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NATUS MEDICAL INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with our Consolidated Financial Statements and the accompanying footnotes. MD&A includes the following sections: • Our Business. A general description of our business. • Year 2013 Overview. A summary of key information concerning the financial results for 2013 and changes from 2012. • Application of Critical Accounting Policies. A discussion of the accounting policies that are most important to the portrayal of our financial condition and results of operations and that require critical judgments and estimates. • Results of Operations. An analysis of our results of operations for the three years presented in the financial statements. • Liquidity and Capital Resources. An analysis of capital resources, sources and uses of cash, investing and financing activities, and contractual obligations. Business Natus is a leading provider of healthcare products used for the screening, detection, treatment, monitoring and tracking of common medical ailments in newborn care, hearing impairment, neurological dysfunction, epilepsy, sleep disorders, and balance and mobility disorders. We have completed a number of acquisitions since 2003, consisting of either the purchase of a company, substantially all of the assets of a company, or individual products or product lines. Recent significant acquisitions include Nicolet in 2012 and Grass in 2013. We expect to continue to pursue opportunities to acquire other businesses in the future. Year 2013 Overview In 2013 we completed the purchase of the Grass Technologies Product Group ("Grass") from Astro-Med Inc. for a cash consideration of $18.6 million. The Grass product group includes clinically differentiated neurodiagnostic and monitoring products, including a portfolio of electroencephalography (EEG) and polysomnography (PSG) systems for both clinical and research use and related accessories and proprietary electrodes. The addition of Grass products enhanced our existing neurology portfolio and provided new product offerings. Our consolidated revenue increased $51.8 million for the year ended December 31, 2013 compared to 2012. Grass, acquired in February 2013, contributed to $12.8 million of incremental revenue in 2013. Nicolet, acquired in July 2012, contributed $41.7 million of incremental revenue in 2013. We experienced revenue declines across other business units in the United States, Europe, South America, and Canada in 2013. We incurred $4.7 million of restructuring charges in 2013 as we took additional steps to improve efficiencies in operations and eliminate redundant costs from our recent acquisitions. Application of Critical Accounting Policies We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP"). In so doing, we must often make estimates and use assumptions that can be subjective and, consequently, our actual results could differ from those estimates. For any given individual estimate or assumption we make, there may also be other estimates or assumptions that are reasonable. 37-------------------------------------------------------------------------------- Table of Contents We believe that the following critical accounting policies require the use of significant estimates, assumptions, and judgments. The use of different estimates, assumptions, and judgments could have a material effect on the reported amounts of assets, liabilities, revenue, expenses, and related disclosures as of the date of the financial statements and during the reporting period. Revenue recognition Revenue, net of discounts, is recognized from sales of medical devices and supplies, including sales to distributors, when the following conditions have been met: a purchase order has been received, title has transferred, the selling price is fixed or determinable, and collection of the resulting receivable is reasonably assured. Terms of sale for most domestic sales are FOB origin, reflecting that title and risk of loss are assumed by the purchaser at the shipping point; however, terms of sale for some domestic customers are FOB destination, reflecting that title and risk of loss are assumed by the purchaser upon delivery. Terms of sales to international distributors are generally shipped "ex works," in which title and risk of loss are passed to the distributor at the shipping point. We previously accounted for arrangements with multiple deliverables under ASC Topic 605, where revenue was allocated to the deliverables based on vendor specific objective evidence ("VSOE"). In October 2009 the FASB issued ASU 2009-13, Multiple Deliverable Revenue Arrangements, which amends ASC Topic 605, and we prospectively adopted the provisions of ASU 2009-13 on January 1, 2010. Under the revenue recognition rules for tangible products as amended by ASU 2009-13, we now allocate revenue from arrangements with multiple deliverables to each of the deliverables based upon their relative selling prices as determined by a selling-price hierarchy. A deliverable in an arrangement qualifies as a separate unit of accounting if the delivered item has value to the customer on a stand-alone basis. The principal deliverables in our multiple deliverable arrangements that qualify as separate units of accounting consist of (i) sales of medical devices and supplies, (ii) installation services, (iii) extended service and maintenance agreements, and (iv) upgrades to embedded software. The new rules establish a hierarchy to determine the selling price to be used for