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NATUS MEDICAL INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Natus®, AABR®, ABaer ®, ALGO®, AOAE®, AuDX ®, Balance Manager®, Balance Master®, Biliband ®, Bio-logic®, Ceegraph®, CHAMP ®, Cochlea Scan®, Cool Cap®, Ear Couplers ®, Echo Screen®, EquiTest®, Fischer-Zoth ®, Flexicoupler®, Gumdrop®, Keypoint ®, Keypoint AU®, Keypoint EU®, Keypoint JP ®, MASTER®, Medix®, MedixI.C.S.A ®, Navigator®, Neatnick®, neoBLUE ®, Neuromax®, NeuroWorks®, Oxydome ®, Sleeprite®, Sleepscan®, Smart Scale ®, Tootsweet®, Traveler®, Warmette ® and VAC PAC® are registered trademarks of Natus Medical Incorporated and its subsidiaries. Accuscreen™, Bili Lite Pad™, Bili-Lite™, Biomark™, Circumstraint™, Coherence™, Deltamed™, inVision™, MiniMuffs™, Neometrics™ and Smartpack™ are non-registered trademarks of Natus and its subsidiaries. Solutions for Newborn CareSM is a non-registered service mark of Natus. Overview The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") supplements the MD&A in the Annual Report on Form 10-K for the year ended December 31, 2010 of Natus Medical Incorporated ("Natus," "we," "us," or "our Company"), and presumes that readers have read or have access to the discussion and analysis in our Annual Report. Management's discussion and analysis should be read in conjunction with our condensed consolidated financial statements and accompanying footnotes, the discussion of certain risks and uncertainties contained in Part II, Item 1A of this report, and the cautionary information regarding forward-looking statements at the end of this section. MD&A includes the following sections: • Our Business. A general description of our business; • 2011 Second Quarter Overview. A summary of key information concerning the financial results for the three months ended June 30, 2011; • Application of Critical Accounting Policies. A discussion of the accounting policies that are most important to the portrayal of our financial condition and results of operations and that require significant estimates, assumptions, and judgments; • Results of Operations. An analysis of our results of operations for the periods presented in the financial statements; • Liquidity and Capital Resources. An analysis of capital resources, sources and uses of cash, investing and financing activities, off-balance sheet arrangements, contractual obligations and interest rate hedging; • Recent Accounting Pronouncements. See Note 1 to our Condensed Consolidated Financial Statements for a discussion of new accounting pronouncements that affect us; and • Cautionary Information Regarding Forward-Looking Statements. Cautionary information about forward-looking statements. Our Business Natus is a leading provider of healthcare products used for the screening, detection, treatment, monitoring and tracking of common medical ailments in newborn care, hearing impairment, neurological dysfunction, epilepsy, sleep disorders, and balance and mobility disorders. Product offerings include computerized neurodiagnostic systems for audiology, neurology, polysomnography, and neonatology, as well as newborn care products such as hearing screening systems, phototherapy devices for the treatment of newborn jaundice, head-cooling products for the treatment of brain injury in newborns, incubators to control the newborn's environment, and software systems for managing and tracking disorders and diseases for public health laboratories. We have completed a number of acquisitions since 2003, consisting of either the purchase of a company, substantially all of the assets of a company, or individual products or product lines. The businesses we have acquired are Neometrics in 2003, Fischer-Zoth in 2004, Bio-logic, Deltamed, and Olympic Medical in 2006, Xltek in 2007, Sonamed, Schwarzer Neurology, and Neurocom in 2008, Hawaii Medical and Alpine Biomed in 2009, and Medix in 2010. Product Families We categorize our products into the following product families, which are more fully described in our Annual Report on Form 10-K for the year ended December 31 2010: • Hearing - Includes products for newborn hearing screening and diagnostic hearing assessment. -14- -------------------------------------------------------------------------------- Table of Contents • Neurology - Includes products for diagnostic electroencephalography (EEG), electromyography (EMG), intra-operative monitoring (IOM), diagnostic sleep analysis, or polysomnography (PSG), newborn brain monitoring, and assessment of balance and mobility disorders. • Newborn Care - Includes thermoregulation devices and products for the treatment of brain injury and jaundice in newborns. Segment and Geographic Information We operate in one reportable segment in which we provide healthcare products used for the screening, detection, treatment, monitoring and tracking of common medical ailments in newborn care, hearing impairment, neurological dysfunction, epilepsy, sleep disorders and balance and mobility disorders. Our end-user