XNAS:IART Integra Lifesciences Holdings Corp Quarterly Report 10-Q Filing - 9/30/2012

Effective Date 9/30/2012

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 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 September 30, 2012
 
o
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. 0-26224
 
INTEGRA LIFESCIENCES HOLDINGS CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
DELAWARE
 
51-0317849
(STATE OR OTHER JURISDICTION OF
INCORPORATION OR ORGANIZATION)
 
(I.R.S. EMPLOYER
IDENTIFICATION NO.)
 
 
311 ENTERPRISE DRIVE
PLAINSBORO, NEW JERSEY
 
08536
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
 
(ZIP CODE)
REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (609) 275-0500
 
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  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer
x
Accelerated filer
o
 
 
 
 
Non-accelerated filer
o  (Do not check if a smaller reporting company)
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  ý
The number of shares of the registrant’s Common Stock, $0.01 par value, outstanding as of October 22, 2012 was 27,045,530.




INTEGRA LIFESCIENCES HOLDINGS CORPORATION
INDEX
 
 
Page
Number
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exhibit 31.1
 
Exhibit 31.2
 
Exhibit 32.1
 
Exhibit 32.2
 
EX-101 INSTANCE DOCUMENT
 
EX-101 SCHEMA DOCUMENT
 
EX-101 CALCULATION LINKBASE DOCUMENT
 
EX-101 DEFINITION LINKBASE DOCUMENT
 
EX-101 LABELS LINKBASE DOCUMENT
 
EX-101 PRESENTATION LINKBASE DOCUMENT
 




PART I. FINANCIAL INFORMATION

Item  1. Financial Statements

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME
(UNAUDITED)
(In thousands, except per share amounts)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
Total Revenue
$
210,084

 
$
202,185

 
$
616,439

 
$
576,555

Costs and Expenses:
 
 
 
 
 
 
 
Cost of goods sold
79,548

 
78,651

 
232,497

 
216,410

Research and development
13,105

 
13,187

 
38,148

 
38,049

Selling, general and administrative
93,077

 
87,508

 
276,585

 
263,324

Intangible asset amortization
4,618

 
4,548

 
13,985

 
11,609

Total costs and expenses
190,348

 
183,894

 
561,215

 
529,392

Operating income
19,736

 
18,291

 
55,224

 
47,163

Interest income
100

 
154

 
893

 
354

Interest expense
(5,549
)
 
(7,587
)
 
(20,581
)
 
(19,778
)
Other income (expense), net
(31
)
 
429

 
(118
)
 
379

Income before income taxes
14,256

 
11,287

 
35,418

 
28,118

Income tax (benefit) expense
1,045

 
44

 
7,000

 
4,689

Net income
$
13,211

 
$
11,243

 
$
28,418

 
$
23,429

Basic net income per common share
$
0.46

 
$
0.39

 
$
1.00

 
$
0.80

Diluted net income per common share
$
0.46

 
$
0.39

 
$
0.99

 
$
0.79

Weighted average common shares outstanding (See Note 12):
 
 
 
 
 
 
 
Basic
28,446

 
28,583

 
28,403

 
29,234

Diluted
28,777

 
29,029

 
28,629

 
29,820

Comprehensive income (loss) (See Note 13)
$
17,106

 
$
(7,894
)
 
$
28,016

 
$
21,945


The accompanying notes are an integral part of these condensed consolidated financial statements.

3


INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(In thousands)
 
 
September 30,
2012
 
December 31,
2011
ASSETS
 
 
 
Current Assets:
 
 
 
Cash and cash equivalents
$
125,718

 
$
100,808

Trade accounts receivable, net of allowances of $6,695 and $6,978
119,527

 
118,129

Inventories, net
169,376

 
171,261

Deferred tax assets
64,575

 
36,155

Prepaid expenses and other current assets
14,366

 
25,904

Total current assets
493,562

 
452,257

Property, plant and equipment, net
161,189

 
131,383

Intangible assets, net
218,345

 
237,122

Goodwill
292,426

 
292,980

Deferred tax assets
8,028

 
21,477

Other assets
11,956

 
13,128

Total assets
$
1,185,506

 
$
1,148,347

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current Liabilities:
 
 
 
Accounts payable, trade
$
43,239

 
$
27,656

Deferred revenue
3,645

 
4,543

Accrued compensation
28,099

 
28,010

Accrued expenses and other current liabilities
37,591

 
41,659

Total current liabilities
112,574

 
101,868

Long-term borrowings under senior credit facility
321,875

 
179,688

Long-term convertible securities
195,860

 
352,576

Deferred tax liabilities
14,893

 
5,726

Other liabilities
13,603

 
15,851

Total liabilities
$
658,805

 
$
655,709

Commitments and contingencies

 

Stockholders’ Equity:
 
 
 
Preferred Stock; no par value; 15,000 authorized shares; none outstanding


 


Common stock; $0.01 par value; 60,000 authorized shares; 35,905 and 35,734 issued at September 30, 2012 and December 31, 2011, respectively
359

 
357

Additional paid-in capital
613,721

 
607,676

Treasury stock, at cost; 8,903 shares at September 30, 2012 and December 31, 2011
(367,121
)
 
(367,121
)
Accumulated other comprehensive (loss):
(9,495
)
 
(9,093
)
Retained earnings
289,237

 
260,819

Total stockholders’ equity
526,701

 
492,638

Total liabilities and stockholders’ equity
$
1,185,506

 
$
1,148,347


The accompanying notes are an integral part of these condensed consolidated financial statements.

4


INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(In thousands)
 
 
Nine Months Ended September 30,
 
2012
 
2011
OPERATING ACTIVITIES:
 
 
 
Net income
$
28,418

 
$
23,429

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
39,122

 
37,303

Deferred income tax provision (benefit)
(3,184
)
 
(4,450
)
Amortization of debt issuance costs
2,103

 
2,630

Non-cash interest expense
8,284

 
7,119

Payment of accreted interest
(30,617
)
 

Loss on disposal of property and equipment
807

 

Share-based compensation
6,632

 
18,897

Excess tax benefits from stock-based compensation arrangements
(432
)
 
(844
)
Changes in assets and liabilities, net of business acquisitions:
 
 
 
Accounts receivable
(1,333
)
 
(777
)
Inventories
1,080

 
(6,788
)
Prepaid expenses and other current assets
8,148

 
(546
)
Other non-current assets
(877
)
 
(61
)
Accounts payable, accrued expenses and other current liabilities
6,528

 
(4,185
)
Deferred revenue
(913
)
 
(816
)
Other non-current liabilities
(1,263
)
 
(1,278
)
Net cash provided by operating activities
$
62,503

 
$
69,633

INVESTING ACTIVITIES:
 
 
 
Purchases of property and equipment
(44,359
)
 
(25,381
)
Cash used in business acquisition
(2,177
)
 
(149,420
)
Purchases of short-term investments
(67,907
)
 

Maturities of short-term investments
64,940

 

Net cash used in investing activities
$
(49,503
)
 
$
(174,801
)
FINANCING ACTIVITIES:
 
 
 
Borrowings under senior credit facility
155,000

 
135,000

Repayments under senior credit facility
(12,812
)
 
(190,625
)
Proceeds from liability component of convertible notes

 
186,830

Proceeds from equity component of convertible notes

 
43,170

Proceeds from sale of stock purchase warrants

 
28,451

Payment of liability component of convertible notes
(134,383
)
 

Purchase of option hedge on convertible notes

 
(42,895
)
Debt issuance costs

 
(8,064
)
Purchases of treasury stock

 
(69,011
)
Proceeds from exercised stock options
696

 
3,544

Excess tax benefits from stock-based compensation arrangements
432

 
844

Net cash provided by (used in) financing activities
8,933

 
87,244

Effect of exchange rate changes on cash and cash equivalents
2,977

 
152

Net change in cash and cash equivalents
24,910

 
(17,772
)
Cash and cash equivalents at beginning of period
100,808

 
128,763

Cash and cash equivalents at end of period
$
125,718

 
$
110,991

The accompanying notes are an integral part of these condensed consolidated financial statements.

5


INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION
General
The terms “we,” “our,” “us,” “Company” and “Integra” refer to Integra LifeSciences Holdings Corporation, a Delaware corporation, and its subsidiaries unless the context suggests otherwise.
In the opinion of management, the September 30, 2012 unaudited condensed consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of the financial position, results of operations and cash flows of the Company. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements for the year ended December 31, 2011 included in the Company’s Annual Report on Form 10-K. The December 31, 2011 condensed consolidated balance sheet was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States. Operating results for the three- and nine-month periods ended September 30, 2012 are not necessarily indicative of the results to be expected for the entire year.
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent liabilities, and the reported amounts of revenues and expenses. Significant estimates affecting amounts reported or disclosed in the consolidated financial statements include allowances for doubtful accounts receivable and sales returns and allowances, net realizable value of inventories, valuation of intangible assets including in-process research and development, amortization periods for acquired intangible assets, discount rates and estimated projected cash flows used to value and test impairments of long-lived assets and goodwill, estimates of projected cash flows and depreciation and amortization periods for long-lived assets, computation of taxes, valuation allowances recorded against deferred tax assets, the valuation of stock-based compensation, valuation of pension assets and liabilities, valuation of derivative instruments, valuation of the equity component of convertible debt instruments, and loss contingencies. These estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the current circumstances. Actual results could differ from these estimates.
Certain amounts from the prior year’s financial statements have been reclassified in order to conform to the current year’s presentation.
Recently Issued and Adopted Accounting Standards
On July 27, 2012, the Financial Accounting Standard Board issued Accounting Standards Update No. 2012-02, Testing Indefinite-Lived Intangible Assets for Impairment. The revised standard is intended to reduce the cost and complexity of testing indefinite-lived intangible assets other than goodwill for impairment by providing entities with an option to perform a "qualitative" assessment to determine whether further impairment testing is necessary. The revised standard allows an entity first to assess qualitative factors to determine whether events and circumstances indicate that it is more likely than not (that is, a likelihood of more than 50 percent) that an indefinite-lived intangible asset is impaired. If it is more likely than not that the asset is impaired, the entity must calculate the fair value of the asset, compare the fair value to its carrying amount, and record an impairment charge, if the carrying amount exceeds fair value. However, if an entity concludes that it is not more likely than not that the asset is impaired, no further action is required. The qualitative assessment is not an accounting policy election. An entity can choose to perform the qualitative assessment on none, some, or all of its indefinite-lived intangible assets. Moreover, an entity can bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to the quantitative impairment test, and then choose to perform the qualitative assessment in any subsequent period. The revised standard is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. However, an entity can choose to early adopt the revised standard even if its annual or interim impairment test date is before July 27, 2012 (the date on which the revised standard was issued), provided that its financial statements for the most recent annual or interim period have not yet been issued. The Company elected to adopt this standard early and such adoption did not have a material impact on the Company's financial statements.

