-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, NWdE2WKWbqvDFwdcKxZxgca6h0EYMi6HDxHjiJSL2jPqrA9y7A9tTqWQsYCqRXZE oxejkU6QMJ9iy5TWaSEQAw== 0000950144-98-005931.txt : 19980513 0000950144-98-005931.hdr.sgml : 19980513 ACCESSION NUMBER: 0000950144-98-005931 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19980331 FILED AS OF DATE: 19980512 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOFAMOR DANEK GROUP INC CENTRAL INDEX KEY: 0000873730 STANDARD INDUSTRIAL CLASSIFICATION: ORTHOPEDIC, PROSTHETIC & SURGICAL APPLIANCES & SUPPLIES [3842] IRS NUMBER: 351580052 STATE OF INCORPORATION: IN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 001-12544 FILM NUMBER: 98617204 BUSINESS ADDRESS: STREET 1: 1800 PYRAMID PLACE CITY: MEMPHIS STATE: TN ZIP: 38132 BUSINESS PHONE: 9013962695 MAIL ADDRESS: STREET 1: 1800 PYRAMID PL CITY: MEMPHIS STATE: TN ZIP: 38132 FORMER COMPANY: FORMER CONFORMED NAME: DANEK GROUP INC /IN DATE OF NAME CHANGE: 19930328 10-Q 1 SOFAMOR DANEK GROUP INC. FORM 10-Q 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 1998 ----------------------------------------------- OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________________ to ________________________ Commission File Number: 000-19168 ------------------------------------------------------ Sofamor Danek Group, Inc. - ------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Indiana 35-1580052 - ------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer Identification Number) incorporation or organization) 1800 Pyramid Place, Memphis, Tennessee 38132 - ------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (901) 396-2695 - ------------------------------------------------------------------------------- (Registrant's telephone number, including area code) - ------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 26,358,942 shares of common stock outstanding as of March 31, 1998 - ------------------------------------------------------------------------------- 1 2 PART I - FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARES)
MARCH 31, DECEMBER 31, 1998 1997 ---------- ------------ ASSETS (UNAUDITED) Current Assets: Cash and cash equivalents $ 83,696 $ 2,729 Short-term investments 35 36 Accounts receivable--trade, less allowance for doubtful accounts of $1,857 and $1,812 at March 31, 1998 and December 31, 1997, respectively 97,460 88,209 Other receivables 29,951 29,374 Inventories 40,227 40,575 Loaner set inventories 23,144 21,511 Prepaid expenses 6,158 6,061 Prepaid income taxes -- 3,052 Current deferred income taxes 3,996 8,013 -------- -------- Total current assets 284,667 199,560 Property, plant and equipment Land 1,468 1,477 Buildings 10,838 10,905 Machinery and equipment 37,285 35,677 Automobiles 926 759 -------- -------- 50,517 48,818 Less accumulated depreciation (25,161) (23,797) -------- -------- 25,356 25,021 Investments 934 954 Intangible assets, net 96,970 97,048 Other assets 31,258 31,649 Non-current deferred income taxes 33,263 31,425 -------- -------- Total assets $472,448 $385,657 ======== ========
The accompanying notes are an integral part of the consolidated financial statements. 2 3 SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONTINUED) (IN THOUSANDS, EXCEPT SHARES)
MARCH 31, DECEMBER 31, 1998 1997 ----------- ------------ LIABILITIES (UNAUDITED) Current Liabilities: Notes payable and lines of credit $ 11,389 $ 11,731 Current maturities of long-term debt 7,569 7,586 Current portion of product liability litigation 12,010 8,606 Accounts payable 8,413 4,684 Income taxes payable 14,040 2,473 Accrued expenses 35,087 41,488 --------- -------- Total current liabilities 88,508 76,568 Long-term debt, less current maturities 28,400 60,650 Product liability litigation, less current portion 26,494 33,970 Minority interest 3,912 3,171 Commitments and contingencies STOCKHOLDERS' EQUITY Preferred stock, no par value, 5,000,000 shares authorized, no shares outstanding Common stock, no par value 150,000,000 shares authorized: 30,382,122 and 25,867,749 shares issued (including 4,023,180 and 685,908 shares held in treasury) at March 31, 1998 and December 31, 1997, respectively 360,546 74,014 Retained earnings 171,323 154,828 Accumulated other comprehensive loss (5,280) (4,294) --------- -------- 526,589 224,548 Less: Cost of common stock held in treasury (198,190) (9,985) Stockholder notes receivable (3,265) (3,265) --------- -------- Total stockholders' equity 325,134 211,298 --------- -------- Total liabilities and stockholders' equity $ 472,448 $385,657 ========= ========
The accompanying notes are an integral part of the consolidated financial statements. 3 4 SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 1998 1997 ------- ------- Revenues $88,453 $69,759 Cost of goods sold 15,748 12,370 ------- ------- Gross Profit 72,705 57,389 Operating Expenses: Selling, general and administrative 41,039 32,698 Research and development 6,234 4,730 ------- ------- 47,273 37,428 ------- ------- Income from operations 25,432 19,961 Other income 246 76 Interest expense (1,135) (1,176) ------- ------- Income from operations before provision for and charge in lieu of income taxes 24,543 18,861 Provision for and charge in lieu of income taxes 7,354 5,470 ------- ------- Income before minority interest 17,189 13,391 Minority interest 694 617 ------- ------- Net income $16,495 $12,774 ======= ======= Net income per share - diluted $ 0.59 $ 0.49 ======= ======= Net income per share - basic $ 0.65 $ 0.52 ======= =======
The accompanying notes are an integral part of the consolidated financial statements. 4 5 SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW (IN THOUSANDS) (UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 1998 1997 -------- ------- Cash flows from operating activities: Net income $16,495 $ 12,774 Adjustments to reconcile net income to net cash provided (used) by operating activities: Depreciation and amortization 4,416 3,630 Provision for doubtful accounts receivable 89 70 Deferred income tax expense 2,069 222 Loss (gain) on disposal of equipment 71 (7) Minority interest 694 617 Changes in assets and liabilities: Accounts receivable (9,829) (6,771) Other receivables (642) (3,549) Inventories and loaner set inventories (1,729) (10,631) Prepaid expenses 345 1,302 Prepaid income taxes 3,053 (479) Other assets 382 (315) Accounts payable 3,848 4,230 Income taxes payable (463) 44 Accrued expenses (6,233) (4,590) Product liability litigation (3,986) (985) ------- -------- Net cash provided by (used by) operating activities 8,580 (4,438) ------- -------- Cash flows from investing activities: Purchase of short-term investments -- (2) Proceeds from maturities of short-term investments -- 33
The accompanying notes are an integral part of the consolidated financial statements. 5 6 SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW (CONTINUED) (IN THOUSANDS) (UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 1998 1997 --------- -------- Payments for purchase of property, plant and equipment (2,429) (1,549) Proceeds from sale of equipment -- 14 Purchase of intangible assets (2,760) (3,867) Increase in notes receivable, other (259) (23) Repayments of notes receivable, other 318 9 Payments for investment (5) (55) -------- ------- Net cash used by investing activities (5,135) (5,440) -------- ------- Cash flows from financing activities: (Decrease) increase in short-term borrowings (24) 8,423 Proceeds from long-term debt 18,151 130 Repayment of long-term debt (50,390) (41) Proceeds from issuance of common stock 111,749 3,197 Cash paid in the SOFYC exchange (1,930) -- Capital contribution by minority shareholder -- 148 -------- ------- Net cash provided by financing activities 77,556 11,857 -------- ------- Effect of exchange rate changes on cash (34) 274 -------- ------- Increase in cash and cash equivalents 80,967 2,253 Cash and cash equivalents, beginning of period 2,729 2,830 -------- ------- Cash and cash equivalents, end of period $ 83,696 $ 5,083 ======== =======
The accompanying notes are an integral part of the consolidated financial statements. 6 7 SOFAMOR DANEK GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (IN THOUSANDS, EXCEPT FOR NOTE 7 AND SHARE AND PER SHARE DATA) 1. Financial Statement Presentation The consolidated balance sheet as of March 31, 1998 and the consolidated statements of income and consolidated statements of cash flows for the three months ended March 31, 1998 and 1997, are unaudited but, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of financial position, results of operations and cash flows. Certain amounts for prior periods have been reclassified to conform with the presentation at March 31, 1998. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. It is suggested that these consolidated financial statements be read in conjunction with the financial statements and notes thereto included in the Company's 1997 Annual Report on Form 10-K. 2. Inventories and Loaner Set Inventories Net inventories and loaner set inventories consist of:
------------------------------------------------------------------------- March 31, December 31, 1998 1997 ------------------------------------------------------------------------- Finished goods $34,242 $35,029 Work-in-process 3,873 3,405 Raw materials 2,112 2,141 ------------------------------------------------------------------------- Net inventories $40,227 $40,575 ------------------------------------------------------------------------- Loaner set inventories, net $23,144 $21,511 -------------------------------------------------------------------------
