TMCnet News

GREATBATCH, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
[August 12, 2014]

GREATBATCH, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


(Edgar Glimpses Via Acquire Media NewsEdge) Our Business In connection with the realignment of our operating structure in 2013 to optimize profitable growth, which included changing our management and reporting structure, we reevaluated our operating and reporting segments. Beginning in the fourth quarter of 2013, we have two reportable segments: Greatbatch Medical and QiG Group ("QiG"). As required, prior year amounts have been reclassified in order to conform them to the current year presentation. Greatbatch Medical designs and manufactures products where Greatbatch either owns the intellectual property or has unique manufacturing and assembly expertise. The financial results of Greatbatch Medical include the former Implantable Medical and Electrochem Solutions ("Electrochem") segments, excluding QiG. These products include medical devices and components for the cardiac, neuromodulation, orthopaedic, portable medical, vascular, and energy, military and environmental ("EME") markets. The Greatbatch Medical segment also offers value-added assembly and design engineering services for medical devices that utilize its component products.



QiG focuses on developing medical device systems for some of healthcare's most pressing challenges and reflects Greatbatch's strategic evolution of its product offerings in order to raise the growth and profitability profile of the Company.

Through the research and development professionals in QiG, the Company is now investing in three areas - new medical device systems commercialization, collaborative programs with original equipment manufacturers ("OEM") customers, and strategic equity positions in start-up companies - to grow a diversified and distinctive portfolio. The medical device systems developed by QiG will be manufactured by Greatbatch Medical. Currently, no revenue earned by QiG is manufactured by Greatbatch Medical.


Our Customers The nature and extent of our selling relationships with each of our customers is different in terms of breadth of products purchased, product volumes, length of contractual commitment, ordering patterns, inventory management and selling prices. Our Greatbatch Medical customers include large multi-national OEMs, such as Biotronik, Boston Scientific, Halliburton, Johnson & Johnson, Medtronic, Philips Healthcare, Smith & Nephew, Sorin Group, St. Jude Medical, Stryker, and Zimmer. For the six months ended July 4, 2014, Johnson & Johnson, Medtronic and St. Jude Medical collectively accounted for 47% of our total sales.

Current QiG customers include numerous scientists, hospitals and universities throughout the world who perform research for the neuroscience and clinical markets.

Financial Overview On an organic constant currency basis, second quarter 2014 sales were consistent with the prior year period. However, for the first six months of 2014, sales increased 8% on an organic constant currency basis, which is ahead of our strategic goal of 5% organic constant currency growth. In comparison to the prior year second quarter and year-to-date periods, foreign currency exchange rate fluctuations increased sales by approximately $1.5 million and $2.5 million, respectively. During the second quarter and for the first half of 2014, we experienced double digit growth in sales from our orthopaedic and vascular product lines as we continue to realize the benefits of our increased sales force productivity, marketing efforts and market growth. For the second quarter of 2014, our cardiac and neuromodulation sales decreased 4% due to the timing of shipments of customer orders, as well as the initial end of life impact for two legacy products. However, for the first six months of 2014, cardiac and neuromodulation sales increased 9% due to the timing of customer product launches and inventory replenishments. As expected, our portable medical sales decreased 24% and 12% for the 2014 second quarter and year-to-date periods, respectively, as we are refocusing our product line offerings in the portable medical space to products that have higher profitability and correspondingly have discontinued or reduced volumes in certain of our lower margin products.

We prepare our condensed 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, adjusted earnings per diluted share and organic constant currency growth rates. These adjusted amounts, other than organic constant currency growth rates, consist of GAAP amounts excluding the following adjustments to the extent they occur during the period: (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 certain non-cash charges to interest expense, (vii) unusual or infrequently occurring items, (viii) for 2013, certain R&D expenditures (such as medical device design verification ("DVT") expenses in connection with developing our neuromodulation platform), (ix) gain/loss on the sale of investments, (x) the income tax (benefit) related to these adjustments and (xi) certain tax items related to the Federal R&D Tax Credit which are outside the normal benefit received. To calculate organic constant currency growth rates, which excludes the impact of changes in foreign currency - 27 --------------------------------------------------------------------------------- Table of Contents exchange rates, as well as the impact of any acquisitions or divestitures of product lines on sales growth rates, we convert current period sales from local currency to U.S. dollars using the previous periods' foreign currency exchange rates and exclude the amount of sales acquired/divested during the period from the current/previous period amounts, respectively.

We believe that reporting these amounts provides important supplemental information to our investors and creditors seeking to understand the financial and business trends impacting our financial condition and results of operations.