2. BUSINESS ACQUISITIONS
Ascension Orthopedics, Inc.
On September 23, 2011, the Company acquired Ascension Orthopedics, Inc. (“Ascension”) for $66.0 million, which includes amounts paid for working capital adjustments of $0.2 million less amounts received from escrow of $0.7 million. Ascension,

6


based in Austin, Texas, develops and distributes a range of implants for the shoulder, elbow, wrist, hand, foot and ankle.
The following summarizes the final allocation of the purchase price based on fair value of the assets acquired and liabilities assumed:
 
 
Final
Purchase Price
Allocation
 
 
 
(Dollars in thousands)
 
 
Cash
$
627

 
 
Inventory
12,760

 
 
Accounts receivable
2,917

 
 
Other current assets
2,398

 
 
Property, plant and equipment
4,649

 
 
Other long-term assets
70

 
 
Deferred tax asset — long term
12,543

 
 
Intangible assets
 
 
Wtd. Avg. Life:
Technology
7,885

 
10 years
Customer relationships
5,750

 
12 years
In-process research and development
1,739

 
Indefinite
Supplier relationship
4,510

 
10 years
Trade name
560

 
1 year
Goodwill
15,460

 
 
Total assets acquired
71,868

 
 
Accounts payable and other liabilities
5,827

 
 
Net assets acquired
$
66,041

 
 

Management determined the preliminary fair value of net assets acquired during the third quarter of 2011 and finalized the working capital adjustment in the second quarter of 2012. Measurement period adjustments included above reflected a decrease in the total fair value of inventory acquired and a decrease in the value of long-term deferred tax assets acquired which was recorded in the fourth quarter of 2011. The measurement period adjustments were made to reflect facts and circumstances existing as of the acquisition date, and did not result from intervening events subsequent to the acquisition date. These adjustments did not have a significant impact on the Company’s previously reported consolidated financial statements and, therefore, the Company has not retrospectively adjusted those financial statements.
The goodwill recorded in connection with this acquisition is based on (i) expected cost savings, operating synergies and other benefits expected to result from the combined operations, (ii) the value of the going-concern element of Ascension’s existing business (that is, the higher rate of return on the assembled net assets versus if the Company had acquired all of the net assets separately), and (iii) intangible assets that do not qualify for separate recognition such as Ascension’s assembled workforce. The goodwill acquired will not be deductible for tax purposes.
SeaSpine, Inc.
On May 23, 2011, the Company acquired all of the outstanding common stock of SeaSpine, Inc. (“SeaSpine”) for $89.0 million, less working capital adjustments of $0.3 million and indemnification holdbacks totaling $7.4 million of which $4.9 million remains accrued at September 30, 2012. SeaSpine is based in Vista, California and designs, develops and manufactures spinal fixation products and synthetic bone substitute products.
The following summarizes the final allocation of the purchase price based on fair value of the assets acquired and liabilities assumed:
 

7


 
Final
Purchase Price
Allocation
 
 
 
(Dollars in thousands)
 
 
Cash
$
201

 
 
Inventory
14,900

 
 
Accounts receivable
7,608

 
 
Other current assets
623

 
 
Property, plant and equipment
9,177

 
 
Deferred tax asset—long term
302

 
 
Intangible assets:
 
 
Wtd. Avg. Life:
Technology
3,000

 
8 years
Customer relationships
41,200

 
13 years
Non-compete agreements
1,900

 
4 years
Trade name
300

 
1 year
Goodwill
14,572

 
 
Total assets acquired
93,783

 
 
Accounts payable and other liabilities
5,108

 
 
Net assets acquired
$
88,675

 
 

Management determined the preliminary fair value of net assets acquired during the second quarter of 2011 and finalized the working capital adjustment in the first quarter of 2012. Measurement period adjustments included above reflect a decrease in the total fair value of consideration to be transferred pursuant to the final working capital adjustment. These measurement period adjustments were made to reflect facts and circumstances existing as of the acquisition date, and did not result from intervening events subsequent to the acquisition date. This adjustment did not have a significant impact on the Company’s previously reported consolidated financial statements and, therefore, the Company has not retrospectively adjusted those financial statements.
The goodwill recorded in connection with this acquisition is based on the benefits the Company expects to generate from SeaSpine’s future cash flows. For tax purposes, the Company is treating the acquisition as an asset acquisition; therefore, the goodwill will be deductible for tax purposes.
Pro Forma Results
The following unaudited pro forma financial information summarizes the results of operations for the three and nine months ended September 30, 2011 as if the acquisitions completed by the Company during 2011 had been completed as of January 1, 2010. The pro forma results are based upon certain assumptions and estimates, and they give effect to actual operating results prior to the acquisitions and adjustments to reflect (i) increased interest expense, depreciation expense, intangible asset amortization and fair value inventory step-up, (ii) decreases in certain expenses that will not be recurring in the post-acquisition entity, and (iii) income taxes at a rate consistent with the Company’s statutory rate. No effect has been given to other cost reductions or operating synergies. As a result, these pro forma results do not necessarily represent results that would have occurred if the acquisitions had taken place on the basis assumed above, nor are they indicative of the results of future combined operations.
 
 
Three Months Ended 
 
Nine Months Ended
 
September 30,
2011
 
September 30,
2011
 
(in thousands except per share amounts)
Total Revenue
$
206,048

 
$
608,375

Net income
$
9,416

 
$
17,690

Net income per share
 
 
 
Basic
$
0.33

 
$
0.61

Diluted
$
0.32

 
$
0.59



8


3. INVENTORIES
Inventories, net consisted of the following:
 
 
September 30,
2012
 
December 31,
2011
 
(In thousands)
Finished goods
$
103,870

 
$
106,972

Work-in process
37,515

 
36,070

Raw materials
27,991

 
28,219

 
$
169,376

 
$
171,261


4. SHORT-TERM INVESTMENTS
The Company’s short-term investments consist entirely of time deposits held by investment grade banks. These investments have maturity dates ranging from approximately three months to six months from the original date of purchase. The carrying value of these short-term investments is a reasonable estimate of their fair value. All such investments matured during the third quarter of 2012.

5. GOODWILL AND OTHER INTANGIBLE ASSETS

The Company revised its operating segments and reporting segments in connection with the change in the Company’s Chief Executive Officer (who serves as the Company’s chief operating decision maker) effective January 3, 2012. As a result, the Company reassigned the goodwill to these new reportable segments based on the relative fair value of the Company’s eight underlying reporting units as of January 1, 2012. On July 31, 2012, the Company performed the annual goodwill impairment test. The Company first assessed the qualitative factors to determine whether it is more likely than not that the fair value of the reporting units is less than their carrying amounts. The Company performed this qualitative assessment for seven reporting units that each had an estimated fair value that was in excess of its carrying value by a significant amount. For each reporting unit, the Company weighed the relative impact of factors that are specific to the reporting unit as well as industry and macroeconomic factors. The reporting unit specific factors that were considered included the results of the most recent impairment tests, as well as financial performance and changes to the reporting units' carrying amounts since the most recent impairment tests. The Company concluded that each of the reporting unit specific and industry factors had either a positive or neutral impact on their fair values. The Company also determined that macroeconomic factors during 2012 did not have a significant impact on the discount rates and growth rates used for the January 1 tests. Based on the qualitative assessment, the Company concluded that for these seven reporting units, it is more likely than not that their carrying values are less than their fair values at July 31, 2012.

The Company performed the first step of the goodwill impairment test for its U.S. Spine business. This component has $31.7 million of allocated goodwill. As a result of the annual impairment assessment, the Company determined that the fair value exceeded its carrying value by approximately 13% at July 31, 2012. However, if future results do not meet or exceed the Company's forecasts, or if unfavorable changes occur in the weighted-average cost of capital, growth assumptions for future revenue, terminal value growth rate and/or forecasted cash flows utilized in the discounted cash flow analysis, the Company may record an impairment of this goodwill at a future date.
Changes in the carrying amount of goodwill for the nine months ended September 30, 2012 were as follows:
 

9


 
U.S.
Neurosurgery
 
U.S.
Instruments
 
U.S.
Extremities
 
U.S.
Spine
and
Other
 
International
 
Total
 
(In thousands)
Goodwill, gross
$
93,913

 
$
57,270

 
$
60,544

 
$
55,693

 
$
25,560

 
$
292,980

Accumulated impairment losses


 


 


 


 


 


Goodwill at December 31, 2011
93,913

 
57,270

 
60,544

 
55,693

 
25,560

 
292,980

SeaSpine, Inc. working capital adjustment


 


 


 
289

 


 
289

Ascension Orthopedics, Inc. working capital adjustment and other


 


 
(448
)
 


 


 
(448
)
Foreign currency translation


 


 


 


 
(395
)
 
(395
)
Balance, September 30, 2012
$
93,913

 
$
57,270

 
$
60,096

 
$
55,982

 
$
25,165

 
$
292,426


The components of the Company’s identifiable intangible assets were as follows:
 
 
Weighted
Average
Life
 
September 30, 2012
 
December 31, 2011
 
Cost
 
Accumulated
Amortization
 
Net
 
Cost
 
Accumulated
Amortization
 
Net
 
(Dollars in Thousands)
Completed technology
11 years
 
$
75,553

 
$
(36,707
)
 
$
38,846

 
$
75,990

 
$
(32,157
)
 
$
43,833

Customer relationships
11 years
 
147,550

 
(66,783
)
 
80,767

 
147,230

 
(57,348
)
 
89,882

Trademarks/brand names
32 years
 
33,764

 
(14,116
)
 
19,648

 
33,669

 
(10,897
)
 
22,772

Trademarks/brand names
Indefinite
 
48,484

 

 
48,484

 
48,484

 

 
48,484

Supplier relationships
26 years
 
33,810

 
(5,783
)
 
28,027

 
33,810

 
(5,389
)
 
28,421

All other (1)
6 years
 
5,582

 
(3,009
)
 
2,573

 
11,434

 
(7,704
)
 
3,730

 
 
 
$
344,743

 
$
(126,398
)
 
$
218,345

 
$
350,617

 
$
(113,495
)
 
$
237,122

 
(1) 
At September 30, 2012 and December 31, 2011, all other included in-process research and development of $1.7 million, which was indefinite lived.
During the nine months ended September 30, 2012, the Company recorded impairment charges of $0.1 million in cost of goods sold related to technology assets whose related products are being discontinued.
Based on quarter-end exchange rates, annual amortization expense is expected to approximate $25.1 million in 2012, $19.0 million in 2013, $18.1 million in 2014, $16.3 million in 2015 and $14.0 million in 2016. Identifiable intangible assets are initially recorded at fair market value at the time of acquisition using an income or cost approach.

6. DEBT
Amended and Restated Senior Credit Agreement
On August 10, 2010, the Company entered into an amended and restated credit agreement with a syndicate of lending banks (the “Senior Credit Facility”), it amended the Senior Credit Facility on June 8, 2011, and further amended it on May 11, 2012.
The June 8, 2011 amendment:
i.
increased the revolving credit component from $450 million to $600 million and eliminated the $150 million term loan component that existed under the original amended and restated credit agreement;
ii.
allows the Company to further increase the size of the revolving credit component by an aggregate of $200 million with additional commitments;
iii.
provides the Company with decreased borrowing rates and annual commitment fees, and provides more favorable financial covenants; and
iv.
extended the maturity date from August 10, 2015 to June 8, 2016.