3. Income Taxes The Company's effective income tax rates were 30.0% and 29.0%, respectively, for the quarters ended March 31, 1998 and March 31, 1997. The difference between the Company's effective and statutory tax rates for both 1998 and 1997 resulted primarily from the impact of certain elections made for U.S. tax purposes following the combination (the "Combination") of Danek Group, Inc. with Sofamor S.A. ("Sofamor"), and the subsequent reorganization of Sofamor from a Societe Anonyme (S.A.) under French law to a Societe en 7 8 Nom Collectif (S.N.C.) in late 1993. Management cannot be certain that such a favorable effective income tax rate will be achieved in future periods, since the effective tax rate calculation is dependent upon the Company's pre-tax income dollar amount. Higher future pre-tax income could lead to higher future effective tax rates. At March 31, 1998, the balance sheet of the Company reflected a net deferred tax asset of $37,259. No valuation allowance was recorded since sufficient taxable income exists in available carryback periods to recognize fully these net deferred tax assets. During the first quarters of 1998 and 1997, charges in lieu of income taxes of $1,018 and $1,622, respectively, were recorded by the Company as a result of certain common stock options being exercised and vesting of certain restricted common stock. 4. Net Income Per Common Share In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard ("FAS") No. 128. This statement establishes standards for computing and presenting earnings per share ("EPS"). Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. FAS 128 requires restatement of all prior-period EPS data presented. Potential common stock is in the form of stock options which have an effect on the diluted net income per common share calculations for the three months ended March 31, 1998 and 1997. Potential common stock also includes assumed converted debt securities. For the three months ended March 31, 1998 and 1997, net income was adjusted by $30 and $31, respectively, to calculate EPS. This adjustment represented the interest charges, net of taxes, from convertible debt which was assumed to be converted for the diluted weighted average number of shares calculation. The following table presents information necessary to calculate diluted EPS for the three months ended March 31, 1998 and 1997:
FOR THE THREE MONTHS ENDED MARCH 31, ----------------------------------------------------------------------------- 1998 1997 ----------------------------------------------------------------------------- Weighted average shares outstanding - Basic 25,488,628 24,514,438 Shares equivalents 2,444,736 1,795,747 ------------------------------------------------------------------------------ Weighted average shares outstanding - Diluted 27,933,364 26,310,185 ------------------------------------------------------------------------------
8 9 5. Comprehensive Income During the first quarter of 1998, the Company adopted the provisions of FAS No. 130, "Reporting Comprehensive Income." The standard requires that entities include within their financial statements information on comprehensive income, which is defined as all activity impacting equity from nonowner sources. For the Company, comprehensive income is comprised of net income and changes in cumulative translation adjustments. Other comprehensive loss, for the three months ended March 31, 1998 and 1997 was $986 and $3,287, respectively. 6. Stock Exchange and Public Offering On January 26, 1998, the Company purchased all of the outstanding capital stock of SOFYC, S.A. ("SOFYC") for an aggregate of 2,806,080 privately placed shares of the Company's common stock, $1,000 in cash (less certain expenses relating to the repurchase) and the Company's agreement to repay certain outstanding loans of SOFYC equal to approximately $930 (the "SOFYC Exchange"). In connection with the SOFYC Exchange, a foreign tax liability of $13,000 was reflected at March 31, 1998, which represents an estimate of the tax the Company will incur upon retiring the shares owned by SOFYC. SOFYC, which was the personal holding company of the Cotrel family, owns 3,337,272 shares of the Company's Common Stock. As a result of the SOFYC Exchange, the outstanding shares of common stock of the Company were reduced by 531,192 shares. In connection with the transaction, certain registration rights were granted to the former SOFYC shareholders. In accordance with these rights, the Company filed a registration statement with the Securities and Exchange Commission related to a public offering on behalf of the former SOFYC shareholders of 1,600,000 of their 3,689,711 shares of Sofamor Danek common stock that they own in aggregate. The registration also provided for a public offering of up to 1,200,000 shares of common stock to be sold by the Company for its own account. In addition, Sofamor Danek granted to the underwriters a maximum over-allotment option of 420,000 shares of common stock. The net proceeds received by the Company pursuant to the offering totaled $110,134. 7. Commitments and Contingencies The Company is involved from time to time in litigation on various matters which are routine to the conduct of its business, including product liability and intellectual property cases. PRODUCT LIABILITY LITIGATION Beginning in 1994, the Company and other spinal implant manufacturers were named as defendants in a number of product liability lawsuits brought in various federal and state courts around the country. These lawsuits allege that plaintiffs were injured by spinal implants manufactured by the Company and others. The essence of the plaintiff's claims appears to be that the Company (including Sofamor and its former U.S. distributor) 9 10 marketed some of its spinal systems for pedicle fixation in contravention of the Food and Drug Administration ("FDA") rules and regulations (governing marketing and labeling of medical devices), that pedicle fixation has not been proven safe and effective in the context of FDA labeling standards, that some or all of the spinal systems are defectively designed and manufactured and that plaintiffs have suffered a variety of injuries as a result of their physicians' use of such systems in pedicle fixation. The Company has also been named as a defendant in a number of lawsuits instituted by plaintiffs who have received spinal implants manufactured by other manufacturers and in which the Company is alleged to have participated in a conspiracy among doctors, manufacturers, hospitals, teaching institutions, professional societies and others to promote, in violation of applicable law, the use of spinal implants. In a number of cases, plaintiffs have sought to proceed as representatives of classes of spinal implant recipients. All efforts to obtain class certification have been denied or withdrawn, except with respect to a class-action settlement entered into between the plaintiffs and another spinal implant manufacturer, AcroMed Corporation (see below under the heading entitled "AcroMed Corporation Settlement"). Some plaintiffs have filed individual lawsuits, whereas other lawsuits list multiple plaintiffs and, in certain instances, multiple lawsuits have been filed on behalf of the same individual plaintiffs. Plaintiffs typically seek relief in the form of monetary damages, often in unspecified amounts. Many of the plaintiffs only allege as monetary damage an amount in excess of the jurisdictional minimum for the court in which the case has been filed. A few suits also name as defendants various officers and directors of the Company. As of March 31, 1998, the claims of approximately 2,200 plaintiffs remain active in litigation against the Company. The majority of these plaintiffs filed their claims in 1995. A number of plaintiffs have failed to pursue their claims, and their claims have been dismissed without prejudice. The Company is also named as a defendant in lawsuits involving about 2,600 plaintiffs where the Company is alleged to have conspired with competitors and others, in violation of applicable law, to promote the use of spinal implant systems. The Company believes that it has defenses, including, without limitation, defenses based upon the failure of a cause of action to exist where no malfunction of the implant has occurred or the plaintiff has suffered no injury attributable to the Company's product, the expiration of the applicable statute of limitations and the learned intermediary defense. The Company has asserted and will continue to assert these defenses primarily through the filing of dispositive motions. The Company believes that all product liability lawsuits currently pending against it are without merit and will continue to defend against them vigorously. FEDERAL MULTIDISTRICT LITIGATION (MDL 1014) On August 4, 1994, the Federal Judicial Panel for Multidistrict Litigation ordered all federal court lawsuits to be transferred to and consolidated for pretrial proceedings, including the determination of class certification, in the United States District Court for the Eastern 10 11 District of Pennsylvania in Philadelphia (the "Multidistrict Litigation"). Lawsuits filed in federal court after August 4, 1994 have also been transferred to and consolidated in the Multidistrict Litigation in the Eastern District of Pennsylvania. In addition, a number of lawsuits filed in state courts around the country were removed to federal courts and then transferred into the Multidistrict Litigation. On February 22, 1995, Chief Judge Emeritus, Louis C. Bechtle ("Judge Bechtle"), denied class certification. A large number of plaintiffs filed individual lawsuits as a result of the denial of class certification. In some instances, lawsuits that had been removed and transferred into the Multidistrict Litigation have been remanded to the state courts in which they were filed because there was no federal court jurisdiction. As of March 31, 1998, the Company is a defendant in approximately 920 individual claims and 1,065 conspiracy claims consolidated in the Multidistrict Litigation. On April 16, 1997, Judge Bechtle dismissed conspiracy claims alleging fraud on the FDA, but deferred the remaining conspiracy claims for later consideration by the federal trial courts to whom the cases will be remanded for trial. Discovery has been completed in a number of the federal court cases and is continuing in the remainder. A small number of cases have been transferred to the federal courts in which they were filed for further proceedings and trial. Judge Bechtle has begun the process of transferring the remaining federal court cases to various federal courts throughout the United States. As of March 31, 1998, the Federal Judicial Panel on Multidistrict Litigation ordered the remand of approximately 210 cases to transferor courts for further proceedings. It is anticipated that the first federal court cases will be tried in 1998. STATE COURT LITIGATION A number of cases filed in state courts were not eligible for removal and transfer into the Multidistrict Litigation. As of March 31, 1998, there were approximately 1,800 individual claims pending against the Company in several courts around the country, principally in Tennessee, Oklahoma, Texas and Pennsylvania. In addition, there were approximately 1,600 conspiracy claims pending in state courts. Approximately 1,550 plaintiffs, who had joined together in several complaints which had been removed to the Multidistrict Litigation proceedings, have had their cases remanded to the state court in Memphis, Tennessee, where they were originally filed when it was determined that the federal court lacked jurisdiction over their claims. A number of plaintiffs have failed to pursue claims made on their behalf and their claims were dismissed without prejudice. As of March 31, 1998, the lawsuits of approximately 1,000 plaintiffs remain active in the litigation pending in Memphis, Tennessee. The presiding state court judge in Memphis has established a case management plan which calls for the preparation of eight representative cases for preparation and trial. Discovery is proceeding in all remaining state court cases. Some state cases have been given trial dates in 1998. It is anticipated that a number of other state court cases around the country may be scheduled for trial in 1998, although delays in trial dates are common. The first case in Memphis against the Company is scheduled for trial in September, 1998. 