable.
Over the last two decades, the orthopedic products market, which consists of implants for joint replacement, spinal implants, trauma products, certain arthroscopic, sports medicine and soft goods products, bone cement and related products and instrumentation, has experienced significant growth in both revenues and unit sales. Recent advances in technology require the addition to the orthopedic products market tissue technology image-guided surgery, osteobiologics and diagnostic products related to osteoporosis. Based on this expanded scope, in 1998, the worldwide market for orthopedic products produced approximately $11.2 billion in revenue. In the United States, the orthopedic products market represented approximately $6.5 billion in revenue in 1998. From 1992 to 1998 the average annual revenue growth rate was approximately 10%. Unit growth accounted for approximately half of this growth; the remainder of the growth was attributable to technology driven price increases.
Joint reconstruction products accounted for approximately $2.1 billion of the overall orthopedic market in the U.S. in 1998 and approximately $3.8 billion worldwide. Among the joint replacement products, hip and knee replacement products account for approximately 95% of worldwide revenues (with approximately $3.6 billion in worldwide sales in 1998) and shoulder replacement and other related products (spinal, elbow, wrist, finger, toe, ankle and ligament prostheses) account for approximately 5% of worldwide revenues (with approximately $190 million in worldwide sales in 1998). The trauma, or fracture fixation, segment of the orthopedic products market approached $750 million in 1998, representing approximately 10% growth over 1997. The trauma product market is divided between internal and external fixation products. In 1998, internal fixation products accounted for about 75% of the revenues from the sale of all trauma products.
Of particular note is the dynamic growth of both the spinal and tissue/osteobiological market segments. It is estimated that the U.S. spinal market exceeded $600 million in 1998 and was approaching $1 billion worldwide. Rapid advances in technology and product design are predicted to produce growth rates exceeding 20% per year for several years. Interbody fusion devices have contributed greatly to this rapid growth, achieving approximately a 30% market share since appearing on the market in 1996.
Tissue technology, i.e., osteobiologics, was estimated at approximately $500 million in 1998. Growth potential is concentrated in bone graft substitutes and biologically active bone morphogenic proteins (BMP) as they replace more traditional autografts and allografts, i.e. bone bank bone, which account for more than 75% of the procedures requiring bone graft. As with spine, growth rates for this market segment should exceed 20% for several years.
The remaining segments of the orthopedic products market (soft goods, cast room products, power and hand instruments, arthroscopy, etc.) account for approximately 40% of the revenue for the total orthopedic products market.
The international orthopedic market remains concentrated in a few primary areas. The United States alone accounts for approximately 58% of the worldwide market, and five countries, the United States, Germany, France, Japan and the United Kingdom, account for approximately 80% of the worldwide market for such products. There are, however, other markets being developed in areas such as China, Eastern Europe, Russia and the Middle East, where there is significant growth potential for sales of orthopedic products such as Encore markets.
STRATEGY
Encore has established its knee, hip and shoulder total joint products as the core of its product line. Encore's management believes that it must offer a complete line of reconstructive total joint implant products, along with specialty trauma, biologic and spinal products, to remain competitive in the orthopedic products marketplace. Encore will continue to design and acquire technology to assemble complete, high quality, competitively-priced, globally-designed product lines and will continue to expand its network of independent sales agents and direct sales representatives for the sale of its products in the United States and its distributor relationships worldwide. Encore's goal is to increase its penetration in the United States and foreign markets by introducing line extensions to its already broad array of total joint replacement products, entering the revision total hip market, growing its line of trauma products, concentrating on specialty and niche products, and entering the biologic and spinal implant marketplace through internal development, distribution agreements and the acquisition of existing products or companies.
Outside the United States, Encore's strategy is to explore alternative avenues for distribution in Europe and Japan and enter into new distribution agreements in other parts of the world. For both its United States and its international products, Encore will continue to work with a team of experienced orthopedic surgeons to help design and promote its products, develop clinical results, assist in marketing the products and participate in educational programs focusing on Encore's products.
PRODUCTS
Encore currently designs, manufactures and markets over 7,500 separate orthopedic reconstructive joint products, trauma products, spinal products and instruments used by surgeons to perform orthopedic surgery. Encore plans to continue to develop or acquire new hip, knee and shoulder systems as well as new trauma products, spinal products, biological products and line extensions that address the differing preferences of surgeons, and new systems for new indications.
RECONSTRUCTIVE KNEE PRODUCTS
Encore currently offers the Foundation(R) Knee System in both cruciate sparing and posterior stabilized versions, for both primary and revision applications, all of which are designed to duplicate as closely as possible the anatomical function of the patient's knee, thereby improving its range of motion and stability. Encore's knee systems are used to replace the
articulating surfaces of the knee: the knee cap (patella), top of the shin bone (tibia), and bottom of the thigh bone (femur). The knee system consists of eight different sizes of knee components, which are made of cobalt chrome alloy, titanium alloy and high-density polyethylene. Sales of knee products accounted for approximately 55% of total sales in 1999.
RECONSTRUCTIVE HIP PRODUCTS
Encore is currently marketing four internally designed hip systems. These include the Foundation(R) Hip System, the Vitality(R) Hip Stem, the Linear(R) Hip Stem and the Revelation(TM) Hip Stem. Encore's hip implant consists of the same basic parts as the normal hip, including a femoral stem (thighbone) with a spherical femoral head (ball) and an acetabular cup (socket) on which the femoral head articulates. Sales of hip products accounted for approximately 30% of total sales in 1999.
RECONSTRUCTIVE SHOULDER PRODUCTS
Encore markets its internally designed Foundation(R) Shoulder System. Encore's shoulder implant consists of the same basic parts as the normal shoulder, including a humeral stem with a spherical humeral head (ball) and a glenoid component on which the humeral head articulates. Sales of shoulder products accounted for approximately 4% of total sales in 1999.
TRAUMA PRODUCTS
Encore has built its trauma product line through a series of acquisitions. The first acquisition, Applied Osteo Systems in 1996, gave Encore the True/Flex(R) intramedullary nails, a patented system of intramedullary nails used in repairing bone fractures, primarily for use in correcting upper extremity fractures, and the True/Lok(TM) external fixation system, developed by Texas Scottish Rite Hospital. Encore has recently begun to sell True/Flex(R) intramedullary nail products in the higher volume market for products used in correcting lower extremity conditions. The acquisition of Biodynamic Technologies, Inc. ("BTI") in March 1999 allowed Encore to offer a complete line of specialty products for use in the treatment of upper extremity orthopedic trauma and added other trauma products used in the hip and ankle areas of the body. Sales of trauma products accounted for approximately 10% of total sales in 1999.
INSTRUMENTATION
Approximately 1% of 1999 sales were the instrumentation used to implant the above products. Virtually all of these sales were outside the United States.
SPINAL PRODUCTS
In 1999 Encore began selling spinal products pursuant to an exclusive distribution agreement for the United States for products produced by Paris-based SCIENT'X. The SCIENT'X line contains many products which Encore began to obtain FDA approval to market in 1999. The Isolock(TM) and Isobar(TM) systems consist of rods, plates, cortical screws, and pedicle screws used to achieve fusion of the spine. Of particular note is the Isomorphic(TM) Lumbar Cage System that will allow Encore to compete in the interbody fusion cage market after completion of clinical trials. The cervical spine is addressed with the PCB(TM) Cervical Plate System. These product lines will continue to expand as more products are developed and U.S. regulatory approval is obtained.
BIOLOGICAL PRODUCTS
Encore's initial entry into the biological marketplace was with Stimulan(TM) - Calcium Sulphate Bone Void Filler. This product provided Encore with entry into the high margin synthetic bone graft substitute market. A seven-year agreement Encore signed in late 1998 with Biocomposites, Ltd. of England will also lead to the introduction of several orthopedic bioresorbable products that address the repair of damaged soft tissue in and around the joints.