10


On May 11, 2012, the Company entered into another amendment to the Senior Credit Facility (the “2012 Amendment”). The 2012 Amendment modified certain financial and negative covenants. The 2012 Amendment provides that the Company’s Maximum Consolidated Total Leverage Ratio (a measure of net debt to consolidated EBITDA, in each case as defined in the Senior Credit Facility, as amended) during any consecutive four quarter period should not be greater than 3.75 to 1.00 during any such period ending on December 31, 2013 (instead of March 31, 2012). In addition, when calculating consolidated EBITDA for any period, the 2012 Amendment permits the addition of certain costs and expenses in the calculation of consolidated net income for such period, to the extent deducted in the calculation of consolidated net income. The Senior Credit Facility is collateralized by substantially all of the assets of the Company’s U.S. subsidiaries, excluding intangible assets. The Senior Credit Facility is subject to various financial and negative covenants and at September 30, 2012, the Company was in compliance with all such covenants.
Borrowings under the Senior Credit Facility currently bear interest, at the Company’s option, at a rate equal to (i) the Eurodollar Rate (as defined in the Senior Credit Facility, which definition has not changed) in effect from time to time plus the applicable rate (ranging from 1.00% to 1.75%) or (ii) the highest of (x) the weighted average overnight Federal funds rate, as published by the Federal Reserve Bank of New York, plus 0.5%, (y) the prime lending rate of Bank of America, N.A. or (z)  the one-month Eurodollar Rate plus 1.0%. The applicable rates are based on the Company’s consolidated total leverage ratio (defined as the ratio of (a) consolidated funded indebtedness less cash in excess of $40 million that is not subject to any restriction of the use or investment thereof to (b) consolidated EBITDA) at the time of the applicable borrowing.
The Company will also pay an annual commitment fee (ranging from 0.15% to 0.30%, based on the Company’s consolidated total leverage ratio) on the daily amount by which the revolving credit facility exceeds the outstanding loans and letters of credit under the credit facility.
At September 30, 2012 and December 31, 2011, there was $321.9 million and $179.7 million outstanding, respectively, under the Senior Credit Facility at a weighted average interest rate of 1.8% and 2.0%, respectively. At September 30, 2012, there was approximately $278.1 million available for borrowing under the Senior Credit Facility. The fair value of outstanding borrowings under the Senior Credit Facility at September 30, 2012 was approximately $299.1 million. The fair value of the Senior Credit Facility was determined by using a discounted cash flow model based on current market interest rates available to the Company. These inputs are corroborated by observable market data for similar liabilities and therefore classified within Level 2 of the fair value hierarchy. Level 2 inputs represent inputs that are observable for the asset or liability, either directly or indirectly and are other than active market observable inputs that reflect unadjusted quoted prices for identical assets or liabilities. The Company considers the balance to be long term in nature based on its current intent and ability to repay the borrowing outside of the next twelve-month period.
2016 Convertible Senior Notes
On June 15, 2011, the Company issued $230.0 million aggregate principal amount of its 1.625% Convertible Senior Notes due 2016 (the “2016 Notes”). The 2016 Notes mature on December 15, 2016, and bear interest at a rate of 1.625% per annum payable semi-annually in arrears on December 15 and June 15 of each year. The portion of the debt proceeds that was classified as equity at the time of the offering was $43.2 million, an equivalent of that amount is being amortized to interest expense using the effective interest method through December 2016. The effective interest rate implicit in the liability component is 5.6%. The fair value of the liability of the 2016 Notes was determined using a discounted cash flow model based on current market interest rates available to the Company. These inputs are corroborated by observable market data for similar liabilities and therefore classified within Level 2.
At September 30, 2012, the carrying amount of the liability component was $195.9 million, the remaining unamortized discount was $34.1 million, and the principal amount outstanding was $230.0 million. The fair value of the 2016 Notes at September 30, 2012 was approximately $227.1 million. At December 31, 2011, the carrying amount of the liability component was $190.6 million, the remaining unamortized discount was $39.4 million and the principal amount outstanding was $230.0 million.
The 2016 Notes are senior, unsecured obligations of the Company, and are convertible into cash and, if applicable, shares of its common stock based on an initial conversion rate, subject to adjustment of 17.4092 shares per $1,000 principal amount of 2016 Notes (which represents an initial conversion price of approximately $57.44 per share). The Company will satisfy any conversion of the 2016 Notes with cash up to the principal amount of the 2016 Notes pursuant to the net share settlement mechanism set forth in the indenture and, with respect to any excess conversion value, with shares of the Company’s common stock. The 2016 Notes are convertible only in the following circumstances: (1) if the closing sale price of the Company’s common stock exceeds 150% of the conversion price during a period as defined in the indenture; (2) if the average trading price per $1,000 principal amount of the 2016 Notes is less than or equal to 98% of the average conversion value of the 2016 Notes during a period as defined in the indenture; (3) at any time on or after June 15, 2016; or (4) if specified corporate

11


transactions occur. The issue price of the 2016 Notes was equal to their face amount, which is also the amount holders are entitled to receive at maturity if the 2016 Notes are not converted. As of September 30, 2012, none of these conditions existed with respect to the 2016 Notes and as a result, the 2016 Notes are classified as long term.
In connection with the issuance of the 2016 Notes, the Company entered into call transactions and warrant transactions, primarily with affiliates of the initial purchasers of such notes (the “hedge participants”). The initial strike price of the call transaction is approximately $57.44 per share, subject to customary anti-dilution adjustments. The initial strike price of the warrant transaction is approximately $70.05 per share, subject to customary anti-dilution adjustments.
2012 Senior Convertible Notes
On June 11, 2007, the Company issued $165.0 million aggregate principal amount of its 2012 Notes (the “2012 Notes”). In June 2012, the Company repaid the 2012 Notes at maturity with long-term borrowings from its Senior Credit Facility and cash on hand. The related bond hedge contracts will terminate in components over the 100 trading day period commencing 90 days after the maturity of the 2012 Note.
Convertible Note Interest
The interest expense components of the Company’s convertible notes are as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(amounts in thousands)
2016 Notes:
 
 
 
 
 
 
 
Amortization of the discount on the liability component
$
1,788

 
$
1,691

 
$
5,289

 
$
2,026

Cash interest related to the contractual interest coupon
934

 
934

 
2,803

 
1,090

Total
$
2,722

 
$
2,625

 
$
8,092

 
$
3,116

2012 Notes:
 
 
 
 
 
 
 
Amortization of the discount on the liability component
$

 
$
1,726

 
$
2,995

 
$
5,093

Cash interest related to the contractual interest coupon

 
980

 
1,633

 
2,940

Total
$

 
$
2,706

 
$
4,628

 
$
8,033


7. DERIVATIVE INSTRUMENTS
Interest Rate Hedging
The Company’s interest rate risk relates to U.S. dollar denominated variable LIBOR interest rate borrowings. The Company uses an interest rate swap derivative instrument entered into on August 10, 2010 with an effective date of December 31, 2010 to manage its earnings and cash flow exposure to changes in interest rates by converting a portion of its floating-rate debt into fixed-rate debt beginning on December 31, 2010. This interest rate swap expires on August 10, 2015.
The Company designates this derivative instrument as a cash flow hedge. The Company records the effective portion of any change in the fair value of a derivative instrument designated as a cash flow hedge as unrealized gains or losses in accumulated other comprehensive income (“AOCI”), net of tax, until the hedged item affects earnings, at which point the effective portion of any gain or loss will be reclassified to earnings. If the hedged cash flow does not occur, or if it becomes probable that it will not occur, the Company will reclassify the amount of any gain or loss on the related cash flow hedge to interest expense at that time.
The Company expects that approximately $2.0 million of pre-tax losses recorded as net in AOCI related to the interest rate hedge could be reclassified to earnings within the next twelve months.
Foreign Currency Hedging
From time to time the Company enters into foreign currency hedge contracts intended to protect the U.S. dollar value of certain forecasted foreign currency denominated transactions. The Company records the effective portion of any change in the fair value of foreign currency cash flow hedges in AOCI, net of tax, until the hedged item affects earnings. Once the related hedged item affects earnings, the Company reclassifies the effective portion of any related unrealized gain or loss on the foreign currency cash flow hedge to earnings. If the hedged forecasted transaction does not occur, or if it becomes probable that it will not occur, the Company will reclassify the amount of any gain or loss on the related cash flow hedge to earnings at that time.

12


The success of the Company’s hedging program depends, in part, on forecasts of certain activity denominated in euros. The Company may experience unanticipated currency exchange gains or losses to the extent that there are differences between forecasted and actual activity during periods of currency volatility. In addition, changes in currency exchange rates related to any unhedged transactions may affect its earnings and cash flows.
Counterparty Credit Risk
The Company manages its concentration of counterparty credit risk on its derivative instruments by limiting acceptable counterparties to a group of major financial institutions with investment grade credit ratings, and by actively monitoring their credit ratings and outstanding positions on an ongoing basis. Therefore, the Company considers the credit risk of the counterparties to be low. Furthermore, none of the Company’s derivative transactions are subject to collateral or other security arrangements, and none contain provisions that depend upon the Company’s credit ratings from any credit rating agency.
Fair Value of Derivative Instruments
The Company has classified all of its derivative instruments within Level 2 of the fair value hierarchy because observable inputs are available for substantially the full term of the derivative instruments. The fair value of the foreign currency forward exchange contracts related to inventory purchases is determined by comparing the forward rate as of the period end and the settlement rate specified in each contract. The fair value of the interest rate swaps was developed using a market approach based on publicly available market yield curves and the terms of the related swap. The Company performs ongoing assessments of counterparty credit risk.
The following table summarizes the fair value, notional amounts presented in U.S. dollars, and presentation in the consolidated balance sheet for derivatives designated as hedging instruments as of September 30, 2012 and December 31, 2011:
 
 
Fair Value as of
 
Notional Amount as of
Location on Balance Sheet (1):
September 30,
2012
 
December 31,
2011
 
September 30,
2012
 
December 31,
2011
 
(In thousands)
Derivatives designated as hedges — Liabilities:
 
 
 
 
 
 
 
Interest rate swap — Accrued expenses and other current liabilities (2)
$
1,954

 
$
1,634

 
 
 
 
Foreign currency forward contracts — Accrued expenses and other current liabilities

 
108

 
$

 
$
1,597

Interest rate swap — Other liabilities (2)
2,688

 
2,458

 
 
 
 
Total Derivatives designated as hedges — Liabilities
$
4,642

 
$
4,200

 
 
 
 
 
(1) 
The Company classifies derivative assets and liabilities as current based on the cash flows expected to be incurred within the following 12 months.
(2) 
At September 30, 2012 and December 31, 2011, the notional amount related to the Company’s sole interest rate swap was $131.3 million and $139.7 million, respectively. In the next twelve months, the Company expects to reduce the notional amount by $14.1 million.