11 12 ACROMED CORPORATION SETTLEMENT In December 1996, AcroMed Corporation ("AcroMed"), a spinal implant manufacturer and a defendant in many of the cases pending in the Multidistrict Litigation, and the Plaintiff's Legal Committee in the Multidistrict Litigation announced that they had entered into a conditional settlement regarding all product liability claims involving the use of AcroMed devices to achieve pedicular fixation with screws in spinal fusion surgery. Under the terms of the settlement, AcroMed will establish a settlement fund consisting of $100 million in cash plus the proceeds of its product liability insurance policies. In January 1997, the parties submitted a formal class settlement agreement and related documentation for approval by Judge Bechtle. By order dated October 17, 1997, Judge Bechtle certified the proposed settlement class and approved the proposed settlement. All appeals of Judge Bechtle's certification and approval order have been withdrawn. As a consequence of the class-certified settlement, all federal proceedings involving AcroMed devices have been stayed. INSURANCE Several insurance carriers have asserted reservation of rights concerning the scope and timing of the Company's remaining insurance coverage, but have not denied insurance coverage to the Company. Three of the carriers, Royal Surplus Lines Insurance Company ("Royal"), Steadfast Insurance Company ("Steadfast") and Agricultural Excess and Surplus Insurance Company ("Agricultural"), have each filed declaratory judgment actions against the Company seeking clarification of their rights and obligations, if any, under their respective policies. Neither Royal nor Agricultural has paid amounts due to the Company; Steadfast has paid only a portion of the amounts due to the Company. The Royal and Steadfast lawsuits are pending in the United States District Court for the Western District of Tennessee in Memphis. The Agricultural lawsuit is pending in the United States District Court for the Southern District of Ohio in Cincinnati. The Company believes that the receivables are recoverable under the terms of the Royal, Steadfast and Agricultural policies. The Company has filed an answer and counterclaim in the Royal litigation and a motion seeking the interim payment of the Company's defense costs. The Company has filed answers and counterclaims in the Steadfast and the Agricultural litigations. All three litigations are in the preliminary stages. The Company believes that Royal's, Steadfast's and Agricultural's claims are without merit and will defend against them vigorously. As is common in the insurance industry, the Company's insurance policies covering product liability claims must be renewed annually. The Company has in force insurance coverage for product liability claims including orthopedic bone screw claims, subject to the terms, conditions and limits of the individual insurance policies. Except for a policy issued by Royal, the Company's insurance policies are reduced by the costs of defense. In some instances, the cost of defending these claims has been reimbursed by certain of the primary 12 13 and excess insurance carriers. Although the Company has been able to obtain insurance relating to product liability claims at a cost and on other terms and conditions that are acceptable to the Company, there can be no assurance that in the future it will be able to do so. On January 6, 1997, the Company announced that its 1996 financial results would include a pre-tax charge of $50 million relating to costs associated with the product liability litigation described above. The charge, which is reflected in the Company's 1996 financial statements, covers the reasonable foreseeable costs that the Company was positioned in late December 1996 to estimate because the litigation had progressed and because changes in the fourth quarter of 1996 had occurred in facts and circumstances relating to the litigation. Among the changed facts and circumstances were the announcement of the AcroMed settlement described above, the likelihood that the litigation will continue for several years, in part, due to the additional financial resources provided to the plaintiff's attorneys as a result of the AcroMed settlement, the absence of AcroMed as a member of the joint defense group, the status of the Company's insurance described above and the continuing absence of dispositive rulings relating to the Company's defense motions. While it is not possible to accurately predict the outcome of litigation, the amount of the accrual, which remained on the Company's consolidated balance sheet at March 31, 1998, represents the Company's best judgment of the probable reasonable costs (in excess of amount of insurance the Company believes are recoverable) to defend and conclude the lawsuits based on the facts and circumstances currently existing. The costs provided for in the accrued liability include, but are not limited to, legal fees paid or anticipated to be paid and other costs related to the Company's defense and conclusion of these matters. The actual costs to the Company could differ from the estimated charge and will be dependent upon a number of factors that will not be known for some time, including, among other things, the resolution of defense motions and the extent of further discovery. Although an adverse resolution of lawsuits could have a material effect on the Company's results of operations and cash flows in future periods, the Company does not believe that these matters will in the future have a material adverse effect on its consolidated financial position. The Company is unable to predict the ultimate outcome or the financial impact of the product liability litigation. SECURITIES LAWS ACTIONS Beginning in April 1994, the Company and four of its officers and directors were named in five shareholder lawsuits filed in the United States District Court in Memphis, Tennessee. Four of the lawsuits purported to be class actions. All of the lawsuits were consolidated into one case in the United States District Court in Memphis through an amended complaint which added four new individual defendants who are either current or former directors of the Company. The lawsuit alleges that the defendants made false and misleading statements and failed to disclose material facts to the investing public and seeks money damages. The alleged securities law violations are based on the claim that the defendants failed to disclose 13 14 that the Company sold its products illicitly, illegitimately and improperly and to timely disclose facts concerning the termination of the former U.S. distributor of Sofamor products, National Medical Specialties, Inc. ("NMS"). The allegations relating to illicit and illegitimate sales of product are, for the most part, copies from product liability complaints filed against the Company and other manufacturers currently being coordinated in improper sales related to one of the Company's selling programs which has been publicly disclosed since May 1991. The allegations concerning NMS relate to the termination of the NMS distribution agreement covering Sofamor products in the United States. On October 3, 1995, the United States District Court Judge in Memphis dismissed with prejudice the entire case against the Company and each of the individual defendants. The plaintiffs appealed the dismissal to the United States Court of Appeals for the Sixth Circuit. On August 14, 1997, the Court of Appeals affirmed the dismissal of the plaintiffs' complaint. The Court of Appeals denied the plaintiffs' request for reconsideration on October 9, 1997. The plaintiffs filed a petition for certiorari in the United States Supreme Court, which the Company opposed. The United States Supreme Court has denied the plaintiffs' petition for certiorari. The dismissal of the plaintiffs' case is now final. INTERNAL REVENUE SERVICE DOCUMENT PRODUCTION On April 29, 1998, the Internal Revenue Service (the "IRS") served the Company with a summons covering the 1993, 1994 and 1995 taxable years. Generally, the IRS is requiring the production of (i) documents supporting expenses incurred in connection with trips attended by physicians, (ii) documents relating to payments made to physicians for consulting, (iii) documents relating to stock options granted, royalty agreements and payments, fellowship grants/awards, scholarships and honorariums, (iv) a list of Company customers, (v) certain revenue information and (vi) a report with respect to governmental customers. While the scope of the document production is currently under review, it is the Company's intention to cooperate with the IRS in connection with this matter. 14 15 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following table sets forth for the periods indicated selected unaudited financial information expressed as a percentage of revenues and the period-to-period change in such information.
