UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the fiscal year ended December 31, 1997
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 No. 000-21517
XOMED SURGICAL PRODUCTS, INC.
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(Exact name of registrant as specified in its charter)
DELAWARE 06-1393528
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6743 SOUTHPOINT DRIVE, NORTH
JACKSONVILLE, FLORIDA 32216-0980
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (904) 296-9600
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
- ------------------- -----------------------------------------
Not applicable Not applicable
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, $.01 PAR VALUE
----------------------------
(Title of class)
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. YES [X] NO [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
The aggregate market value of registrant's Common Stock held by non-affiliates
based on the closing price on February 27, 1998 was $106,565,215.
As of February 27, 1998 there were 7,342,274 shares of Common Stock $.01 par
value outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement to be filed with the
Securities and Exchange Commission prior to April 30, 1998 are incorporated by
reference in Part III of this Form 10-K.
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PART I
ITEM 1. BUSINESS
AS USED IN THIS ANNUAL REPORT ON FORM 10-K, REFERENCES TO THE "COMPANY" OR
"XOMED" REFER TO XOMED SURGICAL PRODUCTS, INC. AND ITS DIRECT AND INDIRECT
SUBSIDIARIES, UNLESS OTHERWISE INDICATED OR THE CONTEXT OTHERWISE REQUIRES.
THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS, WHICH
INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS MAY DIFFER
SIGNIFICANTLY FROM THE RESULTS DISCUSSED IN THE FORWARD-LOOKING STATEMENTS.
FACTORS THAT MIGHT CAUSE SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE
DISCUSSED IN "RISK FACTORS" UNDER THIS ITEM AND IN "MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
OVERVIEW
Xomed is a leading developer, manufacturer and marketer of a broad line of
surgical products for use by ear, nose and throat ("ENT") specialists and
opthalmic surgeons. The Company's broad line of products includes, in its core
ENT market, powered tissue-removal systems and other micro endoscopy
instruments, implantable devices, nerve monitoring systems and disposable
fluid-control products. The Company also offers a line of ophthalmic and other
products. For the year ended December 31, 1997, approximately 80% of Xomed's
revenues was derived from disposable and implantable products. The Company
distributes its products on a worldwide basis through an 82-person direct sales
organization in the U.S. and selected other countries and through a network of
over 130 independent distributors. Xomed is the only major manufacturer and
marketer of ENT surgical products with a direct U.S. sales force exclusively
serving ENT specialists. Approximately 30% of the Company's net sales were
derived from international markets for the year ended December 31, 1997. With
over 25 years of industry experience, Xomed believes that it has established a
long-standing reputation for innovative, high-quality products and is uniquely
positioned as the only major surgical products company focused on the ENT
market.
Xomed believes that the ENT market is in the midst of a conversion from
conventional surgical approaches to less-traumatic approaches that involve the
use of advanced surgical tools, such as powered tissue-removal systems and
small-diameter surgical endoscopes, thereby minimizing patient trauma and
reducing procedure times. Xomed believes that the adoption of these
less-traumatic techniques is being driven by several factors, including economic
pressures and patient demand. Minimally invasive techniques have the potential
to expand the number of ENT procedures that can be performed in lower-cost
outpatient or day surgery settings. Patient demand is likely to increase due to
the reduced morbidity and improved outcomes. Xomed believes that the conversion
in the ENT market to less-traumatic approaches will be similar to recent
conversions in the general surgery market to less invasive techniques and the
orthopaedic surgery market to powered instrumentation systems.
BACKGROUND
The business of Xomed, Inc. was established in 1970 to manufacture and
distribute ventilation tube implants for the middle ear. In 1979, the business
was acquired by Bristol-Myers Squibb Company ("Bristol-Myers"). In 1989,
Bristol-Myers acquired Treace Medical, Inc. and merged the two companies
together forming Xomed-Treace, Inc. On April 15, 1994, Bristol-Myers sold
Xomed-Treace, Inc. to the Company for a purchase price of approximately $81.0
million (the "Xomed Acquisition"). The Company is a Delaware corporation
formerly known as Merocel/Xomed Holdings, Inc., which was organized for the
purpose of acquiring all of the outstanding stock of Merocel Corporation
("Merocel,") Xomed-Treace, Inc. and Xomed-Treace, P.R. Inc. (collectively,
"Xomed-Treace"). Merocel, which was formed in 1970, manufactures and markets a
line of disposable fluid-control products primarily used in sinus surgery and
rhinology. The Company, prior to April 15, 1994, consisted solely of Merocel.
XOMED ACQUISITION. The Xomed Acquisition has significantly affected the
Company's results of operations following the April 15, 1994 consummation of the
transaction. The Xomed Acquisition has been accounted for under the purchase
method of accounting. Accordingly, the purchase price of approximately $81.0
million was allocated to the assets acquired and liabilities assumed based upon
their respective fair values at date of acquisition. The excess of the purchase
price over the fair market value of the net assets acquired of approximately
$56.0 million
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was allocated to goodwill. Of this amount, $49.9 million related to continuing
operations and $6.1 million related to the surgical drapes segment, which was
sold in July 1995 and has been presented as discontinued operations. As a
result, amortization of intangibles (over a 25-year life) has significantly
increased. Further, the value of inventory of continuing operations was
increased by $4.8 million and was charged to cost of goods sold for the 1994
period following the Xomed Acquisition ($3.9 million) and the first quarter of
1995 ($0.9 million) (the "Inventory Valuation Adjustment"). These costs reduced
gross profit in these periods. Other intangible assets relating to foreign
distribution rights were valued in connection with the acquisition, and as a
result, amortization of intangibles was increased by $0.8 million for the 1994
period following the Xomed Acquisition and $0.2 million for the first quarter of
1995 (the "International Distribution Rights Amortization"). In addition,
interest expense increased due to the increased borrowings to finance the Xomed
Acquisition.
The Xomed Acquisition and the Company's initial working capital were funded
primarily through the issuance of $43.5 million of preferred stock and from the
incurrence of approximately $45.9 million in long-term debt. In connection with
the Xomed Acquisition, management implemented a restructuring plan for
Xomed-Treace that included the closing of manufacturing operations in Puerto
Rico and the elimination of certain overhead in other facilities.
CHANGE IN DISTRIBUTION CHANNELS. On January 1, 1996 the Company effected
two changes in its product distribution to focus the Company's resources on its
core product lines of sinus and rhinology, head and neck and otology. The first
involved changing from distributing its ophthalmic product line through its
direct sales force to distributing this line through an independent dealer
network. As a result of this change, the Company's net sales were approximately
$2.1 million lower in 1996 than they would have been if the ophthalmic product
line had continued to be distributed through the Company's direct sales force.
The second change involved moving the distribution of the Company's Merocel
fluid-control products from an independent dealer network to the Company's U.S.
direct sales force. As a result of this change, the Company's net sales were
approximately $1.2 million higher in 1996 than they would have been if the
Merocel product line had continued to be distributed through independent
dealers.
ACQUISITION OF TREBAY. The Company's acquisition of TreBay Medical
Corporation ("TreBay") in April 1996 has been accounted for under the purchase
method of accounting. Accordingly, the purchase price of approximately $6.6
million was allocated to the individual assets acquired and liabilities assumed,
based upon their respective fair values at the date of acquisition. The
transaction resulted in cost in excess of net assets acquired of $4.4 million,
of which $2.4 million was allocated to in-process research and development and
charged to expense in the second quarter of 1996. The in-process research and
development was valued based upon an independent valuation utilizing
management's projections of cash flows and cost to achieve technological
feasibility of the products.
RESTRUCTURING CHARGES. During the second quarter of 1996, the Company's new
management team initiated cost savings programs that resulted in reductions of
50 employees at the Company's three domestic locations. The reductions included
20 management and administrative employees at the Company's Mystic, Connecticut
manufacturing facility, 17 management and administrative employees at the
Company's Jacksonville, Florida headquarters and 13 management and production
employees at the Company's St. Louis, Missouri manufacturing facility that was
closed in December 1996. The restructuring eliminated redundant overhead at the
sites, and the Company expects these actions to yield cost savings primarily in
general and administrative expense. The Company incurred a restructuring charge
of approximately $3.1 million during the second quarter of 1996 primarily to
reflect the cost of the severance payments to terminated employees. Most of the
affected employees were terminated in the second quarter of 1996 with severance
beginning at that time. Through December 31, 1997, the Company had terminated
all employees under the plan and had paid out severance cost totaling
approximately $2.5 million and had incurred approximately $500,000 in other exit
costs. See Footnote 7 of the Consolidated Financial Statements, which is
included in this Annual Report on Form 10-K.
INITIAL PUBLIC OFFERING. On October 11, 1996, the Company completed its
initial public stock offering, followed on October 31, 1996 by the underwriters'
exercise of their overallotment option. The Company raised net proceeds of $54.0
million through the sale of 2,875,000 shares of its Common Stock, $.01 par value
("Common Stock"). The net proceeds were used to repay the Company's term loan
totaling $20.8 million including interest,
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repay $8.2 million under its revolving line of credit and redeem $25 million of
Redeemable Preferred Stock.
OTHER RECENT EVENTS. In December 1996, the Company appointed Kobayashi
Japan as its exclusive distributor of its full line of products within Japan. In
February 1997, the Company introduced the XPS StraightShot micro resector system
used in endoscopic sinus procedures. In July and August of 1997, the Company
introduced a number of new procedure specific curved micro resector blades
including the RAD 40 curved sinus blade, the RADendoid curved adenoid blade and
the RAD airway laryngeal blade. In October 1997 the Company became the exclusive
distributor of the Endius Navigator articulating instruments and micro resector
blades for the ENT market and all areas of the orthopaedic market except spine.
The Company also entered into a distribution agreement with Endius Corporation
granting Endius exclusive distribution rights for the Company's XPS StraightShot
micro resector system into the spine market. In December 1997 the Company
introduced the XPS 2000 micro resector system which includes enhancements from
the original XPS StraightShot(R) system.
MARKET OPPORTUNITY
More than an estimated 22,000 ENT specialists, also known as
otorhinolaryngologists, currently practice in the U.S., Canada, Western Europe,
Japan, Australia, South America and the Middle East (collectively, "worldwide"),
with approximately 9,000 of those specialists practicing in the U.S. ENT
practitioners specialize in the diagnosis and treatment of diseases and
conditions affecting the ear, nose and throat. ENT surgeons are also typically
experts in tumor-related diseases of the head and neck. Increasingly, ENT
surgeons are expanding their practice to include facial plastic and
reconstructive surgery. Of the estimated 9,000 ENT specialists in the U.S.,
approximately 3,300 currently practice facial plastic and reconstructive
surgery.
ENT procedures currently pose the following challenges:
(i) In many of these procedures, the target tissue is adjacent to critical
anatomy, including the brain, sensory centers and facial motor nerves,
limiting the surgeon's maneuverability and requiring very small,
precise movements;
(ii) The anatomy in the region generally contains many blood vessels,
leading to significant blood loss during surgery that may obscure the
surgeon's vision, as well as increase patient complications, or
morbidity;
(iii) The affected areas are often very small in size and require the
surgeon to perform microsurgery through the use of magnifying devices
such as small-diameter surgical endoscopes ("microendoscopy"); and
(iv) The affected areas are often behind significant bony structures,
including the skull, the penetration of which can entail significant
patient trauma and lengthy procedure times.
Conventional hand-held surgical instruments typically used during ENT
procedures do not provide the surgeon with sufficient power or precision to
minimize trauma and blood loss during the procedure and can contribute to
unnecessary pain, swelling and scarring following the procedure. In addition,
the need to repeatedly remove and reinsert conventional hand-held
instrumentation from the surgical site during procedures can increase patient
trauma and operating time. The Company believes that the limitations of
conventional hand-held surgical instruments create a significant opportunity for
the development of instruments designed for specific ENT procedures, including
powered tissue-removal instrumentation and visualization products, that will
make these procedures easier and faster to perform and less traumatic to the
patient.
The Company believes that the following factors will drive growth in the
market for surgical instruments, devices and supplies for ENT surgeons:
ADVANCEMENTS IN PROCEDURE-SPECIFIC INSTRUMENTATION . The Company believes
that the introduction of new tools and instrumentation is enabling ENT surgeons
to better address the current challenges of ENT procedures. For example, powered
cutting devices adapted for use in particular surgical procedures allows
surgeons to cut and extract tissue and penetrate bone with more speed, control
and precision than conventional hand-held instruments, thereby minimizing
patient trauma and reducing procedure times. The blades for these newly
developed powered
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cutting devices are disposable and thus sales of these blades represent a
significant portion of the market growth of these devices. By providing ENT
surgeons with greater access to difficult-to-reach surgical sites and reducing
trauma to the patient, new procedure-specific instruments potentially will
increase the total number of procedures performed.
CLINICAL AND COST BENEFITS FOR PATIENT, SURGEON AND PAYOR. The Company
believes that the adoption of these less-traumatic ENT procedures may be driven,
in part, by economic pressures. Due to the reduced patient morbidity associated
with less-traumatic techniques, certain procedures previously performed in
hospitals and requiring longer stays can now be performed in lower-cost
outpatient or day surgery settings. In addition, powered tissue-removal
instrumentation allows for reduced operating times.
DEMAND FROM SIGNIFICANT PATIENT POPULATIONS. Sizable patient populations
suffer from conditions, which can be treated by ENT surgical procedures. As
less-traumatic instrumentation and techniques become available, the portion of
these patients who will elect to undergo these procedures is likely to increase.
In particular, patient demand for endoscopic sinus surgery as well as facial
plastic surgery will, in the Company's view, increase as the pain and morbidity
associated with these procedures is reduced through better instrumentation and
techniques.
EASE OF MARKET CONVERSION. The Company believes that ENT surgeons are
readily adopting new devices and instrumentation designed to meet the challenges
of specific surgical procedures because of the advantages they offer over
conventional instrumentation. The Company further believes that physicians
require minimal additional training (usually two to three days) to use these
instruments. In addition to its functional advantages, powered instrumentation
should, in the Company's view, be attractive to ENT surgeons because it requires
only a relatively modest capital investment.
STRATEGY
The Company's objective is to maintain its leading position in the ENT
market and to leverage the Company's core competencies by entering new markets.
The principal elements of its strategy to meet this objective are outlined
below.
CONTINUE TO FOCUS ON THE ENT MARKET. The Company believes that, as the only
major provider of surgical products with a direct sales force exclusively
serving the ENT surgeon, it is well positioned to participate in any growth in
the ENT surgical market. The Company intends to continue to develop and maintain
close relationships with ENT specialists from whom it has gained significant
brand recognition and loyalty. The Company believes that it presently sells
products to substantially all the ENT specialists in the U.S. Accordingly, the
Company believes that a significant opportunity exists to leverage these
relationships with new and existing products and increase penetration of its
existing customer base.
FACILITATE ENT MARKET CONVERSION TO LESS-TRAUMATIC APPROACHES. The ENT
market is in the midst of a conversion to less-traumatic approaches that is
similar to recent conversions in the general surgery market to less invasive
techniques and the orthopaedic surgery market to powered instrumentation
systems. The Company is facilitating conversion of high volume ENT procedures to
less-traumatic techniques. The procedures targeted by the Company include sinus
surgery, the removal of adenoids, laryngeal procedures, face and brow lifts and
facial sculpting. As part of facilitating this conversion, the Company is
continuing its collaborative efforts with leading ENT surgeons to create
products that allow physicians to re-engineer standard operating procedures to
reduce patient trauma and operating time. The Company believes that continued
advances in powered tissue-removal instrumentation systems for use in ENT
procedures will play a central role in this conversion and accordingly will
continue in its efforts to develop and introduce such powered instrumentation.
EMPHASIZE PRODUCT INNOVATIONS THROUGH INTERNAL RESEARCH AND DEVELOPMENT.
The Company plans to develop new proprietary products and product enhancements
primarily through internal research and development efforts. The Company will
continue to invest significantly in research and development in an effort to
introduce numerous technological advancements in the ENT market and leverage
these relationships in order to sell both new and existing products.
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MAINTAIN A BROAD LINE OF ENT PRODUCT WITH PARTICULAR EMPHASIS ON DISPOSABLE
AND IMPLANTABLE PRODUCTS. The Company seeks to maintain a broad product line
that addresses all of the surgical needs of ENT specialists. The Company's
current product line consists of approximately 4,000 stock keeping units (SKUs),
including equipment, disposable products and implantable devices. The Company
places particular emphasis on disposable products and implantable devices, which
represented approximately 80% of the Company's sales in 1997. One of the
Company's principal goals is to continue to develop additional disposable
products for use with its instrumentation systems.
EXPAND ITS GLOBAL DISTRIBUTION NETWORK. The Company believes that
significant growth opportunities exist through the expansion of its global
distribution network. The Company distributes its products worldwide through an
82-person direct sales force in the U.S. and selected other countries and
through a network of over 130 independent distributors. The Company's core ENT
products are sold in the U.S. only on a direct sales basis. Approximately 30% of
its net sales in 1997 was made outside the U.S. through direct operations in the
United Kingdom, Canada, France, Germany and Australia, as well as through over
100 independent international distributors, many of whom distribute the
Company's products exclusively.
LEVERAGE CORE COMPETENCIES BY ENTERING NEW MARKETS. The Company intends to
enter new medical and surgical products markets through acquisition and new
product development. The Company believes that it can leverage its core
competencies, including the ability to rapidly develop innovative new products,
expertise in commercializing clinical knowledge, relationships with physician
opinion leaders, and managerial expertise beyond the ENT market, to enter new
markets on a selective basis. Potential areas for new market entry and expansion
include orthopaedics, plastic and reconstructive surgery, and ophthalmology.
MAJOR ENT SUBSPECIALTIES
The three major ENT subspecialties within the ENT market are sinus and
rhinology, head and neck and otology.
SINUS AND RHINOLOGY
The majority of surgical procedures within the sinus and rhinology
subspecialty addresses disease and inflammation of the sinuses, due to enlarged
tissue, deviated septum, infection, trauma or allergies.
ENDOSCOPIC SINUS SURGERY. Large numbers of the U.S. population suffer from
chronic sinusitis. Although sinus medications provide temporary relief from
symptoms, they may not resolve the underlying cause of the disease or
inflammation and surgery is frequently required. ENT specialists utilize several
methods of treatment, including medication and surgical intervention, to provide
patients with symptomatic relief of sinus disease. In traditional sinus surgical
procedures, surgeons remove the affected tissue or obstruction, such as a polyp,
through the use of forceps. However, with traditional surgical instruments, ENT
surgeons may have limited ability to visualize and gain access to the deeper
sinus cavities through the natural sinus passageways and also experience
significant difficulty gaining the control needed to remove the tissue
effectively. This can result in uneven cutting and tearing, which in turn causes
trauma to the surrounding tissue. In some cases, bony structures and tissue
obstruct the nasal passageway, further complicating the procedure.
Although a less traumatic method for performing sinus surgery with powered
tissue-removal instrumentation was introduced in 1993, much of the
instrumentation used at the time was originally designed for arthroscopic
procedures (less invasive knee surgery). Since this instrumentation was not
designed specifically for sinus surgery, its use for these procedures was
cumbersome and prone to clogging. Overall operating time of procedures performed
with this method can be reduced by approximately 25% from that of traditional
surgical methods due to the greater ease of accessing structures, the improved
visualization at the site and the quicker removal of tissue with powered
instrumentation.
RHINOPLASTY AND SEPTOPLASTY. Rhinoplasty involves the surgical
reconstruction of the nose to treat bone defects or trauma or to improve the
appearance of the nose cosmetically. ENT surgeons generally use either a bone
shaver or a rasp to shape or reduce the targeted area or a chisel to cut the
bone. The use of a shaver or rasp results in
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significant post-operative swelling and the use of a chisel carries with it a
significant risk of error. Septoplasty, the surgical correction of a defect,
disease or trauma to the septum, is often done in conjunction with sinus surgery
or rhinoplasty.