Additionally, certain performance-based compensation incentives provided to our executives are determined utilizing these adjusted amounts.

A reconciliation of GAAP operating income (loss) to adjusted amounts is as follows (dollars in thousands): Three Months Ended Greatbatch Medical QiG Unallocated Total July 4, 2014 June 28, 2013 July 4, 2014 June 28, 2013 July 4, 2014 June 28, 2013 July 4, 2014 June 28, 2013 Sales $ 171,216 $ 170,494 $ 865 $ 837 $ - $ - $ 172,081 $ 171,331 Operating income (loss) as reported $ 32,439 $ 29,845 $ (6,173 ) $ (7,377 ) $ (6,727 ) $ (5,333 ) $ 19,539 $ 17,135 Adjustments: Medical device DVT expenses (RD&E)(a) - - - 1,235 - - - 1,235 Consolidation and optimization (income) costs 3,342 3,191 38 - (5 ) 517 3,375 3,708 Acquisition and integration (income) expenses 30 31 (173 ) 40 190 - 47 71 Asset dispositions, severance and other 3 43 - - 836 - 839 43 Adjusted operating income (loss) $ 35,814 $ 33,110 $ (6,308 ) $ (6,102 ) $ (5,706 ) $ (4,816 ) $ 23,800 $ 22,192 Adjusted operating margin 20.9 % 19.4 % N/A N/A N/A N/A 13.8 % 13.0 % Six Months Ended Greatbatch Medical QiG Unallocated Total July 4, 2014 June 28, 2013 July 4, 2014 June 28, 2013 July 4, 2014 June 28, 2013 July 4, 2014 June 28, 2013 Sales $ 344,811 $ 318,116 $ 1,551 $ 1,480 $ - $ - $ 346,362 $ 319,596 Operating income (loss) as reported $ 67,567 $ 56,360 $ (12,086 ) $ (14,733 ) $ (13,418 ) $ (10,153 ) $ 42,063 $ 31,474 Adjustments: Medical device DVT expenses (RD&E)(a) - - - 2,969 - - - 2,969 Consolidation and optimization costs 2,920 5,951 66 - 232 819 3,218 6,770 Acquisition and integration (income) expenses 30 71 (603 ) 110 192 1 (381 ) 182 Asset dispositions, severance and other (7 ) 108 - - 1,217 - 1,210 108 Adjusted operating income (loss) $ 70,510 $ 62,490 $ (12,623 ) $ (11,654 ) $ (11,777 ) $ (9,333 ) $ 46,110 $ 41,503 Adjusted operating margin 20.4 % 19.6 % N/A N/A N/A N/A 13.3 % 13.0 % (a) As a result of our premarket approval ("PMA") submission to the United States Food & Drug Administration ("FDA") for our Spinal Cord Stimulation ("SCS") system to treat chronic pain of the trunk and limbs in December 2013, we no longer exclude design verification testing ("DVT") costs associated with this system from adjusted operating income and adjusted diluted EPS. DVT costs incurred in connection with the development of this system during the three and six month periods ended July 4, 2014 were $455 thousand and $1.2 million, respectively.

GAAP operating income for the second quarter and first six months of 2014 increased 14% and 34%, respectively, in comparison to the prior year. Adjusted operating income, which excludes net other operating expenses and DVT costs (for the 2013 period only), increased 7% and 11%, respectively, for the second quarter and first six months of 2014. These GAAP and adjusted operating income variances are primarily due to the following: - 28 --------------------------------------------------------------------------------- Table of Contents Second Quarter 2014 • A 2% increase in gross profit driven primarily by higher sales volumes.

Additionally, in comparison to the prior year second quarter, gross profit as a percentage of sales increased 60 basis points due to production efficiencies and lower performance-based compensation in comparison to the prior year quarter, which more than offset the impact of contractual price concessions granted in exchange for long-term agreements with our customers; • A 2% decrease in selling, general, and administrative ("SG&A") expenses primarily attributable to our operating unit realignment in the second half of 2013 and lower performance-based compensation, partially offset by our continued investments in sales and marketing and increased legal fees, which includes higher patent filing costs; • A 9% decrease in our net research, development and engineering ("RD&E") costs primarily due to a lower level of DVT costs incurred in connection with the development of our SCS system, an increase in customer cost reimbursements due to the timing of achievement of milestones on various projects, and lower performance-based compensation; and • The increase in GAAP operating income for the second quarter of 2014 in comparison to 2013 also included a higher level of net other operating expenses incurred in connection with our 2014 investments in capacity and capabilities, offset by lower costs incurred in connection with our orthopaedic facility optimization initiative and 2013 operating unit realignment. See Cost Savings and Consolidation Initiatives section for further description of these projects.