The following presents the effect of derivative instruments designated as cash flow hedges on the accompanying consolidated statements of operations during the three and nine months ended September 30, 2012 and 2011:
 

13


 
Balance in AOCI
Beginning of
Quarter
 
Amount of
Gain (Loss)
Recognized in
AOCI-
Effective Portion
 
Amount of Gain (Loss)
Reclassified from
AOCI into
Earnings-Effective
Portion
 
Balance in AOCI
End of Quarter
 
Location in
Statements of
Operations
 
(In thousands)
Three Months Ended September 30, 2012
 
 
 
 
 
 
 
 
 
Forward currency forward contracts
(176
)
 
(9
)
 
(6
)
 
(179
)
 
Costs of goods sold
Interest rate swap
(4,374
)
 
(744
)
 
(476
)
 
(4,642
)
 
Interest (expense)
 
(4,550
)
 
(753
)
 
(482
)
 
(4,821
)
 
 
Three Months Ended September 30, 2011
 
 
 
 
 
 
 
 
 
Interest rate swap
(1,908
)
 
(3,116
)
 
(592
)
 
(4,432
)
 
Interest (expense)
 
Balance in AOCI
Beginning of
Year
 
Amount of
Gain (Loss)
Recognized in
AOCI-
Effective Portion
 
Amount of Gain (Loss)
Reclassified from
AOCI into
Earnings-Effective
Portion
 
Balance in AOCI
End of Quarter
 
Location in
Statements of
Operations
 
(In thousands)
Nine Months Ended September 30, 2012
 
 
 
 
 
 
 
 
 
Forward currency forward contracts
(216
)
 
(140
)
 
(177
)
 
(179
)
 
Cost of goods sold
Interest rate swap
(4,092
)
 
(1,952
)
 
(1,402
)
 
(4,642
)
 
Interest (expense)
 
(4,308
)
 
(2,092
)
 
(1,579
)
 
(4,821
)
 
 
Nine Months Ended September 30, 2011
 
 
 
 
 
 
 
 
 
Interest rate swap
(270
)
 
(5,897
)
 
(1,735
)
 
(4,432
)
 
Interest (expense)

The Company recognized no gains or losses resulting from ineffectiveness of cash flow hedges during the three and nine months ended September 30, 2012 and 2011.

8. STOCK-BASED COMPENSATION
As of September 30, 2012, the Company had stock options, restricted stock awards, performance stock awards, contract stock awards and restricted stock unit awards outstanding under five plans, the 1998 Stock Option Plan (the “1998 Plan”), the 1999 Stock Option Plan (the “1999 Plan”), the 2000 Equity Incentive Plan (the “2000 Plan”), the 2001 Equity Incentive Plan (the “2001 Plan”), and the 2003 Equity Incentive Plan (the “2003 Plan,” and collectively, the “Plans”). No new awards may be granted under the 1998 Plan or the 1999 Plan.
Stock options issued under the Plans become exercisable over specified periods, generally within four years from the date of grant for officers, directors and employees, and generally expire six years from the grant date for employees and from six to ten years for directors and certain executive officers. Restricted stock issued under the Plans vests over specified periods, generally three years after the date of grant.
Stock Options
The Company granted approximately 254,000 and 34,000 stock options during the nine months ended September 30, 2012 and September 30, 2011, respectively. As of September 30, 2012, there were approximately $2.4 million of total unrecognized compensation costs related to unvested stock options. These costs are expected to be recognized over a weighted-average period of approximately two years. The Company received net proceeds of $0.7 million and $3.5 million from stock option exercises for the nine months ended September 30, 2012 and 2011, respectively.
Awards of Restricted Stock, Performance Stock and Contract Stock
Performance stock awards have performance features associated with them. Performance stock, restricted stock and contract stock awards generally have requisite service periods of three years. The Company expenses the fair value of these awards on a

14


straight-line basis over the vesting period or requisite service period, whichever is shorter. The Company granted approximately 240,000 and 274,000 restricted stock awards/stock units during the nine months ended September 30, 2012 and September 30, 2011, respectively. As of September 30, 2012, there were approximately $12.6 million of total unrecognized compensation costs related to unvested awards. The Company expects to recognize these costs over a weighted-average period of approximately two years.
The Company has no formal policy related to the repurchase of shares for the purpose of satisfying stock-based compensation obligations.
The Company also maintains an Employee Stock Purchase Plan (the “ESPP”), which provides eligible employees with the opportunity to acquire shares of common stock at periodic intervals by means of accumulated payroll deductions. The ESPP is a non-compensatory plan based on its terms.

9. TREASURY STOCK
On October 29, 2010, the Company’s Board of Directors authorized the Company to repurchase shares of the Company’s common stock for an aggregate purchase price not to exceed $75.0 million through December 31, 2012. Shares may be purchased either in the open market or in privately negotiated transactions.
As of September 30, 2012, there remained $29.1 million available for repurchases under this authorization. In addition to the authorization above, on June 3, 2011, the Company’s Board of Directors separately authorized the Company to repurchase shares of common stock from the proceeds of the 2016 Notes in connection with that offering. The following table sets forth the Company’s treasury stock activity:
 
 
Nine Months Ended
 
Nine Months Ended
 
September 30, 2012
 
September 30, 2011
 
$
 
# of Shares
 
$
 
# of Shares
 
(In thousands)
Shares repurchased in the open market in connection with the Board approved buyback program
$

 

 
$
31,441

 
704

Shares repurchased in connection with the issuance of the 2016 Notes

 

 
37,570

 
805

Total

 

 
$
69,011

 
1,509


On October 23, 2012, the Company's Board of Directors terminated the October 2010 authorization and authorized the repurchase of up to $75.0 million of its outstanding common stock through December 2014.

10. RETIREMENT BENEFIT PLANS
The Company maintains defined benefit pension plans that cover employees in its manufacturing plants located in Andover, United Kingdom (the “UK Plan”) and Tuttlingen, Germany (the “Germany Plan”). The Company closed the Tuttlingen, Germany plant in December 2005. The Company did not terminate the Germany Plan, and the Company remains obligated for the accrued pension benefits related to this plan. The plans cover certain current and former employees.
Effective March 31, 2011, the Company froze the benefits due to the participants of the UK Plan in their entirety; this curtailment resulted in a $0.3 million reduction in the projected benefit obligations which the Company recorded on that date. The Company recorded the entire curtailment gain as an offset to the unrecognized net actuarial loss in accumulated other comprehensive income; therefore, this gain had no impact on the condensed consolidated statements of operations.


15


Net periodic benefit costs for the Company’s defined benefit pension plans included the following amounts:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(In thousands)
Service cost
$
6

 
$

 
$
19

 
$
53

Interest cost
157

 
167

 
478

 
501

Expected return on plan assets
(142
)
 
(147
)
 
(432
)
 
(443
)
Net period benefit cost
$
21

 
$
20

 
$
65

 
$
111


The Company made $0.6 million and $0.9 million of contributions to its defined benefit pension plans during the nine months ended September 30, 2012 and 2011, respectively.

11. INCOME TAXES
The following table provides a summary of the Company’s effective tax rate:
 
 
Three Months Ended September 30,
 
2012
 
2011
Reported tax rate
7.3
%
 
0.4
%
 
Nine Months Ended September 30,
 
2012
 
2011
Reported tax rate
19.8
%
 
16.7
%

The Company expects its effective income tax rate for the full year to be approximately 20.5%. The annual effective tax rates for the periods ending in 2012 and 2011 are lower than the U.S. statutory rate of 35% due, in part, to foreign earnings taxed at lower tax rates, benefits from U.S. manufacturing incentives, tax planning and other discrete events.  This estimate could be revised in the future as additional information is presented to the Company.

The Company’s effective income tax rate for the three months ended September 30, 2012 and 2011 were 7.3% and 0.4%, respectively. Income tax expense for the three months ended September 30, 2012 was higher than the three month period ended September 30, 2011, as a result of a change in the mix of income reported in 2012, offset by a benefit of $2.1 million for the release of a tax contingency reserves and a benefit of $0.2 million change in state tax law effective this quarter. Furthermore, in this quarter, the Company settled its 2008-2010 Federal tax audit for which it recorded $0.2 million income tax expense.

The Company's effective income tax rates for the nine months ended September 30, 2012 and 2011 were 19.8% and 16.7%, respectively. The change in year-to-date effective tax rates is attributable to the change in the mix in year-to-date worldwide pretax income, as well as a reduction in the estimated domestic manufacturing deduction, caused by a change in U.S. taxable income for 2012. The year-to-date tax increase is offset by a benefit of $2.1 million for the release of a tax contingency reserves and a benefit of $0.2 million for a change in state tax law effective this quarter.

Income tax expense for the nine months ended September 30, 2011 included a $1.7 million correction to a deferred tax asset relating to 2009, and a $0.7 million income tax expense for a state tax law change, which became effective in the quarter ended September 30, 2011.


12. NET INCOME PER SHARE
Certain of the Company’s restricted unvested share units contain rights to receive nonforfeitable dividends, and thus, are participating securities requiring the two-class method of computing earnings per share. The participating securities had an insignificant impact on the calculation of earnings per share (impacts the rounding by less than $0.01 per share) on all of the 2011 periods presented; therefore, the Company does not present the full calculation below.
Basic and diluted net income per share was as follows (in thousands, except per share amounts):
 

16


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
Basic net income per share:
 
 
 
 
 
 
 
Net income
$
13,211

 
$
11,243

 
$
28,418

 
$
23,429

Weighted average common shares outstanding
28,446

 
28,583

 
28,403

 
29,234

Basic net income per common share
$
0.46

 
$
0.39

 
$
1.00

 
$
0.80

Diluted net income per share:
 
 
 
 
 
 
 
Net income
$
13,211

 
$
11,243

 
$
28,418

 
$
23,429

Weighted average common shares outstanding — Basic
28,446

 
28,583

 
28,403

 
29,234

Effect of dilutive securities:
 
 
 
 
 
 
 
Stock options and restricted stock
331

 
446

 
226

 
586

Weighted average common shares for diluted earnings per share
28,777

 
29,029

 
28,629

 
29,820

Diluted net income per common share
$
0.46

 
$
0.39

 
$
0.99

 
$
0.79


At September 30, 2012 and 2011, the Company had 1.7 million and 1.5 million of outstanding stock options, respectively. The Company also has warrants outstanding relating to its 2016 Notes at September 30, 2012 and 2011. Stock options, restricted stock and warrants are included in the diluted earnings per share calculation using the treasury stock method, unless the effect of including the stock options would be anti-dilutive. For the three months ended September 30, 2012 and 2011, 1.0 million and 0.5 million of anti-dilutive stock options, respectively, were excluded from the diluted earnings per share calculation. For the nine months ended September 30, 2012 and 2011, 1.2 million and 0.2 million of anti-dilutive stock options, respectively, were excluded from the diluted earnings per share calculation. As the strike price of the warrants exceeded the Company’s average stock price for the period, the warrants are anti-dilutive and the entire number of warrants was also excluded from the diluted earnings per share calculation.

13. COMPREHENSIVE (LOSS) INCOME
Comprehensive (loss) income was as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(In thousands)
Net Income
$
13,211

 
$
11,243

 
$
28,418

 
$
23,429

Foreign currency translation adjustment
4,051

 
(17,712
)
 
(106
)
 
688

Change in unrealized gain on derivatives, net of tax
(154
)
 
(1,439
)
 
(290
)
 
(2,372
)
Pension liability adjustment, net of tax
(2
)
 
14

 
(6
)
 
200

Comprehensive income (loss)
$
17,106

 
$
(7,894
)
 
$
28,016

 
$
21,945


14. SEGMENT AND GEOGRAPHIC INFORMATION
Starting in the first quarter of 2012, because of changes in how the Company internally manages and reports the results of its businesses to its chief operating decision maker, the Company began to disclose five reportable segments. The five reportable segments are U.S. Neurosurgery, U.S. Instruments, U.S. Extremities, U.S. Spine and Other, and International. The U.S. Neurosurgery segment sells a full line of products specifically for neurosurgery and critical care such as tissue ablation equipment, dural repair products, cerebral spinal fluid management devices, intracranial monitoring equipment, and cranial stabilization equipment. The U.S. Instruments business sells more than 60,000 instrument patterns and surgical products and lighting to hospitals, surgery centers, and dental, podiatry, and veterinary offices. The U.S. Extremities segment includes the U.S. extremity reconstruction business, which includes such offerings as skin and wound repair, bone and joint fixation, implants in the upper and lower extremities, bone grafts and nerve and tendon repair. The U.S. Spine and Other segment includes (i) the U.S. Spine business, which focuses on spinal fusion, spinal implants, and deformity correction, (ii) the U.S. Orthobiologics business, which focuses on bone graft substitutes and other related medical devices that are used to enhance the repair and regeneration of bone in various types of orthopedic surgical procedures, and (iii) the Private Label business, which sells the Company’s regenerative medicine and other products to strategic partners. The International segment sells similar products to those discussed above, but are managed through the following geographies: (i) Europe, Middle East and Africa, and (ii) Central/South America, Asia-Pacific and Canada. The Corporate and other category includes (i) various legal, finance,

17


executive, and human resource functions, (ii) brand management, (iii) share-based compensation costs, and (iv) costs related to procurement, manufacturing operations and logistics for the Company’s entire organization. Accordingly, the segment information for the prior years has been restated in accordance with authoritative guidance on segment reporting.