MARKETING AND SALES
Encore's products are currently marketed and sold in the United States, Western Europe and Japan. In the United States, products are sold to hospitals and orthopedic surgeons through a network of independent commissioned sales agents and direct representatives. Outside the United States, Encore's total joint products are sold through distributors. In 1999, Encore began rebuilding its international sales force which in the past had been also exclusively with the PLUS Endoprothetik AG family based in Switzerland. This rebuilding is being accomplished on a territory by territory basis. During 1999, distributors were added for France and the Middle East. It is Encore's practice to now require that international distributors carry the complete line of Encore total joint and trauma products. This differs from past practice when PLUS-Switzerland only carried
the Foundation Total Knee System. In Japan, its trauma products are sold by Century Medical, Inc. Senko Medical Trading Co. carries both Encore's total joint and trauma products in Japan.
Encore's management is continuing to look for opportunities to expand the international market for Encore's products and will continue its efforts to identify international markets in which its U.S.-designed products can obtain rapid acceptance with surgeons, hospitals and other buyer groups. Encore's management will also continue to seek markets that have sufficient profit potential, size and market conditions.
Encore strives to place its United States sales agents in sales territories whose populations contain significant concentrations of individuals over 55 years of age. As of December 31, 1999, Encore had independent sales agents selling either reconstructive products, trauma products, spinal products or all of these systems, in 33 sales territories in 21 states of the United States. Sales agents are generally granted a contract with a term of one to five years. Agents are typically paid a sales commission of 20% of the gross selling price of all products sold. Encore's current sales agents are also eligible to receive stock options under the 1997 Distributor Advisory Panel Stock Option Plan. Each of Encore's sales agents are assigned an exclusive sales territory. Some of the sales agents may sell non-competing lines of orthopedic products manufactured by other companies, but no agent may carry competing product lines. Encore provides its agents with product inventories on consignment for their use in marketing its products and for filling customer orders. All sales agents are required to participate in periodic product and sales training courses given by Encore at its corporate offices in Austin, Texas, as well as at other locations around the United States.
Encore has developed an on-line inventory control system and a comprehensive distribution support system that provides for instrument and inventory loaners in order to enable sales agents to service low volume territories. Encore is also developing a dedicated field support group to provide rapid response to technical issues.
Encore continues to evaluate the most efficient methods of product marketing and distribution and to assess its use of sales agents and stocking distributors. Encore is designing its sales efforts to take into account the fact that the customer base for its products now includes hospital administrators, material management personnel, purchasing agents and review committees, in addition to surgeons. The need to sell effectively to all of these groups will continue to grow, and Encore intends to continue to address the evolving landscape of the orthopedic marketplace.
AFFILIATED SURGEONS
A key aspect in Encore's development, marketing and sale of its products is the use of designing and consulting surgeons. Each major product is supported by several designing surgeons who assist Encore not only with the design of the product, but who also give demonstrations using the product, assist in developing marketing materials and participate at symposia addressing both clinical and economic aspects of the product. The designing surgeons working on a product are compensated with an aggregate royalty of approximately 5%, which is typically split among the group members. The designing and consulting surgeons may also receive stock options. Encore has encouraged interaction among the surgeons with visits to designing surgeons' institutions (e.g., viewing surgeries, training meetings and regional workshops) by attempting to regionalize the designing surgeon groups. Encore also has established relationships with consulting surgeons, who perform various consulting services for Encore. Such services include conducting clinical studies on various products, analysis of economic issues relating to use of the products, establishment of protocols for use of the products and participation at various symposia. Current consulting surgeons do not receive royalty payments but may be granted stock options under the 1997 Surgeon Advisory Stock Option Plan. Consulting surgeons are also occasionally paid consulting fees for their services to Encore in support of Encore products.
RESEARCH AND DEVELOPMENT
Encore conducts extensive research and development programs at its facility in Austin, Texas. Such activities are focused on making improvements to existing products, developing new products using new materials and surgical applications and obtaining regulatory approval to market products in the United States and around the world.
COMPETITION
The market for orthopedic products is highly competitive and is dominated by a number of large companies, each of which have research and development, sales, marketing and manufacturing capabilities greater than those of Encore. These competitors also feature a wider range of product offerings than Encore, and many have the endorsement of leading orthopedic surgeons for their products.
In the last ten years, new technologies and product concepts have been introduced into the orthopedic market at a rapid rate, often before prior technologies and concepts have been fully integrated. Many of Encore's competitors have entered into various agreements and joint ventures with other companies to develop innovative products for the industry. Furthermore, most orthopedic product companies are attempting to develop new implant surfaces to enhance bone ingrowth and are experimenting with new materials such as hydroxylapatite and ceramics. It is the opinion of Encore's management that this evolution in high technology products will continue for the foreseeable future.
In addition to the race for technology, orthopedic product companies must now devote attention to the prices of their products. Price has become increasingly important as a competitive factor, due particularly to governmental and third party payors' adoption of prospective payment systems. Thus, although Encore's management believes that the design and quality of its products compare favorably with those of its competitors, should Encore be unable to offer products with the latest technological advances at relatively modest prices, its ability to successfully compete with its competitors could be materially and adversely affected. Currently, Encore competes favorably on price with most of its competitors.
MANUFACTURING
Encore's management believes that Encore must be a low-cost manufacturer in order to effectively compete and that its manufacturing system must be flexible and responsive to ongoing supply demands. Encore uses both in-house manufacturing capabilities and relationships with third-party vendors to supply products. The third-party vendors may have special manufacturing capabilities (e.g., casting, forging, porous coating or sterilization) or may be general suppliers of finished components. With the exception of those vendors supplying special capabilities, the choice of in-house or vendor supply is based on available in-house capacity, lead time control, and cost control.
Encore's in-house capacity includes CNC machine tools, belting, polishing, cleaning, packaging and quality control. Encore obtained ISO 9001 qualification and Medical Device Directive "CE" certification in 1996. At present, the machining capacity is used to produce about 75% of the implant units; third party manufacturers produce the remainder. The primary raw materials used in the manufacture of Encore's reconstructive products are cobalt chromium alloy, stainless steel alloys, titanium alloy and ultra high molecular weight polyethylene. Encore has alternate sources for all of its vendors and suppliers and believes that adequate capacity exists at its suppliers to meet all anticipated needs.
All implants and instruments go through in-house quality control, cleaning and packaging operations. Quality control measures begin with an inspection of all raw materials and castings to be used. Each piece is inspected at each step of the manufacturing process. As a final step, products pass through a "clean room" environment designed and maintained to reduce product exposure to particulate matter.
INTELLECTUAL PROPERTY
Encore holds one United States patent, covering a tibia base plate design, used in connection with its Foundation(R) Knee System. It also has approximately ten (10) exclusive patent licenses, which protect Encore both in the United States and in several foreign countries. Encore has eight trademarks registered in the United States, one of which is also registered in Germany, Switzerland, Austria, China, Japan and the European Community, and another one that is also registered in Japan. Encore also depends on numerous unregistered trademarks, some of which have been submitted for registration in the United States. In the future, Encore will apply for such additional patents and trademarks as it deems appropriate. Finally, Encore relies on non-patented proprietary know-how, trade secrets, process and other proprietary information, which it protects through a variety of methods, including confidentiality agreements and proprietary information agreements.