First Six Months 2014 • A 9% increase in gross profit driven primarily by higher sales volumes.

Additionally, in comparison to the prior year first half, gross profit as a percentage of sales increased 30 basis points due to production efficiencies and an increased sales mix of higher margin products, which more than offset the impact of price concessions granted in exchange for long-term agreements with our customers; • A 3% increase in SG&A expenses primarily attributable to our increased investments in sales and marketing and increased legal fees, which includes higher patent filing costs, partially offset by cost savings realized in connection with our operating unit realignment in the second half of 2013; • A 5% increase in our net RD&E costs primarily attributable to lower customer cost reimbursements due to the timing of achievement of milestones on various projects. Additionally, lower DVT costs were offset by higher costs incurred in connection with the development of our next generation cardiac products (i.e. batteries, capacitors, filtered feedthoughs); and • The increase in GAAP operating income for the first six months of 2014 in comparison to 2013 also included a lower level of net other operating expenses incurred in connection with our orthopaedic facility optimization initiative.

Additionally, in the first quarter of 2014, we recognized a $2.5 million gain in connection with the achievement of contingent earnouts related to the sale of certain Swiss orthopaedic product lines in 2013.

- 29 --------------------------------------------------------------------------------- Table of Contents A reconciliation of GAAP net income and diluted EPS to adjusted amounts is as follows (in thousands, except per share amounts): Three Months Ended Six Months Ended July 4, 2014 June 28, 2013 July 4, 2014 June 28, 2013 Per Per Per Per Net Diluted Net Diluted Net Diluted Net Diluted Income Share Income Share Income Share Income Share Net income as reported $ 12,348 $ 0.48 $ 9,752 $ 0.39 $ 27,270 $ 1.06 $ 15,415 $ 0.62 Adjustments: Medical device DVT expenses (RD&E)(a) - - 803 0.03 - - 1,930 0.08 Consolidation and optimization costs(a) 2,181 0.08 2,956 0.12 1,255 0.05 5,296 0.21 Acquisition and integration (income) expenses(a) 31 - 46 - (248 ) (0.01 ) 118 - Asset dispositions, severance and other(a) 545 0.02 26 - 787 0.03 91 - Loss (gain) on cost and equity method investments, net(a)(b) 27 - 352 0.01 (507 ) (0.02 ) 398 0.02 CSN conversion option discount and deferred fee accelerated amortization(a)(c) - - - - - - 2,906 0.12 R&D Tax Credit(d) 400 0.02 - - 800 0.03 (1,500 ) (0.06 ) Adjusted net income and diluted EPS(e) $ 15,532 $ 0.60 $ 13,935 $ 0.56 $ 29,357 $ 1.14 $ 24,654 $ 0.99 Adjusted diluted weighted average shares 25,901 24,922 25,823 24,818 (a) Net of tax amounts computed using a 35% tax rate for all non-Swiss items and a 0% tax rate for Swiss items for both the 2014 and 2013 periods.

(b) Pre-tax amount is a loss of $42 thousand and a gain of $780 thousand for the 2014 quarter and year-to-date periods, respectively, and a loss of $542 thousand and $612 thousand for the 2013 quarter and year-to-date periods, respectively.

(c) Pre-tax amount is $4.5 million for the 2013 year-to-date period.

(d) The Federal R&D tax credit has not yet been extended for 2014. The 2014 amount assumes that the tax credit will be enacted for the full year 2014.

The 2013 amount relates to the 2012 portion of the R&D tax credit which was reinstated in the first quarter of 2013 retroactive to the beginning of 2012.

As required, the impact of the R&D tax credit relating to 2012 was recognized in the first quarter of 2013.

(e) The per share data in this table has been rounded to the nearest $0.01 and therefore may not sum to the total.

GAAP and adjusted diluted EPS for the second quarter of 2014 were $0.48 and $0.60, respectively, compared to $0.39 and $0.56, respectively, for the second quarter 2013. For the first six months of 2014, GAAP and adjusted diluted EPS were $1.06 and $1.14, respectively, compared to $0.62 and $0.99 per share, respectively, for the same period of 2013. These variances were primarily due to the same factors impacting GAAP and adjusted operating income discussed above, as well as the following: • Lower interest expense as a result of lower interest rates paid on our long-term debt due to the repayment of our convertible subordinated debt with availability under our Credit Facility in 2013; • The changes in the GAAP effective tax rate between the 2014 second quarter and year-to-date periods in comparison to the same periods of 2013 were primarily due to the timing of the Federal R&D tax credit, as well as the 2014 periods having higher income in lower tax rate jurisdictions. The Federal R&D tax credit expired at the end of 2013 and has not yet been extended for 2014. Additionally, we recognized the full year 2012 R&D tax credit in the first quarter of 2013 as the credit was reinstated, retroactive to the beginning of 2012, in that period.

