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GREATBATCH, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS OF OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS IN CONJUNCTION WITH OUR FINANCIAL STATEMENTS AND RELATED NOTES INCLUDED ELSEWHERE IN THIS REPORT. Our Business • Our business • Our acquisitions • Our customers • Strategic and financial overview • 2013 financial guidance • Cost savings and consolidation efforts • Product development • Government regulation Our Critical Accounting Estimates • Valuation of goodwill and other identifiable intangible assets • Stock-based compensation • Inventories • Tangible long-lived assets • Provision for income taxes Our Financial Results • Results of operations table • Fiscal 2012 compared with fiscal 2011 • Fiscal 2011 compared with fiscal 2010 • Liquidity and capital resources • Off-balance sheet arrangements • Litigation • Contractual obligations • Inflation • Impact of recently issued accounting standards Our Business We operate our business in two reportable segments - Implantable Medical and Electrochem Solutions ("Electrochem"). The Company's customers include large multi-national original equipment manufacturers ("OEMs"). The Implantable Medical segment is comprised of our Greatbatch Medical and QiG Group brands and designs and manufactures medical devices and components for the cardiac, neuromodulation, vascular and orthopaedic markets. The Implantable Medical segment offers complete medical devices including design, development, manufacturing, regulatory submission and supporting worldwide distribution, which is facilitated through the QiG Group and leverages the component technology of Greatbatch Medical. The devices designed and developed by the QiG Group are manufactured by Greatbatch Medical. The Implantable Medical segment also offers value-added assembly and design engineering services for its component products. - 35 - -------------------------------------------------------------------------------- Table of Contents Electrochem provides industry-leading total power solutions for rechargeable and non-rechargeable battery power systems, charging and docking stations, and power supplies, for critical applications in the portable medical and energy markets, where safety, reliability, quality and innovation are critical. Electrochem's product lines cover a number of highly-customized battery-powered applications in remote and demanding environments, including down hole drilling tools and in life-saving and life-enhancing applications, including automated external defibrillators, portable oxygen concentrators, ventilators and powered surgical tools, among others. Our Acquisitions On December 15, 2011, Electrochem acquired all of the outstanding stock of Micro Power Electronics, Inc. ("Micro Power") headquartered in Beaverton, OR. Micro Power is a leading supplier of custom battery solutions, serving the portable medical, military and handheld automatic identification and data collection markets. Micro Power's commercial portfolio is highly complementary to the products and services offered by Electrochem. The results of Micro Power were included in our Electrochem segment from the date of acquisition. The aggregate purchase price of Micro Power was $71.8 million, which we funded with cash on hand and $45 million borrowed under our revolving credit facility. Total assets acquired from Micro Power were $88.2 million. Total liabilities assumed from Micro Power were $16.4 million. For 2012, Micro Power added approximately $82.4 million to our revenue. On February 16, 2012, Greatbatch purchased all of the outstanding common stock of NeuroNexus Technologies, Inc. ("NeuroNexus") headquartered in Ann Arbor, MI. NeuroNexus is an active implantable medical device design firm specializing in developing and commercializing neural interface technology, components and systems for neuroscience and clinical markets. NeuroNexus has an extensive intellectual property portfolio, core technologies and capabilities to support the development and manufacturing of innovative neural interface devices across a wide range of functions including neuromodulation, sensing, optical stimulation and targeted drug delivery applications. The results of NeuroNexus were included in our Implantable Medical segment from the date of acquisition. The aggregate purchase price of NeuroNexus was $13.2 million, which we funded with cash on hand and $10 million borrowed under our revolving credit facility. Total assets acquired from NeuroNexus were $14.6 million. Total liabilities assumed from NeuroNexus were $1.4 million. For 2012, NeuroNexus added approximately $2.5 million to our revenue. Going forward, we will continue to pursue potential acquisitions. Our Customers Our products are designed to provide reliable, long-lasting solutions that meet the evolving requirements and needs of our customers and the end users of their products. The nature and extent of our selling relationships with each customer are different in terms of breadth of products purchased, purchased product volumes, length of contractual commitment, ordering patterns, inventory management and selling prices. Our Implantable Medical customers include large multi-national OEMs, such as Biotronik, Boston Scientific, Johnson & Johnson, Medtronic, Smith & Nephew, Sorin Group, St. Jude Medical, Stryker and Zimmer. During 2012, Boston Scientific, Johnson & Johnson, Medtronic and St. Jude Medical collectively accounted for 52% of our total sales. Our Electrochem customers are primarily companies involved in demanding markets where highly sophisticated power solutions needs exist, such as energy, portable medical, military and environmental. Some of our larger OEM customers include General Electric, Halliburton Company, Scripps Institution of Oceanography, Thales, Weatherford International and Zoll Medical Corp. - 36 --------------------------------------------------------------------------------- Table of Contents Strategic and Financial Overview Since 2007, we have been implementing a strategy centered on continually strengthening three aspects of our business that can most affect profitable growth: our top line, our bottom line and our pipeline. This strategy includes three facets; growth in our core business, growth through acquisitions and growth through the development and commercialization of complete medical devices. As a result of this strategy, sales increased 14% for 2012 and 7% for 2011. Sales growth for 2012 and 2011 included the benefit from our acquisitions of $84.8 million and $2.5 million, respectively. Additionally, sales include the impact from foreign currency exchange rate fluctuations, which decreased 2012 sales by $6 million in comparison to 2011 and increased 2011 sales by $8 million in comparison to 2010. On a constant currency, organic basis sales were consistent from 2011 to 2012 and increased 5% from 2010 to 2011 as growth from our vascular and portable medical product lines more than offset the impact the declining cardiac rhythm management ("CRM") market had on our cardiac and neuromodulation product line. Our portable medical product line is benefiting from new product introductions and market shift in patient care from clinical settings to the home, and an aging population, which is driving the need for lightweight and portable devices for patients and caregivers. Our vascular product line growth is being driven by growth in the underlying market, market share gains and the commercialization of our medical devices. Despite the declining CRM market, we were able to grow our cardiac business faster than the underlying market through innovation as well as deepening customer relationships. For 2013, we expect revenue, after adjusting for the sale of a portion of our orthopaedic product line, to organically grow 5-8% driven primarily by our portable medical, vascular and orthopaedic product lines along with above market growth in cardiac and neuromodulation. Simultaneous with the initiation of our growth strategy, we began evolving our product offerings to include the development of complete medical devices in order to raise the growth and profitability profile of the Company. This medical device strategy is being facilitated through our QiG Group and leverages the component technology of Greatbatch Medical. More specifically, this strategy includes the development of a neuromodulation platform that can be used to support several devices most notably of which is our spinal cord stimulator for the treatment of chronic pain in the trunk and limbs, which we call Algostim. We currently expect to submit this device to regulatory authorities in the second half of 2013. Incremental investments in all of our medical device products, including Algostim, totaled $33.9 million, $27.3 million and $21.9 million for 2012, 2011 and 2010, respectively, and included charges to selling, general and administrative expenses ("SG&A") and research, development and engineering, net ("RD&E"). As a result of this strategy, as well as our acquisitions, SG&A increased 12% during both 2012 and 2011 while RD&E increased 15% and 1%, respectively, for the same periods. During the second half of 2012, we began a process to more fully optimize our research and development efforts. This included the reallocation of research and development resources to higher priority projects, the postponement of some research and development projects, and the decision to pursue various alternatives to monetize our existing non-core intellectual property and entering into more co-development arrangements with our customers. As a result, RD&E for the second half of 2012 was $3.7 million lower than the first half of 2012. These reductions are also expected to benefit 2013. - 37 --------------------------------------------------------------------------------- Table of Contents We have a longstanding history of operational excellence, which is one of our core competencies. As we move forward, investing in our operations will continue to be critical to the success of our growth and medical device strategies. Since 2007, we have invested substantial resources in integrating our acquisitions and streamlining our operations. This strategy continued during 2012 as we worked diligently to resolve the operational issues we were experiencing at our Swiss orthopaedic facilities, expanded our manufacturing infrastructure to support the commercialization of our medical devices and upgraded our global ERP system in order to support our future growth. As a result of these initiatives, our other operating expense totaled $47.5 million over the last three years, $42.3 million of which was incurred during 2012. These expenses are expected to be reduced significantly in 2013 and to range from $6.7 million to $8.2 million, which will improve the overall earnings of Greatbatch. While we continually identify and implement cost improvement initiatives, we have now completed all of our major plant consolidations, which began in 2007, so our leadership team can focus on achieving sustainable organic growth to leverage our available capacity. We prepare our consolidated financial statements in accordance with generally accepted accounting principles in the United States of America ("GAAP"). Additionally, we consistently report and discuss in our quarterly earnings releases and investor presentations adjusted operating income and margin, adjusted net income and adjusted earnings per diluted share, which are non-GAAP measures. These adjusted amounts consist of GAAP amounts and, to the extent occurring during a period, excludes (i) acquisition-related charges, (ii) facility consolidation, optimization, manufacturing transfer and system integration charges, (iii) asset write-down and disposition charges, (iv) severance charges in connection with corporate realignments or a reduction in force (v) litigation charges and gains, (vi) the impact of non-cash charges to interest expense due to the accounting