Period-to-Period As a Percentage of Revenues Change ----------------------------- --------------------- Three Months Ended Three Months Ended March 31, March 31, 1998 1997 1998 vs. 1997 ----------------------------- --------------------- Revenues 100.0% 100.0% 26.8% Cost of goods sold 17.8 17.7 27.3 ----- ----- Gross profit 82.2 82.3 26.7 Operating expenses: Selling, general and administrative 46.4 46.9 25.5 Research and development 7.0 6.8 31.8 ----- ----- Total operating expenses 53.4 53.7 26.3 Income from operations 28.8 28.6 27.4 Other income 0.3 0.1 223.7 Interest expense (1.4) (1.7) (3.5) ----- ----- Income from operations before provision for and charge in lieu of income taxes 27.7 27.0 30.1 Provision for and charge in lieu of income taxes 8.3 7.8 34.4 ----- ----- Income before minority interest 19.4 19.2 28.4 Minority interest 0.8 0.9 12.5 ----- ----- Net income 18.6% 18.3% 29.1% ===== =====
RESULTS OF OPERATIONS* The Company reported record first quarter revenues of $88.5 million for the quarter ended March 31, 1998, which represented a $18.7 million, or 26.8%, increase over the first quarter of 1997. An increase in volume comprised 27.5% of the revenue growth. The Company's conversion of certain portions of its international distribution network to direct sales and other net pricing changes contributed a 4.6% increase. Changes in exchange rates negatively impacted revenues by 5.3%. - ------------------------------- * Except for the historical information contained in this Quarterly Report on Form 10-Q, the matters discussed herein (including, in particular, those discussed in Part II, Item 1, "Legal Proceedings") are forward-looking statements that involve risks and uncertainties, including (without limitation) the timely development and acceptance of new products, the impact of competitive products, the timely receipt of regulatory clearances required for new products, the regulation of the Company's products generally, the disposition of certain litigation involving the Company and certain other risks and uncertainties detailed from time to time in the Company's periodic reports (including the Annual Report on Form 10-K for the year ended December 31, 1997 and the Current Report on Form 8-K dated February 3, 1998) filed with the Securities and Exchange Commission. 15 16 U.S. revenues grew to $61.8 million for the quarter ended March 31, 1998, a 27.9% increase from the same period in 1997. The Company believes the improvement in U.S. revenues is primarily the result of an increased number of instrumented fusions. This growth in the number of fusions has occurred, in part, due to the broad range of quality products provided by the company to assist physicians in treating their patients. Non-U.S. revenues advanced 24.2% during first quarter 1998, when compared to first quarter 1997. The increase would have been 41.4% if exchange rates had been constant. Higher volume was the primary source of the increase in revenues during the first quarter of 1998, compared with the same period of 1997. In addition, the Company's revenues continued to benefit from the direct sales operations, which were established in selected countries during 1997. The Company's gross margin of 82.2% during the first quarter of 1998 was essentially flat compared with 82.3% for the same period of 1997. Selling, general and administrative expenses were 46.4% of revenues in the first quarter of 1998, compared with 46.9% during the same period of 1997. This decrease in selling, general and administrative expenses, expressed as a percentage of revenues, resulted from the leveraging of fixed costs over greater revenue volume, even though higher expenses were incurred related to direct sales operations established during 1997 in selected countries. Research and development expenses totaled $6.2 million, or 7.0% of revenues, for the first quarter of 1998, compared with $4.7 million, or 6.8% of revenues, for the first quarter of 1997. The first quarter 1998 dollar spending represents an increase of 31.8% over the same period in 1997. These development and clinical costs are incurred as the Company continues to enhance existing product lines and develop new and complementary products, such as the interbody fusion devices, biological products for use in spinal applications, and products related to frameless stereotactic surgery in the spinal and neurological fields of use. These expenditures demonstrate the Company's continued commitment to producing product opportunities through the application of new medical technologies. The Company reported other income of $246,000 for the quarter ended March 31, 1998, compared with $76,000 for the same period in 1997. The improvement in the first quarter 1998 other income related principally to higher interest income on cash equivalents generated from the public offering discussed in the "Liquidity and Capital Resources" section. Interest expense for the first quarter of 1998 was $1.1 million compared with $1.2 million during the same period in 1997. The slight decrease in interest expense occurred as the Company reduced its borrowings against credit facilities in March of 1998 after receiving the proceeds of its public offering. The Company's effective income tax rates were 30.0% and 29.0%, respectively, for the quarters ended March 31, 1998 and March 31, 1997. The difference between the Company's effective and statutory tax rates for both 1998 and 1997 resulted primarily from the impact of certain elections made for U.S. tax purposes following the combination (the "Combination") of Danek Group, Inc. with Sofamor S.A. ("Sofamor"), and the subsequent reorganization of Sofamor from a Societe Anonyme (S.A.) under French law to a Societe en Nom Collectif (S.N.C.) in late 1993. 16 17 Management cannot be certain that such a favorable effective income tax rate will be achieved in future periods, since the effective tax rate calculation is dependent upon the Company's pre-tax income dollar amount. Higher future pre-tax income could lead to higher future effective tax rates. At March 31, 1998, the balance sheet of the Company reflected a net deferred tax asset of $37.3 million. No valuation allowance was recorded since sufficient taxable income exists in available carryback periods to recognize fully these net deferred tax assets. LIQUIDITY AND CAPITAL RESOURCES On January 26, 1998, the Company purchased all of the outstanding capital stock of SOFYC, S.A. ("SOFYC") for an aggregate of 2,806,080 privately placed shares of the Company's common stock, $1.0 million in cash (less certain expenses relating to the repurchase) and the Company's agreement to repay certain outstanding loans of SOFYC equal to approximately $930,000 (the "SOFYC Exchange"). In connection with the SOFYC Exchange, a foreign tax liability of $13.0 million was reflected at March 31, 1998, which represents an estimate of the tax the Company will incur upon retiring the shares owned by SOFYC. SOFYC, which was the personal holding company of the Cotrel family, owns 3,337,272 shares of the Company's common Stock. As a result of the SOFYC Exchange, the outstanding shares of common stock of the Company were reduced by a net 531,192 shares. In connection with the transaction, certain registration rights were granted to the former SOFYC shareholders. In accordance with these rights, the Company filed a registration statement with the Securities and Exchange Commission related to a public offering on behalf of the former SOFYC shareholders of 1,600,000 of their 3,689,711 shares of Sofamor Danek common stock that they owned in the aggregate before the offering. The registration statement also provided for a public offering of up to 1,200,000 shares of common stock to be sold by the Company for its own account. In addition, Sofamor Danek granted to the underwriters a maximum over-allotment option of 420,000 shares of common stock. The over allotment option was exercised. The Company issued 1,620,000 shares and received net proceeds pursuant to the offering of $110.1 million. The Company intends to use the net proceeds for repayment of outstanding borrowings, general corporate purposes, which may include research and product development, capital expenditures, the scheduled payment pursuant to the Company's license agreement with Genetic's Institute, certain foreign taxes due in connection with the SOFYC transaction, acquisitions and working capital. Cash generated from operations and the Company's revolving lines of credit are the principal ongoing sources of funding available for growth of the business, including working capital and additions to property, plant and equipment, as well as debt service requirements and required contractual payments. The Company believes that these sources of funding together with the proceeds from the public offering mentioned above will be sufficient to meet its expected cash needs for the foreseeable future. Cash, cash equivalents and short-term investments totaled $83.7 million at March 31, 1998, compared with $2.8 million at December 31, 1997. The Company's working capital increased by $73.2 million during the first quarter of 1998. The increase in working capital resulted primarily from the proceeds from the public offering, partially offset by the amounts paid against long-term credit facilities. Accounts receivable increased $9.3 million from December 31, 1997, due principally to the mix of receivables across 17 18 various product categories and geographic regions. Inventories and loaner set inventories increased by $1.3 million