• An increase in weighted average diluted shares outstanding for the second quarter and first six months of 2014 versus the same periods of 2013 as a result of the increase in our stock price during those respective periods.

This increase reduced the 2014 second quarter and year to date diluted EPS by $0.02 and $0.04 per share, respectively, on both a GAAP and adjusted basis.

- 30 --------------------------------------------------------------------------------- Table of Contents Financial Guidance Based upon our results for the first two quarters of 2014, as well as our expectations for the remainder of the year, we believe that our revenue and adjusted diluted EPS for 2014 will be in-line with our guidance provided at the beginning of the year as follows: Sales $685 - $705 million GAAP Operating Income as a % of Sales 11.0% - 11.5% Adjusted Operating Income as a % of Sales 13.0% - 13.3% GAAP Diluted EPS $1.94 - $1.99 Adjusted Diluted EPS $2.25 - $2.35 Adjusted operating income for 2014 is expected to consist of GAAP operating income excluding items such as acquisition, consolidation, integration and asset disposition/write-down charges totaling approximately $12 million to $15 million. The after tax impact of these adjustments is estimated to be $7.5 million to $10 million or $0.31 to $0.35 per share.

Our CEO's View As we continue to invest and execute our global strategy, we are seeing results in line with our expectations. We currently expect our vascular and orthopaedic product lines to continue to deliver double digit growth, which will be balanced by our large, slower growth markets, such as cardiac rhythm management and portable medical. We remain focused on delivering 5% year over year revenue growth and returning two times that amount to the bottom line leveraging our deep customer relationships, the strength of our intellectual property and our culture of continuous improvement. During the quarter, we announced several capacity realignments, including investment of up to $45 million to complete these projects. Additionally, we received CE Mark for our spinal cord stimulator - Algovita, and we remain on track with our active implantable medical device strategy.

Product Development Greatbatch Medical Our core business is well positioned because our OEM customers leverage our portfolio of intellectual property, and we continue to build a healthy pipeline of diverse medical technology opportunities. We continue to deepen our relationships with our OEM customers and continue to see an increased pace of product development opportunities. These product development opportunities, when combined with our increased sales and marketing resources, are expected to allow us to continue to grow faster than our underlying markets. Some of the product development opportunities Greatbatch Medical is pursuing are as follows: Product Line Product Development Opportunities Developing next generation technology programs including Gen 2 Cardiac/ QHR battery, next generation filtered feedthroughs, and high Neuromodulation voltage capacitors.

Orthopaedic Developing single use instruments and a suite of reusable bone preparation instruments with an emphasis on increased efficacy and longer life.

Portable Developing wireless power solutions for the surgical tool Medical marketplace.

Vascular Developing introducer technologies to expand into new clinical markets, as well as line extensions for current introducer platforms to better serve existing clinical markets and customers.

EME Developing wide range temperature battery packs.

QiG Through QiG, we provide our Greatbatch Medical customers with complete medical device systems. This medical device strategy includes strategic equity investments and medical devices developed independently, as well as in conjunction with our OEM partners. While we do not intend to discuss each of these projects individually, we will discuss significant milestones as they occur.

Algovita (formerly known as Algostim), our spinal cord stimulator to treat chronic intractable pain of the trunk and/or limbs, was designed to target unmet clinical needs with a focus on safety and product differentiation for all user groups. This product was submitted for PMA to the FDA in December 2013, and in January 2014 documentation for European CE Mark was submitted to the notified body, TÜV SÜD America. CE Mark approval was received in June 2014. We continue to move through the regulatory approval process and we believe we will be in a position to receive PMA approval in early 2015.

- 31 --------------------------------------------------------------------------------- Table of Contents CardiomoniX is an implantable loop recorder for cardiac arrhythmia diagnostics that is being designed to address the unmet needs of remote patient monitoring and data quality.

QiG is in the early stages of development of two additional medical device systems, which are targeting approved and emerging indications. Additionally, based upon the technology acquired from NeuroNexus Technologies, Inc.

("NeuroNexus"), QiG is developing a platform of thin-film electrodes for neuromodulation leads, sub-systems and components.