HEAD AND NECK
The head and neck subspecialty encompasses a wide range of procedures,
including laryngeal (throat) surgery, skull-base surgery, facial tumor removal
and facial plastic surgery.
LARYNGEAL SURGERY. Throat-based procedures include the removal of the
tonsils (tonsillectomy) and adenoids (adenoidectomy), the removal of lesions,
polyps and tumors on the throat or vocal cords and the surgical reduction of the
uvula (the flap of tissue at the back of the throat and the soft palate).
Tonsillectomies and adenoidectomies are performed to treat chronic
inflammation and soreness. In traditional tonsillectomies, surgeons use either
forceps or snares to grasp and pull the tonsils out, or alternatively they cut
away the tonsils with an electrocautery device. The use of these instruments can
cause swelling, pain and post-operative bleeding. For adenoidectomies, surgeons
traditionally utilize a curette, a small hand instrument, to scrape out the
inflamed tissue. Due to the limited precision of a curette in removing this
tissue, adenoidectomies involve many of the same problems experienced in
tonsillectomies.
Lesions, polyps or tumors on the throat or vocal cords are presently
removed using either hand instrumentation, an electrocautery device or a laser.
The use of hand instrumentation, electrocautery devices or lasers may result in
damage to the surrounding tissue. In addition, lasers and electrocautery devices
can destroy the affected tissue and thus prevent the subsequent pathological
testing of a tissue sample.
Uvulopharyngoplasty is a procedure in which the uvula and the soft palate
are surgically reduced in the throat to reduce snoring and breathing
interruptions (sleep apnea). The use of electrocautery devices or lasers to
perform this procedure is again associated with swelling and pain.
SKULL-BASE SURGERY. Skull-base surgery includes those procedures in
which the affected anatomy, generally a tumor, is located within or near the
skull. A common skull-base procedure is the removal of an acoustic neuroma, a
benign tumor located on the cranial nerve adjacent to the inner ear. The
symptoms of this condition include hearing loss, ringing in the ears, loss of
balance, pain and headaches. Surgical removal is the only treatment alternative
for persons with an acoustic neuroma; however, the traditional procedure
involves drilling through the dense bone behind the ear to access the nerve, a
procedure that generally takes between six to eight hours to perform and
frequently results in a residual hearing loss.
FACIAL TUMOR REMOVAL. ENT surgeons perform numerous procedures in order to
remove facial tumors from the head and neck area. Surgical resections in this
area are particularly critical procedures to perform because of the numerous
motor nerve branches within the surgical area. Due to the potential
complications from severing a nerve, the identification and monitoring of nerves
during most facial tumor procedures are becoming a standard of care. These
surgeries frequently require laser incisions in cosmetically important areas and
post-operative cosmetic and functional defects are common.
FACIAL PLASTIC SURGERY. Approximately one-third of ENT surgeons in the U.S.
currently perform facial plastic procedures. The number of elective procedures
for cosmetic purposes is likely to increase in conjunction with the general
aging demographic trend of the U.S. The procedures covered in this area include:
the placement of facial implants to correct defects or augment features in the
face; correction and smoothing of wrinkles; facial lifts, which involve
stretching the muscles and skin of the face; and facial sculpting, which
involves the removal of fat around the neck.
Other common facial plastic surgical procedures include face and brow
lifts. During these procedures, the surgeon peels the skin at the hairline,
pulls the facial muscles and skin taut and then stitches the long incision made
at the hairline. In addition to the post-operative swelling and bruising from
the procedure, the patient is left with a relatively large scar at the hairline
from the long incision needed to access the entire facial region. During facial
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sculpting, the surgeon removes fat away from the neck area using a suction
cannula, a device which evacuates fat from the facial tissue. As a result of the
aggressive way in which the suction cannula evacuates the fat from the neck
area, the patient experiences significant swelling and bruising following the
surgical procedure.
OTOLOGY
Common otology procedures include myringotomies (which generally involve
the insertion of ventilation tubes in the middle ear) and stapedectomies (the
replacement of middle ear bones with middle ear prosthetic implants).
Ventilation tubes are used to treat chronic middle ear infection. Their
placement is one of the most common surgical procedures performed in children,
with over 1.0 million of these procedures performed in 1996 in the U.S.
Conductive hearing loss is caused by damage to the ossicular bone chain in the
middle ear from disease, trauma or aging. The replacement of diseased bones of
the middle ear with specially designed implants is the preferred method to
restore hearing to these patients, and nearly 60,000 reconstructive middle ear
procedures are performed in the U.S. each year. Re-engineering in the design and
material of the prostheses has, in recent years, improved surgeon technique and
patient hearing outcomes.
PRODUCTS
The Company designs, develops, manufactures, and markets surgical
instruments and related disposables and accessories for use by ENT surgeons. The
Company believes its broad product lines focused on ENT procedures allow it to
be a complete provider to its ENT customer base. The Company also designs,
develops and manufactures surgical products for use during ophthalmic and
orthopaedic procedures. Set forth below is a description of the Company's
products by related subspecialty:
SINUS AND RHINOLOGY
Approximately 37%, 34% and 28% of the Company's net sales in 1997, 1996 and
1995, respectively, were derived from a broad line of powered tissue-removal
instrumentation systems, visualization products, fluid-control products and hand
instruments designed for microendoscopic sinus surgery. The Company has devoted
a significant portion of its investment in research and development to the
development of procedure-specific products to capitalize on and facilitate the
conversion to microendoscopic sinus surgery.
POWERED TISSUE-REMOVAL INSTRUMENTATION SYSTEMS. To date, the most
significant product innovation facilitating the conversion of sinus procedures
to less-traumatic techniques has come from the introduction of powered
instrumentation designed for ENT procedures. In 1995, the Company introduced the
first powered micro resector product designed exclusively for use in ENT
procedures. These products cut soft tissue and bone through a unique oscillating
blade design powered by a small, lightweight, surgical handpiece. In the first
quarter of 1997, the Company introduced its XPS powered tissue-removal system
and then in the Fourth Quarter of 1997, the Company introduced the enhanced XPS
2000 system. This new ENT specific system, which employs straight and curved
disposable blades and burrs, offers the ENT surgeon significantly increased
power with limited blade clogging. The XPS system accounted for 54% of Xomed's
domestic core business sales growth and the Company had over 800 units in place
worldwide at the end of 1997. It is estimated that each unit in the U.S.
currently generates an average of approximately $10,000 in annual disposable
blade revenues.
VISUALIZATION PRODUCTS. The Company produces and distributes a competitive
line of visualization endoscopic equipment designed for use in less-traumatic
sinus, head and neck and otology surgery. These products include the Sharpsite
rigid endoscopes and EndoScrub(R) endoscope lense cleaning system. The
EndoScrub(R) endoscope lens cleaning system, which was introduced in 1992 and is
exclusive to the Company, allows the ENT surgeon to clean a scope lens during
surgical procedures without the need to remove and reposition the scope
repeatedly.
MEROCEL FLUID-CONTROL PRODUCTS. The Company maintains a strong franchise
with its proprietary disposable fluid-control products (surgical sponges),
developed with proprietary polymer technology to control blood loss and
simultaneously minimize adhesions at the surgical site. Under its Merocel brand
name, the Company markets its fluid-control products in a broad array of sizes
and shapes, designed primarily for use in sinus and rhinology
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procedures.
HAND INSTRUMENTATION. In February 1996, the Company became the exclusive
distributor for BOSS Instruments, Ltd. in the U.S. ENT market, and as a result
now provides a complete line of sinus surgery hand instrumentation. Over 400
patterns have been developed to provide surgeons with an ergonomic design and
performance that affords surgeons precision during surgical procedures.
RHINOLOGY PRODUCTS. The Company's products for use during surgical repair
of the nose include internal and external nasal splints, nasal catheters, airway
and irrigation catheters and powered sinus burs.
HEAD AND NECK
Approximately 23%, 25% and 24% of the Company's net sales in 1997, 1996 and
1995, respectively, were derived from products and devices related to the head
and neck anatomy. The Company has a strong brand franchise in this product
subspecialty with its nerve monitoring systems, powered systems and facial
plastic implant products. Head and neck surgical techniques are being developed
which use the more precise tissue removal of powered instrumentation systems,
similar to those being used in sinus surgery, to lessen trauma and bleeding. The
Company believes there is significant opportunity to capitalize on and
facilitate the conversion of this subspecialty to these new techniques.
POWERED TISSUE-REMOVAL INSTRUMENTATION SYSTEMS. In mid-1997, the Company
introduced several procedure specific blades to address perceived market
opportunities for the conversion of certain Head & Neck procedures to powered
instrumentation, thereby further leveraging the Company's installed base of XPS
StraightShot(R) systems. Specifically, the Company has introduced cutter blades
for use in facial sculpting procedures where facial fatty tissue is removed for
cosmetic and other reasons; adenoidectomy blades for more complete and less
traumatic removal of adenoids; and laryngeal blades for the removal of polyps,
lesions and tumors located on the vocal cords. The Company believes that the
market opportunity for conversion of these procedures to powered technology is
at least as significant as the powered sinus conversion opportunity.
POWERED DRILL SYSTEMS. Precision, high-powered drilling is required in head
and neck surgery to access tumors or tissue behind bone structures. The Company
manufactures and markets a line of electric and air powered drilling systems for
such procedures, including the Powerforma electric drill system introduced in
the fourth quarter of 1996, which consists of a power console, surgical
handpiece and disposable and reusable cutting burrs. This new system provides
the ENT surgeon with significantly increased cutting speed and precision that
will reduce the time necessary to complete these head and neck surgical
procedures.
NERVE MONITORING SYSTEMS. The Company's NIM-2(R) XL nerve monitor products,
which were first introduced in February 1995, identify and monitor crucial motor
nerve branches during various head and neck procedures. The identification of
nerves during many head and neck procedures is becoming a standard of care
because the inadvertent cutting of any branches of these nerves could result in
facial paralysis. The NIM-2(R) XL provides surgeons with visual and audio
indicators through a system which includes a battery-powered electromyographic
(EMG) monitor, disposable electrodes and nerve stimulators.
FACIAL PLASTICS PRODUCTS. Increasingly, ENT surgeons are performing more
facial plastic procedures, including face and brow lifts, facial sculpting and
cosmetic facial implants. The Company provides a broad array of products and
devices for the facial plastic market. The Company is a worldwide distributor
for Implantech Associates, Inc. in the ENT market, and thereby provides a broad
line of facial plastic implants, including implants to augment the chin, nose
and cheek.
HAND INSTRUMENTATION. As the exclusive distributor for BOSS Instruments,
Ltd. in the U.S. ENT market, the Company provides a broad line of hand
instrumentation for facial plastic surgery. These products are designed to
increase surgeon precision and reduce patient swelling and recovery time.
SPECIALTY PRODUCTS. The Company's Laser-Shield II(R) is a laser resistant
endotracheal tube used in throat-
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related surgery performed with lasers. The Company believes that the
Laser-Shield II(R) is safer and more reliable than current alternatives.
OTOLOGY
Approximately 19%, 21% and 21% of the Company's net sales in 1997, 1996 and
1995, respectively, were derived from otology products. The Company possesses a
strong franchise and significant market share in this segment of the ENT market.
The Company's otology products include ventilation tubes, middle ear implants
and instrumentation used to repair conductive hearing loss and correct other
problems associated with the ear. The Company believes that the conversion of
ENT procedures to less traumatic techniques is more likely to have a significant
effect on the sinus and rhinology and head and neck subspecialties than on the
otology subspecialty.
VENTILATION TUBES. Vent tubes are small tubes surgically implanted into the
eardrum to provide ventilation to the middle ear. Vent tubes are primarily used
in younger children with severe middle ear infection. The Company markets a full
line of vent tubes, including its proprietary Activent anti-microbial tube.
MIDDLE EAR IMPLANTS. The Company develops and markets middle ear prostheses
used to reconstruct any or all of the three bones of the middle ear, primarily
in cases of otosclerosis and chronic middle ear infection. These permanent
implants are made of stainless steel, porous polyethylene, hydroxyapatite and
other biocompatible materials.
MICROSURGICAL INSTRUMENTS. The Company sells a broad line of microsurgical
hand-held instruments such as otoscopes, vent tube inserters, disposable blades,
proprietary suction irrigators and specialized instruments to insert and implant
middle ear prostheses.
SPECIALTY PRODUCTS. The Company's specialty otology products include
absorbent dressings, ear plugs, ear protectors, disposable kits for ear surgery
and other disposable surgical instruments. The Company also produces and markets
the Skeeter(R) otologic drill system, which is designed for middle ear
procedures.
OPHTHALMIC AND OTHER
Approximately 21% of the Company's net sales in 1997 and 1996 and 27% of
its net sales in 1995 were derived from ophthalmic and other products, with
substantially all of such sales from ophthalmic products. The Company develops
and manufactures instruments and disposable products for use during various
ophthalmic procedures. These products are marketed under the Solan trademark
through distributors specializing in the ophthalmic products market. These
instruments include forceps, needle holders, hooks, probes and scissors. The
Company's disposable products relating to ophthalmic surgery and procedures are
micro knives, cannulae, trephines, blades, sponges, cauteries, penlights and
other miscellaneous products and kits. The Solan team has a management team
dedicated to the marketing of its ophthalmic products. In connection with its
acquisition of TreBay in April 1996, the Company acquired certain devices and
disposable products for use during orthopaedic surgery which the Company markets
through distributors under the TreBay name. The sales of orthopaedic products
totaled 9% and 0% of the Ophthalmic and Other category for 1997 and 1996,
respectively.
SALES AND MARKETING
The Company has an established worldwide distribution system with an
ENT-focused direct sales force, international distributor alliances and
independent distributors for select product specialties and geographic markets.
The Company sells to substantially all of the approximately 9,000 ENT
specialists in the U.S. through its direct sales force. The Company is the only
major manufacturer and marketer of ENT surgical products with a direct sales
force exclusively serving ENT specialists. The Company's 56-person U.S. sales
force focuses its efforts on developing and maintaining business relationships
with ENT specialists and those surgeons at leading academic institutions who are
considered to be influential in the ENT field. The ability of the Company to
build and maintain
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these relationships within the medical community provides a powerful base for
the distribution network and what the Company believes to be a significant
competitive advantage, especially in the area of product development. The
Company's direct U.S. sales representatives are compensated exclusively through
sales commissions. The Company's thirteen marketing personnel specialize
according to subspecialty within the ENT market as well as by category of
product.
In the international market, the Company sells through both a 26-person
direct sales force and through over 100 distributors. The Company maintains a
direct sales presence in Canada, the United Kingdom, France, Australia and
Germany. The Company sells its products to other countries in Europe, Asia
Pacific, Africa, Central and South America using distribution partners. The
Company believes it has experienced significant international sales gains as a
result of creating in certain markets a dedicated sales force focused
exclusively on selling its products.
The Company has an exclusive arrangement with the International Center for
Otologic Training (ICOT), an organization affiliated with the Georgia Ear
Institute in Savannah, Georgia. The charter of ICOT is to train internationally
based ENT surgeons, many from developing countries, in new and advanced ENT
surgical techniques. The Company provides financial support and equipment to
ICOT in connection with the training of these ENT surgeons. As a result of this
relationship with the Company, the Company believes that these physicians and
their affiliated hospitals will be more inclined to purchase the Company's
products upon returning to their respective countries.
The Company utilizes specialty distributors to market its non-ENT products
in the U.S. The Company's Solan ophthalmic products are marketed in the U.S.
through a network of dealers specializing in ophthalmic in product sales.
Outside of the U.S., the Solan ophthalmic product line is typically marketed
through the same direct and independent distributor system as the Company's ENT
product lines. The TreBay brand of orthopaedic hip revision instruments is
marketed in the U.S. through an exclusive arrangement with a major orthopaedic
company. The Company recently announced several innovative new products
including the TreBay Universal Total Hip Removal System and a micro-power tissue
resector with associated disposable cutter blades for spinal surgery.
The Company seeks to maintain inventory levels that provide its customers
with a high standard of service. In addition, the Company may build inventories
in advance of new product launches to support sales as well as to provide its
sales force with product samples. The Company generally allows its customers to
return products for any reason within 45 days of shipment.
PRODUCT DEVELOPMENT
In each of the last four years, new products have accounted for an
increasing percentage of the Company's total sales. In 1997, 1996 and 1995,
products introduced within the last three years of the relevant fiscal year
represented approximately 29%, 23%, and 14% of the Company's ENT sales,
respectively.
The Company believes that it has a strong base of proprietary engineering,
manufacturing and biomaterials capabilities. The Company also believes it has
expertise in the core research and development areas relevant to the production
of new ENT surgical products. Primarily through internal research and
development efforts, the Company plans to continue to develop new proprietary
products, often in collaboration with leading ENT and head and neck surgeons,
that allow surgeons to perform their current or future procedures in a
less-traumatic manner with more precision, less surgical time and greater
simplicity. The Company believes that the strong network it has built through
its marketing focus on ENT specialists helps implement this strategy. The
Company also from time to time may evaluate strategic acquisitions and licensing
of third party technology to further expand and enhance its product line.
The Company has entered into royalty agreements or, in certain cases,
consulting agreements, with more than 30 ENT specialists as part of its product
development activities. The royalty agreements generally provide that the
specialist is entitled to a percentage of the revenues generated from the
Company's sales of products developed by the Company in collaboration with the
specialist. In addition, the royalty agreements generally provide that all
products developed in collaboration between the specialist and the Company will
be the exclusive property of the
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Company, subject to the specialist's right to receive royalties. The Company is
not obligated to make material payments under any of the royalty or consulting
agreements.
The Company employs mechanical, electrical, materials and polymer engineers
to develop the various products offered or contemplated by the Company. The
Company's research and development department has a broad range of
electro-mechanical skills to address its variety of hand instruments, implants,
electrical powered systems, polymer products and disposable products. Currently,
the Company's research and development department consists of thirteen engineers
experienced in various technical specialties relevant to the Company's core
products.
The research and development engineers work closely with leading surgeons
in assessing new surgical procedures for opportunities to develop products that
will complement current products and new "state of the art" devices that fit
within the overall Company's business strategy. During 1997, 1996 and 1995, the
Company spent $4.1 million, $3.7 million, and $2.4 million, respectively, in
connection with research and development activities. The Company expects to
expend approximately $4.8 million in 1998 for research and development.
SUPPLIERS
Although most of the purchased components utilized by the Company in
manufacturing are available from more than one vendor, certain materials,
including TPE-based materials and certain fluoropolymers used in its ventilation
tubes, are only supplied by a single vendor. Although it is not presently the
case, if the supply of materials from a single source vendor were interrupted in
the future, replacement or alternative sources may not be readily obtainable due
to the regulatory requirements that the Company certify as to the quality and
suitability of the new or alternate material. In addition, a new or supplemental
filing would be required to be approved prior to the Company's marketing a
product containing new material. This approval process may take a substantial
period of time and there is no assurance that the Company would be able to
identify, certify or obtain the necessary regulatory approval for the new
material to be used in the Company's products. In addition, certain suppliers
could terminate or limit the sales of certain materials to the Company for use
in medical devices in an attempt to limit their potential exposure to product
liability claims.