The operating results of the various reportable segments as presented are not comparable to one another because (i) certain operating segments are more dependent than others on corporate functions for unallocated general and administrative and/or operational manufacturing functions, and (ii) the Company does not allocate certain manufacturing costs and general and administrative costs to the operating segment results.
Net sales and profit by reportable segment for the three and nine months ended September 30, 2012 and 2011 are as follows:
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2012
 
2011
 
2012
 
2011
 
 
(In thousands)
Segment Net Sales
 
 
 
 
 
 
 
 
U.S. Neurosurgery
 
$
43,269

 
$
42,800

 
$
125,776

 
$
122,246

U.S. Instruments
 
41,469

 
41,543

 
120,732

 
116,932

U.S. Extremities
 
32,961

 
24,825

 
91,596

 
69,341

U.S. Spine and Other
 
49,188

 
48,293

 
142,821

 
128,885

International
 
43,197

 
44,724

 
135,514

 
139,151

Total revenues
 
$
210,084

 
$
202,185

 
$
616,439

 
$
576,555

Segment Profit
 
 
 
 
 
 
 
 
U.S. Neurosurgery
 
$
23,201

 
$
22,624

 
$
66,247

 
$
62,489

U.S. Instruments
 
9,293

 
8,779

 
26,259

 
22,029

U.S. Extremities
 
14,996

 
9,657

 
37,484

 
27,692

U.S. Spine and Other
 
14,771

 
13,390

 
42,166

 
38,576

International
 
14,550

 
14,721

 
45,456

 
48,911

Segment profit
 
76,811

 
69,171

 
217,612

 
199,697

Amortization
 
(4,618)

 
(4,548)

 
(13,985)

 
(11,609)

Corporate and other
 
(52,457
)
 
(46,332
)
 
(148,403
)
 
(140,925
)
Operating income
 
$
19,736

 
$
18,291

 
$
55,224

 
$
47,163

The segment profits for the U.S. Instruments and U.S. Extremities segments for the three months ended March 31, 2012 and 2011 have been revised and are reflected in the segment profits for the nine months ended September 30, 2012 and 2011.
Revenue by major product category consisted of the following: 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(In thousands)
Orthopedics
$
94,186

 
$
85,698

 
$
276,033

 
$
239,429

Neurosurgery
69,667

 
69,768

 
203,499

 
203,129

Instruments
46,231

 
46,719

 
136,907

 
133,997

Total Revenues
$
210,084

 
$
202,185

 
$
616,439

 
$
576,555


The Company attributes revenues to geographic areas based on the location of the customer. There are certain revenues that the various U.S. segments manage that are generated from non-U.S. customers and therefore included in Europe and the Rest of World revenues below. Total revenue by major geographic area consisted of the following:
 

18


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(In thousands)
United States
$
165,930

 
$
156,530

 
$
478,087

 
$
434,324

Europe
20,351

 
21,839

 
66,903

 
72,203

Rest of World
23,803

 
23,816

 
71,449

 
70,028

Total Revenues
$
210,084

 
$
202,185

 
$
616,439

 
$
576,555


15. COMMITMENTS AND CONTINGENCIES
In consideration for certain technology, manufacturing, distribution, and selling rights and licenses granted to the Company, the Company has agreed to pay royalties on sales of certain products that we sell. The royalty payments that the Company made under these agreements were not significant for any of the periods presented.
The Company is subject to various claims, lawsuits and proceedings in the ordinary course of its business, including claims by current or former employees, distributors and competitors in respect to its products. In the opinion of management, such claims are either adequately covered by insurance or otherwise indemnified, or are not expected, individually or in the aggregate, to result in a material adverse effect on the Company’s financial condition. However, it is possible that these contingencies could materially affect its results of operations, financial position and cash flows in a particular period.
The Company has settled, or has pending against it, various lawsuits, claims and proceedings. The Company accrues for loss contingencies when it is deemed probable that a loss has been incurred and that loss is estimable. The amounts accrued are based on the full amount of the estimated loss before considering insurance proceeds, and do not include an estimate for legal fees expected to be incurred in connection with the loss contingency. The Company consistently accrues legal fees expected to be incurred in connection with loss contingencies as a period cost as outside counsel incurs those fees.















19


ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the related notes thereto appearing elsewhere in this report and our consolidated financial statements for the year ended December 31, 2011 included in our Annual Report on Form 10-K.
We have made statements in this report which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). These forward-looking statements are subject to a number of risks, uncertainties and assumptions about the Company. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those set forth above under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011 and under the heading "Risk Factors" in this Report. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
You can identify these forward-looking statements by forward-looking words such as “believe,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should,” “would” and similar expressions in this report.

GENERAL
Integra is a world leader in medical devices focused on limiting uncertainty for surgeons so they can concentrate on providing the best patient care. Integra provides customers with clinically relevant, innovative and cost-effective products that improve the quality of life for patients. We focus on cranial and spinal procedures, small bone and joint injuries, the repair and reconstruction of soft tissue, and instruments for surgery.
We manage our business through a combination of product groups and geography, and accordingly, we report our financial results under five reportable segments - U.S. Instruments, U.S. Neurosurgery, U.S. Extremities, U.S. Spine and Other (which consists of our U.S. Spine, U.S. Orthobiologics and Private Label businesses) and International.
We present revenues in the following three product categories: Orthopedics, Neurosurgery and Instruments. Our orthopedics products group includes specialty metal implants for surgery of the extremities, shoulder and spine, orthobiologics products for repair and grafting of bone, dermal regeneration products and tissue-engineered wound dressings and nerve and tendon repair products. Our neurosurgery products group includes, among other things, dural grafts that are indicated for the repair of the dura mater, ultrasonic surgery systems for tissue ablation, cranial stabilization and brain retraction systems, systems for measurement of various brain parameters and devices used to gain access to the cranial cavity and to drain excess cerebrospinal fluid from the ventricles of the brain. Our instruments products group includes a wide range of specialty and general surgical and dental instruments and surgical lighting for sale to hospitals, outpatient surgery centers, and physician, veterinarian and dental practices.
We manufacture many of our products in plants located in the United States, Puerto Rico, France, Germany, Ireland, the United Kingdom and Mexico. We also source most of our handheld surgical instruments and specialty metal and Pyrocarbon implants through specialized third-party vendors.
In the United States, we have several sales channels. Orthopedics products are sold through a large direct sales organization and through specialty distributors focused on their respective surgical specialties. Neurosurgery products are sold through directly employed sales representatives. Instruments products are sold through two sales channels, both directly and through distributors and wholesalers, depending on the customer call point. We sell in the international markets through a combination of a direct sales organization and specialty distributors.
We also market certain products through strategic partners in the United States.
Our objective is to become a diversified global medical device company that helps patients by limiting uncertainty for medical professionals, and to be a high-quality investment for shareholders. We will achieve these goals by delivering on our Brand Promises to our customers worldwide and by becoming a top player in all markets in which we compete. Our strategy includes the following key elements: geographic expansion, margin expansion, leveraging platform synergies, disciplined focus and execution, global quality assurance and acquiring or in-licensing products that fit existing sales channels.
We aim to achieve growth in our revenues while maintaining strong financial results. While we pay attention to any meaningful trend in our financial results, we pay particular attention to measurements that are indicative of long-term profitable growth. These measurements include (1) revenue growth (including internal growth and by acquisitions), (2) gross margins on total revenues, (3) operating margins (which we aim to continually expand as we leverage our existing infrastructure), (4) earnings

20


before interest, taxes, depreciation, and amortization, and (5) earnings per diluted share of common stock.
We believe that we are particularly effective in the following aspects of our business:
Regenerative Medicine Platform. We have developed numerous product lines through our proprietary collagen matrix and demineralized bone matrix technologies that are sold through every one of our sales channels.
Diversification and Platform Synergies. Each of our three selling platforms contributes a different strength to our core business. Orthopedics enables us to grow our top line and increase gross margins. Neurosurgery provides stable growth as a market with few elective procedures. Instruments has a strong capacity to generate cash flows. We have unique synergies among these platforms, such as our regenerative medicine technology, instrument sourcing capabilities, and Group Purchasing Organization (“GPO”) contract management.
Unique Sales Footprint. Our sales footprint provides us with a unique set of customer call-points and synergies. Each of our sales channels can benefit from the GPO and Integrated Delivery Network (“IDN”) relationships that our Instruments group manages. We have market leading products among neurosurgeons, many of whom also perform spine surgeries, and we have yet to fully leverage those relationships to sell our spine products. We also have clinical expertise across all of our channels in the United States, and have an opportunity to expand and leverage this expertise in markets worldwide.
Ability to Change and Adapt. Our corporate culture is truly what enables us to adapt and reinvent ourselves. We have demonstrated that we can quickly and profitably integrate new products and businesses. This core strength has made it possible for us to grow over the years, and is key to our ability to grow into a multi-billion dollar company.