GOVERNMENT REGULATION
Encore's products are subject to rigorous government agency regulation in the United States and certain other countries. In the United States, the FDA regulates the testing, labeling, manufacturing and marketing of medical devices to ensure that medical products distributed in the United States are safe and effective for their intended uses. The FDA also regulates the export of medical devices manufactured in the United States to international markets. Encore's products are subject to such FDA regulation.
Under the Food, Drug and Cosmetic Act, as amended, medical devices are classified into one of three classes depending on the degree of risk imparted to patients by the medical device. Class I devices are those for which safety and effectiveness can be assured by adherence to General Controls, which include compliance with Good Manufacturing Practices ("GMPs"), facility and device registrations and listings, reporting of adverse medical events, and appropriate truthful and non-misleading labeling, advertising and promotional materials. Some Class I devices also require pre-market review and clearance by the FDA through the 510(k) Premarket Notification process described below. Class II devices are subject to General Controls, as well as premarket demonstration of adherence to certain performance standards or other special controls as specified by the FDA. Premarket review and clearance
by the FDA is accomplished through the 510(k) Premarket Notification procedure. In the 510(k) Premarket Notification procedure, the manufacturer submits appropriate information to the FDA in a Premarket Notification submission. If the FDA determines that the device is "substantially equivalent" to a device that was legally marketed prior to May 28, 1976, the date upon which the Medical Device Amendments of 1976 were enacted, or to another similar commercially available device subsequently cleared through the 510(k) Premarket Notification process, it will grant clearance to commercially market the device. It generally takes three to 12 months from the date of submission to obtain clearance of a 510(k) Premarket Notification submission, but the process may take longer. If the FDA determines that the device, or its "labeled" intended use, is not "substantially equivalent," the FDA will automatically place the device into Class III.
A Class III product is a product that has a wholly new intended use or is based on advances in technology for which the device's safety and effectiveness cannot be assured solely by the General Controls, performance standards and special controls applied to Class I and II devices. These devices often require formal clinical investigation studies to assess their safety and effectiveness. A Pre-Market Approval ("PMA") from the FDA is required before the manufacturer of a Class III product can proceed in marketing the product. The PMA process is much more extensive than the 510(k) Premarket Notification process. In order to obtain a PMA, Class III devices, or a particular intended use of any such device, must generally undergo clinical trials pursuant to an application submitted by the manufacturer for an IDE. An approved IDE exempts the manufacturer from the otherwise applicable FDA regulations and grants approval for the conduct of human clinical investigation in order to generate the clinical data necessary to scientifically evaluate the safety and efficacy of the Class III device or intended use.
When a manufacturer believes that sufficient pre-clinical and clinical data has been generated to prove the safety and efficacy of the new device or new intended use, it may submit a PMA application to the FDA. An FDA review of a PMA application generally takes one to two years from the date the PMA application is accepted for filing, but the process may take significantly longer. In approving a PMA application, the FDA may also require some form of post-market surveillance whereby the manufacturer follows certain patient groups for a number of years, making periodic reports to the FDA on the clinical status of those patients. This helps to ensure that the long-term safety and effectiveness of the device are adequately monitored for adverse events. Most pre-amendment devices (those marketed prior to the enactment of the Medical Device Amendment of 1976) are, in general, exempt from such Premarket Approval requirements, as are Class I and Class II devices.
Encore's products include both pre-amendment and post-amendment Class I, II and III medical devices. All currently marketed devices hold the relevant exemptions or premarket clearances or approvals, as appropriate, required under federal medical device law.
Encore's manufacturing processes are also required to comply with GMP regulations that cover the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging and shipping of Encore's products. Further, Encore's facilities, records and manufacturing processes are subject to periodic unscheduled inspections by the FDA or other agencies. Failure to comply with applicable U.S. medical device 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, refusal of the FDA to grant future pre-market clearances or approvals, withdrawals or suspensions of current clearances or approvals and criminal prosecution. There are currently no adverse regulatory compliance issues or actions pending with the FDA, and no FDA GMP audits conducted at Encore's facilities have resulted in any adverse compliance enforcement actions.
Encore must obtain export certificates from the FDA before it can export certain of its products and is subject to regulations in many of the foreign countries in which it sells its products. These include produce standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. Many of the regulations applicable to Encore's devices and products in such countries are similar to those of the FDA. The national health or social security organizations of certain countries require Encore's products to be qualified before they can be marketed in those countries. To date, Encore has not experienced any difficulty in complying with these regulations. Encore has also implemented policies and procedures allowing it to position itself for the changing international regulatory environment. The ISO 9000 series of standards has been developed as an internationally recognized set of guidelines that are aimed at ensuring the design and manufacture of quality products. A company that passes an ISO audit and obtains ISO registration becomes internationally recognized as well run and functioning under a competent quality system. In certain foreign markets, it may be necessary or advantageous to obtain ISO 9000 series certification, which is in some ways analogous to compliance with the FDA's GMP requirements. The European Community promulgated rules requiring medical products to receive a CE mark by mid-1998. A CE mark is an international symbol of adherence to certain standards and compliance with applicable European
medical device requirements. ISO 9000 series certification is one of the prerequisites for CE marking for most of Encore's products. ISO 9001 is the highest level of ISO certification, covering both the quality system for manufacturing, as well as the quality system for product design controls. Encore has received an ISO 9001 certification and "CE" certification.
Certain provisions of the Social Security Act, commonly known as the "Medicare Fraud and Abuse Statute," prohibit entities, such as Encore, 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. Violation of this statute is a felony, punishable by fines of up to $25,000 per violation and imprisonment of up to five years. In addition, the U. S. Department of Health and Human Services may impose civil penalties excluding violators from participation in Medicare or state health programs. Many states have adopted similar prohibitions against payments intended to induce referrals of Medicaid and other third party payor patients.
Subject to certain exemptions, federal physician self-referral legislation prohibits 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. Penalties for violations include a prohibition on payment by these government programs and civil penalties of as much as $15,000 for each referral in violation of the statute and $100,000 for participation in a "circumvention scheme."
ITEM 2.
ITEM 2. PROPERTIES
Encore owns no real property, however, Encore leases an approximately 70,000 square foot facility in Austin, Texas for its corporate headquarters, manufacturing facilities and warehouse for its business operations. This lease is a 10-year lease that commenced on April 1, 1997, with the option to renew for five years and with an option to terminate the lease after 5 years upon the payment of the unamortized leasehold improvement costs. The Company's monthly lease payments are approximately $35,422, for an annual lease payment of approximately $425,064, which amounts do not include the Company's share of applicable common area maintenance, property taxes and public utility charges.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Encore is currently a defendant in a lawsuit styled Wright Medical Technologies, Inc. v. Encore Orthopedics, Inc., et al., C. A. No. 99CV4900(SSB), filed in the United States District Court of New Jersey. In this case, Wright alleges that Encore tortuously interfered with certain of Wright's contractual relationships and conspired to cause a former Wright sales person to breach its contract with Wright. Encore is actively and aggressively defending itself and does not believe that it has committed any act which would give rise to a finding that Encore is guilty of the charges leveled against it. The case is in the very preliminary stages and significant discovery and motions must still be undertaken.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders through the solicitation of proxies or otherwise.
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock and $5 Warrants are traded on the NASDAQ National Market System under the symbols "ENMC" and "ENMCW," respectively. The $7 Warrants is not traded on a public market. The following tables set forth for the periods indicated the high and low sales prices of the Company's Common Stock and $5 Warrants as reported on the NASDAQ National Market since January 1, 1998:
As of March 15, 2000, the Company had approximately 88 shareholders of record of the Company's Common Stock. There are in excess of 1,100 beneficial owners of the Company's Common Stock. As of March 15, 2000, the Company had approximately 14 holders of record of the Company's $5 Warrants. There are in excess of 300 beneficial owners of the Company's $5 Warrants. As of March 15, 2000, the Company had approximately 63 holders of record of the Company's $7 Warrants and approximately 70 beneficial owners.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following sets forth selected financial data with respect to the Company for the periods indicated. The data as of December 31, 1995, 1996, 1997, 1998 and 1999 and for each of the five years in the period ended December 31, 1999, have been derived from audited financial statements appearing elsewhere in this report. The selected financial data should be read in conjunction with the financial statements and related notes thereto, and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this report.
