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