customer base includes hospitals, clinics, laboratories, physicians, nurses, audiologists, and governmental agencies. Most of our international sales are to distributors who resell our products to end-users or sub-distributors. Information regarding our sales and long-lived assets in the U.S. and in countries outside the U.S. is contained in Note 12- Segment, Customer and Geographic Information of our condensed consolidated financial statements included in this report. Revenue by Product Category We generate our revenue either from sales of Devices and Systems, which are generally non-recurring, and from related Supplies and Services, which are generally recurring. Other revenue consists primarily of freight revenue. The products that are attributable to these categories are described in our Annual Report on Form 10-K for the year ended December 31, 2010. Revenue from Devices and Systems and Supplies and Services, as a percent of total revenue for the three and six months ended June 30, 2011 and 2010 is as follows: Three Months Ended Six Months Ended June 30, June 30, 2011 2010 2011 2010 Devices and Systems 63% 61% 65% 62% Supplies and Services 35% 37% 33% 36% Other 2% 2% 2% 2% Total 100% 100% 100% 100% During the three and six months ended June 30, 2011 and 2010, no single customer or foreign country contributed to more than 10% of revenue, and revenue from services was less than 10% of revenue. 2011 Second Quarter Overview Our revenue increased 10% to $58.1 million in the second quarter ended June 30, 2011, compared to $53.0 million in the comparable quarter of the previous year. Net income decreased 30% to $2.3 million or $0.08 per diluted share, for the second quarter of 2011, compared with net income of $3.3 million, or $0.12 per diluted share, for the second quarter of 2010. Medix contributed $6.8 million to our second quarter revenue, while revenue from our existing product lines decreased 6% in the 2011 period, resulting in lower earnings. During the second quarter of 2011, we continued the reorganization plan to improve efficiencies in operations at Medix, which was acquired in October, 2010. This reorganization resulted in a charge of $630,000 for the three months ended June 30, 2011. Application of Critical Accounting Policies We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP"). In so doing, we must often make estimates and use assumptions that can be subjective, and, consequently, our actual results could differ from those estimates. For any given individual estimate or assumption we make, there may also be other estimates or assumptions that are reasonable. We believe that the following critical accounting policies require the use of significant estimates, assumptions, and judgments. The use of different estimates, assumptions, or judgments could have a material effect on the reported amounts of assets, liabilities, revenue, expenses, and related disclosures as of the date of the financial statements and during the reporting period: • Revenue recognition • Inventory is carried at the lower of cost or market value -15- -------------------------------------------------------------------------------- Table of Contents • Carrying value of intangible assets and goodwill • Liability for product warranties • Share-based compensation These critical accounting policies are described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2010, under Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. There have been no changes to these policies during the three and six months ended June 30, 2011. Results of Operations The following table sets forth, for the periods indicated selected consolidated statements of operations data as a percentage of total revenue. Our historical operating results are not necessarily indicative of the results for any future period. Three Months Six Months Ended Ended June 30, June 30, 2011 2010 2011 2010 Revenue 100.0 % 100.0 % 100.0 % 100.0 % Cost of revenue 43.1 40.6 42.1 40.0 Gross profit 56.9 59.4 57.9 60.0 Operating expenses: Marketing and selling 27.1 25.6 25.7 26.9 Research and development 10.6 9.9 10.6 10.1 General and administrative 13.7 14.7 14.5 18.4 Total operating expenses 51.4 50.2 50.8 55.4 Income from operations 5.5 9.2 7.1 4.6 Other income (expense), net (0.1 ) 0.5 (0.2 ) 0.2 Income before provision for income tax 5.4 9.7 6.9 4.8 Provision for income tax 1.2 3.4 2.1 1.8 Net income 4.2 % 6.3 % 4.8 % 3.0 % We acquired Medix in October 2010. Where significant, we have noted the impact of this acquisition on our results of operations for the three and six months ended June 30, 2011, as compared to the same periods in 2010. Three Months Ended June 30, 2011 and 2010 Our revenue increased 10%, or $5.1 million, to $58.1 million for the three month period ended June 30, 2011 compared to $53.0 million in the comparable 2010 period. Revenue from Medix contributed to $6.8 million of the increase. Revenue from our neurology products increased $1.5 million in the quarter while revenue from newborn care products other than