(a) Due to changes in valuation in put warrants issued in 1995 and 1996, net income (loss) applicable to common stockholders would be $1,370 in 1995 and ($236) in 1996. These warrants had this put feature eliminated in connection with the merger with HCAC and these warrants were exercised in 1997.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Encore develops, manufactures, markets and sells orthopedic implant devices and related surgical instrumentation to hospitals and stocking distributors. In the past five years, Encore has introduced its total joint replacement and trauma products to the marketplace and established both domestic and international distribution. Encore's strategy reflects its founders' beliefs that Encore must design and market high quality orthopedic products to a worldwide audience. Encore's past financial results
are reflective of its efforts to develop the necessary infrastructure and relationships to make Encore a competitive participant in the orthopedics industry.
Encore has invested in building a flexible infrastructure consisting of experienced personnel, business and management information systems, and floor space to provide the highest level of customer responsiveness at the lowest possible cost. The most current technology is employed to provide the visibility required throughout the Company to plan for and manage rapid growth.
Encore has expanded its full line of total joint implants to cover knee, hip and shoulder applications. In addition, in May 1996, Encore acquired all of the assets and liabilities of Applied Osteo Systems, Inc. ("AOS"), an orthopedic company with products in the trauma implant area, in a transaction accounted for as a pooling of interest. In March 1999, Encore acquired substantially all of the stock of BTI, a company that had developed several trauma products. This acquisition was accounted for as a purchase. Encore merged with Healthcare Acquisition Corp. ("HCAC") in March 1997, which was treated as a recapitalization of Encore for financial statement purposes. All financial information included herein reflects these transactions.
Encore has developed a network of independent sales representatives and direct sales persons that sell Encore's products throughout the United States. Encore has also established relationships with several international stocking distributors. Encore must receive 510(k) or PMA approval from the FDA for every product that it desires to sell in the United States and similar regulatory approvals in other countries in which it sells its products. Encore has received such approvals for all of its products that it currently markets.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998.
Sales were $26,095,000 for the year ended December 31, 1999, representing a decrease of $2,895,000 or 10% compared to total sales of $28,990,000 for the year ended December 31, 1998. This decrease in absolute sales reflects two different trends for Encore sales. On one hand, U.S. sales increased 6% over 1998. More productive sales territories, an increase in the number of sales territories and an increase in the number of products offered for sale fueled the increase in U.S. sales. On the other hand, outside the U.S., sales decreased 35% compared to the year ended December 31, 1998. This was mainly due to the significant decrease in the sales of Encore's former primary distributor for Europe. This relationship was changed in the summer of 1999 and Encore is actively engaged in pursuing alternative avenues for international distribution to remedy this situation. Encore has recently entered into distribution agreements for France and the Middle East and is actively engaged in negotiations with other distributors for other countries in Europe. In addition, Encore had terminated its relationship with its distributor for total joint products in Japan as of December 31, 1998. During 1999, Encore located and contracted with a new, highly experienced sales distribution company for carrying not only Encore's total joint lines of products, but also its new trauma products that it acquired when it acquired the trauma specialty company BTI. This sales force will complement the other Japanese sales force that is distributing Encore's specialty trauma line of intramedullary rods and external fixation system.
Overall, while sales of reconstructive products decreased 14% to $23,490,000 in 1999, this decrease masks the significant increase in hip sales for Encore. These products were significantly aided by the addition of several new products that were introduced during 1998 and showed strong sales growth in 1999. The overall decrease in total joint sales was fueled by decreased sales of the Foundation(R) Total Knee Systems which were the only product being sold by Encore's former European distributor. Another strong indication of the progress that Encore made during 1999 is that trauma product sales have increased 56.9% over 1998. This increase was a result of having a broader product line, in part due to the acquisition of BTI, and having the products gain more acceptance throughout the United States. Another factor in the increased U.S. sales was the transition from a non-exclusive to an exclusive sales force. Going forward, rapid geographical expansion in the United States, an improvement in the quality of the sales force, adding new international distributors who will carry the full Encore product line and introduction of new products will fuel additional increases in sales in both the total joint and trauma segments of the business. Additionally, Encore received several of the needed FDA approvals to market spinal products during the later half of 1999 and will be able to bring these products to the United States during 2000.
As an indication of the fiscal management and cost control that Encore exercised during 1999, gross margin as a percent of sales increased in 1999 even though sales overall decreased. Gross margin was 68.6% of sales in 1999 compared to 66.9% of sales for 1998. This was due both to the increase in U.S. sales, which generate a greater gross margin than sales outside the U.S., and continued monitoring of manufacturing costs.
Even with a decrease in sales for 1999, Encore kept up its strong research and development program since it recognizes that new products are the lifeblood of expansion of an orthopedics company. As a percentage of sales, research and development expenses increased to 6.3% in 1999 from 5.8% in 1998. Current activities include a joint design effort with Norton Desmarquest Fine Ceramics to develop a ceramic knee femoral component to address the issue of polyethylene wear in the knee, clinical trials for a ceramic/ceramic hip system and a metal/metal hip system, development of a mobile bearing knee, development of a revision hip system and regulatory submissions for spine.
Part of controlling expenses in a year when sales decreased was that selling, general and administrative expenses decreased by $1,284,000, or 9%, in 1999 when compared to the same period in 1998. While a part of this decrease came from lower commissions and royalties associated with the overall decrease in sales, significant portions of the savings came from management efforts undertaken in 1999. For example, the Company incurred costs in 1998 relating to consigned inventory discrepancies. Discrepancy charges in 1999 were insignificant.
As a result of the fiscal management of Encore during a year of decreasing sales, operating income as a percent of sales increased 0.6% to 11.6% as compared to 1998 of 11%. So even though sales decreased by 10%, operating income only decreased 5.8% to $3,015,000, as compared to $3,201,000 for the year ended December 31, 1998.
Interest expense increased by $523,000 in 1999 compared to 1998. This was due to an increase during 1999 in the average line of credit balance over the same period last year and the addition of interest on notes payable related to the acquisition of BTI on March 30, 1999. Other income increased $229,000 in 1999 due to licensing income and favorable foreign exchange gains.
The total effect of the decrease in sales coupled with the strong fiscal management of Encore was that net income as a percent of sales increased to 6.2% in 1999 from 6.1% in 1998. In pure dollar terms, net income for the year ended December 31, 1999, decreased to $1,619,000 from $1,777,000 in 1998.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997.
Sales were $28,990,000 for the year ended December 31, 1998, representing an increase of $4,550,000 or 18.6% over the year ended December 31, 1997. In 1998, U.S. sales and sales outside the U.S. increased 26.7% and 8.0%, respectively, over 1997. The increase in U.S. sales was fueled primarily by the growth of the U.S. sales force in the number of sales agents and more productive sales territories. Outside the U.S., the economic environment that existed in Asia affected sales. However, sales to the Japanese market rebounded substantially in the fourth quarter with the addition of new distribution, which was experienced in the orthopedic market. Sales of reconstructive products increased 20.4% to $27,373,000 in 1998, led by the Foundation(R) Total Knee, Hip and Shoulder Systems. Trauma product sales remained relatively flat. The increase in reconstructive products was attributed primarily to the expansion of the U.S. sales force. Continued transition from a non-exclusive to an exclusive sales force was a major factor for the flat sales of trauma products.