allocating revenue to deliverables as follows: (i) vendor-specific objective evidence of fair value ("VSOE"), (ii) third-party evidence of selling price ("TPE"), and (iii) best estimate of the selling price ("ESP"). VSOE of fair value is defined as the price charged when the same element is sold separately, or if the element has not yet been sold separately, the price for the element established by management having the relevant authority when it is probable that the price will not change before the introduction of the element into the marketplace. We have established VSOE for substantially all of the undelivered elements in our multiple element arrangements and ESPs on delivered elements. In the future we may rely on ESPs, reflecting our best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis, to establish the amount of revenue to allocate to the undelivered elements. TPE generally does not exist for our products because of their uniqueness. For products shipped under FOB origin or ex-works terms, delivery is generally considered to have occurred when shipped. Undelivered elements in our sales arrangements, which are not considered to be essential to the functionality of a product, generally include installation or training services that are performed after the related products have been delivered. Revenue related to undelivered installation services is deferred until such time as installation is complete at the customer's site. Revenue related to training services is recognized when the service is provided. Fair value for installation or training services is based on the price charged when the service is sold separately. The fair value of installation and training services is based upon billable hourly rates and the estimated time to complete the service. Revenue from extended service and maintenance agreements, for both medical devices and data management systems, is recognized ratably over the service period. Freight charges billed to customers are included in revenue and freight-related expenses are charged to cost of revenue. Advance payments from customers are recorded as deferred revenue and recognized as revenue as otherwise described above. We generally do not provide rights of return on products. 38 -------------------------------------------------------------------------------- Table of Contents Inventory is carried at the lower of cost or market value We may be exposed to a number of factors that could result in portions of our inventory becoming either obsolete or being held in quantities that exceed anticipated usage. These factors include, but are not limited to: technological changes in our markets, competitive pressures in products and prices, and our own introduction of new product lines. We regularly evaluate our ability to realize the value of our inventory based on a combination of factors, including historical usage rates, forecasted sales, product life cycles, and market acceptance of new products. When we identify inventory that is obsolete or in excess of anticipated usage we write it down to realizable salvage value. The estimates we use in projecting future product demand may prove to be incorrect. Any future determination that our inventory is overvalued could result in increases to our cost of sales and decreases to our operating margins and results of operations. Carrying value of intangible assets and goodwill We amortize intangible assets with finite lives over their useful lives; any future changes that would limit their useful lives or any determination that these assets are carried at amounts greater than their estimated fair value could result in additional charges. We carry goodwill and any other intangible assets with indefinite lives at original cost but do not amortize them. Any future determination that these assets are carried at amounts greater than their estimated fair value could result in additional charges, which could significantly impact our operating results. We test our intangible assets with finite lives for impairment whenever changes in circumstances indicate the carrying value of these assets may be impaired. Impairment indicators include, but are not limited to, net book value as compared to market capitalization, significant negative industry and economic trends, and significant underperformance relative to historical and projected future operating results. Impairment is considered to have occurred when the estimated undiscounted future cash flows related to the asset are less than its carrying value. Estimates of future cash flows involve consideration of many factors including the marketability of new products, product acceptance and lifecycle, competition, appropriate discount rates, and operating margins. Goodwill and indefinite-lived intangible assets are tested for impairment at least annually as of October 1st; this assessment is also performed whenever there is a change in circumstances that indicates the carrying value of these assets may be impaired. As of October 1, 2012, Natus performed its impairment testing based on five reporting units, Natus U.S., Natus Canada, Natus Europe, Medix, and Nicolet. The reporting unit structure was driven by a combination of legal entity status and geographic proximity, as a result of a series of strategic acquisitions. Each business unit functioned through its individual management team and measured its performance against its individual annual budget. This reporting unit structure was not based upon similar economic characteristics including product mix. As