RESULTS OF OPERATIONS
Executive Summary
Net income for the three months ended September 30, 2012 was $13.2 million, or $0.46 per diluted share as compared with net income of $11.2 million or $0.39 per diluted share for the three months ended September 30, 2011.
Net income for the nine months ended September 30, 2012 was $28.4 million, or $0.99 per diluted share as compared with net income of $23.4 million or $0.79 per diluted share for the nine months ended September 30, 2011.
The increase in net income for the three months ended September 30, 2012 over the same period last year resulted primarily from higher revenues, higher gross margin on our revenues, and a decrease in our interest expense as a result of the June 2012 repayment of our 2012 Notes.
The increase in net income for the nine months ended September 30, 2012 over the same period last year resulted primarily from an increase in revenue from the addition of SeaSpine and Ascension's existing products and the margin contribution from those higher revenues. The prior year period included $8.4 million of incremental stock based compensation charges related to our former chief executive officer’s employment agreement.
Our costs and expenses include the following charges:
 

21


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(In thousands)
 
(In thousands)
Plainsboro, New Jersey manufacturing facility remediation costs
$
3,788

 
1,748

 
$
7,193

 
1,748

Global ERP implementation charges
4,821

 
6,245

 
12,097

 
11,832

Facility optimization charges
2,861

 
34

 
7,481

 
2,127

Certain employee termination charges
638

 

 
1,139

 
846

Discontinued product lines charges
223

 
485

 
1,058

 
3,664

Acquisition-related charges
602

 
1,665

 
2,323

 
4,227

Impairment charges

 

 
141

 
2,648

European entity restructuring charges

 

 

 
378

Convertible debt non-cash interest
1,787

 
3,417

 
8,284

 
7,049

Certain executive compensation charges

 
100

 

 
8,479

Financing charges

 

 

 
790

Total
$
14,720

 
$
13,694

 
$
39,716

 
$
43,788


The items reported above are reflected in the condensed consolidated statements of operations as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(In thousands)
 
(In thousands)
Cost of goods sold
$
5,661

 
$
3,518

 
$
13,890

 
$
8,372

Research and development


 

 


 
300

Selling, general and administrative
7,272

 
6,759

 
17,542

 
26,129

Intangible asset amortization


 

 


 
1,148

Interest expense
1,787

 
3,417

 
8,284

 
7,839

Total
$
14,720

 
$
13,694

 
$
39,716

 
$
43,788


We typically define special charges as items for which the amounts and/or timing of such expenses may vary significantly from period to period, depending upon our acquisition, integration and restructuring activities, and for which the amounts are non-cash in nature, or for which the amounts are not expected to recur at the same magnitude as we implement certain tax planning strategies. We believe that given our ongoing strategy of seeking acquisitions, our continuing focus on rationalizing our existing manufacturing and distribution infrastructure and our continuing review of various product lines in relation to our current business strategy, certain of the special charges discussed above could recur with similar materiality in the future. In 2010 we began investing significant resources in the global implementation of a single enterprise resource planning system. We began capitalizing certain costs for the project starting in 2011, and as other aspects of the project reach the application development stage, we will capitalize those expenditures as well.
We believe that the separate identification of these special charges provides important supplemental information to investors regarding financial and business trends relating to our financial condition and results of operations. Investors may find this information useful in assessing comparability of our operating performance from period to period, the business model objectives that management has established, and other companies in our industry. We provide this information to investors so that they can analyze our operating results in the same way that management does and to use this information in their assessment of our core business and valuation of Integra.
Plainsboro, New Jersey Regenerative Medicine Facility Update
Remediation activities in our regenerative medicine facility in Plainsboro, New Jersey affected revenues and gross margin in the third quarter and first nine months of 2012. We received a warning letter from the FDA in December 2011, related to quality systems and compliance issues at that plant. The letter resulted from an inspection held at that facility in August 2011, and did not identify any new observations that were not provided in the Form 483 that followed the inspection. The warning letter did not restrict our ability to manufacture or ship products, nor did it require the recall of any product. In July 2012, the FDA again

22


inspected the regenerative medicine facility; the second inspection closed out on July 30, 2012 and a FDA Form 483 Inspectional Observations was issued. We have been addressing the FDA 483 Inspectional Observations, Warning Letter citations and communicating with the FDA on a monthly basis. Our efforts with respect to closing out the warning letter are well along, and we do not expect the FDA to return for another inspection until late 2012 or in 2013. See Part II - Item 1A. Risk Factors for more detailed discussion.
Since August 2011, we have undertaken significant efforts to remediate the observations that the FDA has made and continue to do so, including both capital investment for new equipment, leasehold improvements and incremental spending to improve or revise quality systems. We expensed approximately $3.8 million and $7.2 million in the three and nine months of 2012, respectively. For the three month period, the $3.8 million consisted of $0.4 million of expenses associated with remediation of the Plainsboro, New Jersey collagen device facility and $3.4 million for unplanned idle time and underutilization. For the nine month period, the $7.2 million consisted of $2.5 million of expenses associated with remediation of the Plainsboro, New Jersey collagen device facility and $4.7 million for unplanned idle time and underutilization. The capital expenditure directed to the remediation of our regenerative medicine facility was $2.8 and $4.9 million for the three and nine months ended September 30, 2012, respectively.
We anticipate spending another $0.5 million including underutilization over the remainder of the year.
Revenues and Gross Margin on Product Revenues
Our revenues and gross margin on product revenues were as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(In thousands)
 
(In thousands)
Orthopedics
$
94,186

 
$
85,698

 
$
276,033

 
$
239,429

Neurosurgery
69,667

 
69,768

 
203,499

 
203,129

Instruments
46,231

 
46,719

 
136,907

 
133,997

Total revenue
210,084

 
202,185

 
616,439

 
576,555

Cost of goods sold
79,548

 
78,651

 
232,497

 
216,410

Gross margin on total revenues
$
130,536

 
$
123,534

 
$
383,942

 
$
360,145

Gross margin as a percentage of total revenues
62.1
%
 
61.1
%
 
62.3
%
 
62.5
%
Net Revenues by Reportable Segment
Net sales by reportable segment for the three and nine months ended September 30, 2012 and 2011 are as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2012
 
2011
 
2012
 
2011
 
 
(In thousands)
 
(In thousands)
Segment Net Sales
 
 
 
 
 
 
 
 
U.S. Neurosurgery
 
43,269

 
42,800

 
125,776

 
122,246

U.S. Instruments
 
41,469

 
41,543

 
120,732

 
116,932

U.S. Extremities
 
32,961

 
24,825

 
91,596

 
69,341

U.S. Spine and Other
 
49,188

 
48,293

 
142,821

 
128,885

International
 
43,197

 
44,724

 
135,514

 
139,151

Total revenues
 
210,084

 
202,185

 
616,439

 
576,555


Three Months Ended September 30, 2012 as Compared to Three Months Ended September 30, 2011
Revenues and Gross Margin
For the three months ended September 30, 2012, total revenues increased by $7.9 million, or 4%, to $210.1 million from $202.2 million for the same period during 2011. Domestic revenues increased 6% to $165.9 million, or 79% of total revenues, for the three months ended September 30, 2012 from $156.5 million, or 77% of total revenues, for the three months ended

23


September 30, 2011. International revenues decreased to $44.2 million from $45.7 million in the prior-year period, a decrease of 3%, driven in part by foreign exchange fluctuations from a weaker euro versus the U.S. dollar compared to the third quarter of 2011. Overall foreign exchange rate fluctuations accounted for a $2.5 million decrease in revenues during the third quarter of 2012 as compared to the same period last year. Finally, total revenues were negatively impacted by various supply disruptions, none of which were material individually, resulting in a larger than usual total backorder at the end of the quarter.  The Company expects to resolve most of these disruptions by the end of 2012, but there can be no assurance that backorder levels will return to normal.
U.S. Neurosurgery revenues were $43.3 million, an increase of 1% from the prior year. The increase was due to stronger sales of our duraplasty and specialty products offset by softer capital sales in cranial fixation.
U.S. Instruments revenues were $41.5 million, in line with the prior year. We continued to experience strong sales within instruments, largely driven by strength in our acute care sales channel, and continued growth of our LED surgical headlamp product, which was launched in late 2011. Our strong growth was offset by the timing of alternate site channel that experienced a significant spike in sales in the third quarter of 2011.
U.S. Extremities revenues were $33.0 million, an increase of 33% from the prior year. The growth resulted primarily from significant increases in sales of our dermal and wound care products and Ascension products. We are still experiencing some backorders that resulted from the remediation work in our Plainsboro, New Jersey manufacturing facility, which delayed production of regenerative medicine products.
U.S. Spine and Other revenues, which include our Spine hardware, orthobiologics and private label products, were $49.2 million, an increase of 2% from the prior year. We continued double digit growth in our orthobiologics business, led by a strong demand for our EVO3 and Mozaik products. Our sales team has been focused on signing up new distributors and as a result we have seen increases in sales of our products. Our Spine hardware products business has experienced some price erosion because of increasing competition. Increased spine procedure delays have also affected demand for our products. Sales of our private label products increased from the prior year.
International segment revenues were $43.2 million, down 3% from the prior year. We experienced a negative foreign currency impact of $2.5 million, which primarily affected our sales in Europe. With constant currency rates, Europe would have increased approximately 4%. In addition, we saw decreases in capital spending, as European hospitals have been reducing spending and tightening their budgets. Increases in skin and wound-healing product sales partially offset these decreases. We also saw revenue increases in the Asia-Pacific and Latin America markets across all product categories.
Gross margin increased 6% to $130.5 million for the three-month period ended September 30, 2012 from $123.5 million for the same period last year. Gross margin as a percentage of total revenue increased slightly to 62.1% for the third quarter 2012 from 61.1% for the same period last year. The increase in gross margin percentage resulted primarily from a decrease in our inventory reserves.
We expect our consolidated gross margin percentage for the full year 2012 to be flat to up slightly compared to 2011. We expect to complete the remediation work at our Plainsboro, New Jersey regenerative medicine manufacturing facility in the fourth quarter of 2012 and accordingly, expect to return to normal levels of production during the fourth quarter of 2012. That said, higher costs resulting from the amortization of the Ascension and SeaSpine inventory to cost of goods sold at acquisition value, costs related to the expansion of our regenerative medicine activities, and continued downward pressure on our private-label and spine hardware product sales volumes will negatively affect our consolidated gross margin.
Operating Expenses
The following is a summary of operating expenses as a percent of total revenues: 

 
Three Months Ended September 30,
 
2012

2011
Research and development
6.2
%

6.6
%
Selling, general and administrative
44.3
%

43.3
%
Intangible asset amortization
2.2
%

2.2
%
Total operating expenses
52.7
%

52.1
%

Total operating expenses, which consist of research and development expenses, selling, general and administrative expenses and amortization expense, increased $5.6 million, or 5%, to $110.8 million in the three months of 2012, compared to $105.2

24


million in the same period last year.

Research and development expenses in the third quarter of 2012 remained relatively flat compared to the same period last year. We target full-year 2012 spending on research and development to be between 6% and 6.5% of total revenues.

Selling, general and administrative expenses in the third quarter of 2012 increased by $5.6 million to $93.1 million compared to $87.5 million in the same period last year. Selling and marketing expenses increased by $2.9 million, primarily resulting from a higher proportion of sales through distributors, which generally have a higher cost than the direct selling model. Additionally, bonuses and commission costs were higher as a result of increases in revenue.  General and administrative costs were up $2.7 million, primarily because of an increase in accrued non-selling bonuses and consulting costs to support various strategic projects.  These increases were somewhat offset by lower costs in our European operations resulting from lower headcount and severance costs paid in third quarter 2011.
Amortization expense in the third quarter of 2012 was $4.6 million compared to $4.5 million in the same period last year. The increase primarily resulted from amortization of the significant intangible assets added as part of our Ascension acquisition that occurred during the third quarter of 2011.
Non-Operating Income and Expenses
The following is a summary of non-operating income and expenses:
 
 
Three Months Ended September 30,
 
2012
 
2011
 
(In thousands)
Interest income
$
100

 
$
154

Interest expense
(5,549
)
 
(7,587
)
Other income (expense)
(31
)
 
429


Interest Income and Interest Expense
Interest expense in the three months ended September 30, 2012 decreased primarily as a result of the June repayment of our 2012 Notes which decreased our interest expense by $2.9 million, offset by an additional $0.8 million of higher interest because of increased borrowing on our revolver. Our reported interest expense for the three-month periods ended September 30, 2012 and 2011 includes non-cash interest related to the accounting for convertible securities of $1.8 million and $3.4 million, respectively.
Other Income (Expense)
Other expense for the third quarter of 2012 was primarily attributable to foreign exchange gains and losses on intercompany balances.
Other income for the third quarter of 2011 of $0.4 million consists primarily of foreign exchange gains on intercompany balances.
Income Taxes
 
 
Three Months Ended September 30,
 
2012
 
2011
 
(In thousands)
Income before income taxes
14,256

 
11,287

Income tax expense
1,045

 
44

Effective tax rate
7.3
%
 
0.4
%

Our effective income tax rate for the three months ended September 30, 2012 and 2011 were 7.3% and 0.4%, respectively. Income tax expense for the three months ended September 30, 2012 was higher than the three-month period ended September 30, 2011, as a result of a change in the mix of income reported in 2012, offset by a benefit of $2.1 million for the release of a tax contingency reserve and a benefit of $0.2 million change in state tax law effective this quarter. Furthermore, in this quarter, the Company settled its 2008-2010 Federal tax audit for which it recorded $0.2 million income tax expense.