change governing convertible debt, (vii) unusual or infrequently occurring items, (viii) certain RD&E expenditures, such as design verification testing ("DVT") expenses incurred in connection with the development of our neuromodulation platform, (ix) gain/loss on the sale of investments, (x) the income tax (benefit) related to these adjustments and (xi) certain tax charges related to the consolidation of our Swiss Orthopaedic facility. We believe that reporting these amounts provides important supplemental information to our investors and creditors seeking to understand the financial and business trends relating to our financial condition and results of operations. Additionally, the performance based compensation of our executive management is determined utilizing these adjusted amounts. A reconciliation of GAAP operating income (loss) to adjusted amounts is as follows (dollars in thousands): Implantable Medical Electrochem Unallocated Total Dec. 28, Dec. 30, Dec. 28, Dec. 30, Dec. 28, Dec. 30, Dec. 28, Dec. 30, 2012 2011 2012 2011 2012 2011 2012 2011 Total sales $ 483,165 $ 489,065 $ 163,012 $ 79,757 $ - $ - $ 646,177 $ 568,822 Operating income (loss) as reported $ 24,908 $ 62,461 $ 21,631 $ 14,965 $ (20,718 ) $ (15,727 ) $ 25,821 $ 61,699 Adjustments: Inventory step-up amortization (COS) - - 532 177 - - 532 177 Medical device DVT expenses (RD&E) 5,190 5,133 - - - - 5,190 5,133 Consolidation and optimization costs 34,378 425 - - 4,670 - 39,048 425 Integration expenses 167 - 1,287 - 6 - 1,460 - Asset dispositions, severance and other 247 51 883 117 708 - 1,838 168 Adjusted operating income (loss) $ 64,890 $ 68,070 $ 24,333 $ 15,259 $ (15,334 ) $ (15,727 ) $ 73,889 $ 67,602 Adjusted operating margin 13.4 % 13.9 % 14.9 % 19.1 % N/A N/A 11.4 % 11.9 % Medical device related adjusted expenses (excluding DVT) $ 28,453 $ 22,080 $ - $ - $ - $ - $ 28,453 $ 22,080 Adjusted operating income excluding medical device initiatives $ 93,343 $ 90,150 $ 24,333 $ 15,259 $ (15,334 ) $ (15,727 ) $ 102,342 $ 89,682 Adjusted operating margin excluding medical device initiatives 19.3 % 18.4 % 14.9 % 19.1 % N/A N/A 15.8 % 15.8 % - 38 - -------------------------------------------------------------------------------- Table of Contents Implantable Medical Electrochem Unallocated Total Dec. 30, Dec. 31, Dec. 30, Dec. 31, Dec. 30, Dec. 31, Dec. 30, Dec. 31, 2011 2010 2011 2010 2011 2010 2011 2010 Total sales $ 489,065 $ 460,269 $ 79,757 $ 73,156 $ - $ - $ 568,822 $ 533,425 Operating income (loss) as reported $ 62,461 $ 62,477 $ 14,965 $ 22,195 $ (15,727 ) $ (15,678 ) $ 61,699 $ 68,994 Adjustments: Inventory step-up amortization (COS) - - 177 - - - 177 - Executive death benefits (SG&A) - 885 - - - - - 885 Medical device DVT expenses (RD&E) 5,133 - - - - - 5,133 - Electrochem litigation gain - - - (9,500 ) - - - (9,500 ) Consolidation and optimization costs 425 573 - 1,000 - - 425 1,573 Integration expenses - (4 ) - - - 46 - 42 Asset dispositions, severance and other 51 2,517 117 100 - 326 168 2,943 Adjusted operating income (loss) $ 68,070 $ 66,448 $ 15,259 $ 13,795 $ (15,727 ) $ (15,306 ) $ 67,602 $ 64,937 Adjusted operating margin 13.9 % 14.4 % 19.1 % 18.9 % N/A N/A 11.9 % 12.2 % Medical device related adjusted expenses (excluding DVT) $ 22,080 $ 21,878 $ - $ - $ - $ - $ 22,080 $ 21,878 Adjusted operating income excluding medical device initiatives $ 90,150 $ 88,326 $ 15,259 $ 13,795 $ (15,727 ) $ (15,306 ) $ 89,682 $ 86,815 Adjusted operating margin excluding medical device initiatives 18.4 % 19.2 % 19.1 % 18.9 % N/A N/A 15.8 % 16.3 % GAAP operating income for 2012 was $25.8 million compared to $61.7 million for 2011 and $69.0 million for 2010. These decreases were primarily due to the costs incurred in connection with our medical device and consolidation and productivity initiatives discussed above, as well as the litigation settlement gain recorded in 2010. Adjusted operating income, which excludes these items, was $73.9 million for 2012, compared to $67.6 million for 2011 and $64.9 million for 2010. This represents an increase of 9% for 2012 and 4% for 2011 as the Company continues to leverage its operating infrastructure and is beginning to see the benefits of its productivity and consolidation initiatives. Beginning in 2012, we are showing adjusted operating income excluding the incremental costs from our medical device initiatives. This information is provided in order to enhance the reader's understanding of our core business, which is being impacted by these medical device investments and has not meaningfully impacted our revenue or gross margins. Sales of complete medical devices developed under the Greatbatch name were $6.6 million during 2012 compared to $4.5 million for 2011, an increase of 47%. - 39 --------------------------------------------------------------------------------- Table of Contents A reconciliation of GAAP net income (loss) and diluted earnings (loss) per share ("EPS") to adjusted amounts is as follows (in thousands, except per share amounts): Year Ended December 28, December 30, December 31, 2012 2011 2010 Impact Impact Impact Net Per Net Per Net Per Income Diluted Income Diluted Income Diluted (Loss) Share (Loss) Share (Loss) Share Net income (loss) as reported $ (4,799 ) $ (0.20 ) $ 33,122 $ 1.40 $ 33,138 $ 1.40 Adjustments:(a) Inventory step-up amortization (COS) 346 0.01 115 - - - Executive death benefits (SG&A) - - - - 575 0.02 Medical device DVT expenses (RD&E) 3,374 0.14 3,336 0.14 - - Electrochem litigation gain - - - - (6,175 ) (0.26 ) Consolidation and optimization costs 28,934 1.21 276 0.01 1,022 0.04 Integration expenses 949 0.04 - - 27 - Asset dispositions, severance and other 1,186 0.05 109 - 1,913 0.08 (Gain) loss on cost and equity method investments, net(b ) 69 - (2,751 ) (0.12 ) 98 - CSN conversion option discount amortization(c ) 6,234 0.26 5,515 0.23 5,119 0.22 Swiss tax impact(d) 6,190 0.26 - - - - Adjusted net income and diluted EPS(e) $ 42,483 $ 1.77 $ 39,722 $ 1.68 $ 35,718 $ 1.51 Adjusted diluted weighted average shares (f) 23,947 23,636 23,802 (a) Net of tax amounts computed using the applicable U.S. and foreign statutory tax rates of 35% and 22.5%, respectively, for items incurred in those geographic locations. (b) Pre-tax amount is a loss of $106 thousand, gain of $4.2 million and loss of $150 thousand for 2012, 2011 and 2010, respectively. (c) Pre-tax amount is $9.6 million, $8.5 million and $7.9 million for 2012, 2011 and 2010, respectively. (d) Relates to the loss of our Swiss tax holiday due to our decision to transfer manufacturing out of Switzerland, as well as the establishment of a valuation allowance on our Swiss deferred tax assets as it is more likely than not that they will not be fully realized. (e) The per share data in this table has been rounded to the nearest $0.01 and therefore may not sum to the total. (f) Adjusted diluted weighted average shares for 2012 include 363 thousand shares of dilution related to outstanding stock incentive awards that were not dilutive for GAAP diluted EPS purposes. GAAP net income (loss) and diluted EPS include the impact of costs incurred in connection with our medical device and consolidation and productivity initiatives, as well as the litigation settlement gain recorded in 2010. Excluding these items, adjusted diluted EPS increased 5% in 2012 and 11% in 2011. In aggregate we estimate that our Swiss operational issues had a negative $0.16 per share of adjusted diluted earnings impact for 2012. - 40 --------------------------------------------------------------------------------- Table of Contents For 2013, we expect our performance to improve as we progress through the year, as the first quarter of 2013 will be impacted by the startup of our recently transferred orthopaedic production lines. The second half of the year is expected to improve as the orthopaedic backlog is relieved and new product introductions in our portable medical business commercialize. As a result of our consolidation initiatives and refocused medical device RD&E investment, we expect improved performance each quarter when compared to the prior year and expect to achieve adjusted diluted EPS growth of 7-13% for 2013. 2013 Financial Guidance For 2013, we estimate annual revenue growth rates for our product lines as follows: Estimated 2013 Annual 2013 Estimated Revenue Product Line Growth Rate (%) (millions) Cardiac & Neuromodulation 0% - 2% $309 - $315 Vascular 7% - 13% $55 - $59 Orthopaedic(1) (5%) - 0% $116 - $122 Portable Medical 15% - 20% $94 - $98 Energy & Other 6% $86 - $86 Total Sales(1) 2% - 5% $660 - $680 (1) Organic revenue growth for orthopaedic product line is 8%-14% due to disposition of approximately $15 million of non-core product lines at the end of 2012. Total consolidated organic revenue growth is expected to be 5%-8%. Adjusted Operating Income as a % of Sales 12.0% - 12.5% Adjusted Diluted EPS $1.90 - $2.00 Adjusted operating income for 2013 is expected to consist of GAAP operating income minus non-recurring, unusual or infrequently occurring items such as acquisition, consolidation and integration charges, certain RD&E expenditures and asset disposition/write-down charges, totaling approximately $11.5 million to $14.0 million. This range has been significantly reduced from the 2012 level as we have essentially completed our current productivity and consolidation initiatives. Included in the above range are residual DVT costs in the range of $4.8 to $5.8 million to complete our Algostim project. Cost Savings and Consolidation Efforts In 2012, 2011 and 2010, we recorded charges in Other Operating Expenses, Net related to cost savings and consolidation efforts. These initiatives were undertaken to improve our operational efficiencies and profitability. Additional information regarding the timing, cash flow impact and amount of future expenditures is set forth in Note 13 "Other Operating Expenses, Net" of the Notes to the Consolidated Financial Statements contained in Item 8 of this report, as well as the "Liquidity and Capital Resources" section of this Item. - 41 - -------------------------------------------------------------------------------- Table of Contents Over the last two years, we have been implementing a multi-faceted plan to further enhance, optimize and leverage our orthopaedics operations. This plan includes the construction of an orthopaedic manufacturing facility in Fort Wayne, IN, updating our Indianapolis, IN facility to streamline operations, increase capacity, and further expand capabilities, and the transfer of most major functions currently performed at our facilities in Orvin and Corgemont, Switzerland into our Fort Wayne, IN and Tijuana, Mexico facilities. The total capital investment expected for these initiatives is between $25 million and $35 million, of which $21 million has been expended to date. Total expense expected to be incurred for these initiatives is between $30 million and $36 million, of which $33.1 million has been incurred to date. Near the end of 2011, we initiated plans to optimize and expand our manufacturing infrastructure in order to support our medical device strategy. This included the transfer of certain product lines to lower cost facilities, expansion of two of our existing facilities, as well as the purchase of equipment to create additional capacity for the manufacture of medical devices and create additional cost savings. Total capital investment under these initiatives is expected to be between $15 million to $20 million of which approximately $9.9 million has been expended to date. Total expenses expected to be incurred on these projects is between $2 million to $3 million of which $1.5 million has been incurred to date. These orthopaedic and medical device initiatives are expected to be completed over the next year and are expected to generate approximately $10 million to $15 million of annual cost savings and increase our capacity in order to support our growth and the manufacturing of complete medical devices. In 2011, we