of January 1, 2013, the Company completed and launched its internal realignment into two strategic business units, Neurology and Newborn Care. We believe that these are the applicable reporting units for these analyses based upon economic characteristics including customer base, sales force, vendor base, product mix, manufacturing/subassembly process, product distribution processes, regulatory environment and related inventory characteristics. The Company performed an impairment test under the old structure at the annual test date of October 1, 2012. Effective with first quarter of 2013, the Company transitioned to the new strategic business unit reporting structure. The determination of whether any potential impairment of goodwill exists is based upon a two-step process. In the first step, the fair value of the reporting unit is compared to the reporting unit's carrying value, including goodwill, to determine if there is a potential impairment. If the fair value of the reporting unit exceeds the carrying amount, the goodwill of the reporting unit is considered not impaired and no further analysis or action is 39-------------------------------------------------------------------------------- Table of Contents required. If the first step indicates that the carrying value exceeds the fair value, a second step is performed to determine the amount of the goodwill impairment loss, if any. In step two of the impairment test, the implied fair value of a reporting unit's goodwill is compared to the carrying amount of that goodwill. The implied fair value of the goodwill is determined in the same manner as the amount of goodwill recognized in a business combination is determined. That is, the fair value of a reporting unit is allocated to all the assets and liabilities of that reporting unit, including unrecognized intangible assets as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of that goodwill. To determine the estimated fair value of reporting units, two valuation methodologies are utilized: (i) discounted cash flow analyses, and (ii) guideline publicly-traded companies. The valuations indicated by these methodologies are averaged, with the greatest weight placed on discounted cash flow analyses. Discounted cash flow analyses are dependent upon a number of quantitative and qualitative factors including estimates of forecasted revenue, profitability, earnings before interest, taxes, depreciation and amortization (i.e. EBITDA) and terminal values. The discount rates applied in the discounted cash flow analyses also have an impact on the estimates of fair value, as use of a higher rate will result in a lower estimate of fair value. The estimated total fair value of reporting units is reconciled to the Company's market capitalization. As of the October 1, 2013 testing date, we determined that goodwill was not impaired; however, we determined that certain trade names were impaired and we recorded an impairment charge of $1.5 million. Key assumptions used to determine the fair value were: (i) expected cash flow for the period from October 1, 2013 to December 31, 2022; and (ii) discount rates for the respective reporting units which were 14% and were based on management's best estimate of the after-tax weighted average cost of capital for each reporting unit. Because the fair values of our reporting units significantly exceeded their book value as of October 1, 2013, we did not perform sensitivity analysis as part of the annual impairment test. Future changes in the judgments and estimates underlying our analysis of goodwill for possible impairment, including expected future cash flows and discount rate, could result in a significantly different estimate of the fair value of the reporting units and could result in additional impairment of goodwill. Liability for product warranties Our medical device products are generally covered by a standard one-year product warranty. A liability has been established for the expected cost of servicing our medical device products during this service period. We base the liability on actual warranty costs incurred to service those products. On new products, additions to the reserve are based on a combination of factors including the percentage of service department labor applied to warranty repairs, actual service department costs, and other judgments, such as the degree to which the product incorporates new technology. As warranty costs are incurred, the reserve is reduced. The estimates we use in projecting future product warranty costs may prove to be incorrect. Any future determination that our product warranty reserves are understated could result in increases to our cost of sales and reductions in our operating profits and results of operations. Share-based compensation We record the fair value of share-based compensation awards as expenses in the consolidated statement of operations. In order to determine the fair value of stock options on the date of grant, we apply the Black-Scholes 40-------------------------------------------------------------------------------- Table of Contents option-pricing model. Inherent in this model are assumptions related to expected dividend yield, risk-free interest rate, expected stock-price volatility, expected term, and forfeiture rate. While the risk-free interest rate and dividend yield are less subjective assumptions, typically based on factual data derived from public sources, expected stock-pricevolatility, expected life, and forfeiture rate assumptions require a greater level of judgment