or 2.1% from year-end. Other receivables, which consisted primarily of amounts recoverable from insurance carriers relating to the expenses incurred in connection with product liability litigation, increased $577,000 from the Company's previous year-end. In connection with the Company's 1995 license agreement with Genetic's Institute, which resulted in a special charge of $45.3 million, the Company had a remaining liability of $7.0 million at March 31, 1998. This liability represents the present value of the $7.5 million payment due in June of 1998 under the agreement. The purchase agreements for two acquisitions made by the Company in 1996 contain provisions which provide for contingent payments to the former shareholders of each entity based upon certain calculations relative to revenues and earnings, as defined, through 1999. Such payments are reflected as purchase price adjustments. The Company recorded adjustments to the purchase price of these acquisitions of $5.1 million and $4.2 million in 1997 and 1996, respectively. The amount recorded in 1996 was paid in April 1997, and the amount recorded in 1997 was paid in March 1998. The Company is unable to determine whether such adjustments will be required for 1998 or 1999. Additions to property, plant and equipment during the first quarter of 1998 of $2.4 million were related to capital asset expenditures necessary to support the Company's manufacturing and distribution operations. The Company is in need of additional office and distribution space at its Memphis location. Management has entered into an agreement whereby the Company will lease, with an initial term of 10 years, a new facility adjacent to its existing headquarters with an expected occupancy date of mid 1998. This lease will be accounted for as an operating lease. The Company has committed lines of credit totaling $115.5 million. At March 31, 1998, $34.8 million was outstanding under these lines of credit and other short-term borrowings. The committed lines of credit consist primarily of the $100.0 million U.S. revolving line of credit. In 1996, the Internal Revenue Service began an examination of the Company's federal income tax returns. The years under examination are 1993, 1994 and 1995. Management believes that the resolution of any issues that may be developed as a result of the examination will not have a significant impact on the Company's results of operations or financial condition. The Company invests available funds in short-term investment grade instruments, certificates of deposit or direct or guaranteed obligations of the United States of America. These short-term investments are available to fund the Company's working capital requirements and acquisitions of capital assets. The "Year 2000" issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any computer programs that have time sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar 18 19 normal business activities. Management has conducted an assessment of its exposure to disruption associated with the Year 2000 issue. The Company is currently in the process of implementing purchased software that will serve as an enterprise resource planning system providing enhanced productivity and customer service benefits in addition to mitigating potential consequences of the Year 2000 issue. The cost of the software license and the majority of the costs of implementation will be capitalized. Management expects this implementation to be completed in the first quarter of 1999. The Company believes that with modifications to existing software and conversions to new software, the Year 2000 issue will not pose significant operational problems for its computer systems. However, if such modifications are not made, or are not completed in a timely manner, the Year 2000 issue could have an impact on the Company's ability to operate. The Company does not believe that the costs of addressing this issue will be material to the Company's operations. FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS AND FINANCIAL CONDITION The Company's future operating results and financial condition are subject to risks and uncertainties, including (without limitation) the following matters: Regulatory Clearances and Compliance. The preclinical testing, manufacturing, labeling, distribution and promotion of the Company's products are subject to extensive government regulation by the Food and Drug Administration ("FDA") in the United States and comparable regulatory bodies in other countries. Noncompliance with the applicable regulatory requirements can lead to enforcement action which may result in, among other things, warning letters, fines, recall or seizure of products, total or partial suspension of production, refusal by governments to grant pre-market clearances and criminal prosecution. The process of obtaining marketing clearances can be time-consuming, and there can be no assurance that all necessary clearances will be granted to the Company with respect to new devices or that the process will not involve delays adversely affecting the marketing and sale of new devices. In the United States, even after regulatory clearance or approval to market a device is obtained from the FDA, the Company is subject to continuing FDA regulation. FDA approvals or clearances are required for certain changes to the labeling and marketing of medical devices. FDA regulations depend heavily on administrative interpretation, and there can be no assurance that future interpretations made by the FDA or other regulatory bodies, with possible retroactive effect, will not adversely affect the Company. The Company is also subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices and environmental protection. There can be no assurance that the Company will not be required to incur significant costs to comply with such laws and regulations. Unanticipated changes in existing regulatory requirements, failure of the Company to comply with such requirements or adoption of new requirements could have a material adverse effect on the Company's business. Potential Impact of Healthcare Cost Containment Proposals on Profitability. Sales of a large portion of the Company's products depend to a significant extent on the availability of reimbursement to the Company's customers by government and private insurance plans. In recent years, the cost of healthcare has risen significantly, and there have been numerous 19 20 proposals by legislatures, regulators and third party health care payers to curb these cost increases in the United States and Europe. Some of these proposals have involved limitations on the amount of reimbursement for specific surgical procedures. These proposals have been adopted in some cases. The Company is unable to predict the ultimate timing, scope or effect of any legislation concerning healthcare reform. Any legislation, if adopted, could result in significant changes in the availability, delivery, pricing and payment for healthcare services and products and adversely affect the Company's business. In addition, hospitals and other healthcare providers have become increasingly cost sensitive. To date, the Company does not believe that such healthcare cost containment proposals have negatively affected the profitability or growth of its business; however, the Company is not able to predict the future effect of these proposals on its business. Rapid Technological Change; Technological Obsolescence; Acceptance Of New Products. The medical device industry is characterized by rapidly changing technology and frequent new product introductions. The Company's future success will depend largely on the Company's ability to develop and introduce in a timely manner new products and enhancements that meet changing customer requirements and emerging industry standards. Although the Company's strategy for growth includes the introduction of new products, the development of new technologically advanced products and enhancements is a complex and uncertain process requiring high levels of innovation as well as the anticipation of technology and market trends. The Company may not be able to respond effectively to technological changes, emerging industry standards or product announcements by competitors, it may not be able to identify, develop, manufacture, market, sell or support new products and enhancements successfully and its new products or enhancements may not achieve market acceptance. Market acceptance for products under development could be adversely affected by numerous factors, including the lack of availability of third-party reimbursement to consumers of such products, the cost of the products, clinical acceptance thereof and effective physician training. Market acceptance will also depend on the Company's ability to demonstrate that such products are an attractive alternative to existing products, which will depend on physicians' evaluations of the clinical safety and efficacy, ease of use, reliability and cost-effectiveness of the products. Furthermore, the Company believes that, once the products receive approval, recommendations and endorsements by influential surgeons will be essential to market acceptance of its products. There can be no assurance that the Company's products under development will adequately demonstrate these characteristics or that they will receive market acceptance among consumers or physicians. Any of these events could have a material adverse effect on the Company's business, financial condition and results of operations. Product Liability; Insurance. In