from Medix decreased $1.4 million and revenue from our newborn hearing and diagnostic products decreased $1.8 million. Revenue from devices and systems increased $4.2 million, or 13%, to $36.5 million in the three months ended June 30, 2011, compared to $32.3 million in the same period in 2010. Revenue from Medix contributed to $4.5 million of the increase. Additionally, revenue from our neurology and other diagnostic products was $4.1 million, offset by a decrease from newborn hearing screening and newborn care revenue other than Medix of $4.4 million. Revenue from devices and systems was 63% of total revenue in the three months ended June 30, 2011 compared to 61% of total revenue for the second quarter of 2010. -16- -------------------------------------------------------------------------------- Table of Contents Revenue from supplies and services increased 5%, or $900,000, to $20.8 million in the second quarter of 2011 compared to $19.9 million in the same period in 2010. Medix contributed $2.4 million of supplies and services revenue, in the second quarter of 2011, revenue from hearing supplies increased by $800,000 and revenue from service fees and newborn care supplies other than Medix increased by $800,000, offset by a decrease in revenue from neurology supplies of $3.1 million. Revenue from supplies and services was 35% of total revenue in the three months ended June 30, 2011 compared to 37% of total revenue for the second quarter of 2010. Revenue from sales outside the U.S. increased 39%, or $7.2 million, to $25.7 million in the second quarter of 2011 compared to $18.5 million for the same period in 2010. Revenue from Medix contributed to $6.8 million of the increase in international revenue, while revenue from neurology and hearing products increased by $1.5 million and international revenue from newborn care products other than Medix decreased by $1.1 million. Gross profit as a percentage of revenue was 56.9% for the three months ended June 30, 2011 compared to 59.4% for the respective 2010 period reflecting the lower gross profit margins of Medix products. Gross profit increased $1.6 million, or 5% to $33.1 million in 2011 from $31.5 million in 2010. Total operating costs increased by $3.3 million or 13%, to $29.9 million in the three months ended June 30, 2011, compared to $26.6 million in the same period in 2010. The operations of Medix comprised $3.1 million of the increase. Marketing and selling expenses increased $2.2 million, or 16%, to $15.7 million in the three months ended June 30, 2011, compared to $13.5 million in the same period in 2010. The expenses of Medix contributed to $1.3 million of the increase with the remainder of the increase primarily attributable to higher sales commission costs. Research and development expenses increased $1.0 million, or 18%, to $6.2 million for the three months ended June 30, 2011, compared to $5.2 million in the same period of 2010. The operations of Medix contributed to $600,000 of the increase, while other research and development expenses were approximately 8% higher in the second quarter of 2011 compared to the same period in 2010, reflecting the impact of higher outside service costs. General and administrative expenses increased $200,000, or 2%, to $8.0 million in the three months ended June 30, 2011, compared to $7.8 million in the same period in 2010. The operations of Medix contributed to $1.2 million of general and administrative expenses, including restructuring costs of $630,000. Other general and administrative expenses exclusive of Medix were $1.0 million lower in the 2011 second quarter compared to the same period in 2010, which resulted primarily from a decrease in bonus accruals associated with lower earnings. Other income, net, consists of investment income from our investment portfolio, interest expense, net currency exchange gains and losses, and other miscellaneous income and expenses. We reported net other expense of $69,000 in the three months ended June 30, 2011, compared to net other income of $240,000 in the same period in 2010. We recognized $67,000 of foreign exchange gains and $189,000 of net foreign currency exchange losses during the three months ended June 30, 2011 and 2010 respectively. We recorded a provision for income taxes of $726,000 in the three months ended June 30, 2011, compared to $1.8 million in the same period in 2010. Our effective tax rate in the second quarter of 2011 was 23.5% compared to an effective rate of 34.8% in the second quarter of 2010. The reduction in the effective tax rate was due primarily to an increase in the U.S. Federal manufacturing deduction and research and development tax credit, and tax benefits from international subsidiary tax return true-ups for the quarter. Six Months Ended June 30, 2011 and 2010 Revenue increased $14.9 million, or 15%, for the six month period ended June 30, 2011 from the comparable 2010 period. Revenue from Medix contributed to $12.6 million of the increase, while revenue from our neurology products