COMPETITION
The markets served by the Company are highly competitive. The Company
believes that the primary competitive factors affecting its business are the
reliability, cost-effectiveness, ease of use, safety and effectiveness of its
products, surgeon and purchaser familiarity with its instrumentation and
third-party reimbursement policies. For certain of the Company's potential
products, an important factor in competition may be the timing of market
introduction of its or its competitors' products. Accordingly, the relative
speed with which the Company can develop products, complete approval or
clearance processes and supply commercial quantities of the products to the
market are also important competitive factors. The Company believes that its
ability to compete successfully in the ENT markets will depend on its ability to
maintain market share of its core product base and to facilitate the conversion
of traditional surgical procedures to microendoscopy surgical techniques using
innovative technology developed by the Company. See "Risk Factors--Possible
Adverse Effects of Significant Competition."
The Company competes with Smith & Nephew ENT (a division of Smith & Nephew
plc formerly known as Richards Medical Company) in substantially all of the
Company's ENT product lines. Stryker Corporation, Smith & Nephew Endoscopy (a
division of Smith & Nephew plc) and Linvatec Corporation (a division of Conmed
Corporation) offer endoscopic equipment and sinus power systems that compete
with those of the Company. A number of other medical products companies offer
products which are directly competitive to certain products or product lines
marketed by the Company. Many of the Company's competitors and potential
competitors have substantially greater capital resources than the Company. Some
of the Company's competitors may have long term or preferential supply
arrangements with hospitals. Such arrangements may act as a barrier to market
entry.
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GOVERNMENT REGULATION
The Company's products, product development activities, promotional and
marketing activities and manufacturing processes are subject to extensive and
rigorous regulation by the FDA and comparable agencies in foreign countries. In
the U.S., the FDA regulates the interstate commerce of medical devices as well
as manufacturing, labeling, promotion and recordkeeping procedures for such
devices. For purposes of these regulations, the Company's products are generally
treated as medical "devices." In order for the Company to market its products in
the U.S., the Company must obtain marketing clearance from the FDA through what
is known as a 510(k) pre-market notification or obtain approval through a more
detailed application process resulting in what is known as PMA. The process of
obtaining marketing clearance for new medical devices from the FDA can be costly
and time-consuming. There can be no assurance that such clearance will be
granted for the Company's products that are under development or future products
on a timely basis, if at all, or that FDA review will not involve delays that
will adversely affect the Company's ability to commercialize additional products
or expand permitted uses of existing products.
A manufacturer may seek FDA clearance to distribute a new medical device by
filing a 510(k) pre-market notification. A 510(k) pre-market notification
requires the manufacturer of a medical device to establish that the device is
"substantially equivalent" to medical devices legally marketed in the U.S. The
510(k) pre-market notification must be accompanied by appropriate information or
data establishing the claim of substantial equivalence, which, depending on the
type of product, may require animal or human clinical data. If this substantial
equivalence is established to the satisfaction of the FDA, the manufacturer will
receive FDA clearance for marketing of the medical device. If the manufacturer
cannot establish substantial equivalence or if the FDA determines that a device
requires a more rigorous review, the FDA will require that the manufacturer
submit a PMA application prior to obtaining approval to market the device in the
U.S. The PMA process requires laboratory and animal studies, the submission to
the FDA of a request for permission to clinically evaluate the medical device in
humans under an Investigational Device Exemption ("IDE"), the conduct of human
studies meeting the requirements of the institutional review board of the study
institution, the written informed consent of all participating patients, the
submission of a PMA application, the review of the human studies by an
FDA-selected scientific advisory panel and final review (including manufacturing
facilities review) and approval by the FDA. This process is expensive and
time-consuming, generally taking more than a year and often substantially
longer.
All of the Company's currently marketed products either have received FDA
marketing clearance pursuant to 510(k) pre-market notifications or PMA
applications filed by the Company and cleared by the FDA, or are exempt from
obtaining marketing clearance by virtue of their status as pre-amendment devices
(i.e. devices introduced into interstate commerce prior to May 28, 1976).
Although the Company anticipates that, at least in the near term, its products
will be evaluated under the 510(k) pre-market notification process, there can be
no assurance that the Company's current or future products may not be subjected
to the PMA process or that the Company's current or future products in
development will receive FDA marketing clearance.
Even if regulatory clearance to market a device is obtained from the FDA,
this clearance may entail limitations on the indicated uses of the device.
Marketing clearance can also be withdrawn by the FDA due to the failure to
comply with regulatory standards or the occurrence of unforeseen problems
following initial clearance. The Company may be required to make further filings
with the FDA under certain circumstances such as the addition of new product
claims. The Company has made modifications to its cleared products, which the
Company believes do not require submission of new 510(k) notices. There can be
no assurance, however, that the FDA will agree with any of the Company's
determinations and not require the Company to submit new 510(k) notices for any
of the changes made to its products and/or to stop marketing until new 510(k)s
are cleared by the FDA.
Failure to comply with applicable regulatory requirements could result in,
among other things, warning letters, fines, injunctions, civil monetary
penalties, recall or seizure of products, total or partial suspension of
production, refusal of the government to grant pre-market clearance or
pre-market approval for devices, withdrawal of approvals and criminal
prosecution.
The Company is also required to register with the FDA as a medical device
manufacturer. As such, the Company's manufacturing facilities are subject to
inspection on a routine basis for compliance with GMP. These
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regulations require that the Company manufacture its products and maintain its
documents in a prescribed manner with respect to design, manufacturing, testing
and quality control activities. As a medical device manufacturer, the Company is
further required to comply with FDA requirements regarding the reporting of
allegations of death or serious injury associated with the use of its medical
devices, as well as product malfunctions that would likely cause or contribute
to death or serious injury if the malfunctions were to recur. Other FDA
requirements govern product labeling and prohibit a manufacturer from marketing
an approved device for unapproved applications. If the FDA believes that a
manufacturer is not in compliance with the law, it can institute proceedings to
detain or seize products, issue a recall, enjoin future violations and assess
civil and criminal penalties against the manufacturer, its officers and
employees.
The Company is also subject to numerous federal, state and local laws
relating to such matters as safe working conditions, manufacturing practices,
environmental protection, fire hazard control and disposal of hazardous or
potentially hazardous substances. There can be no assurance that the Company
will not be required to incur significant costs to comply with such laws and
regulations in the future or that such laws or regulations will not have a
material adverse effect upon the Company's ability to do business.
The Company may become subject to future legislation and regulations
concerning the manufacture and marketing of medical devices. This could increase
the cost and time necessary to begin marketing new products and could affect the
Company in other respects not presently foreseeable. The Company cannot predict
the effect of possible future legislation and regulations.
Sales of medical devices outside the U.S. are subject to foreign regulatory
requirements that vary widely from country to country. These laws and
regulations range from simple product registration requirements in some
countries to complex clearance and production controls in others. As a result,
the processes and time periods required to obtain foreign marketing approval may
be longer or shorter than that necessary to obtain FDA approval. These
differences may affect the efficiency and timeliness of international market
introduction of the Company's products, and there can be no assurance that the
Company will be able to obtain regulatory approvals or clearances for its
products in foreign countries.
For countries in the EU, in January 1995, CE mark certification procedures
became available for medical devices, the successful completion of which would
allow certified devices to be placed on the market in all EU countries. In order
to obtain the right to affix the CE mark to its products, medical device
companies must obtain certification that its processes meet European quality
standards, including certification that its design and manufacturing facility
complies with ISO 9001 standards. After June 1998, medical devices may not be
sold in EU countries unless they display the CE mark. The Company successfully
obtained certification under the ISO 9001 standards in November 1995. In
addition, international sales of medical devices manufactured in the U.S. but
not approved by the FDA for distribution in the U.S. are subject to FDA export
requirements. Under these requirements, the Company must assure that the product
is not in conflict with the laws of the country for which it is intended for
export, in addition to complying with the other requirements of Sections 801(e)
and/or 802 of the United States Food, Drug and Cosmetic Act.
THIRD-PARTY REIMBURSEMENT
In the U.S., health care providers that purchase medical devices generally
rely on third-party payors, such as Medicare, Medicaid, private health insurance
plans and health maintenance organizations, to reimburse all or a portion of the
cost of the devices. The Medicare program is funded and administered by the
Health Care Financing Administration ("HCFA"), while the Medicaid program is
jointly funded by HCFA and the states, which administer the program under
general federal oversight. The Company believes its current products and the
procedures in which such products are used are generally eligible for coverage
under these third-party reimbursement programs. The Company also believes that
the products it is developing and the procedures in which such products will be
used will be eligible for third-party reimbursement. The competitive position of
certain of the Company's products will be partially dependent upon the extent of
coverage and adequate reimbursement for such products and for the procedures in
which such products are used.
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The federal government and certain state governments are currently
considering a number of proposals to reform the Medicare and Medicaid health
care reimbursement system. The Company is unable to evaluate what legislation
may be drafted and whether or when any such legislation will be enacted and
implemented. Certain of the proposals, if adopted, could have an adverse effect
on the Company's business, financial condition and results of operations.
During the past several years, the major third-party payors have
substantially revised their reimbursement methodologies in an attempt to contain
their health care reimbursement costs. Medicare reimbursement for inpatient
hospital services is based on a fixed amount per admission based on the
patient's specific diagnosis. As a result, any illness to be treated or
procedure to be performed will be reimbursed only at a prescribed rate set by
the government that is known in advance to the health care provider. If the
treatment costs less, the provider is still reimbursed for the entire fixed
amount; if it costs more, the provider cannot bill the patient for the
difference. No separate payment is made in most cases for products such as the
Company's instrumentation when they are furnished or used in connection with
inpatient care. Many private third-party payors and some state Medicaid programs
have also adopted similar prospective payment systems.
Third-party payors have recently increased their emphasis on managed care,
which has led to an increased emphasis on cost-effective medical devices by
health care providers. In addition, through their purchasing power, these payors
often seek discounts, price reductions or other incentives from medical product
suppliers.
The Company intends to seek international reimbursement approvals for its
products, although there can be no assurance that such approvals will be
obtained in a timely manner or at all. Reimbursement and health care payment
systems in international markets vary significantly by country and include both
government-sponsored health care and private insurance. To the extent that any
of the Company's products are not entitled to reimbursement in any international
market, market acceptance of such products in such international market would be
adversely affected.
PATENTS, TRADE SECRETS AND PROPRIETARY RIGHTS
Proprietary protection for the Company's products and know-how is important
to the Company's business. Thus, the Company's policy is to prosecute and
enforce its patents and proprietary technology. The Company intends to continue
to file patent applications to protect technology, inventions and improvements
that are considered important to the development of its business. The Company
also relies upon trade secrets, know-how, continuing technological innovation
and licensing opportunities to develop and maintain its competitive position.
As of January 31, 1998, the Company held 52 U.S. patents and 11 foreign
patents, and had filed 26 additional U.S. patent applications and 4 patent
applications in certain major industrial countries. The Company is also licensed
under 9 patents owned by third parties.
The patent positions of medical device companies, including the Company,
are generally uncertain and involve complex legal and factual questions.
Consequently, even though the Company currently is pursuing its patent
applications with the U.S. Patent and Trademark Office and certain foreign
patent authorities, the Company does not know whether any of its remaining
applications will result in the issuance of any patents or, if any patents are
issued, whether they will provide significant proprietary protection or will be
circumvented or invalidated. Because patent applications in the U.S. are
maintained in secrecy until patents issue, and since publication of discoveries
in the scientific or patent literature tend to lag behind actual discoveries by
several months and there may be material patents or publications of which the
Company is not aware, the Company cannot be certain that it was the first
creator of inventions claimed by pending patent applications or that it was the
first to file patent applications for such inventions.
The medical device industry is characterized by frequent and substantial
intellectual property litigation, particularly with respect to newly developed
technology. Intellectual property litigation is complex and expensive, and the
outcome of such litigation is difficult to predict. Any future litigation,
regardless of the outcome, is likely to result in substantial expense to the
Company and significant diversion of the efforts of the Company's technical and
management personnel. An adverse determination in any such proceeding could
subject the Company to significant
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liabilities to third parties, require disputed rights to be licensed from such
parties if licenses to such rights could be obtained, and/or require the Company
to cease using such technology. There can be no assurance that if such licenses
were obtainable, they would be obtainable at costs reasonable to the Company. If
forced to cease using such technology, there can be no assurance that the
Company would be able to develop or obtain alternate technology. Additionally,
if third-party patents containing claims affecting the Company's technology are
issued and such claims are determined to be valid, there can be no assurance
that the Company would be able to obtain licenses to such patents at costs
reasonable to the Company, if at all, or be able to develop or obtain
alternative technology. Accordingly, an adverse determination in a judicial or
administrative proceeding or failure to obtain necessary licenses could prevent
the Company from manufacturing, using or selling certain of its products, which
could have a material adverse effect on the Company's business, financial
condition and results of operations.
The Company's practice is to require its employees, consultants, outside
collaborators and researchers and other advisors to execute confidentiality
agreements upon the commencement of employment or consulting relationships with
the Company. These agreements provide that all confidential information
developed or made known to the individual during the course of the individual's
relationship with the Company is to be kept confidential and not disclosed to
third parties, subject to a right to publish certain information in the
scientific literature in certain circumstances and subject to other specific
exceptions. In the case of employees, the agreements provide that all inventions
conceived by the individual shall be the exclusive property of the Company.
There can be no assurance; however, that these agreements will provide
meaningful protection for the Company's trade secrets or adequate remedies in
the event of unauthorized use or disclosure of such information.
PRODUCT LIABILITY AND INSURANCE
The business of the Company entails the risk of product liability claims
and any such claims could have an adverse impact on the Company. The Company has
taken and will continue to take what it believes are appropriate precautions,
including maintaining general liability and commercial liability insurance
policies which include adequate coverage for product liability claims. These
policies currently provide $25 million in aggregate coverage. The Company
evaluates its insurance requirements on an ongoing basis to enable it to
maintain adequate levels of coverage. There can be no assurance that product
liability claims will not exceed such insurance coverage limits or that such
insurance will be available on commercially reasonable terms or at all. The
Company currently is involved in certain legal proceedings involving product
liability claims. Based on information presently available to the Company, the
Company believes that it has adequate legal defenses or insurance coverage for
these actions, and that the ultimate outcome of these actions will not have a
material adverse effect on the Company.
EMPLOYEES
As of December 31, 1997, the Company had 509 full-time employees and 4
temporary employees, including 195 in production, 86 in professional and
technical positions, 62 in administration and 170 in sales and marketing. The
Company believes that its future success will depend in large part upon the
continued service of its senior management personnel, most of whom joined the
Company in April 1996, and upon the Company's continuing ability to attract and
retain highly qualified managerial, operational, technical and sales and
marketing personnel. Competition for highly qualified personnel is intense and
there can be no assurance that the Company will be able to retain its key
personnel or that it will be able to attract and retain additional qualified
personnel in the future. The Company has not experienced any work stoppage and
considers its relations with its employees to be satisfactory.
RISK FACTORS
THE FOLLOWING FACTORS ARE AMONG THOSE THAT MAY CAUSE THE COMPANY'S ACTUAL
RESULTS TO DIFFER SIGNIFICANTLY FROM THE RESULTS DISCUSSED IN THE
FORWARD-LOOKING STATEMENTS CONTAINED IN THIS ANNUAL REPORT ON FORM 10-K.
POSSIBLE OBSOLESCENCE FROM RAPID TECHNOLOGICAL CHANGE; UNCERTAINTY AS TO
MARKET ACCEPTANCE OF COMPANY'S PRODUCTS. The health care industry is
characterized by rapidly changing technology and frequent new product
introductions. The Company believes that its ability to develop and
commercialize new products and enhancements of existing products is critical to
its continued growth and profitability. There can be no assurance that the
Company
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will continue to be successful in identifying, developing and marketing new
products or enhancing its existing products. The Company's business will be
adversely affected if the Company incurs delays in developing new products or
enhancements or if such products or enhancements do not gain market acceptance.
Market acceptance of the Company's products will be determined in large part by
the Company's ability to demonstrate the surgical advantages, safety and
efficacy, cost effectiveness and performance features of such products, as well
as to train surgeons and other operating staff in their use. The Company
believes that use and acceptance by physicians and hospitals will be essential
for market acceptance of certain of its products, and there can be no assurance
that its products will be used or accepted. There can be no assurance those
products or technologies developed by others will not render the Company's
products or technologies noncompetitive or obsolete.
POSSIBLE ADVERSE EFFECTS OF SIGNIFICANT COMPETITION. The Company encounters
significant competition in all markets in which it participates. Many of the
Company's competitors and potential competitors have substantially greater
resources, including capital, name recognition, research and development
experience and regulatory, manufacturing and marketing capabilities. Many of
these competitors offer well-established, broad product lines and ancillary
services not offered by the Company. Some of the Company's competitors have
long-term or preferential supply arrangements with hospitals, which may act as a
barrier to market entry. Other large health care companies may enter the market
for the Company's products in the future. Competing companies may succeed in
developing products that are more efficacious or less costly than any that may
be developed and marketed by the Company, and such companies also may be more
successful than the Company in production and marketing. Competing companies may
also exert competitive pricing pressures that may adversely affect the Company's
sales levels and margins. Rapid technological development by others may result
in the Company's products becoming obsolete before the Company recovers a
significant portion of the research, development and commercialization expenses
incurred with respect to those products. There can be no assurance that the
Company will be able to continue to compete successfully with existing
competitors or will be able to compete successfully with new competitors.
DEPENDENCE ON MANAGEMENT AND OTHER KEY PERSONNEL. The Company's future
success depends to a significant extent on the efforts and abilities of its
executive officers, the majority of whom have joined the Company since April
1996 in connection with the Company's acquisition of TreBay. At the time of the
TreBay acquisition, the Board of Directors decided to replace members of the
Company's senior management with members of the senior management of TreBay who
the Board believed were better suited to implement the Company's business
strategy. Although the Company's new management has extensive experience in
managing medical device companies, the inability of new management to become
integrated fully into the operations of the Company could have a material
adverse effect on the Company's business, financial condition and results of
operations. In addition, the loss of the services of certain of these
individuals or of other key personnel could have a material adverse effect on
the Company. Although the Company has entered into an employment agreement with
each of James T. Treace, its President, Chief Executive Officer and Chairman,
and F. Barry Bays, its Senior Vice President, Operations and Chief Operating
Officer, that includes non-competition covenants, there can be no assurance that
either of these individuals or any other key employee will not terminate his or
her employment with the Company. The Company believes that its future success
also will depend significantly upon its ability to attract, motivate and retain
additional highly skilled managerial, operational, technical and sales and
marketing personnel. Competition for such personnel is intense, and there can be
no assurance that the Company will be successful in attracting, assimilating and
retaining the personnel it requires. See "--Employees."
RISKS ASSOCIATED WITH NEWLY ESTABLISHED INTERNATIONAL SALES OPERATIONS;
CURRENCY EXCHANGE RISKS. Within the past three years, the Company has
established direct sales operations in five countries. The failure of these new
direct sales operations to develop successfully may have a material adverse
effect on the Company's business, financial condition or results of operations.
International sales (including export sales) accounted for approximately 30% of
the Company's net sales in fiscal 1997 and 32% of net sales in 1996, and the
Company expects that international sales will continue to be a significant
portion of the Company's business. Fluctuations in currency exchange rates, as
well as increases in duty rates, and difficulties in obtaining export licenses
may affect the Company's international business. The Company's establishment of
direct international sales operations further increases its exposure to
fluctuations in currency exchange rates, which may adversely affect reported
sales and earnings, because the sales of these operations are denominated in
local currency and not in U.S. dollars. The Company in 1997 began hedging its
intercompany foreign currency receivables to protect against uncertainty in the
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<PAGE>
level of future exchange rates.