Gross margin increased to $19,408,000 in 1998, or 66.9% of sales, as compared to $16,504,000 or 67.5% of sales for 1997. Gross margin as a percent of sales decreased slightly due to discounts and higher costs associated with the initial production of the Revelation(TM) and Linear(R) Hip Systems.
Research and development expenses increased by $23,000 or 1.4% in 1998 when compared to the same period in 1997. Research and development activities increased to complete the design of two new hip stems and two acetabular systems that were released in early 1998. The Company effectively balanced the increased activity at the beginning of the year with expenditures in the remainder of the year to control expenses relative to sales by the end of 1998. Activities included a joint design effort with Norton Desmarquest Fine Ceramics to develop a ceramic knee femoral component to address the issue of polyethylene wear in the knee. Initiation of activities that address polyethylene wear in the hip included a FDA feasibility study for metal/metal articulation, as well as FDA approval to begin full clinical studies for metal/metal and ceramic/ceramic hips.
Selling, general and administrative expenses increased by $2,180,000, or 17.6%, in 1998 when compared to the same period in 1997. This increase was due to additional instrumentation depreciation and continued investment in the development of the U.S. sales infrastructure, increase in commission and royalty expenses in conjunction with the increase in sales, costs associated with unsuccessful acquisition attempts and a charge for inventory discrepancies at consigned locations.
Operating income increased 28% to $3,201,000, as compared to $2,500,000 for the year ended December 31, 1997. This increase was due to increased gross margins, which was partially offset by increased operating expenses.
Interest expense decreased by $201,000 in 1998 compared to 1997. This was primarily related to the existence of $5 million in term debt in the first five months of 1997, which was paid off as of the end of May 1997. In addition, both a higher effective interest rate and the amortization of the related debt discount in the prior year affected the decrease in interest expense.
Income before extraordinary item decreased slightly to $1,777,000 in 1998 from $1,857,000 in 1997. It is important to note that the 1997 result includes a one-time benefit of $537,000 from the reversal of a deferred tax asset valuation allowance. Absent such one time event, income before extraordinary item in 1997 would have been $1,320,000.
There was no extinguishment of debt expense for the year ended December 31,1998, as compared to $598,000 for the same period in 1997. During the second quarter of 1997, the Company repaid $5 million of long term debt plus accrued interest of $39,000. The Company had previously capitalized approximately $476,000 of financing costs and established a debt discount of $821,000 associated with detachable put warrants issued in accordance with the debt. The unamortized portions of these two items were expensed in conjunction with the repayment of the debt, resulting in an extraordinary charge to earnings of $598,000, which was net of an income tax benefit of $308,000.
Net income for the year ended December 31, 1998 increased 41.1% to $1,777,000 from $1,259,000 in 1997.
CAPITAL EXPENDITURES
Encore has spent a significant amount of its resources over the past several years on building a state-of-the-art, fully integrated orthopedic implant company. These expenditures have included the investment in surgical instrumentation, machine tools to increase manufacturing capacity, computer hardware and software, and equipment required to support a growing organization. Over the last several years, Encore has acquired machine tools primarily through capital leases. Encore has made significant investments in surgical instrumentation, as such instrumentation is necessary to implant Encore reconstructive products. Also, the size of the sales force and the increases in the product lines have necessitated increases in the need for additional surgical instruments. In the United States, these instruments are capitalized and depreciated. They are loaned to the sales force without charge to aid in sales. Internationally, these instruments are sold or leased to distributors. The amounts of surgical instruments capitalized in 1997, 1998 and 1999 were $1,180,000, $1,590,000 and $1,373,000 respectively. Other capital expenditures during those periods were $978,000, $1,321,000 and $731,000, respectively.
As a growing organization, Encore has devoted significant capital resources to expanding and improving its management information systems through additions of hardware and software. In addition, during 1999, Encore dealt with Y2K issues. The expenditures for these computer improvements were approximately $249,000 in 1999, $370,000 in 1998 and $454,000 in 1997.
LIQUIDITY
Since its inception, the Company has financed its operations through the sale of equity securities, borrowings and cash flow from operations. The Company has available to it a $15 million revolving credit facility. As of December 31, 1999, the Company had drawn approximately $9 million. A distinguishing feature of the Credit Facility is that Encore's cash management services are intermingled with it on a daily basis. Encore's bank accounts sweep funds to either reduce or increase the loan balance, as needed, and invests any excess funds if the loan balance equals zero, in a money market account. As such, the outstanding loan balance is adjusted daily based on the net amount of cash receipts versus cash outlays, while the cash balance at Wells Fargo remains at zero as long as Encore is a net borrower. This sweep feature has the effect of minimizing interest cost and automatically investing any excess funds.
The Company's continued strong growth has resulted in an increase in its capital requirements. This growth is now primarily funded by the Credit Facility and cash generated from operations to meet its working capital needs. As of December 31, 1999, the Company had net working capital of approximately $21.0 million as compared to approximately $18 million at December 31, 1998. This increase was primarily due to the increases in inventory and a decrease in the current portion of a payment to a related party, and accounts payable and accrued expenses.
During the third quarter of 1998 and continuing in 1999, the Company began actively purchasing its equity securities, both common stock and $5 Warrants, in connection with the buyback program it announced at the beginning of 1998. This program was initiated because Company management and the Board of Directors felt that the Company's equity was undervalued. The Company repurchased 310,800 and 185,200 shares of common stock in 1998 and 1999 respectively, and 231,800 and 81,500 $5 Warrants during those periods, respectively. This program is ongoing.
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 that represent Encore's expectations or beliefs concerning future events, including, but not limited to, statements regarding growth in sales of Encore's products, profit margins and the sufficiency of Encore'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, Encore's dependence on the ability of its third-party manufacturers to produce components on a basis that is cost-effective to Encore, market acceptance of Encore's products and effects of government regulation. Results actually achieved may differ materially from expected results included in these statements as a result of these or other factors.
ITEM 7A.
ITEM 7A. MARKET RISK DISCLOSURE
Not Applicable
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Encore Medical Corporation
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, changes in stockholders' equity, and cash flows present fairly, in all material respects, the financial position of Encore Medical Corporation and its subsidiary at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PRICEWATERHOUSECOOPERS LLP
Austin, Texas January 28, 2000
ENCORE MEDICAL CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
ENCORE MEDICAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The accompanying notes are an integral part of these consolidated financial statements.
ENCORE MEDICAL CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
ENCORE MEDICAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
ENCORE MEDICAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
Encore Medical Corporation (the "Company"), a Delaware corporation, through its primary operating subsidiary, Encore Orthopedics, Inc. ("Encore"), designs, manufactures, markets and sells products for the orthopedic implant industry primarily in the United States, Europe and Asia.
The Company's products are subject to regulation by the Food and Drug Administration ("FDA") with respect to their sale in the United States, and the Company must obtain FDA authorization to market each of its products before they can be sold in the United States. Additionally, the Company is subject to similar regulations in many of the international countries in which it sells products.
BASIS OF PRESENTATION
In November 1996, Encore and Healthcare Acquisition, Inc., a wholly owned subsidiary of Healthcare Acquisition Corp. ("HCAC"), a publicly traded, specified purpose acquisition company, executed a definitive agreement and plan of merger (the "Merger Agreement"). Effective March 25, 1997, the merger was completed and HCAC's name was changed to Encore Medical Corporation.