increased by $5.2 million to $52.6 million and all other product lines combined exclusive of Medix decreased by $2.9 million to $52.0 million. Device and systems revenue increased $12.3 million, or 19%, to $76.2 million in the six months ended June 30, 2011 compared to $63.9 million in the same period in 2010. The acquisition of Medix contributed to $9.8 million of the increase coupled with a $6.1 million increase in neurology devices and systems revenue lead by strong demand for our Xltek EEG products. In addition, an increase in sleep diagnostics, balance monitoring and med-surgical revenue of $1.6 million was offset by a $5.2 million decrease in revenue from our other product lines including hearing and newborn care products other than Medix. Revenue from devices and systems was 65% of consolidated revenue in the six months ended June 30, 2011 compared to 62% of consolidated revenue for the first half of 2010. -17- -------------------------------------------------------------------------------- Table of Contents Supplies and services revenue increased $2.5 million, or 7%, to $39.2 million in the six months ended June 30, 2011 compared to $36.8 million in the same period in 2010. Medix contributed to $2.9 million of revenue from supplies and services while supplies and service revenue from other products decreased $400,000. Revenue from supplies and services was 33% of consolidated revenue in the six months ended June 30, 2011 compared to 36% of consolidated revenue for the six months ended June 30, 2010. Revenue from sales outside the U.S. increased $12.3 million, or 31%, to $52.1 million in the first half of 2011 compared to $39.8 million for the same period in 2010. Revenue from Medix contributed $12.6 million of international revenue. A decrease in international hearing and newborn care revenue of $1.8 million was partially offset by a $1.5 million increase in neurology and other international product revenue. Gross profit as a percentage of revenue was 57.9% for the six months ended June 30, 2011 compared to 60.0% for the respective period in 2010, reflecting sales mix towards lower margin products coupled with Medix products having lower margins than our other product lines. Cost of revenue increased $8.5 million, or 21%, to $49.4 million in the six months ended June 30, 2011, from $40.9 million in 2010 as a result of increased sales. Gross profit increased $6.4 million, or 10%, to $67.8 million in 2011 from $61.4 million in 2010. Total operating costs increased by $2.9 million or 5%, to $59.6 million in the six months ended June 30, 2011, compared to $56.7 million in the same period in 2010. The operations of Medix contributed to $4.7 million of total operating costs. Other general and administrative expenses exclusive of Medix were $1.8 million lower which resulted primarily from lower benefit costs associated with a decrease in bonus accruals and lower restructuring charges in 2011. Marketing and selling expenses increased $2.6 million, or 9%, to $30.1 million in the six months ended June 30, 2011 compared to $27.5 million in the same period in 2010. The expenses of Medix contributed to $2.1 million of the increase with the remainder of the increase primarily attributable to higher sales commission costs associated with the increase in our revenue. Research and development expenses increased $2.1 million, or 20%, to $12.5 million in the six months ended June 30, 2011 compared to $10.4 million in the same period of 2010. The operations of Medix contributed to $1.0 million of the increase, while other research and development expenses were approximately 11% higher in the first half of 2011 compared to the same period in 2010, reflecting the impact of higher outside service costs. General and administrative expenses decreased $1.8 million, or 9%, to $17.0 million in the six months ended June 30, 2011 compared to $18.8 million in the same period in 2010. The operations of Medix contributed to $1.7 million of general and administrative expenses including a restructuring charge of $793,000. In the first six months of 2010 we incurred a restructuring charge of $3.1 million related to Alpine Biomed. Other general and administrative expenses exclusive of Medix and the restructuring charge were $300,000 lower in the first half of 2011 compared to the same period in 2010, which resulted primarily from a decrease in bonus accruals associated with lower earnings. Other income, net consists of investment income from our investment portfolio, interest expense, net currency exchange gains and losses, and other miscellaneous income and expenses. We reported net other expense of $214,000 in the six months ended June 30, 2011, compared to net other income of $185,000 in the same period in 2010. We recognized $107,000 and $367,000 of foreign currency exchange losses during the six months ended June 30, 2011 and 2010, respectively. We recorded income tax expense of $2.5 million in the six months ended June 30, 2011, compared to $1.8 million in the same periods in 2010. Our