SEASONALITY AND QUARTERLY FLUCTUATIONS. The Company's sales and operating
results have varied, and are expected to continue to vary, significantly from
quarter to quarter as a result of seasonal patterns, the timing of new product
introductions and promotional activities. The Company believes that its business
is seasonal in nature, with the third quarter of each year typically having the
lowest sales and the fourth quarter of each year typically having the highest
sales. Quarterly results of operations for any particular quarter may not be
indicative of results of operations for future periods. There can be no
assurance that future seasonal and quarterly fluctuations will not adversely
affect the Company's business, financial condition and results of operations.
UNCERTAINTY RELATING TO THIRD-PARTY REIMBURSEMENT FOR COSTS OF PRODUCTS.
Demand for the Company's products is likely to depend in part on the extent to
which reimbursement for the cost of such products and the procedures in which
such products are used will be available from government third-party payors
(including the Medicare and Medicaid programs), government health administration
authorities, private health insurers and other organizations. These third-party
payors may deny coverage if they determine that a procedure was not reasonable
or necessary as determined by the payor, was experimental or was used for an
unapproved indication. In addition, certain health care providers are moving
towards a managed care system in which such providers contract to provide
comprehensive health care for a fixed cost per person, irrespective of the
amount of care actually provided. Such providers, in an effort to control health
care costs, are increasingly challenging the prices charged for medical products
and services and, in some instances, have pressured medical suppliers to lower
their prices. Although the Company believes that the development of
procedure-specific instrumentation for use in less traumatic procedures may in
certain cases reduce overall operating time and therefore reduce the aggregate
cost of those procedures, there can be no assurance that the development of such
products will have this effect or that third-party payors will reimburse the
costs of such instrumentation. In addition, although the Company does not depend
upon reimbursement from third-party payors with respect to its products used in
surgical cosmetic procedures, there can be no assurance these procedures will
not become subject to third-party reimbursement in the future. The Company is
unable to predict what changes will be made in the reimbursement methods
utilized by third-party health care payors. Furthermore, the Company could be
adversely affected by changes in reimbursement policies of governmental or
private health care payors, particularly to the extent any such changes affect
reimbursement for procedures in which the Company's products are used. If
coverage and adequate reimbursement levels are not provided by government or
third-party payors for use of the Company's products, the Company's business,
financial position and ability to market its technologies or products will be
adversely affected. Reimbursement and health care payment systems in
international markets vary significantly by country, and include both
government-sponsored health care and private insurance. To the extent that any
of the Company's products are not entitled to reimbursement in an international
market, market acceptance of such products in such international market would be
adversely affected. See "--Third-Party Reimbursement."
UNCERTAINTY OF EFFECT OF POTENTIAL HEALTH CARE REFORM MEASURES. Federal,
state and local officials and legislators (and certain foreign government
officials and legislators) have proposed or are reportedly considering proposing
a variety of reforms to the health care systems in the U.S. and abroad. The
Company cannot predict what health care reform legislation, if any, will be
enacted in the U.S. or elsewhere. Significant changes in the health care system
in the U.S. or elsewhere is likely to have a substantial impact over time on the
manner in which the Company conducts its business. Such changes could have a
material adverse effect on the Company's business, financial condition and
results of operations.
EXTENSIVE GOVERNMENT REGULATION. The Company's products, product
development activities, promotional and marketing activities and manufacturing
processes are subject to extensive and rigorous regulation by the U.S. Food and
Drug Administration (the "FDA") and comparable agencies in foreign countries. In
the U.S., the FDA regulates the interstate commerce of medical devices as well
as the manufacturing, labeling, promotion and recordkeeping procedures for such
devices. In order for the Company to market its products in the U.S., the
Company must obtain from the FDA marketing clearance through what is known as a
510(k) pre-market notification or obtain approval through a more detailed
application process resulting in what is known as pre-market approval ("PMA").
The process of obtaining marketing clearance for new medical devices from the
FDA can be costly and time consuming, and there can be no assurance that such
clearance will be granted for the Company's future products on a timely basis,
if at all, or that FDA review will not involve delays that will adversely affect
the Company's ability to
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<PAGE>
commercialize additional products or expand permitted uses of existing products.
Even if regulatory clearance to market a device is obtained from the FDA,
the clearance may entail limitations on the indicated uses of the device. The
clearance can also be withdrawn by the FDA due to the failure to comply with
regulatory standards or the occurrence of unforeseen problems following initial
clearance. The Company may be required to make further filings with the FDA
under certain circumstances such as the addition of new product claims. The FDA
could also limit or prevent the manufacture or distribution of the Company's
products and has the power to seize or require the recall of such products. The
Company has made modifications to its 510(k) cleared devices which the Company
believes do not require submission of new 510(k)s. There can be no assurance,
however, that the FDA would agree with any of the Company's determinations and
will not require the Company to submit new 510(k)s for any of the changes made
to the devices and/or to stop marketing until new 510(k)s are cleared by the
FDA.
All of the products currently marketed by the Company either have received
marketing clearance pursuant to 510(k) pre-market notifications or PMA
applications filed by the Company and cleared by the FDA, or are exempt from
obtaining marketing clearance by virtue of (1) their status as pre-amendment
devices (i.e. devices introduced into interstate commerce prior to May 28, 1976
or (2) their 510(k) exemption by regulation where applicable. A 510(k)
pre-market notification requires the manufacturer of a medical device to
establish that the device is "substantially equivalent" to medical devices
legally marketed in the U.S. For future products, there can be no assurance that
the FDA will concur in the Company's 510(k) request for clearance or that the
FDA will not require the Company to file PMA applications. The process of
obtaining a PMA can be expensive, uncertain and lengthy, frequently requiring
anywhere from one to several years from the date of submission, if approval is
obtained at all. Significant delay or cost in obtaining, or failure to obtain
FDA clearance to market products, or any FDA limitations on the use of the
Company's products, could have a material adverse effect on the business,
financial condition and results of operations of the Company.
In addition, all of the products manufactured by the Company and its
contract manufacturers must be manufactured in compliance with the FDA's Good
Manufacturing Practice ("GMP") regulations. Ongoing compliance with GMP and
other applicable regulatory requirements is monitored through periodic
inspection by state and federal agencies, including the FDA. The FDA may inspect
the Company and its facilities from time to time to determine whether the
Company is in compliance with regulations relating to medical device
manufacturing companies, including regulations concerning design, manufacturing,
testing, quality control, record keeping and product labeling practices.
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. In addition, changes in the existing regulations or adoption of new
governmental regulations or policies could prevent or delay regulatory approval
of the Company's products.
Failure to comply with applicable regulatory requirements could result in,
among other things, warning letters, fines, injunctions, civil monetary
penalties, recall or seizure of products, total or partial suspension of
production, refusal of the government to grant pre-market clearance or
pre-market approval for devices, withdrawal of approvals and criminal
prosecution. Any of the actions could result in adverse publicity for the
Company and could damage the Company's reputation.
A portion of the Company's revenue is dependent upon sales of its products
outside the U.S. Foreign regulatory bodies have established carrying regulations
governing product standards, packaging requirements, labeling requirements,
import restrictions, tariff regulations, duties and tax requirements. After June
1998, medical devices may not be sold in European Union ("EU") countries unless
they display the CE mark, an international symbol of adherence to quality
assurance standards and compliance with applicable European medical device
directives. In order to obtain the right to affix the CE mark to its products,
the Company must obtain and maintain certification that its processes meet
European quality standards, including certification that its design and
manufacturing facility complies with ISO 9001 standards. There can be no
assurance that the Company will be able to obtain CE mark certification for its
products. The inability or failure of the Company or its international
distributors to comply with varying foreign regulations or the imposition of new
regulations could restrict or, in
19
<PAGE>
certain countries, result in the prohibition of the sale of the Company's
products internationally and thereby adversely affect the Company's business,
financial condition and results of operations. See "--Government Regulation."
UNCERTAINTY REGARDING PATENTS AND PROPRIETARY RIGHTS. The Company's
success will depend in part on its ability to develop patentable products,
obtain patent protection for its products both in the U.S. and in other
countries and enforce its patents. However, the patent positions of medical
device companies are generally uncertain and involve complex legal and factual
questions. No assurance can be given that patents will issue from any patent
applications owned by or licensed to the Company or that, if patents do issue,
the claims allowed will be sufficiently broad to protect the Company's
technology. In addition, no assurance can be given that any issued patents owned
by or licensed to the Company will not be challenged, invalidated or
circumvented, or that the rights granted thereunder will provide competitive
advantages to the Company. The enforceability of patents issued with respect to
biomedical products can be highly uncertain. Federal court decisions
establishing legal standards for determining the validity and scope of patents
are in transition. There can be no assurance that the historical legal standard
surrounding questions of validity and scope will continue to be applied or that
current defenses as to issued patents in the field will offer protection in the
future. The Company also relies on unpatented trade secrets to protect its
proprietary technology, and no assurance can be given that others will not
independently develop or otherwise acquire substantially equivalent techniques
or otherwise gain access to the Company's proprietary technology or that the
Company can ultimately protect meaningful rights to such unpatented proprietary
technology.
The commercial success of the Company will also depend in part on its
neither infringing patents issued to others or breaching the licenses upon which
the Company's products might be based. The Company's licenses of patents and
patent applications impose various commercialization, sublicensing, insurance,
royalty and other obligations on the Company. Failure of the Company to comply
with these requirements could result in termination of the licenses or
conversion of the licenses from being exclusive to nonexclusive in nature.
The medical device industry has been characterized by extensive litigation
regarding patents and other intellectual property rights. Litigation, which
would likely result in substantial cost to the Company, may be necessary to
enforce any patents issued or licensed to the Company and/or to determine the
scope and validity of others' proprietary rights. In particular, competitors of
the Company and other third parties hold issued patents and are assumed by the
Company to hold pending patent applications, which may result in claims or
infringement against the Company or other patent litigation. The Company also
may have to participate in interference proceedings declared by the U.S. Patent
and Trademark Office, which could result in substantial cost to the Company, to
determine the priority of inventions. Furthermore, the Company may have to
participate at substantial cost in International Trade Commission proceedings to
abate importation of products which would compete unfairly with products of the
Company.
The Company relies on confidentiality agreements with its collaborators,
employees, advisors, vendors and consultants. There can be no assurance that
these agreements will not be breached, that the Company would have adequate
remedies for any breach or that the Company's trade secrets will not otherwise
become known or be independently developed by competitors. Failure to obtain or
maintain patent and trade secret protection, for any reason, could have a
material adverse effect on the Company's business, financial condition and
results of operations. See "--Patents, Trade Secrets and Proprietary Rights."
DEPENDENCE UPON KEY SUPPLIERS. Although the Company believes that there are
a number of possible vendors for most of the components and subassemblies
required for its products, certain materials, including thermoplastic elastomer
(TPE)-based materials and certain fluoropolymers used in certain of its
ventilation tubes, currently are obtained from a single source. Although it is
not presently the case, if the supply of materials from a single source vendor
were interrupted, replacement or alternative sources might not be readily
obtainable due to the regulatory requirements that the Company certify as to the
quality and suitability of the new or alternate material. In addition, a new or
supplemental filing would be required to be approved prior to the Company's
marketing a product containing new material. This approval process may take a
substantial period of time, and there is no assurance that the Company would be
able to identify, certify or obtain the necessary regulatory approval for the
new material to be used in the Company's products. In addition, certain
suppliers could terminate or limit the sales of certain materials to the Company
for use in medical devices in an attempt to limit their potential exposure to
product
20
<PAGE>
liability claims. See "--Suppliers."
PRODUCT LIABILITY RISK; LIMITED INSURANCE COVERAGE. The manufacture and
sale of medical instrumentation entail significant risk of product liability
claims in the event that the use of such instrumentation is alleged to have
resulted in adverse effects on a patient. The Company has taken and will
continue to take what it believes are appropriate precautions, including
maintaining general liability and commercial liability insurance policies which
include coverage for product liability claims. Although the Company maintains
what it believes to be adequate insurance, there can be no assurance that the
Company's existing insurance coverage limits are adequate to protect the Company
from any liabilities it might incur in connection with the sale of its products.
In addition, the Company may require, or desire to obtain, increased product
liability coverage in the future. Product liability insurance is expensive and
in the future may not be available on acceptable terms, if at all. A successful
product liability claim or series of claims brought against the Company in
excess of its insurance coverage could have a material adverse effect on the
Company's business, financial condition and results of operations. Additionally,
it is possible that adverse product liability actions could negatively affect
the Company's ability to obtain and maintain regulatory approval for its
products, as well as damage the Company's reputation in any or all markets in
which it participates. See "--Product Liability and Insurance."
ENVIRONMENTAL MATTERS. The past and present business operations of the
Company and the past and present ownership and operations of real property by
the Company are subject to extensive and changing federal, state, and local
environmental laws and regulations. The Company believes it is in material
compliance with all such applicable laws and regulations. The Company cannot
predict what environmental legislation or regulations will be enacted in the
future, how existing or future laws or regulations will be administered or
interpreted or what environmental conditions may be found to exist. Compliance
with more stringent laws or regulations or stricter interpretations of existing
laws may require additional expenditures by the Company, some of which may be
material.
INFLUENCE BY EXISTING STOCKHOLDERS. Warburg, Pincus Investors, L.P. ("WP
Investors") beneficially owned approximately 45% of the outstanding shares of
Common Stock as of February 27, 1998. A stockholders agreement among the Company
and substantially all of its current stockholders provides that WP Investors has
the right to designate specified numbers of persons to the Company's Board of
Directors so long as WP Investors maintains specified levels of ownership of the
outstanding Common Stock. WP Investors currently has under the stockholders
agreement the right to designate three persons to be appointed or nominated to
the Company's Board of Directors. Such share ownership and minority
representation on the Company's Board of Directors may confer upon WP Investors
significant influence over the affairs and actions of the Company.
ANTI-TAKEOVER CONSIDERATIONS. The Company's Restated Certificate of
Incorporation authorizes the issuance of Preferred Stock without stockholder
approval and upon such terms as the Board of Directors may determine. The
issuance of Preferred Stock could have the effect of making it more difficult
for a third party to acquire, or of discouraging a third party from acquiring or
making a proposal to acquire, a majority of the outstanding stock of the Company
and could adversely affect the prevailing market price of the Common Stock. The
rights of the holders or Common Stock will be subject to, and may be adversely
affected by, the rights of holders of Preferred Stock that may be issued in the
future. The Company has no present plans to issue any shares of Preferred Stock.
In addition, the Company is subject to the provisions of Section 203 of the
Delaware General Corporation Law, which could prohibit or delay a merger,
takeover or other change in control of the Company and therefore discourage
attempts to acquire the Company.
ITEM 2. PROPERTIES
The Company owns its 52,000 square-foot corporate headquarters and
manufacturing facility and leases a 36,863 square-foot warehouse and
distribution facility in Jacksonville, Florida. At its Jacksonville corporate
headquarters and manufacturing facility, which has 30,000 square feet dedicated
to manufacturing, the Company produces all of the products that it manufactures
other than fluid-control products. The Company has numerous manufacturing
capabilities at the Jacksonville facility, including: injection molding; insert
molding; CNC
21
<PAGE>
machining; CAD/CAM; form, fill and seal; ETO sterilization utilizing a Joslyn
reclamation system; specialty surgical instrument manufacturing; tool design and
manufacturing; design and production of manufacturing equipment; electronics
assembly; bar code technology; and automated storage systems. The Company has
begun construction of additional office and warehouse space at its corporate
headquarters. The construction will take place in three phases and the last
phase will be completed in 1999. The operations housed in the leased facility
will be moved to the newly constructed building.
The Company also owns a 34,000 square-foot manufacturing facility and a
6,300 square-foot distribution facility in Mystic, Connecticut. The Company's
Merocel product line of fluid-control products is manufactured at the Mystic
facility. In December 1996 the Company closed a 6,400 square-foot manufacturing
facility in St. Louis, Missouri.
Currently, the Company operates two manufacturing shifts at both of its
manufacturing facilities and has the ability to increase production levels of
its current product line without expanding its facilities. The Company believes
that the properties, in conjunction with the planned expansion, are adequate to
serve the Company's business operations for the foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
The Company is currently involved in certain legal proceedings incidental
to the normal conduct of its business. The Company does not believe that any
liabilities relating to the legal proceedings to which it is a party are likely
to be, individually or in the aggregate, material to its consolidated financial
position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of 1997.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Common Stock began trading on the NASDAQ National Market on October 11,
1996 at $21 per share.
The following shows the high and low market prices for each quarter since
October 11, 1996:
<TABLE>
<CAPTION>
FIRST SECOND THIRD FOURTH
----------------- ----------------------- ------------------- -------------------
MARKET
PRICE 1997 1996 1997 1996 1997 1996 1997 1996
- ------ ------- ------- --------- --------- --------- ------- --------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
High $20 -- $20-1/8 -- $24-5/8 -- $24 $27-1/4
Low $11-3/4 -- $15-1/4 -- $18-5/8 -- $19-3/4 $18
</TABLE>
The total number of holders of record of Common Stock as of February 27,
1998 was approximately 65. The Company's Common Stock closed at $28.25 on that
date.
The Company historically has not paid cash dividends on the Common Stock
and does not anticipate paying cash dividends in the foreseeable future.
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<PAGE>
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data have been derived from the
consolidated financial statements of the Company for each of the five years
ended December 31, 1997. The information set forth below should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operation" and the consolidated financial statements and notes
thereto included in this Annual Report on Form 10-K.
<TABLE>
<CAPTION>
1997 1996 1995 1994(1) 1993
------- ------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
FINANCIAL RESULTS
Sales, net......................................... $77,240 $65,664 $59,865 $42,475 $10,071
Cost of sales...................................... 30,475 25,926 22,256 15,350 2,876
Amortization of acquisition costs allocated to
inventory....................................... -- -- 919 3,883 --
------- ------- ------- ------- -------
Gross profit....................................... 46,765 39,738 36,690 23,242 7,195
OPERATING EXPENSES
Selling, general and administrative............. 30,334 26,799 27,077 19,126 6,074
Research and development........................ 4,088 3,659 2,405 1,958 311
Amortization of intangibles (2)................. 2,374 2,421 2,579 2,652 394
Write-off of acquired research and development -- 2,380 -- -- --
(3).............................................
Restructuring charges (4)....................... -- 3,093 -- -- --
------- ------- ------- ------- -------
Total operating expenses........................... 36,796 38,352 32,061 23,736 6,779
------- ------- ------- ------- -------
Operating income (loss) from continuing operations. 9,969 1,386 4,629 (494) 416
Interest expense, net.............................. (104) (2,205) (3,063) (2,148) (102)
Other income, net.................................. 234 525 114 313 26
------- ------- ------- ------- -------
Income (loss) from continuing operations before
income tax expense (benefit) 10,099 (294) 1,680 (2,329) 340
Income tax expense (benefit)....................... 3,969 873 1,355 (774) 121
------- ------- ------- ------- -------
Income (loss) from continuing operations........... $ 6,130 $(1,167) $ 325 $(1,555) $ 219
======= ======= ======= ======= =======
PRO FORMA STATEMENT OF OPERATIONS DATA(5)
Income (loss) from continuing operations........... $(1,243) $ (149)
Preferred stock dividends.......................... 1,170 --
------- -------
Income (loss) from continuing operations available
to common shareholders.......................... $(2,413) $ (149)
======= =======
PER SHARE (PRO FORMA 1996 & 1995)(5)
Income (loss) from continuing operations available
to common shareholders.......................... $ 0.84 $ (0.47) $ (0.03)
======= ======= =======
Income (loss) from continuing operations available
to common shareholders - diluted................ $ 0.82 $ (0.46) $ (0.03)
======= ======= =======
Weighted average common shares outstanding-diluted. 7,512 5,243 4,617
======= ======= =======
FINANCIAL CONDITION
Working capital.................................... $26,106 $18,460 $12,234 $12,744 $ 3,126
Cost in excess of net assets acquired, net......... 42,399 44,389 46,381 54,300 --
Total assets....................................... 95,727 94,056 93,123 95,720 9,484
Long-term debt including redeemable preferred stock -- 3,563 90,488 89,985 11,308
Total shareholders' equity (deficit)............... 86,509 79,567 (13,058) (7,336) (3,091)
<FN>
- --------
(1) The statement of operations data includes the results of operations of
Xomed-Treace since the date of its acquisition by the Company in April 1994.