initiated plans to upgrade our existing global ERP system. This initiative is expected to be completed over the next year. Total capital investment under this initiative is expected to be approximately $4 million to $5 million of which approximately $3.0 million has been expended to date. Total expenses expected to be incurred on this initiative is between $5 million to $7 million of which $5.0 million has been incurred to date. Product Development Implantable Medical-As a result of the investments we have made, we are able to provide our Implantable Medical customers with complete medical devices. This medical device strategy is being facilitated through the QiG Group and includes strategic equity investments and medical devices developed independently as well as in conjunction with our OEM partners. Today we have four medical devices that we are independently working on that are in various stages of development. While we do not intend to discuss each of these projects individually each quarter, we will discuss significant milestones as they occur. Some of the medical device projects that we currently are working on include: Cardiovascular portfolio-Venous and arterial introducers, anti-microbial coatings, steerable delivery systems, and MRI conditional brady, gastric stimulation and sleep apnea leads. During 2012, we received U.S. Food and Drug Administration ("FDA") 510(k) clearance on our transradial catheter sheath introducer and steerable delivery sheath for atrial fibrillation ablation and received the CE mark for distribution of our transseptal needle that supports access and delivery of ablation therapies for atrial fibrillation. During 2012, Greatbatch Medical observed manufacturing irregularities during inspection of its bi-directional guiding sheath. This problem was identified after implementing a new inspection tool for use in performing inspections. As a result, Greatbatch Medical decided to perform a field action on this product in late 2012. Revenue on this product, which totaled $3.0 million in 2012, is expected to be temporarily delayed until the second half of 2013. - 42 --------------------------------------------------------------------------------- Table of Contents Neuromodulation portfolio - With regards to Algostim, our spinal cord stimulator for the treatment of chronic pain in the trunk and limbs, we continue to make strong technical progress on the development of this device and continue to retire critical milestones needed for program completion and the ultimate submission to regulatory authorities, which we expect in the second half of 2013. Additionally, we continue to receive strong interest from numerous world-class medical device companies, who appreciate the unique opportunity to market and distribute Algostim to interventional pain physicians, neurosurgeons and orthopaedic spine surgeons around the world. We believe Algostim's unique features and benefits will allow the right commercial partner to capture significant market share in today's $1.3 billion spinal cord stimulation market, which continues to see double digit market growth. We look forward to sharing more details regarding Algostim and our commercial partner progress at our next investor day in March 2013. Approximately $0.5 million of the NeuroNexus purchase price in February 2012 was allocated to the estimated fair value of acquired in process research and development ("IPR&D"). These projects are expected to generate cash flows but have not yet reached technological feasibility, and thus were classified as an indefinite-lived intangible asset until the completion or abandonment of the associated projects. The value assigned to IPR&D related to the development of micro-electrodes for deep brain mapping and electrocorticography. There have been no significant changes from our original estimates with regards to these projects. Electrochem-Electrochem continues to win new customers, new applications and next generation products. Our core competencies enable us to be well-positioned to win existing share and additional new product introductions based on our experience in packaging solutions, our customer relationships, our investment in technology and facilities, our capacity to service our customers, and our legacy of delivering highly reliable and innovative solutions to the medical marketplace. The growth in Electrochem is being driven by successful product launches into the higher growth, higher value portable medical market. Gaining better access to this attractive market was one of the main drivers behind our acquisition of Micro Power as it provides us with a significant opportunity for growth given its $400 million market size. Additionally, this market is benefiting from favorable market trends as patient care shifts from clinical settings to the home and as an aging population drives the need for lightweight and portable devices for patients and caregivers. These favorable trends are expected to allow this market to grow faster than our legacy markets over the next several years. Finally, this market is also attractive to us given that it has long product life cycles that should provide stability and diversification to our revenue base. Government Regulation The Patient Protection and Affordable Care Act and the Health Care and Education Affordability Reconciliation Act (collectively "Health Care Reform") legislated broad-based changes to the U.S. health care system that could significantly impact our business operations and financial results, including higher or lower revenue, as well as higher employee medical costs and taxes. Health Care Reform imposes significant new taxes on medical device OEMs, which will result in a significant increase in the tax burden on our industry and which could have a material negative impact on our financial condition, results of operations and our cash flows. Other elements of Health Care Reform such as comparative effectiveness research, an independent payment advisory board, payment system reforms including shared savings pilots and other provisions could meaningfully change the way healthcare is developed and delivered, and may materially impact numerous aspects of our business, results of operations and financial condition. Many significant parts of Health Care Reform will be phased in over the next several years and require further guidance and clarification in the form of regulations. Management is currently evaluating the impact that the new medical device tax will have on our results from operations beginning in 2013, and has preliminarily estimated that it will reduce gross profit by $1.5 million to $2.5 million. This amount assumes that this tax applies to the first medical device sale in the U.S. and is based upon a wholesale price. - 43 --------------------------------------------------------------------------------- Table of Contents On August 22, 2012, the U.S. Securities and Exchange Commission ("SEC") issued a rule under Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requiring companies to publicly disclose their use of conflict minerals that originated in the Democratic Republic of the Congo ("DRC") or an adjoining country. Under the adopted rule, issuers are required to conduct a "reasonable" due-diligence process to ascertain the source of conflict minerals, defined as tantalum, tin, gold or tungsten, that are necessary to the functionality or production of their manufactured or contracted to be manufactured products. Companies are required to provide this disclosure on a new form to be filed with the SEC called Form SD. Companies are required to file Form SD on May 31, 2014 for the 2013 calendar period and annually on May 31 every year thereafter. We anticipate additional, new compliance costs to be incurred since our Implantable Medical business utilizes all of the minerals specified in the rule, which we are unable to quantify at this time. Our Critical Accounting Estimates The preparation of our consolidated financial statements in accordance with GAAP requires us to make estimates and assumptions that affect reported amounts and related disclosures. The methods, estimates and judgments we use in applying our accounting policies have a significant impact on the results we report in our consolidated financial statements. Management considers an accounting estimate to be critical if (1) it requires assumptions to be made that were uncertain at the time the estimate was made; and (2) changes in the estimate or different estimates that could have been selected could have a material impact on our consolidated results of operations, financial position or cash flows. Our most critical accounting estimates are described below. We also have other policies that we consider key accounting policies, such as our policies for revenue recognition; however, these policies do not meet the definition of critical accounting estimates, because they do not generally require us to make estimates or judgments that are difficult or subjective. Valuation of goodwill and other identifiable intangible assets When we acquire a company, we allocate the purchase price to the tangible and intangible assets we acquire and liabilities we assume based on their fair value at the date of acquisition. Some of our intangible assets are considered non-amortizing intangible assets as they are expected to generate cash flows indefinitely. Goodwill is recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. Indefinite-lived intangibles and goodwill are not amortized but are required to be assessed for impairment on an annual basis or more frequent if certain indicators are present. Definite-lived intangible assets are amortized over their estimated useful lives and are assessed for impairment if certain indicators are present. Assumptions/Approach Used We base the fair value of identifiable tangible and intangible assets on detailed valuations that use information and assumptions provided by management. The fair values of the assets acquired are determined using one of three valuation approaches: market, income or cost. The selection of a particular method depends on the reliability of available data and the nature of the asset. The market approach values the asset based on available market pricing for comparable assets. The income approach values the asset based on the present value of risk adjusted cash flows projected to be generated by that asset. The projected cash flows for each asset considers multiple factors, including current revenue from existing customers, attrition trends, reasonable contract renewal assumptions from the perspective of a marketplace participant, and expected profit margins giving consideration to historical and expected margins. The cost approach values the asset by determining the current cost of replacing that asset with another of equivalent economic utility. The cost to replace the asset reflects the estimated reproduction or replacement cost, less an allowance for loss in value due to depreciation or obsolescence, with specific consideration given to economic obsolescence if indicated. - 44 --------------------------------------------------------------------------------- Table of Contents We perform an annual review on the last day of each fiscal year, or more frequently if indicators of potential impairment exist, to determine if the recorded goodwill and other indefinite-lived intangible assets are impaired. We assess goodwill for impairment by comparing the fair value of our reporting units to their carrying value to determine if there is potential impairment. If the fair value of a reporting unit is less than its carrying value, an impairment loss is recorded to the extent that the implied fair value of the goodwill within the reporting unit is less than its carrying value. Fair values for reporting units are determined based on the income and market approaches. Indefinite-lived intangible assets are evaluated for impairment by using the income approach. Definite-lived