effective tax rate in the first six months of 2011 was 31.5% compared to an effective rate of 37.6% in the same period in 2010. The reduction in the effective tax rate was due primarily to an increase in the U.S. Federal manufacturing deduction and research and development tax credit, and tax benefits from international subsidiary tax return true-ups. Liquidity and Capital Resources Liquidity is our ability to generate sufficient cash flows from operating activities to meet our obligations and commitments. In addition, liquidity includes the ability to obtain appropriate financing and to raise capital. Therefore, liquidity cannot be considered separately from capital resources that consist of our current funds and the potential to increase those funds in the future. We plan to use these resources in meeting our commitments and in achieving our business objectives. -18- -------------------------------------------------------------------------------- Table of Contents As of June 30, 2011, we had cash and cash equivalents of $37.7 million, of which $19.1 million was held in the United States and $18.6 million was held by our foreign subsidiaries; we also had stockholders' equity of $275.1 million, and working capital of $97.2 million, compared with cash, cash equivalents, and short-term investments of $29.4 million, stockholders' equity of $263.3 million, and working capital of $83.9 million as of December 31, 2010. We believe that our current cash and cash equivalents and any cash generated from operations will be sufficient to meet our ongoing operating requirements for the foreseeable future. We completed the acquisition of Medix in 2010, two acquisitions in 2009, four acquisitions in 2008, one in 2007, and three in 2006. We intend to continue to acquire additional technologies, products, or businesses and these acquisitions could be significant. These actions would likely affect our future capital requirements and the adequacy of our available funds. In order to finance future acquisitions, we may be required to raise additional funds through public or private financings, strategic relationships or other arrangements. Any equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants and increase our cost of capital. At June 30, 2011 we had a $50 million revolving credit facility with Wells Fargo Bank, National Association ("Wells Fargo"). The revolving credit facility contains covenants, including covenants relating to liquidity and other financial measurements, and provides for events of default, including failure to pay any interest when due, failure to perform or observe covenants, bankruptcy or insolvency events and the occurrence of a material adverse effect. We have granted Wells Fargo a security interest in substantially all of our assets. We did not draw on the facility during the first half of 2011 or during 2010. We have no other significant credit facilities. Global capital markets have been, and may continue to be, disrupted and volatile. The cost and availability of equity and debt funding has been and may continue to be adversely affected by illiquid capital and credit markets. Some lenders have reduced or, in some cases, ceased to provide funding to borrowers. We believe that we have adequate liquidity to meet our present needs. Continued turbulence in the United States and international financial markets, however, could adversely affect the cost and availability of financing to us in the future and limit our ability to acquire products, other assets, or businesses. Cash provided by operations increased by $253,000 for the six months ended June 30, 2011 to $6.9 million, compared to $6.7 million for the same period in 2010. The sum of our net income and certain non-cash expense items, such as reserves, depreciation and amortization, and share based compensation was approximately $14.5 million in the 2011 period, compared to $9.0 million in 2010. In the 2010 period we paid approximately $2.4 million more restructuring severance benefits than in the 2011 period coupled with a $1.1 million increase in warranty reserves in the 2011 period. The overall impact of changes in certain operating assets and liabilities on total operating cash flows resulted in a cash outflow of $7.5 million in 2011 compared with a cash outflow of $2.5 million in 2010. In particular, our cash flow from operations in the first six months of 2011 was affected by a $4.8 million decrease in accounts payable and accrued expenses coupled with a $3.6 million increase in inventories. Cash used in investing activities was $577,000 for the six months ended June 30, 2011, compared to $2.2 million for the same period in 2010. We used $1.6 million and $2.1 million of cash to acquire property and equipment during the six months ended June 30, 2011 and 2010, respectively. We capitalized $161,000 of software development costs during the six months ended June 30, 2010 for which there was no comparable expenditure in 2011. Cash provided by financing activities was $2.5 million in the