(2) Amortization of intangibles included in total operating expenses includes
amortization of foreign distribution rights of $162,000 and $838,000,
respectively, for the years ended December 31, 1995 and 1994, respectively.
(3) Research and development acquired in the purchase of TreBay Medical. See
Footnote No.1 to the Consolidated Financial Statements included in this
Annual Report on Form 10-K.
(4) Restructuring charge related to combination of certain operations and
termination of employees. See Footnote No.7 to the Consolidated Financial
Statements included in this Annual Report on Form 10-K.
(5) The pro forma presentations have been adjusted to reflect: (i) the
acquisition of TreBay as if the acquisition had occurred on January 1,
1995 (see Notes to Consolidated Financial Statements--Pro Forma Statement
of Operations (Unaudited)); (ii) the capital contribution of accrued
cumulative preferred stock dividends of $7,559,000 in connection with the
acquisition of TreBay; (iii) the conversion of all Series A Convertible
Preferred Stock and Series B Convertible Preferred Stock outstanding as of
April 16, 1996 into Common Stock; (iv) the exercise of all outstanding
options to purchase Common Stock; (v) the conversion of 60,225 shares of
Series C Redeemable Preferred Stock into 300,354 shares of Common Stock on
the date of the initial public offering, based upon the offering price of
$21.00 per share; and (vi) the conversion of 426,777 shares of Nonvoting
Common Stock into Voting Common Stock.
</FN>
</TABLE>
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<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION
THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS, WHICH
INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS MAY DIFFER
SIGNIFICANTLY FROM THE RESULTS DISCUSSED IN THE FORWARD-LOOKING STATEMENTS.
FACTORS THAT MIGHT CAUSE SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE
DISCUSSED IN "BUSINESS--RISK FACTORS" AND BELOW.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
NET SALES. Net sales increased 17.6% to $77.2 million in 1997 from $65.7
million in 1996. On a sequential quarter basis, the Company generated overall
sales growth of 9.2% in the first quarter of 1997, 15.4% in the second quarter,
17.7% in the third quarter and 27.9% in the fourth quarter when compared to the
prior year's comparable quarters. The improvement in sales growth in each
successive quarter of 1997 relates principally to accelerating growth in Sinus
and Rhinology as a result of the Company's introduction of its XPS
StraightShot(R) system used in endoscopic sinus procedures and an overall
improvement in the Company's international business in the third and fourth
quarters due to recent new product introductions and improving availability of
funding in certain international healthcare systems in which the Company
competes. In the core businesses of sinus and rhinology, head and neck and
otology, sales increased 17.2% in 1997 over 1996, which resulted in these
product lines representing 79.2% of the Company's revenue in 1997 as compared to
79.5% in 1996. Total domestic sales increased 20.5% in 1997 compared with 1996,
and international sales increased 11.5% in 1997 compared with 1996. Excluding
the unfavorable effects of foreign currency comparisons, international sales
were up 15% from 1996.
COST OF SALES. Cost of sales increased 17.6% to $30.5 million in 1997 from
$25.9 million in 1996. As a percent of sales, cost of sales was 39.5% in 1997
and 1996. Similarly gross profit was 60.5% for both 1997 and 1996. The margin in
1997 was depressed due to higher volumes of lower margin products, including the
orthopaedic instrument line, which was offset by higher margins in sinus and
rhinology attributed to new product introduction.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased 13.2% to $30.3 million from $26.8 million in
1996. For 1997, as a percent of sales, selling, general and administrative
expenses were 39.3%, as compared to 40.8% in 1996. This decrease, as a percent
of sales, is due to increasing sales and certain semi-fixed general and
administrative expenses.
RESEARCH AND DEVELOPMENT. Research and development expenses increased 11.7%
to $4.1 million in 1997 from $3.7 million in 1996 but decreased as a percent of
sales to 5.3% in 1997 from 5.6% during 1996. Major new product spending in 1997
related to straight and curved cutter blades, enhancements to the XPS micro
resector system - coupled with the introduction of the XPS 2000 micro resector
system in December 1997 - as well as other projects. The Company believes it has
a strong base of proprietary engineering, manufacturing and biomaterial
capabilities upon which to build its future research and development efforts.
OPERATING INCOME. Operating income for 1997 was $10.0 million compared to
$1.4 million for 1996. The increase in operating income of $8.6 million for 1997
from 1996 relates to the discussion above, but also to a $3.1 million
restructuring charge and the write-off of in-process research and development of
$2.4 million in conjunction with the purchase of TreBay Medical Corporation
which were both recorded in the second quarter of 1996. For 1997, operating
income, as a percent of sales was 12.9% compared to 10.4% for 1996, after adding
back the restructuring and write-off charges which occurred only in 1996. This
increase as a percent of sales, related to fixed amortization expense and
semi-fixed expenses within the general and administrative category.
INTEREST AND OTHER. Interest expense decreased 88.3% to $280,000 for
1997 from $2.4 million in 1996 due to lower average debt levels during the
current period. Other income, net was $234,000 for 1997 compared to $525,000 in
1996. This decrease of $291,000 related principally to the expiration of a
royalty agreement in late 1996.
24
<PAGE>
INCOME TAXES. The Company's effective tax rate was 39.3% for 1997. The
Company had tax expense of $873,000 on a loss of $294,000 for the year ended
December 31, 1996. The Company incurred tax expense instead of a tax benefit on
the loss due to the lack of tax benefit related to the write-off of in-process
research and development costs.
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
NET SALES. Net sales increased 9.7% to $65.7 million in 1996 from $59.9
million in 1995. In the core businesses of sinus and rhinology, head and neck
and otology, sales increased 19.6% in 1996 over 1995, which resulted in these
product lines representing 79.5% of the Company's revenue in 1996 as compared to
72.9% in 1995. The increase in sales was principally the result of several new
products introduced late in 1995 and in 1996 including the Company's Wizard and
Wizard Plus powered tissue-removal systems, the BOSS line of ENT hand
instruments, the Activent anti-microbial vent tube line, an otology implant line
acquired in the third quarter of 1995 and a line of facial implant products. In
addition, several existing product lines showed strong sales growth over the
prior period including the Merocel fluid-control products and nerve monitoring
systems. The increase in Merocel products sales was due partly to price
increases resulting from moving the distribution of these products, effective on
January 1, 1996, from an independent dealer network to the Company's U.S. direct
sales force. Sales in this line would have been approximately $1.2 million lower
in 1996 without this distribution channel change. Sales were adversely affected,
however, by a change in the distribution system for the Company's ophthalmic
product line. On January 1, 1996, the Company commenced distribution of its
ophthalmic line through an independent dealer network, with the Company selling
to dealers at wholesale prices. During 1995, these products were distributed
through the Company's direct sales force at retail pricing. This change was made
to better focus the direct sales force on the ENT market. Although unit volume
in the ophthalmic business grew approximately 7% during the year, net sales
decreased approximately $2.1 million in 1996 as a result of the price
differential from changing the distribution channel. Associated ophthalmic
operating expenses also declined. Sales also increased in several other product
lines due to increased penetration of international markets through recently
established direct sales sites. International sales increased 19.3% during the
period and represented 32.0% of the Company's revenue in 1996 compared to 29.4%
in 1995.
COST OF SALES. Cost of sales increased 11.9% to $25.9 million in 1996 from
$23.2 million in 1995. As a percent of sales, cost of sales increased to 39.5%
in 1996 from 38.7% in 1995. In accounting for the Xomed Acquisition, the Company
effected the Inventory Valuation Adjustment in which a portion of the excess
cost of the acquisition over book value of the net assets acquired was allocated
to inventory. This allocation resulted in an increase in inventory value of $5.3
million, of which $4.8 million was allocated to the inventory of continuing
operations. The inventory valued on this basis was charged to cost of sales on a
FIFO basis as it was sold. This increased cost of sales in 1995 by $0.9 million.
No such adjustment affected 1996. Without this charge, cost of sales would have
increased 16.5% to $25.9 million in 1996 from $22.3 million in the prior
comparable period and cost of sales as a percent of sales would have increased
to 39.5% in 1996 from 37.2% in the prior comparable period. This increase was
primarily due to the change in the distribution method described above for the
ophthalmic line, which resulted in lower average selling prices. This increase
was partially offset by the change in the distribution of the Merocel product
line, which resulted in a higher average selling price.
GROSS PROFIT. Gross profit as a percent of sales decreased to 60.5% in 1996
from 61.3% in 1995. Without the effects of the Inventory Valuation Adjustment
discussed above, gross profit as a percent of sales would have decreased to
60.5% in 1996 from 62.8% in the prior comparable period for the reasons
discussed above.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses decreased 1.0% to $26.8 million in 1996 from $27.1
million in 1995. This decrease was primarily due to cost savings realized as a
result of the previously discussed restructuring actions. See
"Business--Background". These savings were partially offset by commissions on a
larger sales base, an increase in the average commission rate, the operating
expenses of a new direct sales subsidiary in Germany, which began operations in
the first quarter of 1996, and promotional expenses related to the Company's
line of sinus endoscopy systems. As a percent of sales, selling, general and
administrative expenses decreased to 40.8% in 1996 from 45.2% in 1995.
25
<PAGE>
RESEARCH AND DEVELOPMENT. Research and development expenses increased 52.1%
to $3.7 million in 1996 from $2.4 million in 1995 and increased as a percent of
sales to 5.6% from 4.0% during the same comparable period. This increase is
primarily the result of project expenses related to the development of the new
XPS powered tissue-removal system and the Powerforma drill system. Although it
has in the past relied in part on strategic acquisitions and licensing of
third-party technology to develop its broad line of ENT products, the Company
believes it has a strong base of proprietary engineering, manufacturing and
bio-material capabilities upon which to build its future research and
development efforts.
AMORTIZATION. Amortization expense in 1996 and in 1995 related principally
to approximately $49.9 million of goodwill related to continuing operations
generated from the Xomed Acquisition in April 1994, which is being amortized
over 25 years.
WRITE-OFF OF ACQUIRED RESEARCH AND DEVELOPMENT. The TreBay acquisition was
accounted for under the purchase method of accounting. Accordingly, the purchase
price of approximately $6.6 million was allocated to the individual TreBay
assets acquired and liabilities assumed based upon their respective fair values
at the date of acquisition. The transaction resulted in cost in excess of net
assets acquired of approximately $4.4 million, of which $2.4 million was
allocated to in-process research and development and charged to expense in the
second quarter of 1996.
RESTRUCTURING CHARGES. As noted previously under "Business--Background" the
Company initiated cost savings programs and recorded a restructuring charge of
approximately $3.1 million during the second quarter of 1996 primarily to
reflect the cost of the severance payments to terminated employees.
INTEREST AND OTHER. Interest expense decreased to $2.4 million in 1996 from
$3.1 million in 1995. Interest expense related principally to the Company's
secured term loan (the "Term Loan") borrowings, which were repaid in October
1996 from the net proceeds of the initial public offering, and the Company's
secured revolving credit facility (the "Revolving Credit Facility") as described
below in "--Liquidity and Capital Resources." Other income of $525,000 in 1996
was $411,000 higher than in 1995 related principally to royalty income on a
product licensed to a third party.
INCOME TAXES. The Company's tax expense of $873,000 on a $294,000 loss for
the year ended December 31, 1996 varies from an effective tax rate of
approximately 40% due to the lack of tax benefit related to the write-off of
in-process research and development costs, described above. Tax expense for the
comparable period of 1995 was $1.4 million on income of $1.7 million for an
effective tax rate of 81%. The tax rate for 1995 was higher than 40% due to
losses recorded on a less than 80% owned subsidiary and losses incurred in
foreign subsidiaries for which a valuation account was provided on the potential
carry forward benefit.
LIQUIDITY AND CAPITAL RESOURCES
The Company historically has financed its operations (including capital
expenditures) through cash flows from operations. Since the Xomed Acquisition in
April 1994, which was financed in part by the incurrence of $45.9 million of
debt under the Company's secured term loan facility (the "Term Loan ") and its
secured revolving credit facility (the "Revolving Credit Facility"), all cash
flow generated from operations has been applied to repay the outstanding
principal on the Term Loan or the Revolving Credit Facility. In October 1996 the
Company completed its initial public stock offering, the proceeds of which were
used to repay the entire Term Loan and the majority of the Revolving Credit
Facility. During 1997 the remaining portion of the Revolving Credit Facility and
long-term capital lease totaling $3.7 million at December 31, 1996 were repaid.
Consequently, interest expense has been substantially reduced.
For the year ended December 31, 1997, the Company generated cash of $6.4
million from operating activities as compared with $4.8 million cash generated
in the prior year. In 1997, the Company had a net use of cash of approximately
$6.6 million within inventory, accounts receivable and accounts payable as
compared to a net use of cash within these components of operations (after
deduction of a $1.7 million cash flow related to one customer, which receipt is
non-recurring) of approximately $3.0 million in 1996. Accounts payable and
accrued expenses
26
<PAGE>
comprised a significant amount of this use of cash during 1997, due to a
$900,000 decrease from December 31, 1996, related principally to payments of
amounts related to the Company's initial public offering. The balance of the use
of cash within these working capital accounts stems from the Company's growth in
sales and related increase in accounts receivable and inventories. In addition,
payments related to the $3.1 million restructuring charge recorded during the
second quarter of 1996 lowered cash flow from operations in 1997 by $1.2
million, which was offset by a reduction of deferred tax assets.
Cash used in investing activities was $2.3 million in 1997 as compared to
cash used of $2.1 million (after eliminating the effects of cash acquired in a
business combination) in the prior year. Capital expenditures were $2.3 million
in 1997 and 1996. Included in capital expenditures for 1997 was a significant
upgrade of the Company's computer system totaling approximately $400,000. This
purchase did not produce an increase over 1996 purchases due to the purchase of
capital assets in 1996 for the start-up of the Company's subsidiary in Germany.
The Company expects to spend approximately $6.4 million in 1998 on capital
acquisitions, related principally to its corporate headquarters expansion (See
Item 2. Properties). The Company expects to fund this level of expenditure from
cash from operations.
Cash used in financing activities was $3.0 million in 1997 as compared with
$4.5 million in 1996. The Company received cash from the exercise of stock
options of $655,000 in 1997 and reduced its long-term debt during 1997 by
approximately $3.7 million. In the first nine months of 1996, the Company made
payments under the then outstanding Term Loan and its capital lease obligation
of $4.1 million, and borrowed a net $1.4 million from its line of credit. In the
fourth quarter of 1996 the Company completed its Initial Public Offering and
repaid its Term Loan and the majority of its Revolving Credit Agreement.
In the fourth quarter of 1997, the Company began hedging its intercompany
foreign currency receivables. See Footnote No. 6 to the Consolidated Financial
Statements included in this Annual Report on Form 10-K.
The Company entered into an Amended and Restated Credit Agreement with the
bank in May, 1997 under which it may borrow up to $25 million to be used for
working capital needs and potential acquisition. See Footnote No. 8 to the
Consolidated Financial Statements included in this Annual Report on Form 10-K.
Based on the Company's ability to generate cash flow from operations and
with the availability of borrowing under its Amended and Restated Credit
Agreement, the Company believes it will be able to finance its working capital
and expansion needs for the next 24 months.
YEAR 2000 ISSUE
The company has assessed and continues to assess the impact of the Year
2000 issue on its operations, including the development and implementation of
project plans and cost estimates required to make its information systems
infrastructure Year 2000 compliant. The Company's focus on this issue is to
ensure there is no adverse effect on business operations and that transactions
with customers, suppliers, and financial institutions are fully supported.
Additionally, the Company has initiated communications with significant
suppliers, customers, and other third parties to determine their Year 2000
readiness. Furthermore, the Company has initiated a formal program to advise
customers of the Year 2000 issue; however, the Company believes it has no
material exposure to contingencies related to the Year 2000 issue for the
products it has sold. While the Company has taken steps, there can be no
certainty that the systems and products of other companies on which the Company
relies will not have an adverse effect on the Company's operations. Based on
existing information, the Company believes the anticipated spending necessary to
become Year 2000 compliant will not have a material effect on the financial
position, cash flows or results of operations of the Company.
SALES BY MARKET
The Company derives sales from various markets within the ENT industry.
Sinus and rhinology, head and neck and otology are the three core markets in
which the Company operates. In addition to products for these markets, the
Company has other product offerings, including a line of ophthalmic products,
which the Company converted in
27
<PAGE>
January 1996 from distributing through its direct sales force to distributing
through independent dealers. The following table summarizes the Company's
worldwide product line sales during the periods indicated:
YEARS ENDED DECEMBER 31,
-------------------------------
1997 1996 1995
------- ------- -------
(IN THOUSANDS)
SALES:
Sinus and Rhinology.................. $28,848 $22,247 $17,038
Head and Neck........................ 17,847 16,114 14,187
Otology.............................. 14,465 13,841 12,406
------- ------- -------
Total Core Business................ 61,160 52,202 43,631
Ophthalmic and Other................. 16,080 13,462 16,234
------- ------- -------
Total.............................. $77,240 $65,664 $59,865
======= ======= =======
YEARS ENDED DECEMBER 31,
------------------------------
1997 1996 1995
----- ----- -----
PERCENTAGE OF TOTAL SALES:
Sinus and Rhinology.................. 37.4% 33.9% 28.5%
Head and Neck........................ 23.1 24.5 23.7
Otology.............................. 18.7 21.1 20.7
----- ----- -----
Total Core Business............. 79.2 79.5 72.9
Ophthalmic and Other................. 20.8 20.5 27.1
----- ----- -----
Total 100.0% 100.0% 100.0%
===== ===== =====
SALES BY GEOGRAPHIC MARKET
The Company distributes its products on a worldwide basis through an
82-person direct sales force in the U.S. and selected other countries and
through a network of over 130 independent distributors. The Company's core ENT
products are sold in the U.S. only on a direct sales basis.