intangible assets are reviewed at least quarterly to determine if any conditions exist or a change in circumstances has occurred that would indicate impairment or a change in their remaining useful life. We do not believe that the indefinite-lived intangible assets or goodwill allocated to our Implantable Medical or Electrochem segments are at risk of failing step one of future annual impairment tests unless operating conditions significantly deteriorate, given the significant amount that our estimated fair value for these assets was in excess of their respective book values as of December 28, 2012, or if there is a change in our reporting units. Effect of Variation of Key Assumptions Used The use of alternative valuation assumptions, including estimated cash flows and discount rates, and alternative estimated useful life assumptions could result in different purchase price allocations. Significant changes in these estimates and assumptions could impact the value of the assets and liabilities recorded, which would change the amount and timing of future intangible asset amortization expense. We make certain estimates and assumptions that affect the expected future cash flows of our reporting units for our goodwill impairment testing. These include discount rates, terminal values and projections of future revenues and expenses. Significant changes in these estimates and assumptions could create future impairment losses to our goodwill. The assumptions used in our 2012 impairment test incorporate the information disclosed in "2013 Financial Guidance" of this section as well as other forward-looking statements made in this Management Discussion and Analysis of Financial Condition and Results of Operations section. For our indefinite-lived intangible assets, we make estimates of royalty rates, future revenues and discount rates. Significant changes in these estimates could create future impairments of these assets. Estimation of the useful lives of indefinite- and definite-lived intangible assets is based upon the estimated cash flows of the respective intangible asset and requires significant management judgment. Events could occur that would materially affect our estimates of the useful lives. Significant changes in these estimates and assumptions could change the amount of future amortization expense or could create future impairments of these intangible assets. The way the Company's management allocates resources and evaluates its businesses determines the reporting unit level which goodwill is tested for impairment. Significant changes to these reporting units could create future impairments of goodwill. - 45 - -------------------------------------------------------------------------------- Table of Contents As of December 28, 2012, we have $457.2 million of intangible assets recorded on our consolidated balance sheet representing 51% of total assets. This includes $87.3 million of amortizing intangible assets, $20.8 million of indefinite-lived intangible assets and $349.0 million of goodwill. A 1% change in the amortization of our intangible assets would change 2012 net income (loss) by approximately $0.09 million, or approximately $0.004 per diluted share. Stock-based compensation We record compensation costs related to our stock-based awards which include stock options, restricted stock and restricted stock units. We measure stock-based compensation cost at the grant date based on the fair value of the award. Compensation cost for service-based awards is recognized ratably over the applicable vesting period. Compensation cost for performance awards based on Company financial metrics is reassessed each period and recognized based upon the probability that the performance targets will be achieved. Compensation cost for performance awards based on market metrics (such as total shareholder return) is expensed each period whether the performance metrics are achieved or not. The amount of stock-based compensation expense recognized during a period is based on the portion of the awards that are ultimately expected to vest, as well as market and nonmarket performance award considerations. The total expense recognized over the vesting period will only be for those awards that ultimately vest, as well as market and nonmarket performance award considerations. Assumptions/Approach Used We utilize the Black-Scholes Option Pricing Model to determine the fair value of stock options. We are required to make certain assumptions with respect to selected Black-Scholes model inputs, including expected volatility, expected life, expected dividend yield and the risk-free interest rate. Expected volatility is based on the historical volatility of our stock over the most recent period commensurate with the estimated expected life of the stock options. The expected life of stock options granted, which represents the period of time that the stock options are expected to be outstanding, is based, primarily, on historical data. The expected dividend yield is based on our history and expectation of dividend payouts. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for a period commensurate with the estimated expected life. The fair value of time-based as well as nonmarket-based performance restricted stock and restricted stock unit awards is equal to the fair value of the Company's stock on the date of grant. The fair value of market-based performance restricted stock unit awards is determined by utilizing a Monte Carlo simulation model, which projects the value of Greatbatch stock versus our peer group under numerous scenarios and determines the value of the award based upon the present value of these projected outcomes. Compensation cost for nonmarket-based performance awards is reassessed each period and recognized based upon the probability that the performance targets will be achieved. That assessment is based upon actual and expected future performance. Stock-based compensation expense is recorded for those awards that are expected to vest, as well as market and nonmarket performance award considerations. Forfeiture estimates for determining appropriate stock-based compensation expense are estimated at the time of grant based on historical experience and demographic characteristics. Revisions are made to those estimates in subsequent periods if actual forfeitures differ from estimated forfeitures. - 46 --------------------------------------------------------------------------------- Table of Contents Effect of Variation of Key Assumptions Used Option pricing models were developed for use in estimating the value of traded options that have no vesting restrictions and are fully transferable. Because our share-based payments have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect our estimates of fair values, existing valuation models may not provide reliable measures of the fair values of our share-based compensation. Consequently, there is a risk that our estimates of the fair values of our share-based compensation awards may bear little resemblance to the actual values realized upon the exercise, expiration or forfeiture of those share-based payments in the future. Stock options may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our consolidated financial statements. Alternatively, value may be realized from these instruments that are significantly in excess of the fair values originally estimated on the grant date and reported in our consolidated financial statements. There are significant differences among valuation models. This may result in a lack of comparability with other companies that use different models, methods and assumptions. There is a high degree of subjectivity involved in selecting assumptions to be utilized to determine fair value and forfeiture assumptions. If factors change and result in different assumptions in future periods, the expense that we record for future grants may differ significantly from what we have recorded in the current period. Additionally, changes in performance of the Company and its stock price will affect the likelihood that performance-based targets are achieved and could materially impact the amount of stock-based compensation expense recognized. A 1% change in our stock-based compensation expense would change 2012 net income (loss) by approximately $0.07 million, or approximately $0.003 per diluted share. Inventories Inventories are stated at the lower of cost, determined using the first-in, first-out method, or market. Assumptions/Approach Used Inventory costing requires complex calculations that include assumptions for overhead absorption, scrap, sample calculations, manufacturing yield estimates and the determination of which costs may be capitalized. The valuation of inventory requires us to estimate obsolete or excess inventory, as well as inventory that is not of saleable quality. Effect of Variation of Key Assumptions Used Variations in methods or assumptions could have a material impact on our results. If our demand forecast for specific products is greater than actual demand and we fail to reduce manufacturing output accordingly, we could be required to record additional inventory write-downs or expense a greater amount of overhead costs, which would have a negative impact on our net income. As of December 28, 2012, we have $106.6 million of inventory recorded on our consolidated balance sheet representing 12% of total assets. A 1% write-down of our inventory would change 2012 net income (loss) by approximately $0.7 million, or approximately $0.03 per diluted share. - 47 --------------------------------------------------------------------------------- Table of Contents Tangible long-lived assets Property, plant and equipment and other tangible long-lived assets are carried at cost. The cost of property, plant and equipment is charged to depreciation expense over the estimated life of the operating assets primarily using straight-line rates. Tangible long-lived assets are subject to impairment assessment if certain indicators are present. Assumptions/Approach Used We assess the impairment of tangible long-lived assets when events or changes in circumstances indicate that the carrying value of the asset (asset group) may not be recoverable. Factors that we consider in deciding when to perform an impairment review include, but are not limited to: a significant decrease in the market price of the asset (asset group); a significant change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition; a significant change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an action or assessment by a regulator; an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction; a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group); or a current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. Recoverability potential is measured by comparing the carrying amount of the asset (asset group) to the related total future undiscounted cash flows. The projected cash flows for each asset (asset group) considers multiple factors, including current revenue from existing customers, proceeds from the sale of the asset (asset group), reasonable contract renewal assumptions, and expected profit margins giving consideration to historical and expected margins. If an asset's (assets group's) carrying value is not recoverable through related cash flows, the asset (asset group) is considered to be impaired. Impairment is measured by comparing the asset's (asset group's) carrying amount to its fair value. When it is determined that useful lives of assets are shorter than originally estimated, and there are sufficient cash flows to support the carrying value of the assets, we accelerate the rate of depreciation in order to fully depreciate the assets over their shorter useful lives. Effect of Variation of Key Assumptions Used Estimation of the cash flows and useful lives of tangible assets that are long-lived requires significant management judgment. Events could occur that would materially affect our estimates and