six months ended June 30, 2011, compared to $2.7 million used in financing activities in the same period of 2010. We received cash from sales of our stock pursuant to our stock options and our employee stock purchase plan in the amount of $1.4 million and $2.0 million in the six months ended June 30, 2011 and 2010, respectively. We received $2.0 million in short-term borrowings in the six months ended June 30, 2011 for which there were no similar proceeds in 2010. We repaid $1.1 million of short-term borrowings and long-term debt as of June 30, 2011 as compared with repayment of $89,000 of long-term debt as of June 30, 2010. In 2011, we realized an excess tax benefit of $296,000 on the exercise of employee stock options that was recorded as an increase to stockholders' equity, as compared with a tax benefit of $779,000 in the first six months of 2010. Our future liquidity and capital requirements will depend on numerous factors, including the: • Extent to which we make acquisitions; • Amount and timing of revenue; • Extent to which our existing and new products gain market acceptance; • Cost and timing of product development efforts and the success of these development efforts; • Cost and timing of marketing and selling activities; and • Availability of borrowings under line of credit arrangements and the availability of other means of financing. -19- -------------------------------------------------------------------------------- Table of Contents Commitments and Contingencies In the normal course of business, we enter into obligations and commitments that require future contractual payments. The commitments result primarily from firm, noncancellable purchase orders placed with contract vendors that manufacture some of the components used in our medical devices and related disposable supply products, as well as commitments for leased office, manufacturing, and warehouse facilities. There have been no material changes to the table of contractual obligations presented in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the year ended December 31, 2010. Under our bylaws, we have agreed to indemnify our officers and directors for certain events or occurrences arising as a result of the officer or director's serving in such capacity. We have a directors and officers liability insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid resulting from the indemnification of our officers and directors. In addition, we enter into indemnification agreements with other parties in the ordinary course of business. In some cases we have obtained liability insurance providing coverage that limits our exposure for these other indemnified matters. We have not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements. We believe the estimated fair value of these indemnification agreements is minimal and have not recorded a liability for these agreements Recent Accounting Pronouncements See Note 1 to our Condensed Consolidated Financial Statements for a discussion of new accounting pronouncements that affect us. Cautionary Information Regarding Forward Looking Statements This report contains 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 about Natus Medical Incorporated. These statements include, among other things, statements concerning our expectations, beliefs, plans, intentions, future operations, financial condition and prospects, and business strategies. The words "may," "will," "continue," "estimate," "project," "intend," "believe," "expect," "anticipate," and other similar expressions generally identify forward-looking statements. Forward-looking statements in this Item 2 include, but are not limited to, statements regarding the following: our belief that the recovery from the worldwide economic downturn has continued, our expectation regarding expansion of our international operations, our expectations regarding our new products, the sufficiency of our current cash, cash equivalents, and short-term investment balances, and any cash generated from operations to meet our ongoing operating and capital requirements for the foreseeable future our expectations as to the necessity of earn out payments related to our recent acquisitions, our expectation that our deferred tax assets will be fully realized, and our intent to acquire additional technologies, products, or businesses. Forward-looking statements are not guarantees of future performance and are subject to substantial risks and uncertainties that could cause the actual results predicted in the forward-looking statements as well as our future financial condition and results of operations to differ materially from our historical results or currently anticipated results. Investors should carefully review the information contained under the caption "Risk Factors" contained in Part II, Item 1A of this report for a description of risks and uncertainties. All forward-looking statements are based on information available to us on the date hereof, and we assume no obligation to update forward-looking statements. |