Approximately 30.0%, 32.0% and 29.4% of the Company's net sales in 1997,
1996 and 1995, respectively, were made outside the U.S. through direct
operations in the United Kingdom, Canada, France, Germany and Australia, as well
as through over 100 independent international distributors, many of whom
distribute the Company's products exclusively. The portion of sales made outside
the U.S. in 1997 was lower than 1996 primarily due to international markets only
having six months of sales from the Company's new XPS system compared with the
twelve months in the U.S. due to a later international introduction date as well
as the unfavorable effects of foreign currency rate comparisons in international
markets in 1997. The following table summarizes the Company's U.S.
and international sales for the periods indicated:
YEARS ENDED
DECEMBER 31,
--------------------------------
1997 1996 1995
------- ------- -------
(IN THOUSANDS)
SALES:
U.S.................................. $53,798 $44,647 $42,249
International........................ 23,442 21,017 17,616
------- ------- -------
Total ........................ $77,240 $65,664 $59,865
======= ======= =======
PERCENTAGE OF TOTAL:
U.S. .............................. 69.7% 68.0% 70.6%
International...................... 30.3 32.0 29.4
------- ------- -------
Total......................... 100.0% 100.0% 100.0%
======= ======= =======
28
<PAGE>
SALES BY PRODUCT TYPE
The Company places particular emphasis on disposable products and
implantable devices, which represented 79.6% of sales in 1997, as compared with
84.3% of the total in 1995. One of the Company's principal objectives is to
continue to develop additional disposable products for use with its
instrumentation systems. The portion of sales from Disposable and Implantable
products was lower in 1997 than 1996 primarily due to the addition of
orthopaedic instrument sales in 1997 which did not occur in 1996 and the
introduction of the XPS system during 1997 which initially generates equipment
sales followed by on-going disposable revenues in later periods. The following
table summarizes the Company's sales of equipment and instrumentation products
as well as disposable and implantable products for the periods indicated:
<TABLE>
<CAPTION>
YEARS ENDED
DECEMBER31,
---------------------------------------------
1997 1996 1995
--------- --------- ---------
<S> <C> <C> <C>
SALES:
Equipment and Instrumentation Products $ 15,768 $ 10,178 $ 9,396
Disposable and Implantable Products .. 61,472 55,486 50,469
--------- --------- ---------
Total ........................... $ 77,240 $ 65,664 $ 59,865
========= ========= =========
PERCENTAGE OF TOTAL SALES:
Equipment and Instrumentation Products 20.4% 15.5% 15.7%
Disposable and Implantable Products .. 79.6 84.5 84.3
--------- --------- ---------
Total ........................... 100.0% 100.0% 100.0%
========= ========= =========
</TABLE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements begin on page F-1 in this Annual Report on Form
10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is hereby incorporated by reference
to such information contained in the Company's definitive proxy statement
relating to the Annual Meeting of Stockholders of the Company to be held on May
21, 1998 (the "Proxy Statement"), which is expected to be filed pursuant to
Regulation 14A of the Securities and Exchange Act of 1934 not later than 120
days after the end of the fiscal year covered by this report.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is hereby incorporated by reference
to such information contained in the Proxy Statement, which is expected to be
filed pursuant to Regulation 14A of the Securities and Exchange Act of 1934 not
later than 120 days after the end of the fiscal year covered by this report.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is hereby incorporated by reference
to such information contained in the Proxy Statement, which is expected to be
filed pursuant to Regulation 14A of the Securities and Exchange Act of
29
<PAGE>
1934 not later than 120 days after the end of the fiscal year covered by this
report.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is hereby incorporated by reference
to such information contained in the Proxy Statement, which is expected to be
filed pursuant to Regulation 14A of the Securities and Exchange Act of 1934 not
later than 120 days after the end of the fiscal year covered by this report.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. FINANCIAL STATEMENTS
The financial statements listed in the accompanying Index to
Financial Statements are filed as part of this Annual Report
on Form 10-K.
2. FINANCIAL STATEMENT SCHEDULES
All schedules have been omitted since the required information
is not present or not present in amounts sufficient to require
submission of the schedule or because the information required
is included in the consolidated financial statements,
including the summary of significant accounting policies and
the notes to the consolidated financial statements.
3. EXHIBITS
EXHIBIT NO. DESCRIPTION
----------- -----------
**3.1.2 Second Restated Certificate of Incorporation
**3.2.2 Restated By-Laws
3.2.3 Restated By-Laws, as amended February 5, 1997
***4. Specimen of Company's Common Stock certificate
*10.1 Stockholders Agreement, dated as of April 16, 1996,
among the Company, Warburg, Pincus Investors, L.P.,
Accel IV L.P., Accel Investors '94 L.P., Accel
Keiretsu L.P., Elmore C. Patterson Partners, Prospect
Partners, Vertical Fund Associates, L.P., Vertical
Medical Partners, L.P., Vertical Partners, L.P., Mark
K. Adams, Solomon Rosenblatt, Ronald J. Cercone,
William R. Miller, Robert A. Reeves, First Union
Capital Partners, Inc., James T. Treace, John R.
Treace, Daniel H. Treace and F. Barry Bays.
*10.2 Credit Agreement, dated as of April 15, 1994, by and
among Merocel/Xomed Holdings, Inc., Merocel
Corporation, Xomed-Treace, Inc., Xomed-Treace, P.R.
Inc., Bank of Boston Connecticut, certain other
lenders which are or may become parties and Bank of
Boston Connecticut, as Agent.
*10.3 Fourth Amendment and Waiver Agreement, dated as of
June 7, 1996, by and among Xomed Surgical Products,
Inc., formerly known as Merocel/Xomed Holdings, Inc.,
Merocel Corporation, Xomed, Inc., formerly known as
Xomed-Treace, Inc., Xomed-Treace, P.R. Inc., TreBay
Medical Corporation, Bank of Boston Connecticut,
Chemical Bank, Bank of Scotland, International
Nederlanden (U.S.) Capital Corporation and Bank of
Boston Connecticut, as Agent.
*10.4 Third Amendment and Waiver Agreement, dated as of
April 15, 1996, by and among Xomed Surgical Products,
Inc., formerly known as Merocel/Xomed Holdings, Inc.,
Merocel Corporation, Xomed, Inc., formerly known as
Xomed-Treace, Inc., Xomed-Treace, P.R. Inc., Bank of
Boston Connecticut, Chemical Bank, Bank of Scotland,
Internationale Nederlanden (U.S.) Capital Corporation
and Bank of Boston Connecticut, as Agent.
30
<PAGE>
*10.5 Second Amendment and Waiver Agreement, dated as of
July 3, 1995, by and among Merocel/Xomed Holdings,
Inc., Merocel Corporation, Xomed-Treace, Inc.,
Xomed-Treace, P.R. Inc., Bank of Boston Connecticut,
Chemical Bank, Bank of Scotland, Internationale
Nederlanden (U.S.) Capital Corporation and Bank of
Boston Connecticut, as Agent.
*10.6 Amendment and Waiver Agreement, dated as of March 31,
1995, by and among Merocel/Xomed Holdings, Inc.,
Merocel Corporation, Xomed-Treace, Inc.,
Xomed-Treace, P.R. Inc., Bank of Boston Connecticut,
Chemical Bank, Bank of Scotland, Internationale
Nederlanden (U.S.) Capital Corporation and Bank of
Boston Connecticut, as Agent.
*10.7 First Amendment Agreement, dated as of June 24, 1994,
by and among Merocel/Xomed Holdings, Inc., Merocel
Corporation, Xomed-Treace, Inc., Xomed-Treace, P.R.
Inc., Bank of Boston Connecticut, Chemical Bank, Bank
of Scotland, Internationale Nederlanden (U.S.)
Capital Corporation and Bank of Boston Connecticut,
as Agent.
*10.8 1996 Stock Option Plan
*10.9 Employment Agreement, dated as of April 16, 1996,
between the Company and James T. Treace
*10.10 Employment Agreement, dated as of April 16, 1996,
between the Company and F. Barry Bays.
**10.11 Fifth Amendment and Waiver Agreement, dated as of
September 3, 1996, by and among Xomed Surgical
Products, Inc., formerly known as Merocel/Xomed
Holdings, Inc., Merocel Corporation, Xomed, Inc.,
formerly known as Xomed-Treace, Inc., Xomed-Treace,
P.R. Inc., TreBay Medical Corporation, Bank of Boston
Connecticut, The Chase Manhattan Bank (formerly known
as Chemical Bank), Bank of Scotland, Internationale
Nederlanden (U.S.) Capital Corporation and Bank of
Boston Connecticut, as Agent.
**10.12 Separation Agreement, dated as of May 10, 1996,
between the Company and Mark K. Adams.
***10.13 Agreement, dated as of September 12, 1996, by and
among the Company, Warburg, Pincus Investors, L.P.,
Accel IV L.P., Accel Investors '94 L.P., Accel
Keiretsu L.P., Elmore C. Patterson Partners, Prospect
Partners, Vertical Fund Associates, L.P., Mark K.
Adams, Solomon Rosenblatt, Ronald J. Cercone, William
R. Miller, Robert A. Reeves, First Union Capital
Partners, Inc., James T. Treace, John R. Treace, Dan
H. Treace, F. Barry Bays, Thomas E. Timbie, Thomas
Drury and David R. Grant.
***10.14 Compliance Agreement, dated as of April 1, 1996, by
and between Daikin America, Inc. and Xomed Surgical
Products, Inc.
***10.15 Supply Agreement, dated as of November 9, 1994, by
and between TreBay Medical Corporation (formerly
known as Micromed Development Corporation) and
Consolidated Polymer Technologies.
10.16 Sixth Amendment and Waiver Agreement, dated as of
December 30, 1996, by and among Xomed Surgical
Products, Inc., formerly known as Merocel/Xomed
Holdings, Inc., Merocel Corporation, Xomed, Inc.,
formerly known as Xomed-Treace, Inc., Xomed-Treace,
P.R. Inc., TreBay Medical Corporation, Bank of Boston
Connecticut, The Chase Manhattan Bank (formerly known
as Chemical Bank), Bank of Scotland, Internationale
Nederlanden (U.S.) Capital Corporation and Bank of
Boston Connecticut, as Agent. Incorporated by
reference from the Company's Form 10-K dated December
31, 1996.
10.17 Third Amended and Restated Xomed Surgical Products,
Inc. 1996 Stock Option Plan. Incorporated by
reference from the Company's Form 10-Q dated June 28,
1997.
10.18 Amended and Restated Credit Agreement dated as of
May 5, 1997 among the Company, Bank of Boston
Connecticut, as agent, and the Banks named therein.
Incorporated by reference from the Company's Form
10-Q dated June 28, 1997.
*21 Subsidiaries
23.2 Consent of Ernst & Young LLP
27 Financial Data Schedule
----------
31
<PAGE>
* Incorporated by reference to the identically numbered
exhibit to the Registrant's Registration Statement on Form
S-1 (Registration No. 333-10515).
** Incorporated by reference to the identically numbered
exhibit to Amendment No. 1 to the Registrant's Registration
Statement on Form S-1 (Registration No. 333-10515).
*** Incorporated by reference to the identically numbered
exhibit to Amendment No. 3 to the Registrant's Registration
Statement on Form S-1 (Registration No. 333-10515).
(b) REPORTS ON FORM 8-K
None
32
<PAGE>
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 on March 27, 1998.
XOMED SURGICAL PRODUCTS, INC.
By: /s/ JAMES T. TREACE
--------------------------------
James T. Treace
President, Chief Executive
Officer and Chairman of the
Board of Directors
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.
<TABLE>
<CAPTION>
SIGNATURES TITLE DATE
- ---------- ----- ----
<S> <C> <C>
President, Chief Executive Officer and
Chairman of the Board (Principal March 27, 1998
/s/ JAMES T. TREACE Executive Officer)
- --------------------------------------
James T. Treace
Vice President and Chief Financial
Officer (Principal Financial and March 27, 1998
/s/ THOMAS E. TIMBIE Accounting Officer)
- --------------------------------------
Thomas E. Timbie
/s/ RICHARD B. EMMITT Director March 27, 1998
- --------------------------------------
Richard B. Emmitt
/s/ WILLIAM R. MILLER Director March 27, 1998
- --------------------------------------
William R. Miller
/s/ RODMAN W. MOORHEAD, III Director March 27, 1998
- --------------------------------------
Rodman W. Moorhead, III
/s/ JAMES E. THOMAS Director March 27, 1998
- --------------------------------------
James E. Thomas
/s/ ELIZABETH H. WEATHERMAN Director March 27, 1998
- --------------------------------------
Elizabeth H. Weatherman
</TABLE>
33
<PAGE>
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
REFERENCE
----------------
FORM 10-K PAGE
NUMBER
----------------
<S> <C>
Report of Independent Auditors F-2
Consolidated Balance Sheets at December 31, 1997 and 1996 F-3
Consolidated Statements of Operations for each of the three years in
the period ended December 31, 1997 F-4
Consolidated Statements of Changes in Shareholders' Equity for each of
the three years in the period ended December 31, 1997 F-5
Consolidated Statements of Cash Flows for each of the three years in
the period ended December 31, 1997 F-6
Notes to Consolidated Financial Statements F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT AUDITORS
Board of Directors
Xomed Surgical Products, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheets of Xomed
Surgical Products, Inc. and Subsidiaries (the Company) as of December 31, 1997
and 1996, and the related consolidated statements of operations, changes in
shareholders' equity and cash flows for each of the three years in the period
ended December 31, 1997. 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 in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Xomed Surgical Products, Inc. and Subsidiaries at December 31, 1997 and 1996,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 1997 in conformity with
generally accepted accounting principles.
ERNST & YOUNG LLP
February 16, 1998
Jacksonville, Florida
F-2
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
DECEMBER 31,
---------------------
1997 1996
-------- --------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents ....................................... $ 1,712 $ 629
Accounts receivable, less allowance for doubtful accounts of $735
and $400 at December 31, 1997 and 1996, respectively .......... 13,277 9,935
Other receivables ............................................... 620 1,056
Inventories ..................................................... 16,238 14,675
Prepaid and other assets ........................................ 1,083 1,070
Deferred income taxes ........................................... 1,404 1,721
-------- --------
Total current assets ............................................... 34,334 29,086
Notes receivable from officers ..................................... 724 724
Property, plant and equipment net .................................. 15,403 15,377
Cost in excess of net assets acquired, net ......................... 42,399 44,389
Other assets ....................................................... 2,867 3,444
Deferred income taxes .............................................. -- 1,036
-------- --------
Total assets ....................................................... $ 95,727 $ 94,056
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable ................................................ $ 3,493 $ 4,370
Accrued expenses ................................................ 2,403 3,287
Accrued payroll and commissions ................................. 2,332 1,726
Accrued restructuring costs ..................................... -- 1,155
Current portion long-term debt and capital lease obligations .... -- 88
-------- --------
Total current liabilities .......................................... 8,228 10,626
Deferred credits ................................................... 990 300
Long-term debt and capital lease obligations, less current portion . -- 3,563
Redeemable preferred stock:
Several Series; $1.00 par value, 6,300,000 shares authorized,
-0- shares issued and outstanding ............................. -- --
Shareholders' equity:
Common stock:
Common Stock, voting, $.01 par value; 30,000,000 shares
authorized, 7,335,649 shares issued and outstanding ........ 73 73
Common Stock, non-voting, $.01 par value; 4,000,000 shares
authorized, -0- shares issued and outstanding .............. -- --
Accumulated deficit ............................................. (3,459) (9,589)
Additional paid-in capital ...................................... 90,264 89,475
Cumulative translation adjustments .............................. (88) --
Deferred stock compensation ..................................... (281) (392)
-------- --------
Total shareholders' equity ......................................... 86,509 79,567
-------- --------
Total liabilities and shareholders' equity ......................... $ 95,727 $ 94,056
======== ========
</TABLE>
See accompanying notes.
F-3
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,
---------------------------------------
1997 1996 1995
-------- ------- --------
<S> <C> <C> <C>
Sales, net........................................................... $ 77,240 $65,664 $ 59,865
Cost of sales........................................................ 30,475 25,926 23,175
-------- ------- --------
Gross profit......................................................... 46,765 39,738 36,690
Operating expenses:
Selling, general and administrative............................. 30,334 26,799 27,077
Research and development........................................ 4,088 3,659 2,405
Amortization of intangibles..................................... 2,374 2,421 2,579
Write-off of acquired research and development.................. -- 2,380 --
Restructuring charges........................................... -- 3,093 --
-------- ------- --------
Total operating expenses............................................. 36,796 38,352 32,061
-------- ------- --------
Operating income from continuing operations.......................... 9,969 1,386 4,629
Interest income...................................................... 176 194 55
Interest expense..................................................... (280) (2,399) (3,118)
Other income, net.................................................... 234 525 114
-------- ------- --------
Income (loss) from continuing operations before income
tax expense ....................................................... 10,099 (294) 1,680
Income tax expense .................................................. 3,969 873 1,355
-------- ------- --------
Income (loss) from continuing operations............................. 6,130 (1,167) 325
-------- ------- --------
Discontinued operations:
Income from operations of discontinued surgical
Drapes segment (less applicable income tax expense
of $203 for the period ended December 31, 1995).............. -- -- 306
Loss on disposal of surgical drapes segment (less applicable
income tax benefit of $1,386)................................ -- (2,485)
-------- ------- --------
Net income (loss).................................................... $ 6,130 $(1,167) $ (1,854)
======== ======= ========
Pro forma:
Loss from continuing operations................................. $(1,243) $ (149)
Preferred stock dividends....................................... 1,170 --
------- --------
Loss from continuing operations available to
common shareholders.......................................... $(2,413) $ (149)
======= ========
Per share (1996 and 1995 pro forma):
Income (loss) from continuing operations available to
common shareholders ......................................... $ 0.84 $ (0.47) $ (0.03)
======== ======= ========
Net income (loss) available to common shareholders.............. $ 0.84 $ (0.47) $ (0.52)
======== ======= ========
Income (loss) from continuing operations available to common
Shareholders - assuming dilution............................. $ 0.82 $ (0.46) $ (0.03)
======== ======= ========
Net income (loss) available to common shareholders - assuming
dilution .................................................... $ 0.82 $ (0.46) $ (0.50)
======== ======= ========
Weighted average common shares outstanding........................... 7,323 5,105 4,474
======== ======= ========
Weighted average common shares outstanding - diluted................. 7,512 5,243 4,617
======== ======= ========
</TABLE>
See accompanying notes.
F-4
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
NON-VOTING COMMON
COMMON STOCK STOCK
---------------------- ------------------------ ACCUMULATED
SHARES AMOUNT SHARES AMOUNT DEFICIT
---------- ---------- ---------- ---------- -----------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1994 573,120 $ 6 426,777 $ 4 $ (6,997)
Net loss......................................................... -- -- -- -- (1,854)
Stock options exercised.......................................... 19,000 -- -- -- --
Accretion of cumulative preferred stock dividends................ -- -- -- -- (3,868)
---------- --------- --------- --------- ----------
Balance at December 31, 1995..................................... 592,120 6 426,777 4 (12,719)
Net loss......................................................... -- -- -- -- (1,167)
Accretion of cumulative preferred stock dividends................ -- -- -- -- (3,262)
Forgiveness of cumulative preferred stock dividends.............. -- -- -- -- 7,559
Stock options exercised.......................................... 104,600 1 -- -- --
Shareholders stock returned...................................... -- -- -- -- --
Acquisition of minority interest in subsidiary................... 8,000 -- -- -- --
Stock compensation, net of tax................................... -- -- -- -- --
Proceeds from initial public stock offering...................... 2,875,000 29 -- -- --
Conversion of preferred stock to common stock.................... 3,255,052 33 -- -- --
Conversion of non-voting common stock to voting common stock..... 426,777 4 (426,777) (4) --
---------- --------- --------- --------- ----------
Balance at December 31, 1996..................................... 7,261,549 73 -- -- (9,589)
Net income....................................................... -- -- -- -- 6,130
Stock options exercised.......................................... 74,100 -- -- -- --
Net tax benefits from stock options.............................. -- -- -- -- --
Amortization of unearned compensation............................ -- -- -- -- --
Translation adjustments.......................................... -- -- -- -- --
---------- --------- --------- --------- ----------
Balance at December 31, 1997..................................... 7,335,649 $ 73 -- $ -- $ (3,459)
========== ========= ========= ========= ==========
</TABLE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
SHAREHOLDERS' ADDITIONAL CUMULATIVE
NOTE PAID-IN UNEARNED TRANSLATION
RECEIVABLE CAPITAL COMPENSATION ADJUSTMENTS TOTAL
------------- ---------- ------------ ----------- --------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1994 $(349) $ -- $ -- $ -- $(7,336)
Net loss...................................................... -- -- -- -- (1,854)
Stock options exercised....................................... -- 22 -- -- 22
Accretion of cumulative preferred stock dividends............. -- (22) -- -- (3,890)
----- -------- -------- ----- -------
Balance at December 31, 1995.................................. (349) -- -- (13,058)
Net loss...................................................... -- -- -- -- (1,167)
Accretion of cumulative preferred stock dividends............. -- -- -- -- (3,262)
Forgiveness of cumulative preferred stock dividends........... -- -- -- -- 7,559
Stock options exercised....................................... -- 188 -- -- 189
Shareholders stock returned................................... 162 -- -- -- 162
Acquisition of minority interest in subsidiary................ -- 180 -- -- 180
Stock compensation, net of tax................................ -- 596 (392) -- 204
Proceeds from initial public stock offering................... -- 53,976 -- -- 54,005
Conversion of preferred stock to common stock................. 187 34,535 -- -- 34,755
Conversion of non-voting common stock to voting common stock.. -- -- -- -- --
----- -------- -------- ----- -------
Balance at December 31, 1996.................................. -- 89,475 (392) -- 79,567
Net income.................................................... -- -- -- -- 6,130
Stock options exercised....................................... -- 655 -- -- 655
Net tax benefits from stock options........................... -- 134 -- -- 134
Amortization of unearned compensation......................... -- -- 111 -- 111
Translation adjustments....................................... -- -- -- (88) (88)
----- -------- -------- ----- -------
Balance at December 31, 1997.................................. $ -- $90,264 $ (281) $ (88) $86,509
===== ======== ======== ===== =======
</TABLE>
See accompanying notes.