assumptions. Unforeseen changes in operations or technology could substantially alter the assumptions regarding the ability to realize the return of our investment in long-lived assets or the useful lives. Also, as we make manufacturing process conversions and other facility consolidation decisions, we must make subjective judgments regarding the remaining cash flows and useful lives of our assets, primarily manufacturing equipment and buildings. Significant changes in these estimates and assumptions could change the amount of future depreciation expense or could create future impairments of these long-lived assets (asset groups). As of December 28, 2012 we have $150.9 million of tangible long-lived assets recorded on our consolidated balance sheet representing 17% of total assets. A 1% write-down in our tangible long-lived assets would change 2012 net income (loss) by approximately $1.0 million, or approximately $0.04 per diluted share. - 48 - -------------------------------------------------------------------------------- Table of Contents Provision for income taxes Our consolidated financial statements have been prepared using the asset and liability approach in accounting for income taxes, which requires the recognition of deferred income taxes for the expected future tax consequences of net operating losses, credits, and temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. A valuation allowance is provided on deferred tax assets if it is determined that it is more likely than not that the asset will not be realized. Assumptions/Approach Used In recording the provision for income taxes, management must estimate the future tax rates applicable to the reversal of temporary differences based upon the timing of expected reversal. Also, estimates are made as to whether taxable operating income in future periods will be sufficient to fully recognize any gross deferred tax assets. If recovery is not likely, we must increase our provision for income taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. Alternatively, we may make estimates about the potential usage of deferred tax assets that decrease our valuation allowances. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. We establish reserves for uncertain tax positions when we believe that certain tax positions do not meet the more likely than not threshold. We adjust these reserves in light of changing facts and circumstances, such as the outcome of a tax audit or the lapse of statutes of limitations. The provision for income taxes includes the impact of reserve provisions and changes to the reserves that are considered appropriate. Effect of Variation of Key Assumptions Used Changes could occur that would materially affect our estimates and assumptions regarding deferred taxes. Changes in current tax laws and tax rates could affect the valuation of deferred tax assets and liabilities, thereby changing the income tax provision. Also, significant declines in taxable income could materially impact the realizable value of deferred tax assets. At December 28, 2012, we had $38.5 million of gross deferred tax assets on our consolidated balance sheet and a valuation allowance of $12.8 million has been established for certain deferred tax assets as it is more likely than not that they will not be realized. A 1% change in the effective tax rate would impact the current year provision for income taxes by $0.07 million, and 2012 diluted earnings (loss) per share by $0.003 per diluted share. Our Financial Results We utilize a fifty-two, fifty-three week fiscal year ending on the Friday nearest December 31st. Fiscal years 2012, 2011 and 2010 ended on December 28, 2012, December 30, 2011 and December 31, 2010, respectively. Fiscal years 2012, 2011 and 2010 all contained fifty-two weeks. - 49 --------------------------------------------------------------------------------- Table of Contents Results of Operations Table Year Ended 2012 vs. 2011 2011 vs. 2010 Dec. 28, Dec. 30, Dec. 31, $ % $ % 2012 2011 2010 Change Change Change Change Dollars in thousands, except per share data Implantable Medical Sales Cardiac/Neuromodulation $ 309,124 $ 303,690 $ 303,521 $ 5,434 2 % $ 169 0 % Vascular 51,980 45,098 38,000 6,882 15 % 7,098 19 % Orthopaedic 122,061 140,277 118,748 (18,216 ) -13 % 21,529 18 % Total Implantable Medical 483,165 489,065 460,269 (5,900 ) -1 % 28,796 6 % Electrochem Sales Portable medical 81,659 9,609 8,432 72,050 NA 1,177 14 % Energy/Environmental 67,046 58,934 54,668 8,112 14 % 4,266 8 % Other 14,307 11,214 10,056 3,093 28 % 1,158 12 % Total Electrochem 163,012 79,757 73,156 83,255 104 % 6,601 9 % Total sales 646,177 568,822 533,425 77,355 14 % 35,397 7 % Cost of sales 444,528 388,469 359,844 56,059 14 % 28,625 8 % Gross profit 201,649 180,353 173,581 21,296 12 % 6,772 4 % Gross profit as a % of sales 31.2 % 31.7 % 32.5 % Selling, general and administrative expenses (SG&A) 80,992 72,548 64,510 8,444 12 % 8,038 12 % SG&A as a % of sales 12.5 % 12.8 % 12.1 % Research, development and engineering costs, net (RD&E) 52,490 45,513 45,019 6,977 15 % 494 1 % RD&E as a % of sales 8.1 % 8.0 % 8.4 % Electrochem litigation gain - - (9,500 ) - NA 9,500 -100 % Other operating expenses, net 42,346 593 4,558 41,753 NA (3,965 ) -87 % Operating income 25,821 61,699 68,994 (35,878 ) -58 % (7,295 ) -11 % Operating margin 4.0 % 10.8 % 12.9 % Interest expense 18,055 16,928 18,519 1,127 7 % (1,591 ) -9 % Interest income (1 ) (21 ) (10 ) 20 -95 % (11 ) 110 % (Gain) loss on cost and equity method investments, net 106 (4,232 ) 150 4,338 -103 % (4,382 ) NA Other expense, net 931 632 1,010 299 47 % (378 ) -37 % Provision for income taxes 11,529 15,270 16,187 (3,741 ) -24 % (917 ) -6 % Effective tax rate 171.3 % 31.6 % 32.8 % Net income (loss) $ (4,799 ) $ 33,122 $ 33,138 $ (37,921 ) -114 % $ (16 ) 0 % Net margin -0.7 % 5.8 % 6.2 % Diluted earnings (loss) per share $ (0.20 ) $ 1.40 $ 1.40 $ (2 ) -114 % $ - 0 % - 50 - -------------------------------------------------------------------------------- Table of Contents Fiscal 2012 Compared with Fiscal 2011 Sales Changes to sales by major product lines were as follows (in thousands): Year Ended 2012 vs. 2011 December 28, December 30, $ % 2012 2011 Change Change Sales: Implantable Medical Cardiac/Neuromodulation $ 309,124 $ 303,690 $ 5,434 2 % Vascular 51,980 45,098 6,882 15 % Orthopaedic 122,061 140,277 (18,216 ) -13 % Total Implantable Medical 483,165 489,065 (5,900 ) -1 % Portable Medical 81,659 9,609 72,050 N/A Energy/Environmental 67,046 58,934 8,112 14 % Other 14,307 11,214 3,093 28 % Electrochem 163,012 79,757 83,255 104 % Total sales $ 646,177 $ 568,822 $ 77,355 14 % Implantable Medical - For 2012, our cardiac/neuromodulation sales increased 2% to $309.1 million which exceeded our expectations. During 2012, cardiac and neuromodulation sales benefited from further adoption of our Q series batteries partially offset by the timing of customer inventory builds and product launches between 2011 and 2012. Management remains cautiously optimistic over the short-term prospects of this product line given the continued ongoing challenges surrounding some of our key cardiac customers. It is important to note that our visibility to customer ordering patterns is over a short period of time and that any significant customer field actions or relative market share shifts among OEM manufacturers could impact our results. We believe that the impact of these factors is somewhat muted by the fact that we have business with all of the key cardiac OEMs and have significantly diversified our revenue base. Additionally, we continue to see an increased pace of product development opportunities from our customers. Management believes that this, combined with our increased focus on sales and marketing, will allow the Company to grow this product line faster than the underlying market. For 2012, our vascular product line sales increased 15% to $52.0 million. This increase was primarily attributable to growth in the underlying market and market share gains. Additionally, vascular revenue for the year included $6.6 million from sales of medical devices that were developed under the Greatbatch name compared to $4.5 million for 2011, an increase of 47%. Orthopaedic product line sales for 2012 declined 13% compared to the same period of 2011. On a constant currency basis, orthopaedic sales declined 8% for 2012 as foreign currency exchange rate fluctuations decreased orthopaedic revenue by approximately $6 million. The remaining decline in 2012 orthopaedic sales was a result of price concessions provided to customers, as well as fewer customer product launches and development opportunities due to operational issues at our Swiss orthopaedic facilities, which were aggressively addressed in 2012. In addition to the consolidation of manufacturing, during 2012, we also streamlined our Swiss orthopaedic product line offerings. This included the sale of several non-core product lines to an independent third party near the end of the year, which closed in early 2013. Our current estimate is that the sale of these products will reduce our 2013 orthopaedic revenue by approximately $15 million in comparison to 2012. For 2013, we expect our performance to improve as we progress through the year, as the first quarter of 2013 will be impacted by the startup of these recently transferred orthopaedic production lines. The second half of the year is expected to improve as this orthopaedic backlog is relieved. - 51 - -------------------------------------------------------------------------------- Table of Contents Our Implantable Medical customers have various inventory management, dual sourcing, and vertical integration initiatives in place, and the relative market share among OEM manufacturers' changes continuously. Additionally, we face pricing pressures from our customers and in particular our four largest OEM customers upon which a significant portion of our sales is dependent. These pressures have increased over the last several years due to the downturn in the global economy, and more specifically, the contracting CRM market. Consequently, these and other factors will continue to significantly impact our sales. Electrochem - 2012 sales for Electrochem increased $83.3 million to $163.0 million. 