The merger was effected by HCAC issuing 0.8884 HCAC common shares and 0.13326 HCAC warrants with an exercise price of $7.00 ("HCAC $7 warrants") for each common share of Encore and 1.11049 HCAC common shares and 0.16657 HCAC $7.00 warrants for each preferred share of Encore in accordance with the exchange ratio set forth in the Merger Agreement. In addition, outstanding options and warrants to purchase common stock of Encore were exchanged for options and warrants to purchase HCAC common stock and HCAC $7.00 warrants based on the exchange ratio discussed above.
For financial reporting and accounting purposes, the merger was accounted for as a recapitalization of Encore, with the issuance of shares by Encore for the assets of HCAC, these assets consisting primarily of cash. The capital accounts of Encore for all periods presented, including all share information presented in the notes to consolidated financial statements, have been reflected on an equivalent share basis to give effect to the exchange ratios discussed above. The accompanying consolidated statements of income include the results of operations of HCAC from the effective date of the merger (March 25, 1997) through the end of the period. HCAC did not have significant operations prior to the merger, therefore pro forma presentation of combined results of operations for periods presented is not considered meaningful and has been omitted.
On March 30, 1999, the Company and BTI executed a stock purchase agreement whereby Encore purchased substantially all of the outstanding stock of BTI in exchange for cash and promissory notes payable to the former shareholders of BTI. This acquisition has been accounted for as a purchase and, accordingly, the results of BTI have been included in the accompanying financial statements beginning March 30, 1999. The terms of the agreement require a total cash payment of $1,068,000 and issuance of notes payable of $3,166,000. For financial reporting purposes, $140,000 of the purchase price was recorded as purchased technology, which is being amortized over seven years, and $4,190,000 was recorded as goodwill, which is being amortized over 15 years. BTI did not have significant operations relative to the Company prior to the merger. Therefore, pro forma presentation of combined results of operations for periods presented is not considered meaningful and has been omitted.
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, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
Cash consists of deposits with financial institutions. The Company considers all highly liquid investments with original maturities of less than three months to be cash equivalents.
INVENTORIES
Inventories are stated at the lower of cost or market, with cost being determined under the first-in, first-out method.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets which range from three to seven years. Leasehold improvements and assets subject to capital lease are amortized using the straight-line method over the terms of the leases or lives of the assets, if shorter. Maintenance and repairs are expensed as incurred.
INTANGIBLE AND OTHER ASSETS
Intangible assets consist of goodwill, agency rights and purchased technology and are carried at cost less accumulated amortization. Amortization of intangibles is computed based on the straight-line method over periods ranging from five to fifteen years. Intangible assets are reviewed for impairment whenever the facts and circumstances indicate that the carrying amount may not be recoverable. Other assets consist of the non-current portion of advanced commissions to sales representatives and deferred income taxes. Advanced commissions are offset against future sales commissions earned. Deferred income taxes reflect the differences between the assets and liabilities recognized for financial reporting purposes and amounts recognized for tax purposes based on currently enacted tax laws.
COMMON STOCK PUT WARRANTS
The common stock put warrants were issued in 1995 and 1996 and are further described in Note 7. Changes in the estimate of the redemption amount from the date of issuance have been recognized on a prospective basis as a charge to the accumulated deficit. These warrants were exercised in 1997.
REVENUE RECOGNITION
The Company's products are sold through a network of sales representatives and distributors. Revenues from sales made by representatives, who are paid commissions upon the ultimate sale of the products, are recorded at the time the product is utilized in a surgical procedure. Revenues from sales to distributors are recorded when the product is shipped to the distributor. The distributors, who sell the products to other customers, take title to the products and have no or limited rights of return.
RESEARCH AND DEVELOPMENT
Research and development expenses relate primarily to the technological development and enhancement of reconstructive, trauma and spinal devices. Research and development costs are charged to expense as incurred.
INCOME TAXES
Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts.
EARNINGS PER SHARE
Earnings per share ("EPS") has been presented in accordance with Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share."
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of the Company's financial instruments, including cash and cash equivalents, trade accounts receivable and payable, and long-term debt approximate fair values. The Company estimates the fair value of its long term fixed rate debt generally using discounted cash flow analysis based on the Company's current borrowing rate for debt with similar maturities, terms and characteristics.
2. INVENTORIES
Inventories consist of the following (in thousands):
3. PROPERTY AND EQUIPMENT
Property and equipment consist of the following (in thousands):
Depreciation and amortization expense relating to property and equipment for the years ended December 31, 1999, 1998 and 1997 was $2,026,000, $1,699,000 and $1,276,000, respectively.
4. INTANGIBLE ASSETS
Intangible assets consist of the following (in thousands):
5. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consists of the following (in thousands):
6. LONG-TERM DEBT AND LEASES
LONG-TERM DEBT
Long-term debt (including capital lease obligations and a payable to a related party) consists of the following (in thousands):
The debt agreement related to the revolving credit facility contains warranties and covenants and requires maintenance of certain financial ratios. Default on any warranty or covenant could affect the ability to borrow under the agreement and, if not waived or corrected, could accelerate the maturity of any borrowings outstanding under the applicable agreement. As of December 31, 1999 and 1998, the Company was in compliance with all debt covenants and warranties.
At December 31, 1999, the aggregate amount of annual principal maturities of long-term debt (excluding capital lease obligations) is as follows (in thousands):
LEASES
The Company leases building space, manufacturing facilities and equipment under non-cancelable lease agreements that expire at various dates. At December 31, 1999, future minimum lease payments are as follows (in thousands):
Rental expense under operating leases totaled $669,000, $616,000 and $471,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
Leased equipment and furniture and fixtures under capital leases, included in property and equipment in the accompanying financial statements, is as follows (in thousands):
7. CAPITAL STOCK
PREFERRED STOCK
Preferred stock may be issued at the discretion of the Board of Directors (the "Board") of the Company with such designation, rights and preferences as the Board may determine from time to time. The preferred stock may have dividend, liquidation, conversion, voting or other rights that may be more expansive than the rights of the holders of the common stock. At December 31, 1999, the Company has 1,000,000 shares of authorized preferred stock, none of which has been issued.
STOCK OPTION PLANS
The Company has six stock option plans. All options granted under the plans are exercisable for common stock in the Company as described below. The Company applies Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to Employees," and related interpretations in accounting for its plans. Under APB 25, no compensation cost has been recognized for grants under the stock option plans, except for grants made to individuals other than employees for services provided to the Company. The Company has recorded deferred compensation for the fair value of grants made to individuals other than employees and is amortizing such amount to income over the vesting period or contract period for the options. Deferred compensation amortization was $133,000, $132,000 and $87,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
Had compensation cost for all stock option grants been determined based on their fair value at the grant dates consistent with the method prescribed by SFAS No. 123, "Accounting for Stock-Based Compensation," the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below:
The 1996 Incentive Option Plan provides for the grant of a variety of equity related awards, including, but not limited to, incentive stock options, non-qualified stock options, stock appreciation rights and restricted stock, to key employees of the Company and its subsidiaries. The 1997 Distributor Advisory Panel Stock Option Plan provides for the grant of stock options to those who are sales representatives and distributors of the Company's and its subsidiaries' products. The 1997 Surgeon Advisory Panel Stock Option Plan provides for the grant of stock options to those who are serving as members of the Company's or its subsidiaries' surgeon advisory panel.
In addition, the Company has the following stock option plans under which the Company is no longer issuing new options but which, nevertheless, have outstanding options. The 1992 Stock Option Plan provided for the grant of both incentive and non-qualified stock options to directors, employees and certain other persons affiliated with Encore. The 1993 Distributor Stock Option Plan provided for the grant of stock options to those who were sales representatives and distributors of Encore's products, and the 1993 Surgeon Advisory Panel Stock Option Plan provided for the grant of stock options to those who were serving as members of Encore's surgeon advisory panel.