F-5
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
YEARS ENDED DECEMBER 31
-----------------------------------
1997 1996 1995
-------- -------- ---------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income (loss) ................................................... $ 6,130 $ (1,167) $ (1,854)
Adjustments to reconcile net income (loss) to net cash provided by
Operating activities:
Depreciation .................................................... 2,340 2,285 2,038
Amortization .................................................... 2,776 2,564 2,702
Loss on disposal of property and equipment ...................... 60 301 4,963
Translation adjustments ......................................... 288 41 (67)
Write-off of acquired research and development .................. -- 2,380 --
Changes in operating assets and liabilities net of effects of
purchased business
(Increase) decrease in accounts and other receivables, net .. (3,282) 2,456 (3,161)
(Increase) decrease in inventories, net ..................... (1,563) (2,530) 535
Decrease (increase) in deferred income taxes ................ 2,002 266 (494)
Increase (decrease) in other assets ......................... (251) (141) 130
Increase (decrease) in accounts payable and accrued expenses (980) (1,099) 2,510
Decrease in accrued restructuring costs ..................... (1,155) (512) (1,045)
-------- -------- --------
Net cash provided by operating activities ........................... 6,365 4,844 6,257
INVESTING ACTIVITIES
Purchases of property and equipment ................................. (2,426) (2,379) (2,969)
Loans to officers ................................................... -- 353 --
Proceeds from certificates of deposit ............................... 140 721 338
Purchase of other assets ............................................ -- (807) (1,388)
Purchases of businesses (including cash received) ................... -- 2,000 --
-------- -------- --------
Net cash used in investing activities ............................... (2,286) (112) (4,019)
FINANCING ACTIVITIES
Proceeds from revolving line of credit .............................. 12,302 29,416 28,810
Payments on revolving line of credit ................................ (15,450) (37,034) (24,986)
Payments on term notes payable and capital lease .................... (503) (26,096) (5,927)
Exercise of stock options ........................................... 655 189 --
Issuance of stock ................................................... -- 54,005 22
Repurchases of redeemable preferred stock ........................... -- (25,000) --
-------- -------- --------
Net cash used in financing activities ............................... (2,996) (4,520) (2,081)
-------- -------- --------
Net increase in cash and cash equivalents ........................... 1,083 212 157
Cash and cash equivalents at beginning of period .................... 629 417 260
-------- -------- --------
Cash and cash equivalents at end of period .......................... $ 1,712 $ 629 $ 417
======== ======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during
the period for:
Interest ........................................................ $ 282 $ 2,499 $ 3,118
======== ======== ========
Taxes ........................................................... $ 1,529 $ 579 $ 228
======== ======== ========
Increase (decrease) in preferred stock attributable to accretion
or forgiveness of cumulative preferred stock dividends:
Series A ........................................................ $ -- $ (141) $ 209
Series B ........................................................ -- (1,473) 1,223
Series C ........................................................ -- (2,684) 2,458
-------- -------- --------
$ -- $ (4,298) $ 3,890
======== ======== ========
Non-Cash financing and investing activities
Note receivable accepted in exchange for surgical drapes segment
Assets ........................................................ $ -- $ -- $ 1,125
======== ======== ========
Purchase of business with preferred stock, net of cash received . $ -- $ 4,583 $ --
======== ======== ========
Conversion of preferred stock to common ......................... $ -- $ 34,755 $ --
======== ======== ========
</TABLE>
See accompanying notes.
F-6
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
1. ORGANIZATION
Xomed Surgical Products, Inc. (the Company), a Delaware corporation was
organized on April 5, 1994 for the purpose of acquiring on April 15, 1994, all
of the outstanding stock of Xomed-Treace, Inc. and Xomed-Treace, P.R. Inc.
(collectively, Xomed, Inc.) and Merocel Corporation (Merocel). The Company had
no operations or material assets prior to this transaction. As the owners of the
Company were also owners of Merocel, these transactions have been accounted for
as if Xomed, Inc. were acquired by Merocel. Therefore, the assets and
liabilities of Merocel were not revalued and are presented in the accompanying
balance sheet at historical cost.
Xomed is a leading developer, manufacturer and marketer of a broad line of
surgical products for use by ear, nose and throat (ENT) specialists. The
Company's broad line of products, includes in its core ENT market, powered
tissue-removal systems and other microendoscopy instruments, implantable
devices, nerve monitoring systems and disposable fluid-control products. The
Company also offers a line of ophthalmic and other products. The Company sells
its products worldwide utilizing a sales force domestically and third party
distributors and wholly owned subsidiaries internationally. Trade credit is
extended based on consideration of the financial capabilities of the customer
and letters of credit are obtained in certain situations. Concentrations of
credit risk with respect to the Company's extending of trade credit, which
generally is not collateralized, is limited due to the large number of customers
and their dispersion across different geographic areas.
On April 16, 1996, the Company acquired TreBay Medical Corporation (TreBay)
which was involved in the development of ENT surgical specialty products. The
acquisition, which was accomplished through the issuance of preferred stock, was
accounted for under the purchase method of accounting and accordingly, the
results of operations have been included in the Company's consolidated financial
statements since the date of acquisition. The purchase price of approximately
$6,600 was allocated to the individual assets acquired and liabilities assumed
based upon their respective fair values at the date of acquisition. The
transaction resulted in cost in excess of net assets acquired of approximately
$4,400, of which $2,400 was allocated to in-process research and development and
was subsequently written off. The executive management of TreBay replaced former
management of the Company (see Note 7). The acquisition was funded through the
issuance of approximately $2,800 of redeemable preferred stock and $3,700 of
convertible preferred stock.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements of the Company include the accounts
of Merocel and subsidiary, TreBay, and Xomed, Inc. and subsidiaries. Significant
intercompany transactions and balances between entities have been eliminated.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid short-term investments with
original maturities of three months or less when purchased to be cash
equivalents.
F-7
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INVENTORY VALUATION
Inventories are generally stated at average cost on a first-in, first-out
valuation basis not in excess of market. Market for raw materials is based on
replacement costs and for work-in-process and finished goods on net realizable
value.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at cost. Expenditures for
maintenance and repairs are charged to expense as incurred. Additions,
improvements and major replacements are capitalized. The costs and accumulated
depreciation related to assets sold or retired are removed from the accounts and
any gain or loss is credited or charged to income. Depreciation is computed
using the straight-line method based on the estimated useful lives of the
related asset categories as follows--building and building improvements 27 to 35
years and machinery and equipment including assets under capital leases 3 to 15
years.
INCOME TAXES
The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standard No. 109, "Accounting for Income Taxes", which
requires the use of the liability method of accounting for deferred income
taxes.
REVENUE RECOGNITION
The Company recognizes revenue when inventory is shipped to the customer.
AMORTIZATION
Amortization of cost in excess of assets acquired is amortized over 25
years. Accumulated amortization totaled $7,680 and $5,689 as of December 31,
1997 and 1996, respectively. Amortization of other intangibles is amortized
straight-line over the life of the related agreement ranging from four to 15
years.
The recoverability of goodwill is periodically assessed by the Company at
the product line level. Cash flows and profitability of each product line as
well as changes in the operations of businesses acquired are reviewed to
determine if impairment exists. If this review indicates that goodwill will not
be recoverable, the Company's carrying value of the goodwill is reduced by the
estimated shortfall of discounted cash flows.
In July 1995, the Company disposed of its surgical drapes segment, and
included a reduction of goodwill totaling $5,805 in the loss on disposal of
discontinued operations.
RESEARCH AND DEVELOPMENT
Expenditures related to research and development of new products and
processes, including research related to product alternatives, are expensed as
incurred.
F-8
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
TRANSLATION ADJUSTMENTS
Prior to the fourth quarter of 1997, translation gains and losses of
foreign currencies related to foreign operations are included in income from
operations and totaled $341 (loss), $41 (loss) and $67 (gain) for the ten months
ended October 31, 1997, and years ended December 31, 1996 and 1995,
respectively. The financial results of these foreign operations were translated
using a combination of current and historical rates. Subsequent to October 1997,
translation gains and losses are included as a component of shareholder's
equity, assets and liabilities of the foreign operations are translated at
current rates, and revenues and expenses are translated at average rates during
the period. This change resulted from a change in the designation of the
functional currency from the U.S. Dollar to the foreign currency due to
decreased dependence of the foreign operations on their parent for financing,
marketing and distribution activities.
STOCK COMPENSATION
The Company follows the intrinsic value method of accounting for stock
based compensation prescribed in ACCOUNTING PRINCIPLES BOARD OPINION NO. 25
ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. Accordingly, stock compensation
expense is measured as the excess if any, of the quoted market price of the
Company's stock at the date of grant over the exercise price.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
EARNINGS PER SHARE
In 1997, the Financial Accounting Standards Board issued Statement No. 128,
EARNINGS PER SHARE. Statement 128 replaced the calculation of primary and fully
diluted earnings per share with basic and diluted earnings per share. Unlike
primary earnings per share, basic earnings per share exclude any dilutive
effects of options, warrants and convertible securities. Diluted earnings per
share are very similar to the previously reported fully diluted earnings per
share. All earnings per share amounts for all periods have been presented, and
where appropriate restated, to conform to the Statement 128 requirements.
RECLASSIFICATIONS
Certain prior year amounts in the consolidated financial statements
have been reclassified to conform to the current year presentation.
3. DISCONTINUED OPERATIONS
During mid 1995, the Company approved a plan to dispose of and finalized an
agreement for the disposal of all operating assets, inventory, patents and
license agreements of its surgical drapes segment in exchange for cash, notes
receivable, inventory and fixed assets related to several otology product lines
of a nonrelated entity. Management decided the surgical drapes were not part of
the Company's core business and disposed of this product line in exchange for
the head and neck product line of another entity which is more compatible with
the Company's other products. There was no intent to dispose of the surgical
drapes segment at the time of the Xomed-Treace acquisition. The operating
results of the otology product lines were not significant to the Company's
overall results of operations during 1995.
F-9
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
3. DISCONTINUED OPERATIONS (CONTINUED)
Certain financial information related to the surgical drapes product
line, which was acquired from Xomed-Treace on April 15, 1994, is as follows:
1997 1996 1995
---- ---- ------
Sales....................................... $ -- $ -- $5,385
==== ==== ======
Pre-tax income.............................. $ -- $ -- $ 509
==== ==== ======
Income tax expense.......................... $ -- $ -- $ 203
==== ==== ======
Net income.................................. $ -- $ -- $ 306
==== ==== ======
The surgical drapes business accounts consisted principally of inventory,
fixed assets and related goodwill aggregating approximately $7,100 on the date
of disposition. Interest expense attributed to the drapes business was $56 for
1995. The Company realized a net loss of $2,485, after income tax benefits of
$1,386, on this transaction and has restated its financial statements for the
discontinued operations. The loss on disposal was computed as the difference
between the carrying value of the surgical drapes segment assets disposed of and
the estimated fair value of the assets received related to the otology product
lines. There were no significant intangibles such as customer lists or patents
acquired in connection with the otology product lines, nor was any work force
transferred. The components of the loss on disposal in 1995 are as follows:
Cash and notes receivable acquired..................... $ 2,250
Less: Transaction fees................................. (316)
Goodwill related to the surgical drapes segment.. (5,805)
-------
Pre-tax loss........................................... (3,871)
Tax benefit............................................ 1,386
------
Net loss on disposition................................ $(2,485)
=======
The inventory and fixed assets of the otology product lines acquired were
recorded at fair values of $1,170 and $154, respectively, which approximated the
aggregate carrying value of assets disposed of related to the surgical drapes
business.
Included in other receivables and other assets as of December 31, 1996 are
notes receivable of $375 and $375, respectively, related to this transaction. As
part of the transaction both parties agreed to manufacture their existing
products through the end of 1995 and supply those products to the other party at
cost.
F-10
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
4. INVENTORIES
Inventories are summarized as follows:
DECEMBER 31,
---------------------------
1997 1996
------- -------
Finished goods................................ $10,224 $ 7,654
Work in process............................... 1,447 2,006
Raw materials and packaging................... 6,584 6,066
Reserve for obsolescence...................... (2,017) (1,051)
------- -------
$16,238 $14,675
======= =======
The reserve for obsolescence increased by $966, $650, and $61 for 1997,
1996, and 1995, respectively.
5. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment, at cost, less allowances for depreciation,
is as follows:
DECEMBER 31,
----------------------
1997 1996
-------- --------
Land and land improvements ....... $ 1,413 $ 1,413
Building and building improvements 6,564 6,360
Machinery and equipment .......... 14,959 13,317
-------- --------
22,936 21,090
Allowances for depreciation ...... (8,734) (6,685)
-------- --------
14,202 14,405
Capital projects in process ...... 1,201 972
-------- --------
$ 15,403 $ 15,377
======== ========
Depreciation expense, including expense on assets under capital lease
obligations, is approximately $2,312, $2,285,and $2,038 for the years ended
December 31, 1997, 1996 and 1995, respectively.
6. FINANCIAL INSTRUMENTS
The Company enters into foreign currency forward exchange contracts to
hedge intercompany trade accounts receivable from its foreign subsidiaries. The
Company's forward exchange contracts do not subject the Company to risk from
exchange rate movements because gains and losses on such contracts offset gains
and losses on the trade accounts receivable being hedged. If the counterparties
to the forward exchange contracts do not fulfill their obligations to deliver
the contracted currencies, the Company could be at risk for any currency
exchange rate movements.
For intercompany receivables, the contracts require the Company to sell
foreign currencies, Australian Dollar, Canadian Dollar, British Pound, French
Franc and the German Duetschmark, in exchange for the U.S. Dollar. At December
31, 1997, the Company held $7,000 in foreign currency forward exchange
contracts, which mature, in early 1998. These contracts are marked to market
each month. The resulting gains or losses are reflected in income and are
generally offset by gains or losses on the exposures being hedged.
F-11
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
7. ACCRUED RESTRUCTURING COSTS
Incident to the acquisition of Xomed-Treace in April 1994, the Company
initiated a plan to restructure certain of its operations and established a
reserve of $3,258 as part of the cost of the acquired business associated
primarily with closing a plant facility and significantly reducing the Company's
work force. At December 31, 1996, there was no remaining accrued restructuring
costs.
In conjunction with the purchase of TreBay, the Company recorded an accrual
totaling $647 related to severance and relocation costs ($598) and lease
termination costs ($49). All employees of TreBay were terminated, except the
officers and two other individuals who relocated to Jacksonville, Florida, the
corporate headquarters of the Company. For the period from the acquisition date
through December 31, 1996, $250 was paid related to termination and relocation
benefits, $49 was paid related to lease termination costs and $162 was paid
related to other acquisition cost. During 1997 the Company utilized the
remaining reserve as follows: $82 was paid related to termination and
relocation, $61 was paid related to lease termination, and $43 related to other
exit costs.
Simultaneous with the purchase of TreBay and a plan by new management to
combine certain operations, (see Note 1), the Company recorded a restructuring
accrual of $3,100 which was comprised of $2,500 of termination benefits and $600
of other exit costs. The reductions included 20 management and administrative
employees the Company's Mystic, Connecticut manufacturing facility, 17
management and administrative employees at the Company's Jacksonville, Florida
headquarters, 13 management and production employees at the Company's St. Louis,
Missouri manufacturing facility and 2 management level employees
internationally. For the period from the accrual date through the end of 1996,
the Company had paid out termination benefits totaling $2,000 and paid
approximately $100 related to other exit costs. As of December 31, 1996, the
Mystic, Connecticut facility maintained only manufacturing operations, and in
December 1996, the St. Louis facility was closed. During 1997 the Company
utilized the remaining reserve as follows: paid termination benefits of $500,
wrote off property related to the St. Louis facility closure of approximately
$300, paid other exit costs of $100 and reversed the remaining reserve of
approximately $100 against selling general and administrative expenses.
8. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
The Company was obligated under long-term debt and capital lease
obligations as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------
1997 1996
------ ------
<S> <C> <C>
Revolving line-of-credit agreement with interest payable monthly and
all outstanding principal due May 5, 2000; interest at LIBOR
(5.72% at December 31, 1997) Plus 1.5% or at the lender's base
rate (8.5% at December 31,
1997) ........................................................... $ -- $3,148
Note payable under capital lease obligation to vendor in quar-
terly principal and interest installments of $36 through October
1, 1997 and a final payment of $415 on January 1, 1998. The
note was paid off early in December 1997. The note carried
interest at 10.8% ............................................... -- 503
------ ------
-- 3,651
Less current portion ............................................... -- 88
------ ------
$ -- $3,563
====== ======
</TABLE>
F-12
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
8. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS (CONTINUED)
In May 1997, the Company entered into an Amended and Restated Credit
Agreement (the Credit Agreement) with the bank. Under the terms of the Credit
Agreement, the Company may borrow under a line-of-credit up to a maximum
capacity of $25,000 to be used for working capital and operating needs and
acquisitions. The amount available to the Company at any given time is based
upon various percentages of the Company's outstanding inventories and accounts
receivable and certain other assets. Availability at December 31, 1997 was
approximately $21,000. Any principal amounts outstanding on the line-of-credit
in excess of the borrowing base must be repaid by the Company. In any event, all
outstanding principal on the line-of-credit is due and payable on May 5, 2000.
The Company pays a quarterly commitment fee which varies from .25% to .125% per
annum on the average daily unused balance on the line-of-credit during the
preceding calendar quarter.
The line-of-credit is collateralized by the receivables and inventory
of the Company and certain land and buildings at the Mystic, Connecticut
facility with a net book value of $34,506. The debt agreement has restrictions
regarding payment of dividends, incurrence of additional debt and requires
compliance with various financial covenants.
9. SHAREHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK
In October 1996, in conjunction with the Company's Initial Public
Offering of stock, all Series A and B Convertible Preferred shares were
converted to Common Stock, approximately 80% of the Series C Redeemable
Preferred Stock was redeemed for cash and the balance was converted to Common
Stock and the Non-Voting Common Stock was converted to Common Stock.
In September 1996, the Company authorized 1,000,000 shares of a new
issue of preferred stock. The stock is undesignated as to its rights,
preferences and limitations which the Board of Directors is authorized to set at
a future date prior to issuance.