2012 Electrochem sales included $82.4 million of incremental revenue related to the acquisition of Micro Power in December 2011. On an organic basis, Electrochem revenue was consistent with the prior year. During 2012, the Micro Power acquisition exceeded our expectations, which is benefitting from successful product launches into the higher growth, higher value portable medical market. The market shift in patient care from clinical settings to the home, and an aging population, is driving the need for lightweight and portable devices for patients and caregivers. Electrochem's technology, customer relationships, and legacy of delivering highly reliable and innovative solutions has enabled it to win in this evolving market and continues to position Electrochem to capture market share. Electrochem continues to secure long-term agreements in this space and our funnel of portable medical products from this acquisition continues to be full, which is expected to drive revenue growth for this product line for the next several years. Gross Profit Changes to gross profit as a percentage of sales were primarily due to the following: 2012-2011 % Point Change Impact of acquisitions(a) -1.2 % Excess capacity & Swiss production inefficiencies(b) -1.6 % Volume and productivity(c) 2.2 % Performance-based compensation(d) 0.4 % Selling price(e) -0.5 % Other 0.2 % Total percentage point change to gross profit as a percentage of sales -0.5 % (a) Our gross profit percentage was impacted by the acquisition of Micro Power in December 2011, which had a lower gross margin percentage due to its higher percentage of material costs in comparison to our legacy businesses. Additionally, during 2012 we recognized $0.5 million of inventory step-up amortization in connection with this acquisition, which will not recur in subsequent periods. - 52 - -------------------------------------------------------------------------------- Table of Contents (b) Our gross profit percentage was negatively impacted during 2012 due to production inefficiencies at our Swiss orthopaedic facilities. Additionally, as a result of the addition of our Fort Wayne facility in the second quarter of 2012, we experienced excess capacity costs in comparison to 2011. In accordance with our inventory accounting policy, excess capacity costs are expensed in the period they occur. In 2012, we aggressively right-sized our orthopaedic cost structure, which is expected to help improve our gross margin percentage starting in the first quarter of 2013. (c) Our gross profit percentage benefitted from higher sales volumes, primarily cardiac and vascular, as well as production efficiencies gained at our manufacturing facilities as a result of our various lean and supply chain initiatives. (d) Amount represents lower performance-based compensation expense recorded based upon the results for 2012 compared to 2011. Performance-based compensation is accrued based upon the level of performance achieved relative to targets set at the beginning of the year. (e) Our gross profit percentage has been negatively impacted in comparison to the prior year by price concessions made to our larger OEM customers, which were given in exchange for long-term contracts. Over the long-term, we expect to see gross margin improvements as a result of the consolidation of our orthopaedic operations and from various other productivity improvement initiatives that are being implemented (See "Cost Savings and Consolidation Efforts" section of this item). Additionally, we expect our gross profit margin to improve as more system and device level products are introduced, which typically earn a higher margin. Management is currently evaluating the impact that the new medical device tax will have on our results from operations beginning in 2013, and has preliminarily estimated that it will reduce gross profit by $1.5 million to $2.5 million. This amount assumes that this tax applies to the first medical device sale in the U.S. and is based upon a wholesale price. SG&A Expenses Changes to SG&A expenses were primarily due to the following (in thousands): 2012-2011 $ Change Impact of acquisitions(a) $ 9,552 Professional and consulting expense(b) 743 Medical device strategy communication(c) (501 ) Other(d) (1,350 ) Net increase in SG&A $ 8,444 (a) Amount represents the incremental SG&A expenses in 2012 versus 2011 related to the acquisition of Micro Power and NeuroNexus. (b) Amount represents the change in professional and consulting expense from 2011 and reflects a higher level of costs incurred in connection with our medical device strategy and our increased investment in sales and marketing to drive core business growth. (c) Amount represents the costs incurred during 2011 in connection with the communication of our medical device strategy to shareholders, customers and associates including costs incurred for our Investor Day held in the first quarter of 2011, which did not recur in 2012. (d) Amount represents various decreases in SG&A expenses during 2012 and reflects the cost control initiatives being implemented by the Company including cost reductions in connection with our Swiss orthopaedic consolidations. - 53 - -------------------------------------------------------------------------------- Table of Contents RD&E Expenses, Net Net RD&E costs were as follows (in thousands): Year Ended December 28, December 30, 2012 2011 Change Research and development costs $ 24,071 $ 19,014 $ 5,057 Engineering costs 38,777 35,472 3,305 Less cost reimbursements (10,358 ) (8,973 ) (1,385 ) Total RD&E, net $ 52,490 $ 45,513 $ 6,977 Net RD&E for 2012 increased $7.0 million to $52.5 million. Approximately $2.6 million of this increase was a result of the operations from our recent acquisitions. Additionally, $3.2 million of this increase can be attributed to the investment in the development of complete medical devices, which totaled $24.8 million for 2012 compared to $21.6 million for 2011. These amounts include $5.2 million and $5.1 million, respectively, of DVT costs in connection with our development of a neuromodulation platform. When combined with SG&A expenses, total costs incurred in connection with our medical device initiatives totaled $33.9 million for 2012 versus $27.3 million for 2011. During the second half of 2012, we began to implement an initiative to optimize our RD&E investment. This included the reallocation of RD&E resources to higher priority projects, the postponement of some RD&E projects, as well as the decision to pursue various alternatives to monetize some of our existing intellectual property that are outside our core business. As a result of this initiative, RD&E for the second half of 2012 was $3.7 million lower than the first half of 2012. These reductions are also expected to benefit 2013. The increase in cost reimbursements in 2012 was a result of our NeuroNexus acquisition. These cost reimbursements can vary significantly from year to year due to the timing of the achievement of milestones on development projects. Other Operating Expenses, Net Other operating expenses, net were comprised of the following (in thousands): Year Ended December 28, December 30, 2012 2011 Change Orthopaedic facility optimization(a) $ 32,482 $ 425 $ 32,057 Medical device facility optimization(a) 1,525 - 1,525 ERP system upgrade(a) 5,041 - 5,041 Integration costs(b) 1,460 - 1,460 Asset dispositions, severance and other(c) 1,838 168 1,670 Total other operating expenses, net $ 42,346 $ 593 $ 41,753 (a) Refer to "Cost Savings and Consolidation Efforts" section of this Item and Note 13 "Other Operating Expenses, Net" of the Notes to Consolidated Financial Statements contained in Item 8 of this report for disclosures related to the timing and level of remaining expenditures for these initiatives. - 54 - -------------------------------------------------------------------------------- Table of Contents (b) During 2012, we incurred costs related to the integration of Micro Power and NeuroNexus. These expenses were primarily for retention bonuses, travel costs in connection with integration efforts, and severance, which will not be required in 2013 as these integrations are completed. (c) During 2012 and 2011, we recorded write-downs in connection with various asset disposals, net of insurance proceeds received, if any. Additionally, during 2012, we incurred $1.2 million of costs related to the relocation of our global headquarters to Frisco, Texas. During 2011, we incurred $0.6 million of acquisition related costs in connection with our purchase of Micro Power. Other operating expenses will be reduced significantly in 2013 and are expected to range from $6.7 million-$8.2 million, which will improve the overall earnings of Greatbatch. While we continually identify and implement cost improvement initiatives, we have now completed all of our major plant consolidations, so our leadership team can focus on achieving sustainable organic growth and leverage our available capacity. Interest Expense and Interest Income Interest expense for 2012 increased $1.1 million over 2011 due to the increased discount amortization related to our convertible notes, which is being amortized utilizing the effective interest method. See Note 9 "Debt" of the Notes to Consolidated Financial Statements contained in Item 8 of this report. Interest income for 2012 was relatively consistent with 2011. Gain (Loss) on Cost and Equity Method Investments, Net In 2011, we sold our cost method investment in IntElect Medical, Inc. ("IntElect") in conjunction with Boston Scientific's acquisition of IntElect. We obtained our ownership interest in IntElect through our acquisition of BIOMEC, Inc. in 2007 and two subsequent additional investments. This transaction resulted in a pre-tax gain of $4.5 million. During 2012 and 2011, we recognized impairment charges related to our cost and equity method investments of $0.1 million and $0.3 million, respectively. The aggregate recorded amount of our cost and equity method investments at December 28, 2012 was $9.1 million. These investments are in start-up research and development companies whose fair value is highly subjective in nature and subject to future fluctuations, which could be significant. Our exposure related to these entities is limited to our recorded investment. Other Expense, Net Other expense, net primarily includes the impact of foreign currency exchange rate fluctuations on transactions denominated in foreign currencies. We generally do not expect foreign currency exchange rate fluctuations to have a material impact on our results of operations. Provision for Income Taxes The effective tax rate for the year ended December 28, 2012 was 171.3%, versus 31.6% for 2011. The stand-alone U.S. component of the effective tax rate for the year ended December 28, 2012 was 33.1% versus 31.5% for 2011. - 55 --------------------------------------------------------------------------------- Table of Contents The provision for income taxes for 2012 differs from the U.S. statutory rate due to the following (dollars in thousands): U.S. International Combined $ % $ % $ % Income (loss) before provision for income taxes $ 36,057 $ (29,327 ) $ 6,730 Provision at statutory rate $ 12,620 35.0 % $ (10,265 ) 35.0 % $ 2,355 35.0 % Foreign rate differential - - 3,414 (11.6 ) 3,414 50.7 Change in tax rate-loss of Swiss tax holiday - - 1,721 (5.9 ) 1,721 25.6 Uncertain tax positions (681 ) (1.9 ) - - (681 ) (10.1 ) State taxes, net of federal benefit 329 0.9 - - 329 4.9 Valuation allowance - - 4,552 (15.5 ) 4,552 67.6 Other (350 ) (0.9 ) 189 (0.6 ) (161 ) (2.4 ) Provision (benefit) for income taxes/effective tax rate $ 11,918 33.1 % $ (389 ) 1.4 % $ 11,529 171.3 % The fluctuation between the overall rate of 171.3% in 2012 and the 31.6% in 2011 is primarily attributable to approximately $6.2 million of tax charges (approximately 92% increase in our effective tax rate) recorded in connection with our Swiss orthopaedic restructuring. These charges relate to the loss of our Swiss tax holiday, due to our 2012 decision to transfer manufacturing out of Switzerland, as well as the establishment of a valuation allowance on a portion of our Swiss deferred tax assets as it is more likely than not that they will not be fully realized. Additionally, our 2012 effective tax rate reflects the impact of approximately $31.3 million of losses resulting from our Swiss restructuring, the benefit of which are recorded at the lower Swiss effective tax rate, thus giving rise to an approximate 57% increase in the overall effective tax rate of the Company. The fluctuation of the effective tax rate for the U.S. between 2012 (33.1%) and 2011 (31.5%) is primarily attributable to the expiration of the U.S. R&D tax credit at the end of 2011. On January 2, 2013, the President signed into law the American Taxpayer Relief Act of 2012, which includes a retroactive extension of the section 41 R&D tax credit that had expired on December 31, 2011. Under the American Taxpayer Relief Act of 2012, the tax R&D credit is extended for two years retroactively from January 1, 2012 through December 31, 2013. As the R&D tax credit was signed into law on January 2, 2013, as required by GAAP, the benefit for the R&D tax credits earned in 2012 will be recognized in the first quarter of fiscal 2013. R&D tax credits earned in 2013 will be recorded through the fiscal 2013 effective tax rate. We estimate that the benefit related to the 2012 R&D tax credits will be approximately $1.5 million. There is a potential for volatility of the effective tax rate due to several factors, including changes in the mix of pre-tax income and the jurisdictions to which it relates, business acquisitions, settlements with taxing authorities and foreign