recent years, physicians, hospitals, and other participants in the healthcare industry have become subject to an increasing number of lawsuits alleging malpractice, product liability or related legal theories, many of which involve large claims and significant defense costs. The Company is currently involved in product liability litigation. (See Note 7 to the Consolidated Financial Statements.) There can be no assurance that additional claims will not be asserted against the Company in the future. A successful future claim or aggregation of future claims brought against the Company in excess of insurance coverage could have a material adverse effect upon the financial condition, results of operations and/or cash 20 21 flows of the Company. Claims against the Company, regardless of their merit or eventual outcome, may also have a material adverse effect upon the reputation and business of the Company. The Company currently maintains liability insurance at coverage levels which it deems commercially reasonable. Historically, the Company has been required to call on its insurance for product liability claims, and assuming all amounts are paid by the insurance carriers, the Company will have exhausted its insurance coverage for the coverage year ended November 1995. There can be no assurance that the coverage limits of such insurance policies will be adequate or that all amounts will ultimately be collected from each insurer providing the applicable policy (See Part II - Other information, Item 1 Legal Proceedings - Insurance). Such insurance is expensive, difficult to obtain and may not be available in the future on acceptable terms or at all. Increasing Competition. The medical device industry is subject to intense competition. The market for products designed to treat spinal conditions is highly competitive, and the Company expects competition to increase as a result of new entrants and consolidations. Accordingly, the Company's future success will depend in part on its ability to respond quickly to medical and technological change and user preferences through the development and introduction of new products that are of high quality and that address patient and surgeon requirements and, in part, on its ability to differentiate its mature products from those of its competitors. Worldwide, there are many firms producing spinal implant devices, and certain of the Company's competitors currently manufacture and sell interbody fusion cages that have received a Pre-Market Approval ("PMA") from the FDA. A number of these firms have greater financial, research and development, manufacturing and sales and marketing resources than the Company. The Company's inability to compete effectively against existing or future competitors would have a material adverse effect on its business, financial condition and results of operations. Dependence On Key Personnel. The Company's future success depends in significant part upon the continued service of certain key scientific, technical and managerial personnel and its continuing ability to attract and retain highly qualified scientific, technical and managerial personnel. Competition for such personnel is intense, and there can be no assurance that the Company can retain its current personnel or that it can attract, assimilate or retain other highly qualified scientific, technical and managerial personnel in the future. The Company has taken steps to retain its key employees, including the granting of stock options that vest over time. The loss of key personnel, especially if without advanced notice, or the inability to hire or retain qualified personnel could have a material adverse effect upon the Company's business, financial condition and results of operations. Risks Associated With International Sales. A significant portion of the Company's revenues relate to international sales of its products, which are subject to numerous risks. Regulatory requirements, as well as pricing, marketing and distribution structures, vary significantly from country to country. Additionally, international sales can be adversely affected by limitations or disruptions caused by the imposition of government controls, export licenses, political instability, trade restrictions, changes in foreign tax laws or tariffs, or other trade regulations and difficulties coordinating communications among and managing international operations. Moreover, the Company's business, financial condition and results of operations may be adversely effected by 21 22 fluctuations in overseas economic conditions and international currency exchange rates, as well as by increases in duty rates, difficulty in obtaining export licenses, constraints on its ability to maintain or increase prices and competition. There can be no assurance that the Company will be able to successfully commercialize its existing products or any of its future products in any international market, which could have a material adverse effect on the Company's business, financial condition and results of operations. Dependence On Patents And Proprietary Technology. The patent and trade secret positions of medical device companies, including those of the Company, are uncertain and involve complex and evolving legal and factual questions. The coverage sought in a patent application either can be denied or significantly reduced before or after the patent is issued. Consequently, there can be no assurance that any patents from pending applications or from any future patent application will be issued, that the scope of the patent protection will exclude competitors or provide competitive advantages to the Company, that any of the Company's patents will be held valid if subsequently challenged or that others will not claim rights in or ownership of the patents and other proprietary rights held by the Company. Since patent applications are secret until patents are issued in the United States, or corresponding applications are published in other countries, and since publication of discoveries in the scientific or patent literature lags behind actual discoveries, the Company cannot be certain that it was the first to file patent applications for its inventions. In addition, there can be no assurance that competitors, many of which have substantial resources, will not seek to apply for and obtain patents that will prevent, limit or interfere with the Company's ability to make, use or sell its products either in the United States or in international markets. Further, the laws of certain foreign countries do not protect the Company's intellectual property rights to the same extent as do the laws of the United States. Litigation or regulatory proceedings, which could result in substantial cost and uncertainty to the Company, may also be necessary to enforce patent or other intellectual property rights of the Company or to determine the scope and validity of other parties' proprietary rights. There can be no assurance that the Company will have the financial resources to defend its patents from infringement or claims of invalidity. The Company also relies upon unpatented proprietary technology, and no assurance can be given that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to or disclose the Company's proprietary technology or that the Company can meaningfully protect its rights in such unpatented proprietary technology. The Company's policy is to require each of its key employees, consultants, investigators and advisors to execute a confidentiality agreement upon the commencement of an employment or consulting relationship with the Company. There can be no assurance, however, that these agreements will provide meaningful protection for the Company's proprietary information in the event of unauthorized use or disclosure of such information. Dependence On Suppliers. The Cortical Bone Dowel, a product the Company markets on behalf of Regeneration Technologies, Inc. ("RTI"), a subsidiary of the University of Florida Tissue Bank, is made of human bone tissue obtained from cadavers. RTI supplies significant amounts of such tissue pursuant to an exclusive agreement with the Company. There can be no assurance that the supply of bone tissue will continue to meet current demand, or that the Company, if 22 23 required, will be able to locate alternative sources of human bone tissue on a timely and cost-effective basis. To date, constrained supply of human bone tissue has limited growth in this area. There can be no assurance that the RTI will meet the Company's future delivery requirements of human bone tissue. The inability to procure an adequate supply of such tissue could have a material adverse effect on the Company's business, financial condition and results of operations. PART II -- OTHER INFORMATION Item 1. LEGAL PROCEEDINGS The Company is involved from time to time in litigation on various matters which are routine to the conduct of this business, including product liability and intellectual property cases. PRODUCT LIABILITY LITIGATION Beginning in 1994, the Company and other spinal implant manufacturers were named as defendants in a number of product liability lawsuits brought in various federal and state courts around the country. These lawsuits allege that plaintiffs were injured by spinal implants manufactured by the Company and others. The essence of the plaintiff's claims appears to be that the Company (including Sofamor and its former U.S. distributor) marketed some of its spinal systems for pedicle fixation in contravention of the Food and Drug Administration ("FDA") rules and regulations (governing marketing and labeling of medical devices), that pedicle fixation has not been proven safe and effective in the context of FDA labeling standards, that some or all of the spinal systems are defectively designed and manufactured and that plaintiffs have suffered a variety of injuries as a result of their physicians' use of such systems in pedicle fixation. The Company has also been named as a defendant in a number of lawsuits instituted by plaintiffs who have received spinal implants manufactured by other manufacturers and in which the Company is alleged to have participated in a conspiracy among doctors, manufacturers, hospitals, teaching institutions, professional societies and others to promote, in violation of applicable law, the use of spinal implants. In a number of cases, plaintiffs have sought to proceed as representatives of classes of spinal implant recipients. All efforts to obtain class certification have been denied or withdrawn, except with respect to a class-action settlement entered into between the plaintiffs and another spinal implant manufacturer, AcroMed Corporation (see below under the heading entitled "AcroMed Corporation Settlement"). Some plaintiffs have filed individual lawsuits, whereas other lawsuits list multiple plaintiffs and, in certain instances, multiple lawsuits have been filed on behalf of the same individual plaintiffs. Plaintiffs typically seek relief in the form of monetary damages, often in unspecified amounts. Many of the plaintiffs only allege as monetary damage an amount in excess of the jurisdictional minimum for the court in which the case has been filed. A few suits also name as defendants various officers and directors of the Company. As of March 31, 1998, the claims of approximately 2,200 plaintiffs remain active in litigation against the Company. The majority of these plaintiffs filed their claims in 1995. A number of 23 24 plaintiffs have failed to pursue their claims, and their claims have been dismissed without prejudice. The Company is also named as a defendant in lawsuits involving about 2,600 plaintiffs where the Company is alleged to have conspired with competitors and others, in violation of applicable law, to promote the use of spinal implant systems. The Company believes that it has defenses, including, without limitation, defenses based upon the failure of a cause of action to exist where no malfunction of the implant has occurred or the plaintiff has suffered no injury attributable to the Company's product, the expiration of the applicable statute of limitations and the learned intermediary defense. The Company has asserted and will continue to assert these defenses primarily through the filing of dispositive motions. The Company believes that all product liability lawsuits currently pending against it are without merit and will continue to defend against them vigorously. FEDERAL MULTIDISTRICT LITIGATION (MDL 1014) On August 4, 1994, the Federal Judicial Panel for Multidistrict Litigation ordered all federal court lawsuits to be transferred to and consolidated for pretrial proceedings, including the determination of class certification, in the United States District Court for the Eastern District of Pennsylvania in Philadelphia (the "Multidistrict Litigation"). Lawsuits filed in federal court after August 4, 1994 have also been transferred to and consolidated in the Multidistrict Litigation in the Eastern District of Pennsylvania. In addition, a number of lawsuits filed in state courts around the country were removed to federal courts and then transferred into the Multidistrict Litigation. On February 22, 1995, Chief Judge Emeritus, Louis C. Bechtle ("Judge Bechtle"), denied class certification. A large number of plaintiffs filed individual lawsuits as a result of the denial of class certification. In some instances, lawsuits that had been removed and transferred into the Multidistrict Litigation have been remanded to the state courts in which they were filed because there was no federal court jurisdiction. As of March 31, 1998, the Company is a defendant in approximately 920 individual claims and 1,065 conspiracy claims consolidated in the Multidistrict Litigation. On April 16, 1997, Judge Bechtle dismissed conspiracy claims alleging fraud on the FDA, but deferred the remaining conspiracy claims for later consideration by the federal trial courts to whom the cases will be remanded for trial. Discovery has been completed in a number of the federal court cases and is continuing in the remainder. A small number of cases have been transferred to the federal courts in which they were filed for further proceedings and trial. Judge Bechtle has begun the process of transferring the remaining federal court cases to various federal courts throughout the United States. As of March 31, 1998, the Federal Judicial Panel on Multidistrict Litigation ordered the remand of approximately 210 cases to transferor courts for further proceedings. It is anticipated that the first federal court cases will be tried in 1998. STATE COURT LITIGATION A number of cases filed in state courts were not eligible for removal and transfer into the Multidistrict Litigation. As of March 31, 1998, there were approximately 1,800 individual claims pending against the Company in several courts around the country, principally in 24 25 Tennessee, Oklahoma, Texas and Pennsylvania. In addition, there were approximately 1,600 conspiracy claims pending in state courts. Approximately 1,550 plaintiffs, who had joined together in several complaints which had been removed to the Multidistrict Litigation proceedings, have had their cases remanded to the state court in Memphis, Tennessee, where they were originally filed when it was determined that the federal court lacked jurisdiction over their claims. A number of plaintiffs have failed to pursue claims made on their behalf and their claims were dismissed without prejudice. As of March 31, 1998, the lawsuits of approximately 1,000 plaintiffs remain active in the litigation pending in Memphis, Tennessee. The presiding state court judge in Memphis has established a case management plan which calls for the preparation of eight representative cases for preparation and trial. Discovery is proceeding in all remaining state court cases. Some state cases have been given trial dates in 1998. It is anticipated that a number of other state court cases around the country may be scheduled for trial in 1998, although delays in trial dates are common. The first case in Memphis against the Company is scheduled for trial in September, 1998. ACROMED CORPORATION SETTLEMENT In December 1996, AcroMed Corporation ("AcroMed"), a spinal implant manufacturer and a defendant in many of the cases pending in the Multidistrict Litigation, and the Plaintiff's Legal Committee in the Multidistrict Litigation announced that they had entered into a conditional settlement regarding all product liability claims involving the use of AcroMed devices to achieve pedicular fixation with screws in spinal fusion surgery. Under the terms of the settlement, AcroMed will establish a settlement fund consisting of $100 million in cash plus the proceeds of its product liability insurance policies. In January 1997, the parties submitted a formal class settlement agreement and related documentation for approval by Judge Bechtle. By order dated October 17, 1997, Judge Bechtle certified the proposed settlement class and approved the proposed settlement. All appeals of Judge Bechtle's certification and approval order have been withdrawn. As a consequence of the class-certified settlement, all federal proceedings involving AcroMed devices have been stayed. INSURANCE Several insurance carriers have asserted reservation of rights concerning the scope and timing of the Company's remaining insurance coverage, but have not denied insurance coverage to the Company. Three of the carriers, Royal Surplus Lines Insurance Company ("Royal"), Steadfast Insurance Company ("Steadfast") and Agricultural Excess and Surplus Insurance Company ("Agricultural"), have each filed declaratory judgment actions against the Company seeking clarification of their rights and obligations, if any, under their respective policies. Neither Royal nor Agricultural has paid amounts due to the Company; Steadfast has paid only a portion of the amounts due to the Company. 