During the year ended December 31, 1995, the Company issued 19,000 shares
of Common Stock under the employee stock incentive plan. The stock was issued at
option prices of between $1.00 to $2.00 per share and resulted in $22 of
additional paid-in capital.
COMMON STOCK
Each share of Common Stock and Non-Voting Common Stock (collectively Common
Equity) entitles its holder to receive dividends as declared by the Company's
Board of Directors, subject to the preferences and other rights of the Series A,
Series B and Series C Redeemable Preferred Stock. Each share of Non-Voting
Common Stock is convertible into one share of Common Stock at the election of
the shareholder.
During 1996, the Company amended and restated its Restated Certificate of
Incorporation to, among other things, (i) change the designation of its Class A
Common Stock to "Common Stock," (ii) change the designation of its Class B
Common Stock to "Non-Voting Common Stock," (iii) increase the number of
authorized shares of Common Stock to 30,000,000 and (iv) authorize a class of
undesignated Preferred Stock, par value $.01 per share.
F-13
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
9. SHAREHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK (CONTINUED)
REDEEMABLE PREFERRED STOCK
Each share of Series A (1.2 million shares authorized) and Series B (3.5
million shares authorized) Convertible Preferred Stock (collectively Convertible
Preferred Stock) entitles its holder to receive an annual cumulative cash
dividend at the rate of six percent per annum, payable on a quarterly basis. At
the election of the Board of Directors, dividends may be paid in shares of
Series A or Series B Convertible Preferred Stock, respectively, in lieu of cash.
Dividends are cumulative and must be paid prior to any dividends being paid on
the Common Equity. The Company at its option, with the majority consent of the
holders of the Convertible Preferred Stock, may redeem any or all of the
outstanding shares of the Convertible Preferred Stock at a price of $9.58 per
share, plus accrued dividends. The Series A Convertible Preferred Stock is voted
along with the Common Equity on an as converted basis, whereas the Series B has
no voting rights.
In any event, any outstanding shares of the Convertible Preferred Stock at
April 15, 2001 are required to be redeemed on that date by the Company at $9.58
per share, plus accrued dividends. Each share of Convertible Preferred Stock, at
the election of the holder, may be converted for one share of like Common Equity
(the conversion rate being subject to adjustment from time-to-time).
Each share of Series C Redeemable Preferred Stock (Series C Preferred
Stock) (364,673 shares authorized) entitles its holder to receive an annual
cumulative cash dividend at the rate of nine percent per annum, payable on a
quarterly basis. At the election of the Board of Directors, dividends may be
paid in shares of Series C Preferred Stock in lieu of cash. Dividends are
cumulative and must be paid prior to any dividends being paid on the Common
Equity. The Company at its option, with the majority consent of the holders of
the Series C Preferred Stock, may redeem any or all of the outstanding shares of
the Series C Preferred Stock at a price of $100.00 per share, plus accrued
dividends.
In any event, any outstanding shares of the Series C Preferred Stock at
April 15, 2001 are required to be redeemed on that date by the Company at
$100.00 per share, plus accrued dividends.
In April 1996, the Company acquired all of the outstanding stock of TreBay
in exchange for 390,000 shares of Series A convertible preferred stock and
28,470 shares of Series C redeemable preferred stock.
F-14
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
9. SHAREHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK (CONTINUED)
The following table presents changes in redeemable preferred stock (dollars
in thousands):
<TABLE>
<CAPTION>
SERIES A SERIES B SERIES C
PREFERRED STOCK PREFERRED STOCK PREFERRED STOCK
------------------------ ------------------------ ---------------------------
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT
----------- -------- ---------- --------- --------- -----------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1994....... 364,215 $ 3,632 2,127,838 $ 21,251 273,063 $ 28,996
Accretion of dividends............. -- 209 -- 1,223 -- 2,458
----------- -------- ---------- --------- --------- -----------
Balance at December 31, 1995....... 364,215 3,841 2,127,838 22,474 273,063 31,454
Accretion of dividends............. -- 263 -- 922 -- 2,077
Forgiveness of dividends........... -- (404) -- (2,395) -- (4,761)
Shareholders stock returned........ (9,563) (91) -- -- (2,074) (208)
Issuance of shares for TreBay
Medical.......................... 390,000 3,736 -- -- 28,470 2,847
Redemption of preferred stock...... -- -- -- -- (235,327) (25,000)
Conversion of preferred stock to
common Stock...................... (744,652) (7,345) (2,127,838) (21,001) (64,132) (6,409)
----------- -------- ---------- --------- --------- -----------
Balance at December 31, 1996....... -- $ -- -- $ -- -- $ --
=========== ======== ========== ========= ========= ===========
</TABLE>
10. RETIREMENT BENEFITS
Retirement benefits are provided to all eligible employees through the
participation in defined contribution plans maintained by the Company which
comply with the provisions of Section 401(k) of the Internal Revenue Code (the
"Savings Plans"). The provisions of the Savings Plans differ with respect to
employee contributions, employer matching percentages and profit sharing
depending on the country in which the employees work. Expense recorded by the
Company for the various plans for the years ended December 31, 1997, 1996 and
1995 was approximately $481, $510, and $520, respectively.
11. EMPLOYEE STOCK INCENTIVES
The Company has reserved an aggregate of 1,078,000 shares of its Common
Stock for grant or sale to key employees of the Company. As of December 31, 1997
and 1996, 295,534 and 184,534 options, respectively, were available for
additional grants. These shares may be issued in such amounts and in such a
manner (including stock options, restricted stock grants, stock bonuses, or
other stock incentive programs) as determined by the Company's Board of
Directors from time-to-time. In general, the options are granted at exercise
prices equal to the fair market value of common stock on the date of grant, have
a life of 10 years and provide for vesting over a number of years. As of
December 31, 1997, 160,391 shares were exercisable. Total stock based
compensation cost recognized in the Statement of Operations for the years ended
December 31, 1997, 1996 and 1995 was $111, $54 and $0, respectively. The
following table summarizes option activity, which may be exercised at various
dates through January 2007:
F-15
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
11. EMPLOYEE STOCK INCENTIVES (CONTINUED)
<TABLE>
<CAPTION>
1997 1996
WEIGHTED WEIGHTED
AVERAGE AVERAGE
1997 EXERCISE 1996 EXERCISE
OPTIONS PRICE OPTIONS PRICE 1995
------------- ---------- ------------ -------- -----------
<S> <C> <C> <C> <C> <C>
Beginning of the period options outstanding... 468,866 $ 8.99 251,350 $ 5.67 257,100
Options granted............................... 202,000 15.77 421,666 9.15 8,000
Options exercised............................. (74,100) 8.34 (104,600) 1.81 (6,750)
Options canceled.............................. (13,000) 12.14 (99,550) 8.87 (7,000)
------------- ------------ -----------
End of period options outstanding............. 583,766 11.99 468,866 8.99 251,350
============ ===========
Options granted range of option prices........ $15.06-$20.38 $9.36-$10.65 $9.58
============= ============ ===========
Options exercised range of option prices ..... $1.00-$10.65 $1.00-$9.58 $1.00-$2.00
============= ============ ===========
</TABLE>
The Company has adopted the disclosure-only provisions of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation." Accordingly, no compensation cost has been recognized for stock
options issued with exercise prices equal to the fair value of the common stock
on the date of grant. Statement No. 123 requires the determination of fair value
of all options utilizing stock option valuation models. In management's opinion,
existing stock option valuation models do not provide a reliable single measure
of the fair value of employee stock options that have vesting provisions and are
not transferable. In providing the pro forma disclosures below, the Company used
the Black-Scholes option pricing model with the following weighted average
assumptions: 1) an expected volatility factor for the Company's stock of .31; 2)
a risk-free interest rate of 6.5%; 3) an expected life of options of 3 years;
and 4) no dividend payments. The weighted-average grant date fair value of
options granted in 1997 and 1996 was $4.59 and $4.01, respectively. Had
compensation cost for the Company's stock option plan been determined based on
the fair value at the grant date for awards consistent with the provisions of
SFAS No. 123, the Company's net income (loss) from continuing operations and
income (loss) per share from continuing operations would be as follows:
1997 1996 1995
------ ------- ------
Pro forma net income (loss)--as reported......... $6,130 $(2,413) $(149)
Pro forma net income (loss)--adjusted............ $5,908 $(2,545) $(150)
Pro forma income (loss) per share--as reported... $ .84 $ (0.47) $(0.03)
Pro forma income (loss) per share--adjusted...... $ .81 $ (0.50) $(0.03)
F-16
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
12. EARNINGS PER SHARE
The following table sets forth the computation of shares for purposes of the
earnings per share calculation (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
----- ----- -----
<S> <C> <C> <C>
Weighted average shares outstanding ................... 7,323 5,105 4,474
Net effect of dilutive stock options - based on the
treasury stock method................................ 189 138 --
----- ----- -----
Totals................................................. 7,512 5,243 4,474
===== ===== =====
</TABLE>
13. INCOME TAXES
The provision for income taxes (benefit) from continuing operations
consists of the following:
<TABLE>
<CAPTION>
1997 1996 1995
------- ---- -------
<S> <C> <C> <C>
Current:
Domestic:
Federal....................................... $ 1,801 $496 $ 206
State......................................... 360 206 33
Foreign......................................... 65 -- --
------- ---- -------
2,226 702 239
Deferred:
Domestic........................................ 1,527 540 1,116
Foreign......................................... 216 (369) --
------- ---- -------
$3,969 $873 $ 1,355
======= ==== =======
</TABLE>
During 1997 and 1996, the Company's tax liability was decreased $134 and
$150, respectively, and additional paid-in capital increased due to the early
disposition of stock by a stock option holder. During 1997, the Company utilized
approximately $650 of operating loss carryforwards thereby reducing its current
liability.
F-17
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
13. INCOME TAXES (CONTINUED)
Income tax expense (benefit) from continuing operations reconciled to the
amount computed at statutory rates is as follows:
<TABLE>
<CAPTION>
1997 1996 1995
------ ----- -------
<S> <C> <C> <C>
Federal tax (benefit) at statutory rate..................... $3,434 $(103) $ 588
Purchased in-process research and development............... -- 833 --
State income taxes (net of federal income tax effect)....... 442 92 136
Increase in valuation allowance on foreign losses........... 156 -- 387
Tax benefits related to export sales........................ (209) -- --
Loss from unconsolidated subsidiary for tax purposes........ -- -- 192
Other, net.................................................. 146 51 52
------ ----- -------
$3,969 $ 873 $ 1,355
====== ===== =======
</TABLE>
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred income taxes are as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1997 1996
------- ------
<S> <C> <C>
Deferred income tax assets:
Net operating loss carryforwards...................... $ 1,505 $1,131
Losses from foreign operations........................ 1,008 1,068
Patents and other intangibles......................... 511 553
Inventory............................................. 997 728
Non-deductible accrued expenses....................... 583 436
AMT credit............................................ 44 333
Severance accruals.................................... 27 566
------- ------
4,675 4,815
Valuation allowance................................... (741) (585)
------- ------
3,934 4,230
------- ------
Deferred income tax liabilities:
Amortization of goodwill.............................. (2,118) (570)
Depreciation.......................................... (712) (562)
Purchased research and development.................... (215) (298)
Deductible prepaid expenses........................... -- (27)
------- ------
(3,045) (1,457)
------- ------
$ 889 $2,773
======= ======
</TABLE>
The valuation allowance at December 31, 1997 and 1996 relates to
certain losses from foreign operations incurred prior to 1996 which management
believes the ultimate realization of the related tax benefits is not more likely
than not at the present time. This allowance was increased $156 and $6 for 1997
and 1996, respectively, for losses of these foreign operations. Foreign losses
totaling approximately $2,300 can be carried forward for periods ranging from
five years to indefinitely. Undistributed earnings reinvested indefinitely in
foreign subsidiaries as working capital and plant and equipment aggregated $77.
Domestic loss carryforwards total $4,071 and expire in 2009 through 2011.
F-18
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
14. RELATED PARTY TRANSACTIONS
At December 31, 1997 and 1996, the Company had outstanding a note
receivable totaling $724 from an officer, which is collateralized by 44,460
shares of the Company's common stock, bears interest at 10%, becomes a demand
note on November 7, 2000 and, in any event, is payable in full by November 7,
2002.
In connection with the acquisition of TreBay Medical Corporation in April
1996, a significant shareholder of the Company made loans to three officers to
acquire the Company's stock. At December 31, 1996, the aggregate principal value
of notes payable to the shareholder from the officers was $1,900. The notes are
secured by a total of 172,173 shares of the Company's common stock, bear
interest at 7% and become payable in full on April 16, 2001. The officers are
obligated to apply 50% of the after-tax amount of any Company bonuses to unpaid
interest and principal.
15. LEASE COMMITMENTS
The Company was committed under noncancelable operating leases with terms
in excess of one year involving certain property and equipment. Rental expense
on all rental agreements totaled $706, $790, and $417 for the years ended
December 31, 1997, 1996 and 1995, respectively. In general, the Company has
options to renew its leases for varying periods of time. Annual minimum rental
commitments under these leases are as follows:
YEAR ENDING DECEMBER 31,
------------------------
1998........................................ $ 602
1999........................................ 204
2000........................................ 158
2001........................................ 127
2002 and thereafter......................... 124
------
$1,215
======
16. CONTINGENCIES
The Company is subject to various claims and legal proceedings covering a
wide range of matters that arise in the ordinary course of its business
activities, including product liability claims. Management believes that any
liability that may ultimately result from the resolution of these matters will
not have a material adverse effect on the financial condition or results of
operations of the Company.
The Internal Revenue Service is currently examining tax returns for years
1994 through 1996. Management believes the ultimate resolution of this
examination will not result in a material adverse effect to the Company's
financial position or results of operations.
F-19
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
17. SEGMENT INFORMATION
The Company's subsidiaries operate distribution facilities in a number of
foreign countries. Currently, international subsidiaries are present in Canada,
Australia, United Kingdom, France and Germany. These subsidiaries represent
approximately 15% of 1997 total sales of the Company, with France representing
the largest portion of this with 4% of total sales. Inter-area sales are not
significant to the total sales of any one geographic area.
<TABLE>
<CAPTION>
INFORMATION ABOUT THE COMPANY'S OPERATIONS
IN DIFFERENT GEOGRAPHIC AREAS
--------------------------------------------
INCOME
(LOSS) FROM IDENTIFIABLE
SALES OPERATIONS ASSETS
------- ----------- ------------
<S> <C> <C> <C>
1997:
United States $65,958 $10,124 $89,553
International Operations 11,282 (25) 6,174
------- ------- -------
Consolidated $77,240 $10,099 $95,727
======= ======= =======
1996:
United States $55,034 $ 628 $88,788
International Operations 10,630 (922) 5,268
------- ------- -------
Consolidated $65,664 $ (294) $94,056
======= ======= =======
1995:
United States $51,644 $ 2,801 $87,873
International Operations 8,221 (1,121) 5,250
------- ------- -------
Consolidated $59,865 $ 1,680 $93,123
======= ======= =======
</TABLE>
The Company had export sales of $12,200, $10,400 and $9,400 in 1997, 1996
and 1995, respectively, representing 16%, 16% and 15% of total sales,
respectively.
F-20
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
18. PRO FORMA STATEMENT OF OPERATIONS (UNAUDITED)
PRO FORMA STATEMENT OF OPERATIONS
The following unaudited pro forma statement of operations for the year
ended December 31, 1996 reflects the statement of operations of the Company for
the periods presented as if TreBay was purchased on January 1, 1995. The pro
forma statement of operations should be read in conjunction with the financial
statements and notes thereto included elsewhere herein.
<TABLE>
<CAPTION>
YEAR ENDED THREE MONTHS
DECEMBER 31, ENDED MARCH 30,
1996 1996
------------ ---------------
XOMED TREBAY ADJUSTMENTS PROFORMA
------------ --------------- ----------- --------
<S> <C> <C> <C> <C>
Sales, net ...................................... $ 65,664 $ 279 $-- $ 65,943
Cost of sales ................................... 25,926 219 -- 26,145
-------- ----- ----- --------
Gross profit .................................... 39,738 60 -- 39,798
Operating Expenses:
Selling, general and administrative ........ 26,799 299 (154)(a) 26,944
Research and development ................... 3,659 138 (66)(a) 3,731
Amortization of intangibles ................ 2,421 -- -- 2,421
Write-off of acquired research and
development ............................ 2,380 -- -- 2,380
Restructuring charges ...................... 3,093 -- -- 3,093
-------- ----- ----- --------
Total operating expenses ........................ 38,352 437 (220) 38,569
-------- ----- ----- --------
Operating income (loss) from continuing
operations ................................. 1,386 (377) 220 1,229
-------- ----- ----- --------
Interest expense, net ........................... (2,205) -- -- (2,205)
Other income, net ............................... 525 54 -- 579
-------- ----- ----- --------
Income (loss) before income tax expense
(benefit) .................................... (294) (323) 220 (397)
Income tax expense (benefit) .................... 873 -- (27)(a) 846
-------- ----- ----- --------
Net income (loss) ............................... $ (1,167) $(323) $ 247 (1,243)
======== ===== =====
Preferred stock dividends ....................... 1,170
--------
Net (loss) attributable to common shareholders.. $ (2,413)
========
Pro forma net (loss) per share (b).............. $ (0.47)
========
Pro forma weighted average shares outstanding (b) 5,105
========
<FN>
- ----------
(a) Elimination of general and administrative expenses which are duplicative
and will not be incurred subsequent to the purchase date, amortization of
acquired developed research and development, non-cash compensation expense
related to stock options granted, closing of the TreBay facility and
calculation of income tax benefit on the TreBay loss after adjustments.
(b) See Note 19.
</FN>
</TABLE>
F-21
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
19. PRO FORMA NET INCOME PER SHARE
Pro forma net income per share is computed based on the weighted average
number of shares of common stock outstanding assuming conversion on January 1,
1995 of: 1) all Series A and B Convertible Preferred Stock outstanding as of
December 31, 1995; 2) 390,000 shares of Series A Convertible Preferred Stock
issued in the purchase of TreBay; 3) all stock options issued after December 31,
1995 which have been assumed to be outstanding as of January 1, 1995; and 4) the
conversion of 60,225 shares of Series C Preferred Stock into 300,354 shares of
Common Stock subsequent to the initial public offering, based upon the initial
public offering price of $21.00 per share.
F-22
EXHIBIT 23.2
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement (Form
S-8 No. 333-35541) filed on September 12, 1997 pertaining to the Third Amended
and Restated 1996 Stock Option Plan of Xomed Surgical Products, Inc. of our
report dated February 16, 1998, with respect to the consolidated financial
statements of Xomed Surgical Products, Inc. included in the Annual Report (Form
10-K) for the year ended December 31, 1997.
Ernst & Young LLP
March 25, 1998
Jacksonville, Florida
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-END> DEC-31-1997
<CASH> 1,712
<SECURITIES> 0
<RECEIVABLES> 14,012
<ALLOWANCES> 735
<INVENTORY> 16,238
<CURRENT-ASSETS> 34,334
<PP&E> 24,137
<DEPRECIATION> 8,734
<TOTAL-ASSETS> 95,727
<CURRENT-LIABILITIES> 8,228
<BONDS> 0
0
0
<COMMON> 73
<OTHER-SE> 86,436
<TOTAL-LIABILITY-AND-EQUITY> 95,727
<SALES> 77,240
<TOTAL-REVENUES> 77,240
<CGS> 30,475
<TOTAL-COSTS> 30,475
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 280
<INCOME-PRETAX> 10,099
<INCOME-TAX> 3,969
<INCOME-CONTINUING> 6,130
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 6,130
<EPS-PRIMARY> 0.84
<EPS-DILUTED> 0.82
</TABLE>