which makes them critical accounting estimates. If we used different assumptions, we would have recorded different amounts of share-based compensation. Results of Operations The following table sets forth for the periods indicated selected consolidated statement of operations data as a percentage of total revenue. Our historical operating results are not necessarily indicative of the results for any future period. Percent of Revenue Years Ended December 31, 2013 2012 2011 Revenue 100.0 % 100.0 % 100.0 % Cost of revenue 41.3 44.1 43.6 Gross profit 58.7 55.9 56.4 Operating expenses: Marketing and selling 25.3 26.4 27.1 Research and development 9.3 10.3 11.0 General and administrative 14.1 17.4 14.2 Goodwill impairment charge - - 8.6 Total operating expenses 48.7 54.1 60.8 Income (loss) from operations 10.0 1.8 (4.4 ) Other income (expense), net (0.8 ) (2.9 ) (0.0 ) Income (loss) before provision for income tax 9.2 1.5 (4.5 ) Income tax provision 2.5 1.8 0.3 Net income (loss) 6.6 % 1.3 % (4.8 )% Acquisitions We completed three significant acquisitions during 2013, 2012 and 2011, and the timing of these acquisitions had an impact on the comparison of our results of operations for the years ended December 31, 2013, 2012 and 2011. Comparison of 2013 and 2012 Revenue For the year ended December 31, 2013, our consolidated revenue increased by $51.8 million, or 17.7% to $344.1 million, compared to $292.3 million for the year ended December 31, 2012. The increase was attributable to our recent acquisitions. Grass, acquired in February 2013, contributed $12.8 million of revenue in 2013. Nicolet, acquired in July 2012, contributed $41.8 million of incremental revenue in 2013. Revenue from our products other than Grass and Nicolet experienced a decrease of $2.7 million from the prior year, driven by Newborn Care. Revenue from our neurology products increased $55.6 million, or 33.1% to $223.7 million in the year ended December 31, 2013, compared to $168.1 million in 2012. Revenue from our neurology products, other than 41-------------------------------------------------------------------------------- Table of Contents Grass and Nicolet products, increased by $1.1 million in 2013 compared to 2012, primarily attributable to an increase in sales of our EEG products. Revenue from our newborn care products decreased by $3.8 million, or 3% to $120.4 million in 2013, compared to $124.2 million in 2012. This decline was primarily attributed to lower sales of newborn and diagnostic hearing, balance monitoring and devices in Europe and North America. Revenue from neurology devices and systems was $139.0 million in 2013, representing an increase of 28.6% or $30.9 million, from $108.1 million reported in 2012. Grass contributed $7.6 million of the increase in neurology devices and systems. Nicolet contributed $23.8 million of incremental revenue to neurology devices and systems. Revenue from newborn care and other devices and systems was $66.6 million in 2013, representing a decrease of 9% or $6.6 million, from $73.2 million reported in 2012. This decline in sales of newborn care devices and systems revenue was comprised of newborn hearing, balance monitoring and distributed product revenue. Revenue from devices and systems was 59.8% of consolidated revenue in 2013 compared to 62% of total revenue in 2012. Revenue from neurology supplies and services was $84.6 million in 2013, representing an increase of 41% or $24.6 million, from $60.0 million reported in 2012. Grass contributed $5.1 million of the increase in neurology supplies and services in 2013. Nicolet contributed incremental revenue of $18.0 million of the increase in neurology supplies and services. Neurology supplies and services revenue other than Grass and Nicolet increased by $1.5 million in the year ended December 31, 2013 compared to the year ended December 31, 2012. This increase was primarily attributable to services provided both domestically and internationally. Revenue from newborn care supplies and services was $53.8 million in 2013, representing an increase of 5.5% or $2.8 million, from $51.2 million reported in 2012. This increase was comprised of both domestic newborn care supplies and services revenue. Revenue from supplies and services was 40.2% of consolidated revenue in 2013 compared to 38% of total revenue in 2012. No single customer accounted for more than 10% of our revenue in either 2013 or 2012. Revenue from domestic sales increased 22.5% to $199.6 million in 2013, from $163.0 million in 2012. Revenue from international sales increased 11.8% to $144.5 million in 2013, compared to $129.3 million in 2012. Revenue from domestic sales was 58% of total revenue in 2013 compared to 56% of total revenue in 2012, and revenue from international sales was 42% of total revenue in 2013 compared to 44% of total revenue in 2012. Cost of Revenue and Gross Profit Our cost of revenue increased $13.3 million, or 10.3% to $142.1 million in 2013, from $128.8 million in 2012. Of this increase, $9.9 million was incremental cost from Grass and Nicolet. Gross profit increased $38.5 million, or 23.6%, to $202.0 million in 2013 from $163.5 million in 2012 due to the overall growth in revenue and also as a result of our improved margins associated with product mix. Gross profit as a percentage of revenue was 58.7% in 2013 and 55.9% in 2012. The increase in gross profit as a percentage of revenue was the result of a higher percentage of sales of neurology products which generally carry higher margins than our other products. Operating Costs Total operating costs increased $9.6 million, or 6% to $167.8 million in 2013, from $158.2 million in 2012. The operating expense of Grass and the incremental expense of Nicolet contributed to $17 million in operating costs. We recorded $4.7 million of restructuring charges in 2013 compared to $5.2 million in 2012. These amounts were offset by reduced employee compensation costs resulting from the additional restructuring activities implemented in mid 2013. 