currency exchange rate fluctuations. We believe it is reasonably possible that a reduction of up to $0.1 million of the balance of our unrecognized tax benefits may occur within the next twelve months as a result of the expiration of applicable statutes of limitation and potential audit settlements, which would positively impact the effective tax rate in the period of reduction. - 56 --------------------------------------------------------------------------------- Table of Contents Fiscal 2011 Compared with Fiscal 2010 Sales Changes to sales by major product lines were as follows (in thousands): Year Ended 2011 vs. 2010 December 30, December 31, $ % 2011 2010 Change Change Sales: Implantable Medical Cardiac/Neuromodulation $ 303,690 $ 303,521 $ 169 0 % Vascular 45,098 38,000 7,098 19 % Orthopaedic 140,277 118,748 21,529 18 % Total Implantable Medical 489,065 460,269 28,796 6 % Portable Medical 9,609 8,432 1,177 14 % Energy/Environmental 58,934 54,668 4,266 8 % Other 11,214 10,056 1,158 12 % Electrochem 79,757 73,156 6,601 9 % Total sales $ 568,822 $ 533,425 $ 35,397 7 % Implantable Medical - For the year, cardiac/neuromodulation sales were consistent with 2010. During the first half of 2011, cardiac revenue included the benefit of customer inventory builds and product launches, which did not recur in the second half of 2011. Additionally, cardiac/neuromodulation sales were impacted by pricing pressures and a slowdown in the underlying market. Full year 2011 vascular sales increased 19% over 2010. This increase was primarily attributable to growth in the underlying market and market share gains. Additionally, vascular revenue for 2011 included approximately $4.5 million from sales of medical devices that were developed under the Greatbatch name, including sales of our OptiSeal Valved Peelable Introducer which received FDA clearance in 2010. Orthopaedic sales of $140.3 million for 2011 were 18% above 2010, and included approximately $8 million of favorable foreign currency exchange rate benefit. Excluding this benefit, sales increased 11% organically over 2010 despite slower than expected underlying market growth. These increases occurred across all of our orthopaedic products, which benefitted from customer product launches, as well as from market share gains during 2011. Electrochem - For 2011, sales for the Electrochem business segment increased 9% in comparison to 2010. Fourth quarter 2011 sales for Electrochem included $2.5 million of additional revenue from the Micro Power acquisition. Excluding the additional revenue provided by Micro Power, sales for 2011 increased 6% on an organic basis. During 2011, Electrochem revenue varied from quarter to quarter due to the timing of various customer inventory pulls. For the full year, the increase in Electrochem revenue was a result of an increased investment in sales and marketing, which resulted in market share gains and several new customer contracts, as well as continued strength in the energy markets. - 57 --------------------------------------------------------------------------------- Table of Contents Gross Profit Changes to gross profit as a percentage of sales were primarily due to the following: 2011-2010 % Point Change Capacity & productivity(a) 0.9 % Performance-based compensation(b) -0.9 % Mix change(c) -0.5 % Selling price(d) -0.8 % Other 0.5 % Total percentage point change to gross profit as a percentage of sales -0.8 % (a) Our gross profit percentage for 2011 benefitted from higher sales volumes, which absorbed excess capacity, as well as productivity gains from our various lean initiatives. (b) Amount represents higher performance-based compensation expense recorded based upon the results for 2011 compared to 2010. Performance-based compensation is accrued based upon the level of performance achieved relative to targets set at the beginning of the year. (c) Our gross profit percentage for 2011 was negatively impacted by a lower mix of higher-margin cardiac/neuromodulation sales as a percentage of total sales compared to 2010. (d) Our gross profit percentage throughout 2011 was negatively impacted, in comparison to 2010, by price concessions made to our larger OEM customers near the end of 2010, which were given in exchange for long-term contracts. SG&A Expenses Changes to SG&A expenses were primarily due to the following (in thousands): 2011-2010 $ Change Performance-based compensation(a) $ 3,935 Professional and consulting expense(b) 5,224 Litigation related fees and charges(c) (808 ) Executive death benefits(d) (885 ) Micro Power SG&A costs(e) 358 Other 214 Net increase in SG&A $ 8,038 (a) SG&A costs for 2011 include a higher level of performance-based compensation expense due to achieving a higher percentage of our targets in 2011 in comparison to 2010. Performance-based compensation is accrued based upon management's expectation of performance relative to targets set. (b) Amount represents the change in professional and consulting expense from 2010 and reflects a higher level of costs incurred in connection with our medical device strategy, which impacted SG&A by $4.0 million. These costs included consulting fees paid to outside contractors who are providing technical expertise on our device projects, as well as legal fees incurred in connection with the numerous patent filings that we are making. - 58 - -------------------------------------------------------------------------------- Table of Contents (c) During 2010, the Company incurred fees and charges in connection with two litigation matters that were subsequently settled near the end of 2010. Accordingly, litigation related fees and charges were lower during 2011 in comparison to the prior year. (d) SG&A expenses for 2010 include death benefits provided to the family of the Company's former Senior Vice President-Orthopaedics. (e) Amount represents the SG&A costs related to the operations of Micro Power, which was acquired on December 15, 2011. RD&E Expenses, Net Net RD&E costs were as follows (in thousands): Year Ended December 30, December 31, 2011 2010 Change Research and development costs $ 19,014 $ 17,378 $ 1,636 Engineering costs 35,472 34,208 1,264 Less cost reimbursements (8,973 ) (6,567 ) (2,406 ) Total RD&E, net $ 45,513 $ 45,019 $ 494 Net RD&E costs for 2011 totaled $45.5 million, or 8.0% of sales, versus $45.0 million, or 8.4% of sales for 2010. During 2011, we continued to invest resources in developing complete medical devices for our OEM customers. Total RD&E costs incurred in connection with our medical device initiatives were $21.6 million during 2011 compared to $20.3 million in 2010. This included $5.1 million of design verification testing costs expensed in 2011 related to the QiG Group's development of a neuromodulation platform. When combined with the SG&A expenses discussed above, total costs incurred in connection with our medical device initiatives totaled $27.3 million in 2011 versus $21.9 million in 2010. Partially offsetting these RD&E increases was a higher level of customer cost reimbursements of $2.4 million for 2011. These cost reimbursements can vary significantly from period to period due to the timing of the achievement of milestones on development projects. Electrochem Litigation Charge (Gain) In 2009, a Louisiana jury found in favor of a former Electrochem customer on their claims made in connection with a failed business transaction dating back to 1997. During 2009, we accrued $34.5 million in connection with this litigation after the unfavorable jury verdict. In the fourth quarter of 2010, we settled this litigation for $25 million and accordingly recognized a $9.5 million gain. See Note 15 "Commitments and Contingencies" of the Notes to Consolidated Financial Statements contained in Item 8 of this report. - 59 --------------------------------------------------------------------------------- Table of Contents Other Operating Expenses, Net Other operating expenses, net were comprised of the following (in thousands): Year Ended December 30, December 31, 2011 2010 Change Orthopaedic facility optimization(a) $ 425 $ 225 $ 200 2007 & 2008 facility shutdowns and consolidations(b) - 1,348 (1,348 ) Integration costs(c) - 42 (42 ) Asset dispositions, severance and other(d) 168 2,943 (2,775 ) Total other operating expenses, net $ 593 $ 4,558 $ (3,965 ) (a) During the third quarter of 2010, we began to incur costs in connection with the optimization of our orthopaedic operations in order to increase capacity, further expand our capabilities and reduce dependence on outside suppliers. (b) In 2010, we recorded charges related to our various cost savings and consolidation efforts initiated in 2007 and 2008. (c) During 2010, we incurred costs related to the integration of the companies acquired in 2007 and 2008. (d) During 2011 and 2010, we recorded write-downs in connection with various asset disposals, net of insurance proceeds received, if any. Additionally, during 2011 we incurred $0.6 million of acquisition related costs in connection with our purchase of Micro Power. During 2010, we consolidated our Implantable Medical segment, which included the elimination of certain positions globally. Severance charges associated with this realignment were $2.3 million. Interest Expense and Interest Income Interest expense for 2011 decreased $1.6 million from 2010 primarily due to the repayment of $118.5 million of long-term debt during 2011 and 2010 as well as the impact of lower interest rates, partially offset by increased discount amortization on our convertible notes. Interest income for 2011 was relatively consistent with 2010. Gain (Loss) on Cost and Equity Method Investments In 2011, we sold our cost method investment in IntElect in conjunction with Boston Scientific's acquisition of IntElect. This transaction resulted in a pre-tax gain of $4.5 million. During 2011 and 2010, we recognized impairment charges related to our cost method investments of $0.3 million and $0.2 million, respectively, based upon recent stock offerings by those companies. Other Expense, Net Other expense, net primarily includes the impact of foreign currency exchange rate fluctuations on transactions denominated in foreign currencies. - 60 --------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes The effective tax rate for 2011 was 31.6% versus 32.8% for 2010. The effective tax rates for 2011 and 2010 are lower than the U.S. statutory rate primarily due to the R&D tax credit, as well as the favorable impact of the resolution of tax audits and the lapse of statutes of limitation on certain tax items. See Note 14 "Income Taxes" of the Notes to Consolidated Financial Statements contained in Item 8 of this report for a reconciliation of the U.S. statutory rate to our effective tax rate. Liquidity and Capital Resources At December 28, December 30, (Dollars in thousands) 2012 2011 Cash and cash equivalents $ 20,284 $ 36,508 Working capital $ 176,376 $ 170,907 Current ratio 2.92 2.82 The decrease in cash and cash equivalents from the end of 2011 was primarily due to the cash used in connection with our acquisitions ($17.2 million), the purchase of property, plant and equipment ($41.1 million) in connection with our various cost savings and consolidation initiatives, and the net repayment of long-term debt ($22 million) during the year partially offset by cash flows from operations ($64.8 million). Our working capital and current ratio remained consistent with the prior year. Of the $20.3 million of cash on hand as of December 28, 2012, $4.5 million is being held at our foreign subsidiaries. Revolving Line of Credit - We have a senior credit facility (the "Credit Facility") consisting of a $400 million revolving line of credit, which can be increased to $600 million upon our request and approval by a majority of the lenders. The Credit Facility also contains a $15 million letter of credit subfacility and a $15 million swingline subfacility. The Credit Facility has a maturity date of June 24, 2016; provided, however, if