25



The effective tax rate may vary from period to period depending on, among other factors, the geographic and business mix of taxable earnings and losses, tax planning and settlements with the various taxing authorities. We consider these factors and others, including our history of generating taxable earnings, in assessing our ability to realize deferred tax assets on a quarterly basis.
While it is often difficult to predict the final outcome or the timing of resolution of any particular matter with the various Federal, state and foreign tax authorities, we believe that our reserves reflect the most probable outcome of known tax contingencies. Settlement of any particular issue would usually require the use of cash. Favorable resolution would be recognized as a reduction to our annual effective tax rate in the year of resolution. The tax reserves are presented in the balance sheet within other liabilities, except for amounts relating to items we expect to pay in the coming year which are classified as current income taxes payable.
We expect our effective income tax rate for the full year to be approximately 20.5%.

Nine Months Ended September 30, 2012 as Compared to Nine Months Ended September 30, 2011

Revenues and Gross Margin
For the nine-month period ended September 30, 2012, total revenues increased by $39.9 million or 7%, to $616.4 million from $576.6 million during the prior-year period. Domestic revenues increased by 10% to $478.1 million, and were 78% and 75% of total revenues for the nine months ended September 30, 2012 and 2011, respectively. International revenues decreased by 3% to $138.4 million, driven by foreign exchange fluctuation from a weaker euro versus the U.S. dollar compared to the same period last year. Overall foreign exchange rate fluctuations accounted for a $6.1 million decrease in revenues during the nine month period ended September 30, 2012 as compared to the same period last year.
U.S. Neurosurgery revenues were $125.8 million, an increase of 3% from the prior year. The increase in sales was from continued and growing demand for our market-leading duraplasty products, increases in sales of our ultrasonic tissue ablation systems, as well as strength in our critical care, stereotaxy and cranial stabilization products. We experienced a strong performance in both our capital equipment and disposable products.
U.S. Instruments revenues were $120.7 million, an increase of 3% from the prior year period. Strength in our acute care sales channel largely drove this growth. We also continue to experience strong growth of our LED surgical headlamp product, which was launched in late 2011, as well as growth in our market share. A solid amount of new facility openings have created more selling opportunities, also contributing to this growth.
U.S. Extremities revenues were $91.6 million, an increase of 32% from the prior year. This increase in revenue is derived from the impact of our Ascension acquisition in the third quarter of 2011. Our direct sales force began selling the full line of Ascension’s portfolio of products in early 2012, moving us away from the legacy distributor network. Increases also occurred in dermal and wound care products as the demand for the products continue to be strong. We cleared most, but not all of the backorders caused by shortages of our regenerative medicine products that resulted from remediation work in our Plainsboro, New Jersey facility.
U.S. Spine and Other revenues, which include our spine hardware, orthobiologics and private label products, were $142.8 million, an increase of 11% from the prior year. The increase arose primarily because of the addition of SeaSpine’s revenue and strong growth in our orthobiologics portfolio. Our EVO3 and Mozaik products continue to see high demand through both our existing base and newly added distributors, which are driving double-digit growth for orthobiologics during the period. While the new product launches, new distributor on-boarding and cross-pollination of the two spine hardware lines is progressing well, the spine hardware market remains challenging, both in price and volume. Private label decreased versus the prior-year period.
International segment revenues were $135.5 million, a decrease of 3% from prior year. The current financial situation in Europe has caused hospitals to tighten their budgets. As a result, we saw decreases in capital spending on neurosurgical equipment and purchases of extremity products. These declines were partially offset by our spine and orthobiologics sales, which have increased off a relatively small base in 2011. The shortages of our regenerative medicine products discussed above also affected sales outside the United States. That said, during the second quarter we began our delivery of skin products that had been backordered. We experienced slight increases in the Asia-Pacific and Latin America markets across all product categories.
Gross margin increased 7% to $383.9 million for the nine-month period ended September 30, 2012. Gross margin as a percentage of total revenue decreased to 62.3% for the first nine months of 2012 from 62.5% for the same period last year. The decrease in gross margin percentage primarily resulted from our ongoing remediation efforts in our Plainsboro, New Jersey

26


manufacturing facility. In addition, we discontinued our radiosurgery and radiotherapy product lines and wrote-off the related technology intangible assets and inventory, which resulted in $1.0 million of incremental costs during the first quarter. Finally, we incurred additional costs related to the amortization of the fair value inventory step-up on the acquired SeaSpine and Ascension inventories from 2011.
Operating Expenses
The following is a summary of operating expenses as a percent of total revenues:
 
 
Nine Months Ended September 30,
 
2012
 
2011
Research and development
6.2
%
 
6.6
%
Selling, general and administrative
44.9
%
 
45.7
%
Intangible asset amortization
2.3
%
 
2.0
%
Total operating expenses
53.4
%
 
54.3
%

Total operating expenses, which consist of research and development expenses, selling, general and administrative expenses and amortization expense, increased $15.7 million, or 5%, to $328.7 million in the nine months of 2012, compared to $313.0 million in the same period last year.
Research and development expenses in the first nine months of 2012 remained flat, compared to the same period last year. Product development efforts for our spine and extremity reconstruction product lines were offset by lower spending in neurosurgery and instrument product development activities. We target full-year 2012 spending on research and development to be between 6% and 7% of total revenue.
Selling, general and administrative expenses in the nine months of 2012 increased by $13.3 million to $276.6 million compared to $263.3 million in the same period last year. Selling and marketing expenses increased by $19.0 million primarily resulting from a higher proportion of sales to distributors, which inherently have a higher cost than the direct selling model together with increases in revenue and corresponding commission costs, as well as the impact of our SeaSpine and Ascension acquisitions. Additionally, we incurred $1.1 million of expenses in the second quarter to terminate an exclusive product distribution agreement with a former distributor in China, which included the transfer of certain product registration rights back to us. General and administrative costs decreased $5.7 million primarily due to prior year incremental charges of $8.4 million of stock based compensation related to the renewal of our former chief executive officer’s employment agreement and $2.0 million of acquisition related costs that did not repeat in the current period. These decreases were offset by increases in accrued non-selling bonuses, consulting and other costs related to various strategic projects and the addition of our SeaSpine and Ascension operations.
Amortization expense in the first nine months of 2012 increased by $2.4 million to $14.0 million compared to $11.6 million in the same period last year. The increase was primarily related to amortization of the significant intangible assets added as part of our Ascension acquisition that occurred during the third quarter of 2011 and accelerated amortization on several trade names being phased out as part of our rebranding strategy.
Non-Operating Income and Expenses
The following is a summary of non-operating income and expenses:
 
 
Nine Months Ended September 30,
 
2012
 
2011
 
(In thousands)
Interest income
$
893

 
$
354

Interest expense
(20,581
)
 
(19,778
)
Other income (expense)
(118
)
 
379



Interest Income and Interest Expense
Interest income increased in the nine-month period ended September 30, 2012, compared to the same period last year, primarily

27


from short-term investments in time deposit accounts held outside the United States.
Interest expense in the nine-month period ended September 30, 2012 increased primarily as a result of increased borrowing on our revolver. Our reported interest expense for the nine-month periods ended September 30, 2012 and 2011 includes non-cash interest related to the accounting for convertible securities of $8.3 million and $7.1 million, respectively.
Other Income (Expense)
Other expenses of $0.1 million in 2012 were primarily attributable to foreign exchange gains and losses on intercompany balances. Other income (expense) in the nine months ended September 30, 2011 consisted of research and development reimbursements from third-party partners and foreign governments, which was almost entirely offset by foreign exchange losses.
Income Taxes
 
 
Nine Months Ended September 30,
 
2012
 
2011
 
(In thousands)
Income before income taxes
35,418

 
28,118

Income tax expense
7,000

 
4,689

Effective tax rate
19.8
%
 
16.7
%

The Company's effective income tax rates for the nine months ended September 30, 2012 and 2011 were 19.8% and 16.7%, respectively. The change in year-to-date effective tax rates is attributable to the change in the mix in year-to-date worldwide pretax income, as well as a reduction in the estimated domestic manufacturing deduction, caused by a change in U.S. taxable income for 2012. The year-to-date tax increase is offset by a benefit of $2.1 million for the release of a tax contingency reserves and a benefit of $0.2 million for a change in state tax law effective this quarter.

Income tax expense for the nine months ended September 30, 2011 included a $1.7 million correction to a deferred tax asset relating to 2009, and a $0.7 million income tax expense for a tax law change, which became effective in the quarter ended September 30, 2011.
The effective tax rate may vary from period to period depending on, among other factors, the geographic and business mix of taxable earnings and losses, tax planning and settlements with the various taxing authorities. We consider these factors and others, including our history of generating taxable earnings, in assessing our ability to realize deferred tax assets on a quarterly basis.
While it is often difficult to predict the final outcome or the timing of resolution of any particular matter with the various Federal, state and foreign tax authorities, we believe that our reserves reflect the most probable outcome of known tax contingencies. Settlement of any particular issue would usually require the use of cash. Favorable resolution would be recognized as a reduction to our annual effective tax rate in the year of resolution. The tax reserves are presented in the balance sheet within other liabilities, except for amounts relating to items it expects to pay in the coming year which are classified as current income taxes payable.
We expect our effective income tax rate for the full year to be approximately 20.5%.

GEOGRAPHIC PRODUCT REVENUES AND OPERATIONS
We attribute revenues to geographic areas based on the location of the customer. There are certain revenues that the various U.S. segments manage that are generated from non-U.S. customers and therefore included in Europe and the Rest of World revenues below – these revenues are not significant. Total revenue by major geographic area consisted of the following:
 

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Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(in thousands)
 
(in thousands)
United States
$
165,930

 
$
156,530

 
$
478,087

 
$
434,324

Europe
20,351

 
21,839

 
66,903

 
72,203

Rest of World
23,803

 
23,816

 
71,449

 
70,028

Total Revenues
$
210,084

 
$
202,185

 
$
616,439

 
$
576,555

For more detailed view of revenue fluctuations see our discussion of international revenues under the Item 2 section titled Results of Operations – “Revenues and Gross Margins.”
We generate significant revenues outside the United States, a portion of which are U.S. dollar-denominated transactions conducted with customers who generate revenue in currencies other than the U.S. dollar. As a result, currency fluctuations between the U.S. dollar and the currencies in which those customers do business could have an impact on the demand for our products in foreign countries.
Local economic conditions, regulatory compliance or political considerations, the effectiveness of our sales representatives and distributors, local competition and changes in local medical practice all may combine to affect our sales into markets outside the United States.