42-------------------------------------------------------------------------------- Table of Contents Our marketing and selling expenses increased $9.9 million, or 12.8% to $87.2 million in 2013, from $77.3 million in 2012. Marketing and selling expenses as a percent of total revenue decreased to 25.3% in 2013 from 26.4% in 2012. The marketing and selling expenses of Grass and the incremental marketing and selling expenses of Nicolet were $10.7 million. The remainder of the increase in marketing and selling expenses was primarily related to higher sales commission and sales related costs associated with the increase in our revenue. Our research and development expenses increased $2.1 million, or 7% to $32.1 million in 2013 from $30.0 million in 2012. Research and development expenses as a percent of total revenue decreased to 9.3% in 2013 from 10.3% in 2012. The research and development expenses of Grass and the incremental research and development expenses of Nicolet were $4.6 million, offset by lower employee compensation costs resulting from additional cost cutting activities initiated in 2013. Our general and administrative expenses decreased $2.4 million, or 4.7% to $48.5 million in 2013 from $51.0 million in 2012. General and administrative expenses as a percent of revenue decreased from 17.4% in 2012 to 14.1% in 2013. The general and administrative expense of Grass and the incremental general and administrative expenses of Nicolet resulted in a net reduction of $(0.4) million. The overall reductions in general and administrative expenses were due to $7.3 million reduction in severance expenses offset by increased external audit fees of $1.2 million and increased expenses related to our Oracle implementation of $1.6 million. Other Income (Expense), net Other income (expense), net consists of investment income, interest expense, net currency exchange gains and losses, and other miscellaneous income and expense. We reported other income (expense), net of $(2.7) million in 2013, compared to $(835,000) in 2012. Investment income of $32,456 in 2013 was $23,411 less than the amount reported for 2012. We reported $1.4 million of foreign currency exchange losses in 2013 versus $220,305 of foreign exchange losses in 2012. This increase was driven primarily by foreign denominated sales from our Nicolet business in Europe. Interest expense was $1.7 million in 2013 compared to $489,000 in 2012 due to increased interest associated with the increase in our term loan from Wells Fargo. Provision for Income Tax We recorded income tax expense of $8.7 million and $536,000 in 2013 and 2012, respectively. Our effective tax rate was 27.5% and 12.1% for the years ended December 31, 2013 and 2012, respectively. The higher income tax expense in 2013 is primarily the result of significantly higher pretax earnings. The higher effective tax rate in 2013 compared with 2012 is primarily due to income tax benefits recorded in 2012 as a result of expiration of the statute of limitations on uncertain tax positions for which no similar benefit was taken in 2013. Other significant items impacting the provision for income taxes in 2013 was the income tax benefits derived from the recognition of the 2012 federal research and development tax credit by enactment of the American Taxpayer Relief Act of 2012 in January 2013. Comparison of 2012 and 2011 Revenue For the year ended December 31, 2012, our consolidated revenue increased by $59.4 million, or 25% to $292.3 million, compared to $232.9 million for the year ended December 31, 2011. The increase was attributable to our recent acquisitions. Nicolet, acquired in July 2012, contributed $51.5 million of revenue in 2012. Embla, acquired in September 2011, contributed $28.8 million of revenue in 2012, compared to $10.9 million of revenue in 2011, or an increase of $17.9 million. Revenue from our products other than Nicolet and Embla decreased by $10 million in 2012, compared to 2011, due in large part to our emphasizing the sale of the newly acquired products that serve the same markets as certain of our Xltek, Bio-logicand Schwarzer products. Revenue from our neurology products increased $63.9 million, or 61.3% to $168.1 million in the year ended December 31, 2012, compared to $104.2 million in 2011. Revenue from our neurology products, other than Nicolet and Embla products, decreased by $4.4 million in 2012 compared to 2011. This decline was attributable 43 -------------------------------------------------------------------------------- Table of Contents to weak economic conditions in Europe and to our emphasizing the sales of our newly acquired neurology products. Revenue from our newborn care products decreased by $4.5 million, or 3.5% to $124.2 million in 2012, compared to $128.7 million in 2011. This decline was primarily attributed to lower sales of newborn and diagnostic hearing, balance monitoring and supplies. Revenue from neurology devices and systems was $108.1 million in 2012, representing an increase of 42.6% or $32.3 million, from $75.8 million reported in 2011. Nicolet