The stock options granted under all of these plans are granted at or in excess of fair market value on the date of grant, vest ratably over a predefined period, and generally expire no more than 10 years from the date of grant. At December 31, 1999, the Company had reserved a total of 5,314,842 shares of common stock for the plans.
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 1999, 1998 and 1997:
A summary of the status of the Company's stock option plans is presented below:
The following table summarizes information about stock options outstanding at December 31, 1999:
COMMON STOCK PUT WARRANTS
Encore issued warrants in 1995 and 1996 to purchase a total of 465,601 shares of Encore's common stock at $0.01 per share. The warrants could be put to Encore for cash for a period of 30 days prior to their expiration. The amount payable by Encore would be based on the per share fair market value of the common stock at the date the warrants were put to Encore. In addition, Encore issued warrants in 1995 and 1996 to purchase a total of 98,110 shares of Encore's common stock at $0.01 per share for professional services rendered in connection with obtaining long-term financing. Encore valued these warrants at $175,000 and recorded such amount as a deferred debt issuance cost within other non-current assets. These warrants contained the same put feature described above. In determining net income applicable to common stock during 1995 and 1996, the annual change in the estimated redemption amount of the common stock put warrants was required to be subtracted from or added to net income. Changes in the estimate of the redemption amount of the common stock put warrants were based on independent professional appraisals and estimates made by management.
In connection with the merger with HCAC described in Note 1, the holders of these warrants agreed to cancel the put feature. Subsequent to the merger, all of these warrants were exercised in 1997 and no further adjustment to net income applicable to common stock was required.
HCAC $7 WARRANTS
As discussed in Note 1, HCAC $7 warrants were issued for each common and preferred share of Encore in connection with the merger. These warrants are convertible into one share of common stock for each warrant and expire on March 25, 2001. The Company conducted a tender offer for these $7 warrants and the rights to acquire the $7 warrants in December 1998. Of the 1,673,948 total $7 warrants and rights, 978,383 shares were tendered and purchased by the Company for a total consideration of $239,080.
OTHER HCAC TRANSACTIONS
HCAC issued 3,850,000 warrants (the "$5 warrants") in connection with a public offering in March 1996. These warrants have an exercise price of $5.00 per share and are convertible into one share of common stock for each warrant. These warrants expire on March 8, 2003, but are callable by the Company for $0.01 per warrant at such time as the common shares of the Company have traded at a price of $8.50 per share for 20 consecutive trading days. The Company repurchased 231,800 and 81,500 of these $5 warrants in 1998 and 1999, respectively.
Additionally, in connection with the public offering, HCAC issued 150,000 unit options to the underwriters of the offering. These unit options allow the holder to receive one share of common stock and two $5 warrants for each unit option. These unit options have an exercise price of $6.60. The unit options and the $5 warrants connected with the unit options expire on March 8, 2001.
TREASURY STOCK
The Company began acquiring shares of its common stock and $5 warrants in connection with a stock repurchase program announced in January 1998. That program authorizes the Company to purchase up to one million common shares or $5 warrants from time to time on the open market or pursuant to negotiated transactions at price levels the Company deems attractive. The Company purchased 310,800 shares for $937,000 and 185,200 shares for $495,000 in 1998 and 1999, respectively. The Company purchased 231,800 $5 warrants for $170,000 and 81,500 $5 warrants for $68,000 in 1998 and 1999, respectively. The purpose of the stock and warrant repurchase program is to help the Company achieve its long-term goal of enhancing stockholder value. In connection with a tender offer conducted in December 1998, the Company purchased 978,383 of the 1,673,948 total $7 warrants and rights to acquire $7 warrants for a total consideration of $239,080.
8. SEGMENT INFORMATION
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which the Company adopted in the first quarter of 1998. The statement supersedes SFAS No. 14 "Financial Reporting for Segments of a Business Enterprise," replacing the "industry segment" approach with the "management" approach. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of the Company's reportable segments. It also requires disclosures about products and services, geographic areas and major customers.
While the Company sells its many products in many different markets, management has chosen to organize the Company by geographic areas and, as a result, it has only one reportable segment. All selling and administrative expenses, interest income, interest expense, depreciation and amortization are recorded in the United States. In addition, all identifiable assets are located in the United States.
During the three years ended December 31, 1999, the Company's international sales were primarily to a few foreign distributors, one of which has individually accounted for approximately 20% of total Company sales during such periods. Following are the Company's international sales by geographic area (in thousands) and the percentage of total Company sales generated by one distributor:
Net sales of orthopedic products by product category are as follows (in thousands):
9. INCOME TAXES
The income tax provision (benefit) consists of the following (in thousands):
The difference in income taxes provided and the amounts determined by applying the federal statutory tax rate to income before income taxes result from the following (in thousands):
The components of deferred income tax assets and liabilities are as follows (in thousands):
Prior to 1997, the Company placed a valuation allowance against its otherwise recognizable net deferred tax assets due to uncertainties regarding the realization of these assets. During 1997, management determined that it was more likely than not that the benefits of such deferred tax assets would be realized and, therefore, eliminated the valuation allowance of $537,000.
10. EARNINGS PER SHARE
Basic EPS is computed by dividing net income applicable to common stockholders by the weighted average number of common shares outstanding during each period. Diluted EPS is computed by dividing net income applicable to common stockholders by the weighted average number of common shares and common share equivalents outstanding (if dilutive) during each period. The number of common share equivalents outstanding is computed using the treasury stock method.
Following is a reconciliation of the basic and diluted per share computations (dollars in thousands, except for per share amounts):
Options and warrants to purchase 1,868,948 and 4,670,597 shares of common stock, respectively, were outstanding at December 31, 1999, but were not included in the computation of diluted EPS because their exercise price was greater than the average market price of the common shares.
11. RELATED PARTY TRANSACTIONS
Effective April 1, 1992, a stockholder of the Company sold to the Company certain intellectual property, including trade secrets, manufacturing processes, instrumentation, technical knowledge and patent rights for a knee device for $2,000,000. The Company contracted to pay annually the greater of an amount equal to 1.08% of the total gross sales related to sales of any knee systems incorporating material elements of this knee device (not to exceed $2,000,000) or certain fixed payments (without interest) through March 31, 1999. The Company recorded the related asset at the stockholder's basis of $0 and reflected $2,000,000 in long-term debt. The excess of consideration paid over the stockholder's basis was charged to stockholders' equity.
12. COMMITMENTS AND CONTINGENCIES
As of December 31, 1999, the Company had entered into purchase commitments for inventory, capital acquisitions and other services totaling $1,931,000 in the ordinary course of business.
The Company is, from time to time, subject to claims and suits for damages arising in the normal course of business. The Company maintains insurance, which management believes would cover most claims.
The Company is currently a defendant in a lawsuit styled Wright Medical Technologies, Inc. v. Encore Orthopedics, Inc., et al., C. A. No. 99CV4900(SSB), filed in the United States District Court of New Jersey. In this case, Wright alleges that Encore tortuously interfered with certain of Wright's contractual relationships and conspired to cause a former Wright sales person to breach its contract with Wright. Encore is actively and aggressively defending itself and does not believe that it has committed any act which would give rise to a finding that Encore is guilty of the charges leveled against it. The case is in the very preliminary stages and significant discovery and motions must still be undertaken.