25 26 The Royal and Steadfast lawsuits are pending in the United States District Court for the Western District of Tennessee in Memphis. The Agricultural lawsuit is pending in the United States District Court for the Southern District of Ohio in Cincinnati. The Company believes that the receivables are recoverable under the terms of the Royal, Steadfast and Agricultural policies. The Company has filed an answer and counterclaim in the Royal litigation and a motion seeking the interim payment of the Company's defense costs. The Company has filed answers and counterclaims in the Steadfast and the Agricultural litigations. All three litigations are in the preliminary stages. The Company believes that Royal's, Steadfast's and Agricultural's claims are without merit and will defend against them vigorously. As is common in the insurance industry, the Company's insurance policies covering product liability claims must be renewed annually. The Company has in force insurance coverage for product liability claims including orthopedic bone screw claims, subject to the terms, conditions and limits of the individual insurance policies. Except for a policy issued by Royal, the Company's insurance policies are reduced by the costs of defense. In some instances, the cost of defending these claims has been reimbursed by certain of the primary and excess insurance carriers. Although the Company has been able to obtain insurance relating to product liability claims at a cost and on other terms and conditions that are acceptable to the Company, there can be no assurance that in the future it will be able to do so. On January 6, 1997, the Company announced that its 1996 financial results would include a pre-tax charge of $50 million relating to costs associated with the product liability litigation described above. The charge, which is reflected in the Company's 1996 financial statements, covers the reasonable foreseeable costs that the Company was positioned in late December 1996 to estimate because the litigation had progressed and because changes in the fourth quarter of 1996 had occurred in facts and circumstances relating to the litigation. Among the changed facts and circumstances were the announcement of the AcroMed settlement described above, the likelihood that the litigation will continue for several years, in part, due to the additional financial resources provided to the plaintiff's attorneys as a result of the AcroMed settlement, the absence of AcroMed as a member of the joint defense group, the status of the Company's insurance described above and the continuing absence of dispositive rulings relating to the Company's defense motions. While it is not possible to accurately predict the outcome of litigation, the amount of the accrual, which remained on the Company's consolidated balance sheet at March 31, 1998, represents the Company's best judgment of the probable reasonable costs (in excess of amount of insurance the Company believes are recoverable) to defend and conclude the lawsuits based on the facts and circumstances currently existing. The costs provided for in the accrued liability include, but are not limited to, legal fees paid or anticipated to be paid and other costs related to the Company's defense and conclusion of these matters. The actual costs to the Company could differ from the estimated charge and will be dependent upon a number of factors that will not be known for some time, including, among other things, the resolution of defense motions and the extent of further discovery. Although an adverse resolution of lawsuits could have a material effect on the Company's results of operations and 26 27 cash flows in future periods, the Company does not believe that these matters will in the future have a material adverse effect on its consolidated financial position. The Company is unable to predict the ultimate outcome or the financial impact of the product liability litigation. SECURITIES LAWS ACTIONS Beginning in April 1994, the Company and four of its officers and directors were named in five shareholder lawsuits filed in the United States District Court in Memphis, Tennessee. Four of the lawsuits purported to be class actions. All of the lawsuits were consolidated into one case in the United States District Court in Memphis through an amended complaint which added four new individual defendants who are either current or former directors of the Company. The lawsuit alleges that the defendants made false and misleading statements and failed to disclose material facts to the investing public and seeks money damages. The alleged securities law violations are based on the claim that the defendants failed to disclose that the Company sold its products illicitly, illegitimately and improperly and to timely disclose facts concerning the termination of the former U.S. distributor of Sofamor products, National Medical Specialties, Inc. ("NMS"). The allegations relating to illicit and illegitimate sales of product are, for the most part, copies from product liability complaints filed against the Company and other manufacturers currently being coordinated in improper sales related to one of the Company's selling programs which has been publicly disclosed since May 1991. The allegations concerning NMS relate to the termination of the NMS distribution agreement covering Sofamor products in the United States. On October 3, 1995, the United States District Court Judge in Memphis dismissed with prejudice the entire case against the Company and each of the individual defendants. The plaintiffs appealed the dismissal to the United States Court of Appeals for the Sixth Circuit. On August 14, 1997, the Court of Appeals affirmed the dismissal of the plaintiffs' complaint. The Court of Appeals denied the plaintiffs' request for reconsideration on October 9, 1997. The plaintiffs filed a petition for certiorari in the United States Supreme Court, which the Company opposed. The United States Supreme Court has denied the plaintiffs' petition for certiorari. The dismissal of the plaintiffs' case is now final. INTERNAL REVENUE SERVICE DOCUMENT PRODUCTION On April 29, 1998, the Internal Revenue Service (the "IRS") served the Company with a summons covering the 1993, 1994 and 1995 taxable years. Generally, the IRS is requiring the production of (i) documents supporting expenses incurred in connection with trips attended by physicians, (ii) documents relating to payments made to physicians for consulting, (iii) documents relating to stock options granted, royalty agreements and payments, fellowship grants/awards, scholarships and honorariums, (iv) a list of Company customers, (v) certain revenue information and (vi) a report with respect to governmental customers. While the scope of the document production is currently under review, it is the Company's intention to cooperate with the IRS in connection with this matter. See Item 2, "Management's Discussion and Analysis of Results of Operations and Financial Condition--Factors That May Affect Future Operating Results and Financial Condition--Product Liability; Insurance and Dependence on Patents and Proprietary Technology." 27 28 Item 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibit No. Description ----------- ----------- 10.1 Stock Exchange Agreement dated January 26, 1998 among the Company and the Holders listed on the signature pages thereto. (Incorporated by reference from Amendment No. 2 to the Statement on Schedule 13D dated as of June 21, 1993 as filed by the Cotrel family with the Securities and Exchange Commission (the "Commission") on January 29, 1998 with respect to the Company). 10.2 Registration Rights Agreement dated January 26, 1998 among the Company and the Holders listed on the signature pages thereto. (Incorporated by reference from Amendment No. 2 to the Statement on Schedule 13D dated as of June 21, 1993 as filed by the Cotrel family with the Commission on January 29, 1998 with respect to the Company). 27.1 Financial Data Schedule (For SEC use only) 27.2 Amended March 31, 1997 Financial Data Schedule (For SEC use only)
b) Reports on Form 8-K A report on Form 8-K was filed on February 3, 1998, which included the Sofamor Danek Group, Inc. Consolidated Financial Statements and Notes thereto as of December 31, 1997 and 1996 and for each of the three years in the period ended December 31, 1997 and the related financial statement schedule. The information included in the report was filed in connection with the Registration Statement on Form S-3 of Sofamor Danek Group, Inc. dated February 3, 1998, filed under the Securities Act of 1933, as amended. 28 29 SIGNATURES Pursuant to the requirements 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. SOFAMOR DANEK GROUP, INC. ------------------------------------- (Registrant) DATE: May 12, 1998 BY: /s/ E.R. Pickard --------------------- ---------------------------------- E.R. Pickard Chairman, Chief Executive Officer and Director (Principal Executive Officer) DATE: May 12, 1998 BY: /s/ George G. Griffin, III --------------------- ---------------------------------- George G. Griffin, III Executive Vice President and Chief Financial Officer (Principal Financial Officer) 29 30 SOFAMOR DANEK GROUP, INC. QUARTERLY REPORT ON FORM 10-Q INDEX TO EXHIBITS
Exhibit No. Description ----------- ----------- 10.1 Stock Exchange Agreement dated January 26, 1998 among the Company and the Holders listed on the signature pages thereto. (Incorporated by reference from Amendment No. 2 to the Statement on Schedule 13D dated as of June 21, 1993 as filed by the Cotrel family with the Commission on January 29, 1998 with respect to the Company). 10.2 Registration Rights Agreement dated January 26, 1998 among the Company and the Holders listed on the signature pages thereto. (Incorporated by reference from Amendment No. 2 to the Statement on Schedule 13D dated as of June 21, 1993 as filed by the Cotrel family with the Commission on January 29, 1998 with respect to the Company). 27.1 Financial Data Schedule (For SEC use only) 27.2 Amended March 31, 1997 Financial Data Schedule (For SEC use only)
EX-27.1 2 FINANCIAL DATA SCHEDULE
5 1,000 3-MOS DEC-31-1998 JAN-01-1998 MAR-31-1998 83,696 35 99,317 1,857 63,371 284,667 50,517 25,161 472,448 88,508 28,400 0 0 360,546 (35,412) 472,448 88,453 88,453 15,748 15,748 6,234 89 1,135 24,543 7,354 16,495 0 0 0 16,495 0.59 0.65
EX-27.2 3 AMENDED MARCH 31,1997 FDS-FOR SEC USE ONLY
5 1,000 3-MOS DEC-31-1997 JAN-01-1997 MAR-31-1997 5,083 72 76,103 1,605 57,085 166,861 45,539 20,819 337,069 120,819 12,297 0 0 57,813 96,346 337,069 69,759 69,759 12,370 12,370 4,730 70 1,176 18,861 5,470 12,774 0 0 0 12,774 0.49 0.52
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