and Embla contributed to $32.6 million of the increase in neurology devices and systems. Revenue from newborn care and other devices and systems was $73.2 million in 2012, representing a decrease of 5.7% or $4.4 million, from $77.6 million reported in 2011. This decline in newborn care devices and systems revenue was comprised of newborn hearing, balance monitoring and distributed product revenue. Revenue from devices and systems was 62% of consolidated revenue in 2012 compared to 65.9% of total revenue in 2011. Revenue from neurology supplies and services was $60.0 million in 2012, representing an increase of 105% or $31.5 million, from $28.5 million reported in 2011. Nicolet and Embla contributed to $36 million of the increase in neurology supplies and services. Neurology supplies and services revenue other than Nicolet and Embla decreased by $4.5 million in the year ended December 31, 2012 compared to the year ended December 31, 2011. This decline was primarily attributable to weak economic conditions in Europe. Revenue from newborn care supplies and services was $51.0 million in 2012, no change from the $51.0 million reported in 2011. This increase was driven by domestic newborn care supplies and services revenue. Revenue from supplies and services was 38% of consolidated revenue in 2012 compared to 34.1% of total revenue in 2011. No single customer accounted for more than 10% of our revenue in either 2012 or 2011. Revenue from domestic sales increased 24% to $163.0 million in 2012, from $131.3 million in 2011. Revenue from international sales increased 27% to $129.3 million in 2012, compared to $101.6 million in 2011. Revenue from domestic sales was 55.9% of total revenue in 2012 compared to 56.4% of total revenue in 2011, and revenue from international sales was 44% of total revenue in 2012 compared to 44% of total revenue in 2011. Freight revenue was 1% of total revenue in 2012 compared to 2% of total revenue in 2011. Cost of Revenue and Gross Profit Our cost of revenue increased $27.2 million, or 27%, to $128.8 million in 2012, from $101.6 million in 2011. Of this increase, $27.1 million was attributable to Nicolet and Embla. Gross profit increased $32.2 million, or 25%, to $163.5 million in 2012 from $131.3 million in 2011 also as a result of our increased sales. Gross profit as a percentage of revenue was 55.9% in both 2012 and and 56.4% 2011. Operating Costs Total operating costs increased $16.6 million, or 12%, to $158.2 million in 2012, from $141.6 million in 2011.The operating expense of Nicolet and the incremental expense of Embla contributed to $28.1 million in operating costs and we recorded $8.8 million of restructuring charges. These increases were partially offset by reduced employee compensation costs resulting from the restructuring activities implemented early in 2012. In 2011 we recorded a $20.0 million goodwill impairment charge related to our Neurology reporting unit for which there was no similar charge in 2012. Our marketing and selling expenses increased $14.2 million, or 23%, to $77.3 million in 2012, from $63.0 million in 2011. Marketing and selling expenses as a percent of total revenue decreased to 26.4% in 2012 from 27.1% in 2011. The marketing and selling expenses of Nicolet and the incremental expenses of Embla were $12.8 million. The remainder of the increase in marketing and selling expenses was primarily related to higher sales commission and sales related costs associated with the increase in our revenue, $724,000 of amortization of 44 -------------------------------------------------------------------------------- Table of Contents backlog recognized through purchase accounting associated with the Nicolet acquisition, and a $560,000 impairment charge of certain trade names. Our research and development expenses increased $4.4 million, or 17%, to $30.0 million in 2012 from $25.6 million in 2011. Research and development expenses as a percent of total revenue decreased to 10.3% in 2012 from 11% in 2011. The research and development expenses of Nicolet and the incremental expense of Embla were $6.1 million, partially offset by lower employee compensation costs resulting from cost cutting activities initiated early in 2012. Our general and administrative expenses increased $18.0 million, or 54%, to $51 million in 2012 from $33 million in 2011. General and administrative expenses as a percent of revenue increased from 14.2% in 2011 to 17.4% in 2012. The general and administrative expense of Nicolet and the incremental expense of Embla was $9.2 million, which amount was partially offset by lower general and administrative costs otherwise achieved due to the effects of our 2012 restructuring efforts. The cost of restructuring activities and direct costs of acquisitions increased by $6 million and $2.4 million, respectively, in 2012 compared to 2011. Other Income (Expense), net Other income (expense), net consists of investment income, interest expense, net currency exchange gains and losses, and other miscellaneous income and expense. We reported other income (expense), net of $(835,000) in 2012, compared to $(74,000) in 2011. Investment income of $56,000 in 2012 was $28,000 more than the amount reported for 2011. We reported $220,305 of foreign currency exchange losses in 2012 versus $15,000 of foreign exchange gains in 2011. Interest expense was $489,000 in 2012 compared to $268,000 in 2011 due primarily to borrowings to fund the Nicolet acquisition. Provision for Income Tax We recorded income tax expense of $536,000 and $772,000 in 2012 and 2011, respectively. The lower income tax expense in 2012 is primarily the result of the settlement of foreign and U.S. state income tax audits and the expiration of the statute of limitations on uncertain tax positions that were recorded as a component of income tax expense in prior years. Although we reported a pre-tax loss of approximately $10.4 million in 2011, we recorded income tax expense of $772,000, as only $1.6 million of the $20.0 million goodwill impairment charge is expected to be deductible for tax purposes. Liquidity and Capital Resources Liquidity is our ability to generate sufficient cash flows from operating activities to meet our obligations and commitments. In addition, liquidity includes the ability to obtain appropriate financing and to raise capital. Therefore, liquidity cannot be considered separately from capital resources that consist of our current funds and the potential to increase those funds in the future. We plan to use these resources in meeting our commitments and in achieving our business objectives. As of December 31, 2013, we had cash and cash equivalents of $56.1 million, stockholders' equity of $306.3 million, and working capital of $116.7 million compared with cash and cash equivalents of $23.1 million, stockholders' equity of $268.8 million, and working capital of $70.3 million as of December 31, 2012. The $46.4 million increase in working capital from December 31, 2012 to December 31, 2013 resulted primarily from a $33.0 million increase in cash and cash equivalents and refinancing $11.3 million of short-term borrowings to long-term debt. We believe that our current cash and cash equivalents and any cash generated from operations will be sufficient to meet our ongoing operating and capital requirements for the foreseeable future. As of December 31, 2013, our foreign subsidiaries held cash and short term investment of approximately $30.0 million out of the total cash and short term investment of $56.1 million. We currently intend to permanently reinvest the cash held by our foreign subsidiaries. If, however, a portion of these funds were needed for and distributed to our operations in the United States, we would be subject to additional U.S. income taxes 45-------------------------------------------------------------------------------- Table of Contents and foreign withholding taxes. The amount of taxes due would depend on the amount and manner of repatriation, as well as the location from where the funds are repatriated. If the foreign earnings were repatriated, the cash and short term investments available for other foreign financing activities will be reduced by the foreign taxes paid on the repatriation of earnings in these regions. We do not intend to repatriate the funds for U.S. operations and we have positive cash balances in the U.S. subsidiaries. To add the liquidity of the U.S. operational needs, we have a line of credit with Wells Fargo Bank to support domestic cash needs. We do not foresee to repatriate the foreign funds for the U.S. operations. At December 31, 2013 we had a $75 million credit facility consisting of a $25 million revolving credit line and a $50 million 5-year term loan with Wells Fargo. The credit facility contains covenants, including covenants relating to liquidity and other financial measurements, and provides for events of default, including failure to pay any interest when due, failure to perform or observe covenants, bankruptcy or insolvency events, and the occurrence of a material adverse effect, and restricts our ability to pay dividends. We have granted Wells Fargo a security interest in substantially all of our assets. We have no other significant credit facilities. Comparison of 2013 and 2012 Cash provided by operations increased by $17.2 million for the year ended December 31, 2013 to $36.6 million, compared to $19.4 million in 2012. The sum of our net income and certain non-cash expense items, such as reserves, depreciation and amortization, goodwill and intangible asset impairment charges, and share based compensation was approximately $42.7 million in 2013 due to a greater focus on operational efficiency, compared to $27 million in 2012. The aggregate impact of changes in certain operating assets and liabilities was a cash outflow of $5.9 million in 2013 compared to a cash outflow of $7.7 million in 2012. Cash used in investing activities was $22.3 million for the year ended December 31, 2013, compared to $62.5 million in 2012. We used $1.8 million of cash to acquire property and equipment during the year ended December 31, 2013 and $2.2 million to acquire property and equipment during the year ended December 31, 2012. We used $1.9 million of cash to acquire intangible assets during the year ended December 31, 2013 and $5.0 million to acquire intangible assets during the year ended December 31, 2012. We used $18.6 million of cash to acquire other businesses during the year ended December 31, 2013 compared with $55.1 million during the year ended December 31, 2012. Cash provided by financing activities was $17.25 million in the year ended December 31, 2013 and $33.4 million in the year ended December 31, 2012. In 2013 under our short-term borrowing arrangement we borrowed $18.0 million relating to the funding of the Grass acquisition and $4.0 million for working capital. During the second quarter of 2013, we borrowed $35.3 million under our Wells Fargo facility in connection refinancing and used substantially all the proceeds from the new loan agreement to repay $33.3 of short-term borrowing obligations. We repaid $18.9 million and $4.4 million under term loan agreements in the years ended December 31, 2013 and 2012, respectively. We received cash from sales of our stock pursuant to our stock awards plans and our employee stock purchase plan in the amount of $9.0 million and $1.9 million in the years ended December 31, 2013 and 2012, respectively. Our after-tax cost of stock-based compensation was an excess tax benefit of $3.1 million in 2013 and an expense of $(381,000) in 2012. Comparison of 2012 and 2011 Cash provided by operations decreased by $3.4 million for the year ended December 31, 2012 to $19.4 million, compared to $22.8 million in 2011. The sum of our net income (loss) and certain non-cash expense items, such as reserves, depreciation and amortization, goodwill and intangible asset impairment charges, and share based compensation was approximately $27 million in 2012, compared to $29.7 million in 2011. The aggregate impact of changes in certain operating assets and liabilities was a cash outflow of $7.7 million in 2012 compared to a cash outflow of $7 million in 2011. 46-------------------------------------------------------------------------------- Table of Contents Cash used in investing activities was $62.5 million for the year ended December 31, 2012, compared to $19.4 million in 2011. We used $7.3 million of cash to acquire property and equipment during the year ended December 31, 2012 and $4.2 million to acquire property and equipment during the year ended December 31, 2011. We used $55.1 million of cash to acquire businesses during the year ended December 31, 2012 compared with $15.1 million during the year ended December 31, 2011. During the year ended December 31, 2012 we capitalized $5.3 million of internal use software development costs compared with $666,000 in 2011. In addition, we sold $1.0 million of marketable securities during the year ended December 31, 2011. Cash provided by financing activities was $33.4 million in the year ended December 31, 2012 and $1.7 million in the year ended December 31, 2011. We borrowed $31 million relating to the funding of the Nicolet acquisition and $5.3 million for working capital. We received cash from sales of our stock pursuant to our stock awards plans and our employee stock purchase plan in the amount of $1.9 million and $2.3 million in the years ended December 31, 2012 and 2011, respectively. Our after-tax cost of stock-based compensation was $381,000 and $160,000 more than the tax benefit we received from those arrangements on the exercise of employee stock options in 2012 and 2011, respectively. These amounts were recorded as a decrease to stockholders' equity. We repaid $4.4 million and $3.0 million under term loan agreements in the years ended December 31, 2012 and 2011, respectively. Future Liquidity Our future liquidity and capital requirements will depend on numerous factors, including the: • Amount and timing of revenue; • Extent to which our existing and new products gain market acceptance; • Extent to which we make acquisitions; • Cost and timing of product development efforts and the success of these development efforts; • Cost and timing of marketing and selling activities; and • Availability of borrowings under line of credit arrangements and the availability of other means of financing. Contractual Obligations In the normal course of business, we enter into obligations and commitments that require future contractual payments. The commitments result primarily from purchase orders placed with contract vendors that manufacture some of the components used in our medical devices and related disposable supply products, purchase orders placed for employee benefits and outside services, as well as commitments for leased office space and equipment, leased vehicles and bank debt. The following table summarizes our contractual obligations and commercial commitments as of December 31, 2013 (in thousands): Payments Due by Period Less than More than Total 1 Year 1-3 Years 4-5 Years 5 Years Unconditional purchase obligations $ 29,366 $ 27,957 $ 1,341 $ 68 $ - Operating and financing lease obligations 22,377 4,254 7,338 1,993 8,792 Long-term debt (including current portion and interest) 39,288 11,122 28,166 - - Total $ 91,031 $ 43,333 $ 36,845 $ 2,061 $ 8,792 Purchase obligations are defined as agreements to purchase goods or services that are enforceable and legally binding. Included in the purchase obligations category above are obligations related to purchase orders for 47-------------------------------------------------------------------------------- Table of Contents inventory purchases under our standard terms and conditions and under negotiated agreements with vendors. We expect to receive consideration (products or services) for these purchase obligations. The purchase obligation amounts do not represent all anticipated purchases in the future, but represent only those items for which we are contractually obligated. The table above does not include obligations under employment agreements for services rendered in the ordinary course of business. We are not able to reasonably estimate the timing of any potential payments for uncertain tax positions under ASC 740, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement 109. As a result, the preceding table excludes any potential future payments related to our ASC 740 liability for uncertain tax positions. See Note 14 of our Consolidated Financial Statements for further discussion on income taxes. |