LIQUIDITY AND CAPITAL RESOURCES
Cash and Marketable Securities
We had cash and cash equivalents totaling approximately $125.7 million and $100.8 million at September 30, 2012 and December 31, 2011, respectively. At September 30, 2012, our non-U.S. subsidiaries held approximately $113.5 million of cash and cash equivalents that are available for use by all of our operations outside of the United States. If these funds were repatriated to the United States, or used for United States operations, certain amounts could be subject to tax in the United States for the incremental amount in excess of the foreign tax paid.
Cash Flows
 
 
Nine Months Ended September 30,
 
2012
 
2011
 
(In thousands)
Net cash provided by operating activities
$
62,503

 
$
69,633

Net cash used in investing activities
(49,503
)
 
(174,801
)
Net cash provided by (used in) financing activities
8,933

 
87,244

Effect of exchange rate fluctuations on cash
2,977

 
152

Net increase (decrease) in cash and cash equivalents
$
24,910

 
$
(17,772
)

In the second quarter of 2012, we borrowed $155 million from our senior credit facility to fund the June repayment of our 2012 Notes of $165 million, of which we classified $134 million as a financing use of cash for the repayment of the debt component, and $31 million as an operating use of cash for the repayment of accreted interest. We plan to spend approximately $20 million on capital expenditures in the last quarter of 2012, primarily for the expansion of regenerative medicine manufacturing capacity, our enterprise resource planning system implementation, and additions to our instrument sets used in sales of orthopedic products.

In the fourth quarter, the Company will use cash to pay withheld federal and state taxes in connection with the release to Mr. Essig of approximately 1.67 million deferred stock units (“SUs”) as a result of the termination of his employment. On June 7, 2012, our executive chairman ceased to be an employee of the Company. Mr. Essig continues to serve as Chairman and as a member of the Board of Directors. These SUs will be distributed to him in the form of shares of our common stock within approximately six months after the date he ceased to be an employee of the Company. Most of the payments will be classified as an operating use of cash. Accordingly, the SUs will be distributed and taxes will be withheld in the fourth quarter of 2012. The Company will retain shares equal in value to the required withholding taxes, which may exceed 44% of the then aggregate fair market value of the SUs. The Company will be able to deduct the total amount of such deferred compensation from its

29


Federal and state corporation taxes, but will not receive the cash benefits of such deductions in the same period. The payment of the SUs in the current year will generate net operating losses for the Company which will be utilized as deductions against federal and state corporate income taxes over the next two years.

Cash Flows Provided by Operating Activities
We generated operating cash flows of $62.5 million and $69.6 million for the nine months ended September 30, 2012 and 2011, respectively.
Operating cash flows were lower than the same period in 2011 largely because of the repayment of our convertible 2012 Notes of $165 million, of which $31.0 million we classified as an operating use of cash for the repayment of accreted interest. Net income for the nine months ended September 30, 2012, plus items included in those earnings that did not result in a change to our cash balance, amounted to approximately $51.1 million. Changes in working capital increased cash flows by approximately $13.5 million. Among the changes in working capital, accounts receivable used $1.3 million of cash, inventory provided $1.1 million of cash, prepaid expenses and other current assets provided $8.1 million of cash, and accounts payable, accrued expenses and other current liabilities provided $6.5 million of cash.
Cash Flows Used in Investing Activities
During the nine months ended September 30, 2012, we paid $44.4 million in cash for capital expenditures, most of which was directed to the expansion of our regenerative medicine production capacity and global enterprise system implementation. We had net purchases of $3.0 million in short-term time deposit accounts which is the impact of changes in foreign exchange rates.
During the nine months ended September 30, 2011, we paid $149.4 million (net of $0.8 million of cash acquired) related to our acquisitions of Ascension Orthopedics, Inc. and SeaSpine, Inc. and incurred $25.4 million in capital expenditures related primarily to expanding our regenerative medicine manufacturing capacity and to the implementation of our global enterprise resource planning system.
Cash Flows Provided by Financing Activities
Our principal uses of cash for financing activities in the nine months ended September 30, 2012 were $155.0 million of borrowings under our Senior Credit Facility offset by the repayment of the liability component of our 2012 Notes of $134.4 million and $12.8 million of repayments under our Senior Credit Facility.
Our principal sources of cash from financing activities in the nine months ended September 30, 2011 were from $230.0 million in borrowings under the 2016 Notes issued in June 2011 and proceeds from the related warrant sale of $28.5 million. These amounts were offset by $55.6 million in repayments under our Senior Credit Facility, $42.9 million for the call option on our 2016 Notes, debt issuance costs of $8.1 million, treasury stock purchases of $69.0 million and proceeds from stock option exercises and the tax impact of stock based compensation of $4.4 million.
Working Capital
At September 30, 2012 and December 31, 2011, working capital was $381.0 million and $350.4 million, respectively.
Amended and Restated Senior Credit Agreement
On August 10, 2010, the Company entered into an amended and restated credit agreement (the “First Amendment") with a syndicate of lending banks and further amended the agreement on June 8, 2011 (the “Second Amendment”, and collectively referred to herein as the “Senior Credit Facility”). The Second Amendment increased the revolving credit component from $450.0 million to $600.0 million and eliminated the $150.0 million term loan component that existed under the First Amendment, allows the Company to further increase the size of the revolving credit component by an aggregate of $200.0 million with additional commitments, provides the Company with decreased borrowing rates and annual commitment fees, and provides more favorable financial covenants. The Second Amendment extended the Senior Credit Facility’s maturity date from August 10, 2015 to September 8, 2016. Both the First Amendment and the Second Amendment are collateralized by substantially all of the assets of the Company’s U.S. subsidiaries, excluding intangible assets. The Senior Credit Facility is subject to various financial and negative covenants and at September 30, 2012, the Company was in compliance with all such covenants.
On May 11, 2012, the Company entered into a first amendment to the Senior Credit Facility. The amendment modified certain financial and negative covenants as disclosed in Note 6, the effect of which was to increase the Company’s capacity to borrow.
Borrowings under the Senior Credit Facility currently bear interest, at the Company’s option, at a rate equal to (i) the Eurodollar Rate (as defined in the Senior Credit Facility, which definition has not changed) in effect from time to time plus the

30


applicable rate (ranging from 1.00% to 1.75%) or (ii) the highest of (x) the weighted average overnight Federal funds rate, as published by the Federal Reserve Bank of New York, plus 0.5%, (y) the prime lending rate of Bank of America, N.A. or (z) the one-month Eurodollar Rate plus 1.0%. The applicable rates are based on the Company’s consolidated total leverage ratio (defined as the ratio of (a) consolidated funded indebtedness less cash in excess of $40 million that is not subject to any restriction of the use or investment thereof to (b) consolidated EBITDA) at the time of the applicable borrowing. The Company will also pay an annual commitment fee (ranging from 0.15% to 0.3%, based on the Company’s consolidated total leverage ratio) on the daily amount by which the revolving credit facility exceeds the outstanding loans and letters of credit under the credit facility.
We plan to utilize the Senior Credit Facility for working capital, capital expenditures, share repurchases, acquisitions, debt repayments and other general corporate purposes. At September 30, 2012 and December 31, 2011, there was $321.9 million and $179.7 million outstanding, respectively, under the Senior Credit Facility at a weighted average interest rate of 1.8% and 2.0%, respectively. The Company considers the balance to be long-term in nature based on its current intent and ability to repay the borrowing outside of the next twelve-month period. At September 30, 2012, there was approximately $278.1 million available for borrowing under the Senior Credit Facility.
Convertible Debt and Related Hedging Activities
We pay interest each June 15 and December 15 on our $230.0 million senior convertible notes due December 2016 (“2016 Notes”) at an annual interest rate of 1.625%.
The 2016 Notes are senior, unsecured obligations of Integra, and are convertible into cash and, if applicable, shares of our common stock based on an initial conversion rate, subject to adjustment, of 17.4092 shares per $1,000 principal amount of 2016 Notes (which represents an initial conversion price of approximately $57.44 per share). We expect to satisfy any conversion of the 2016 Notes with cash up to the principal amount pursuant to the net share settlement mechanism set forth in the respective indenture and, with respect to any excess conversion value, with shares of our common stock. The 2016 Notes are convertible only in the following circumstances: (1) if the closing sale price of our common stock exceeds 150% of the conversion price during a period as defined in the applicable indenture; (2) if the average trading price per $1,000 principal amount of the 2016 Notes is less than or equal to 98% of the average conversion value of the 2016 Notes during a period as defined in the applicable indenture; (3) at any time on or after September 15, 2016; or (4) if specified corporate transactions occur. The issue price of the 2012 Notes was equal to their face amounts, which is also the amount holders are entitled to receive at maturity if the 2016 Notes are not converted. None of these conditions existed with respect to the 2016 Notes; therefore the 2016 Notes are classified as long-term.
The 2016 Notes, under the terms of the applicable private placement agreement, are guaranteed fully by Integra LifeSciences Corporation, a subsidiary of Integra. The 2016 Notes are Integra’s direct senior unsecured obligations and will rank equal in right of payment to all of our existing and future unsecured and unsubordinated indebtedness.
In connection with the issuance of the 2016 Notes, we entered into call transactions and warrant transactions, primarily with affiliates of the initial purchasers of the 2016 Notes (the “hedge participants”). The cost of the call transactions to us was approximately $42.9 million for the 2016 Notes. We received approximately $28.5 million of proceeds from the warrant transactions for 2016 Notes. The call transactions involved our purchasing call options from the hedge participants, and the warrant transactions involved us selling call options to the hedge participants with a higher strike price than the purchased call options. The initial strike price of the call transactions is approximately $57.44 for the 2016 Notes, subject to anti-dilution adjustments substantially similar to those in the 2016 Notes. The initial strike price of the warrant transactions is approximately $70.05 for the 2016 Notes, in each case subject to customary anti-dilution adjustments.
We may from time to time seek to retire or purchase a portion of our outstanding 2016 Notes through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. Under certain circumstances, the call options associated with any repurchased 2016 Notes may terminate early, but only with respect to the number of 2016 Notes that cease to be outstanding. The amounts involved may be material.
Share Repurchase Plan
On October 29, 2010, our Board of Directors authorized us to repurchase shares of our common stock for an aggregate purchase price not to exceed $75.0 million through December 31, 2012. Shares may be purchased either in the open market or in privately negotiated transactions. We repurchased no shares under this program during the first nine months of 2012 and $29.1 million remains available under the authorization.

On October 23, 2012, our Board of Directors terminated the October 2010 authorization and authorized the repurchase of up to

31


an additional $75.0 million of outstanding common stock through December 2014.
Dividend Policy
We have not paid any cash dividends on our common stock since our formation. Our Senior Credit Facility limits the amount of dividends that we may pay. Any future determinations to pay cash dividends on our common stock will be at the discretion of our Board of Directors and will depend upon our financial condition, results of operations, cash flows and other factors deemed relevant by the Board of Directors.
Capital Resources
We believe that our cash and available borrowings under the Senior Credit Facility are sufficient to finance our operations and capital expenditures, and potential acquisition-related payments in the near term based on our current plans. The Company considers all such outstanding amounts to be long-term in nature based on its current intent and ability to repay the borrowings outside of the next twelve month period.