our convertible subordinated notes ("CSN") are not repaid in full, modified or refinanced before March 1, 2013, the maturity date of the Credit Facility is March 1, 2013. On February 20, 2013, we redeemed all outstanding CSN, which was funded with availability under the Credit Facility. The Credit Facility is supported by a consortium of fourteen banks with no bank controlling more than 19% of the facility. As of December 28, 2012, each bank supporting the Credit Facility has an S&P credit rating of at least BBB or better, which is considered investment grade. The Credit Facility requires us to maintain a rolling four quarter ratio of adjusted EBITDA to interest expense of at least 3.0 to 1.0. For the twelve month period ended December 28, 2012, our ratio of adjusted EBITDA to interest expense, calculated in accordance with our credit agreement, was 17.3 to 1.00, well above the required limit. The Credit Facility also requires us to maintain a total leverage ratio of not greater than 4.0 to 1.0. As of December 28, 2012, our total leverage ratio, calculated in accordance with our credit agreement, was 2.2 to 1.00, well below the required limit. The Credit Facility contains customary events of default. Upon the occurrence and during the continuance of an event of default, a majority of the lenders may declare the outstanding advances and all other obligations under the Credit Facility immediately due and payable. See Note 9 "Debt" of the Notes to Consolidated Financial Statements contained in Item 8 of this report. - 61 --------------------------------------------------------------------------------- Table of Contents As of December 28, 2012, we had $367 million of borrowing capacity available under the Credit Facility. As of February 27, 2013, we had available $174 million of borrowing capacity available under the Credit Facility as a result of the redemption of all CSN in February 2013. This amount may vary from period to period based upon our debt and EBITDA levels, which impacts the covenant calculations discussed above. We believe that our cash flow from operations and the Credit Facility provide adequate liquidity to meet our short and long term funding needs. Operating activities - Cash flows from operating activities for 2012 were $64.8 million compared to $89.9 million for 2011. The decrease in cash flows from operating activities from the prior year is primarily due to our lower net income as well as a slight increase in working capital balances. Investing activities - Net cash used in investing activities for 2012 was $59.8 million compared to $80.4 million for 2011. This decrease was primarily related to the cash payments made in 2011 for the acquisition of Micro Power of $66.5 million, partially offset by $18.6 million of additional investments made in property, plant and equipment primarily in connection with the consolidation and optimization initiatives discussed in the "Cost Savings and Consolidation Efforts" section of this Item (primarily the construction of our Fort Wayne facility which was completed in 2012) and routine capital expenditures. Our current expectation is that capital spending for 2013 will be in the range of $20 million to $30 million, of which approximately half is discretionary in nature. We anticipate that cash on hand, cash flow from operations and availability under our Credit Facility will be sufficient to fund these capital expenditures. As part of our growth strategy, we have and will continue to consider targeted and opportunistic acquisitions. Financing activities - Net cash used in financing activities for 2012 was $21.5 million compared to cash provided of $3.7 million for the prior year period. During 2012, we repaid $32 million of long-term debt which was partially offset by $10 million borrowed at the beginning of the year to help fund the NeuroNexus acquisition. On February 20, 2013, we redeemed all of our outstanding CSN, which was funded with availability under the Credit Facility. See Note 9 "Debt" of the Notes to the Consolidated Financial Statements contained at Item 8 of this report for further discussion. Going forward, we expect excess cash flow from operations to primarily be used to pay down outstanding debt as well as to fund our various capital projects. Capital Structure - As of December 28, 2012, our capital structure consisted of $197.8 million of convertible subordinated notes, $33.0 million of debt under our revolving line of credit and 23.7 million shares of common stock outstanding. Additionally, we had $20.3 million in cash and cash equivalents, which we believe is sufficient to meet our short-term operating cash needs. If necessary, we have available borrowing capacity under our Credit Facility and are authorized to issue 100 million shares of common stock and 100 million shares of preferred stock. As of February 27, 2013, we had available $174 million of borrowing capacity available under the Credit Facility as a result of the redemption of all CSN in February 2013. We believe that if needed we can access public markets to raise additional capital. We believe that our capital structure provides adequate funding to meet our growth objectives. We continuously evaluate our capital structure as it relates to our anticipated long-term funding needs. Changes to our capital structure may occur as a result of this analysis, or changes in market conditions. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements within the meaning of Item 303(a)(4) of Regulation S-K. - 62 - -------------------------------------------------------------------------------- Table of Contents Litigation We are party to various legal actions arising in the normal course of business. A description of pending legal actions against the Company is set forth at Note 15 "Commitments and Contingencies" of the Notes to Consolidated Financial Statements contained at Item 8 of this report. We do not believe that the ultimate resolution of any individual pending legal action will have a material effect on our consolidated results of operations, financial position or cash flows. However, litigation is subject to inherent uncertainties and there can be no assurance that any pending legal action, which we currently believe to be immaterial, does not become material in the future. - 63 --------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following table summarizes our contractual obligations at December 28, 2012: Payments due by period Less than 1 More than 5 CONTRACTUAL OBLIGATIONS Total year 1-3 years 3-5 years years Debt obligations(a) $ 270,469 $ 229,676 $ 3,800 $ 35,776 $ 1,217 Operating lease obligations(b) 19,044 4,601 8,134 4,379 1,930 Purchase obligations(b) 24,710 12,914 5,378 6,298 120 Foreign currency contracts(b) 12,000 12,000 - - - Defined benefit plan obligations(c) 11,783 8,813 561 671 1,738 Total contractual obligations $ 338,006 $ 268,004 $ 17,873 $ 47,124 $ 5,005 (a) Includes the annual interest expense on our convertible subordinated notes of 2.25%, which is paid semi-annually, and the $33.0 million outstanding on our Credit Facility based upon the period end weighted average interest rate of 2.07%. Also includes $36.6 million of deferred federal and state taxes on the Company's convertible subordinated notes that will be due between 2013 and 2018. This table does not reflect the redemption of all outstanding CSN on February 20, 2013, which was funded with availability under the Credit Facility. CSN were classified as long-term in the December 28, 2012 Consolidated Balance Sheet in accordance with ASC 470. See Note 9 "Debt" of the Notes to Consolidated Financial Statements contained in Item 8 of this report. (b) See Note 15 "Commitments and Contingencies" of the Notes to Consolidated Financial Statements contained in Item 8 of this report for additional information about our operating leases, purchase obligations and foreign currency contracts. (c) See Note 10 "Defined Benefit Plans" of the Notes to Consolidated Financial Statements contained in Item 8 of this report for additional information about our defined benefit plan obligations. During 2012, we transferred most major functions performed at our facilities in Switzerland into existing facilities. As a result, we curtailed our defined benefit plan provided to employees at those facilities in 2012. As nearly all of the Swiss pension liability is expected to be paid off in the next year, the Company moved all Swiss pension plan investments into cash accounts during the quarter. Plan assets are expected to be sufficient to cover plan liabilities. This table does not reflect $1.0 million of unrecognized tax benefits as we are uncertain as to if or when such amounts may be settled. Refer to Note 14 "Income Taxes" of the Notes to Consolidated Financial Statements in Item 8 of this report for additional information about these unrecognized tax benefits. We self-fund the medical insurance coverage provided to our U.S. based employees. We limit our risk through the use of stop loss insurance. As of December 28, 2012, we had $1.4 million accrued, related to our self-insurance obligations under our medical plan. This accrual is recorded in Accrued Expenses in the Consolidated Balance Sheet, and is primarily based upon claim history. For 2013, we have specific stop loss coverage per associate for claims in the year exceeding $225 thousand per associate with no annual maximum aggregate stop loss coverage. This table does not reflect any potential future payments for self-insured medical claims. - 64 - -------------------------------------------------------------------------------- Table of Contents We were a member of a group self-insurance trust that provided workers' compensation benefits to our employees in Western New York (the "Trust"). Based on actual experience, we could receive a refund or be assessed additional contributions for workers' compensation claims. Under the Trust agreement, each participating organization has joint and several liability for Trust obligations if the assets of the Trust are not sufficient to cover those obligations. During 2011, we were notified by the Trust of its intention to cease operations at the end of 2011 and were assessed $0.6 million as an estimate of our pro-rata share of future costs related to the Trust. This amount was accrued and paid in 2011. Beginning in 2012, we utilized traditional insurance to provide workers' compensation benefits to our employees. Inflation We utilize certain critical raw materials (including precious metals) in our products that we obtain from a limited number of suppliers due to the technically challenging requirements of the supplied product and/or the lengthy process required to qualify these materials with our customers. We cannot quickly establish additional or replacement suppliers for these materials because of these requirements. Our results may be negatively impacted by an increase in the price of these critical raw materials. This risk is partially mitigated as many of the supply agreements with our customers allow us to partially adjust prices for the impact of any raw material price increases and the supply agreements with our vendors have final one-time buy clauses to meet a long-term need. Historically, raw material price increases have not materially impacted our results of operations. Impact of Recently Issued Accounting Standards In the normal course of business, we evaluate all new accounting pronouncements issued by the Financial Accounting Standards Board ("FASB"), SEC, Emerging Issues Task Force ("EITF"), American Institute of Certified Public Accountants ("AICPA") or other authoritative accounting body to determine the potential impact they may have on our Consolidated Financial Statements. See Note 1 "Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements contained in Item 8 of this report for additional information about these recently issued accounting standards and their potential impact on our financial condition or results of operations. |