13. EMPLOYEE BENEFIT PLANS
The Company has a qualified defined contribution plan, which allows for voluntary pre-tax contributions by the employees. The Company pays all general and administrative expenses of the plan and may make contributions to the plan. The Company made matching contributions of $262,000, $276,000 and $221,000 to the plan in 1999, 1998 and 1997, respectively, based on 100% of the first 6% of employee contributions.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None in the past two years.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information set forth under the caption "Election of Directors" contained in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 for its 1999 Annual Meeting of Shareholders (the "Proxy Statement") is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information set forth under the sub-captions "Directors Continuing in Office" and "Executive Compensation" contained in the Company's Proxy Statement is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth under the caption "Stock Ownership" contained in the Company's Proxy Statement is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth under the sub-caption "Certain Transactions" contained in the Company's Proxy Statement is incorporated herein by reference.
ITEM 14.
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.
(b) REPORTS ON FORM 8-K None
(c) EXHIBITS:
Exhibit No. Description - -------- -----------
2 Agreement and Plan of Merger dated as of November 12, 1996, by and among Healthcare Acquisition Corp. ("HCAC"), Healthcare Acquisition, Inc. and Encore Orthopedics, Inc., as amended by an Amendment dated February 14, 1997(3)
3.1 Certificate of Incorporation of Healthcare Acquisition Corp.(1)
3.2 Amendment to the Certificate of Incorporation of HCAC(3)
3.3 Bylaws of HCAC(1)
4.1 Form of HCAC Common Stock Certificate(2)
4.2 Form of Certificate for HCAC $5.00 Warrant(2)
4.3 Form of Unit Purchase Option granted to GKN Securities Corp. and Gaines, Berland Inc(2)
4.4 Warrant Agreement between Continental Stock Transfer and Trust Company and HCAC with respect to the HCAC $5.00 Warrants(1)
4.5 Form of Encore Medical Corporation $7.00 Warrant(3)
Exhibit No. Description - -------- -----------
4.6 Warrant Agreement, by and between Encore Medical Corporation and Continental Stock Transfer and Trust Company with respect to the HCAC $7.00 Warrants(3)
4.7 Form of Encore Medical Corporation Common Stock Certificates(5)
10.1 Investment Management Trust Agreement between IBJ Schroder Bank & Trust Company and HCAC(1)
10.2 Stock Escrow Agreement between Continental Stock Transfer and Trust Company and HCAC(1)
10.3 Letter Agreement between GKN Securities Corp. and each of the initial stockholders of HCAC(1)
10.4 Encore Medical Corporation 1996 Incentive Stock Plan(3)
10.5 Employment Agreement between Encore and Nick Cindrich, dated August 26, 1994(5)
10.6 Severance Agreement between Encore and Nick Cindrich, dated September 27, 1995, as amended on March 18, 1997(5)
10.7 Employment Agreement between Encore and Craig L. Smith, dated August 26, 1994(5)
10.8 Severance Agreement between Encore and Craig L. Smith, dated September 19, 1995, as amended on March 18, 1997(5)
10.9 [intentionally omitted]
10.10 [intentionally omitted]
10.11 Employment Agreement between Encore and Ken Ludwig, Jr., dated August 26, 1994(5)
10.12 Severance Agreement between Encore and Ken Ludwig, Jr., dated September 19, 1995, as amended on March 18, 1997(5)
10.13 Employment Agreement between Encore and August Faske, dated August 26, 1994(5)
10.14 Severance Agreement between Encore and August Faske, dated September 20, 1995, as amended on March 18, 1997(5)
10.15 Employment Agreement between Encore and Harry L. Zimmerman, dated August 26, 1994(5)
10.16 Severance Agreement between Encore and Harry L. Zimmerman, dated September 19, 1995, as amended on March 18, 1997(5)
10.17 Employment Agreement between Encore and J.D. Webb, Jr., dated August 26, 1994(5)
10.18 Severance Agreement between Encore and J.D. Webb, Jr., dated September 19, 1995, as amended on March 18, 1997(5)
10.19 Employment Agreement between Encore and Greg Kaseeska, dated March 1, 1998(6)
10.20 Severance Agreement between Encore and Greg Kaseeska, dated March 1, 1998(6)
10.21 Employment Agreement between Encore and Kathy Weiderkehr, dated April 1, 1997(6)
10.22 Severance Agreement between Encore and Kathy Weiderkehr, dated April 1, 1997(6)
10.23 Employment Agreement between Encore and Robert Buckley, dated December 1, 1998(6)
10.24 Severance Agreement between Encore and Robert Buckley dated December 1, 1998(6)
10.25 Employment Agreement between Encore and Jean-Paul Burtin, dated December 1, 1998(6)
10.26 Severance Agreement between Encore and Jean-Paul Burtin, dated December 1, 1998(6)
10.27 Second Amendment to Severance Agreement between Encore and Nick Cindrich dated December 31, 1998(6)
10.28 Second Amendment to Severance Agreement between Encore and Craig Smith dated December 31, 1998(6)
10.29 Second Amendment to Severance Agreement between Encore and August Faske dated December 31, 1998(6)
10.30 Second Amendment to Severance Agreement between Encore and Harry L. Zimmerman dated December 31, 1998(6) 10.31 Second Amendment to Severance Agreement between Encore and Kenneth Ludwig, Jr. dated December 31, 1998(6)
10.32 Second Amendment to Severance Agreement between Encore and J.D. Webb, Jr. dated December 31, 1998(6)
10.33 Amendment to Severance Agreement between Encore and Greg Kaseeska dated December 31, 1998(6)
10.34 Amendment to Severance Agreement between Encore and Kathy Weiderkehr dated December 31, 1998(6)
21 Schedule of Subsidiaries of Encore Medical Corporation
27 Financial Data Schedule
(1) Filed as an exhibit to Amendment No. 1 to HCAC's Registration Statement on Form S-1 (33-92854) filed with the SEC on July 14,
(2) Filed as an exhibit to Amendment No. 2 to HCAC's Registration Statement on Form S-1 (33-92854) filed with the SEC on February 20, 1996
(3) Filed as an exhibit to HCAC's Registration Statement on Form S-4 (333-22053) filed with the SEC on February 19, 1997
(4) Filed as an exhibit to Company Form 8-K filed with the SEC on May 30, 1997
(5) Filed as an exhibit to Company Form 10-K filed with the SEC on March 30, 1998
(6) Filed as an exhibit to Company Form 10-K filed with the SEC on March 23, 1999
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.
ENCORE MEDICAL CORPORATION
3/22/00 By: /s/ Nick Cindrich Date Nick Cindrich, Chairman of the Board and Chief Executive Officer
3/28/00 By: /s/ August Faske Date August Faske, Chief Financial 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.
3/22/00 By: /s/ Jay Haft Date Jay M. Haft, Director
3/22/00 By: /s/ Joel Kanter Date Joel Kanter, Director
3/22/00 By: /s/ Dennis Enright Date Dennis Enright, Director
3/22/00 By: /s/ Craig L. Smith Date Craig L. Smith, Director
3/22/00 By: /s/ John Abeles Date John Abeles, Director
3/22/00 By: /s/ Kenneth Davidson Date Kenneth Davidson, Director
3/22/00 By: /s/ Richard Martin Date Richard Martin, Director
INDEX TO EXHIBITS
(1) Filed as an exhibit to Amendment No. 1 to HCAC's Registration Statement on Form S-1 (33-92854) filed with the SEC on July 14,
(2) Filed as an exhibit to Amendment No. 2 to HCAC's Registration Statement on Form S-1 (33-92854) filed with the SEC on February 20, 1996
(3) Filed as an exhibit to HCAC's Registration Statement on Form S-4 (333-22053) filed with the SEC on February 19, 1997.
(4) Filed as an exhibit to Company Form 8-K filed with the SEC on May 30, 1997.
(5) Filed as an exhibit to Company Form 10-K filed with the SEC on March 30, 1998.
(6) Filed as an exhibit to Company Form 10-K filed with the SEC on March 23, 1999.