Cost Savings and Consolidation Initiatives In 2014 and 2013, we recorded charges in Other Operating Expenses, Net related to various cost savings and consolidation initiatives. These initiatives were undertaken to improve our operational efficiencies and profitability and consist of our 2013 operating unit realignment, optimizing our orthopaedic facilities, and upgrading and expanding our manufacturing infrastructure to support our medical device strategy. When fully implemented, the operating unit realignment is expected to result in annual savings of approximately $7.0 to $7.7 million and the orthopaedic and medical device initiatives are expected to generate approximately $10 million to $15 million of annual cost savings and to increase our capacity in order to support our growth and the manufacturing of complete medical devices.

In the second quarter of 2014, we announced several initiatives to invest in capacity and capabilities and to better align our resources to meet our customers' needs and drive organic growth and profitability. This included transferring certain functions currently performed at our Plymouth, MN and Beaverton, OR facilities into new and existing facilities in Tijuana, Mexico.

Additionally, we announced the establishment a R&D hub in the Minneapolis/St.

Paul, MN area for the Company's Global R&D QiG - Medical Device Systems team and a commercial operations hub at our global headquarters in Frisco, Texas. We believe these initiatives will generate up to $17 million of annualized savings beginning in 2016.

Additional information regarding the timing, cash flow impact and amount of future expenditures for these initiatives is set forth in Note 8 "Other Operating Expenses, Net" of the Notes to the Condensed Consolidated Financial Statements contained in Item 1 of this report. We continually evaluate our operating structure in order to maximize efficiencies and drive margin expansion. Future charges could be incurred if new consolidation and optimization initiatives are undertaken.

Our Financial Results We utilize a fifty-two, fifty-three week fiscal year ending on the Friday nearest December 31st. For 52-week years, each quarter contains 13 weeks. The second quarter and year-to-date periods of 2014 and 2013 ended on July 4, and June 28, respectively, and each contained 13 weeks and 26 weeks, respectively.

The commentary that follows should be read in conjunction with our Condensed Consolidated Financial Statements and related notes and with the Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the fiscal year ended January 3, 2014.

- 32 --------------------------------------------------------------------------------- Table of Contents The following table presents certain selected financial information derived from our Condensed Consolidated Financial Statements for the periods presented (dollars in thousands, except per share data): Three Months Ended Six Months Ended July 4, June 28, Change July 4, June 28, Change 2014 2013 $ % 2014 2013 $ % Sales: Greatbatch Medical Cardiac/Neuromodulation $ 80,005 $ 83,177 $ (3,172 ) (4 )% $ 166,785 $ 153,701 $ 13,084 9 % Orthopaedic 37,865 32,341 5,524 17 % 74,296 61,964 12,332 20 % Portable Medical 16,737 22,167 (5,430 ) (24 )% 35,940 41,056 (5,116 ) (12 )% Vascular 15,257 12,249 3,008 25 % 28,307 22,873 5,434 24 % Energy, Military, Environmental 21,352 20,560 792 4 % 39,483 38,522 961 2 % Total Greatbatch Medical 171,216 170,494 722 - % 344,811 318,116 26,695 8 % QiG 865 837 28 3 % 1,551 1,480 71 5 % Total sales 172,081 171,331 750 - % 346,362 319,596 26,766 8 % Cost of sales 113,611 114,029 (418 ) - % 230,296 213,545 16,751 8 % Gross profit 58,470 57,302 1,168 2 % 116,066 106,051 10,015 9 % Gross profit as a % of sales 34.0 % 33.4 % 33.5 % 33.2 % Selling, general and administrative expenses (SG&A) 21,877 22,248 (371 ) (2 )% 43,632 42,340 1,292 3 % SG&A as a % of sales 12.7 % 13.0 % 12.6 % 13.2 % Research, development and engineering costs, net (RD&E) 12,793 14,097 (1,304 ) (9 )% 26,324 25,177 1,147 5 % RD&E as a % of sales 7.4 % 8.2 % 7.6 % 7.9 % Other operating expenses, net 4,261 3,822 439 11 % 4,047 7,060 (3,013 ) (43 )% Operating income 19,539 17,135 2,404 14 % 42,063 31,474 10,589 34 % Operating margin 11.4 % 10.0 % 12.1 % 9.8 % Interest expense 1,073 1,445 (372 ) (26 )% 2,157 8,433 (6,276 ) (74 )% Other (income) expense, net 334 679 (345 ) (51 )% (287 ) 964 (1,251 ) (130 )% Provision for income taxes 5,784 5,259 525 10 % 12,923 6,662 6,261 94 % Effective tax rate 31.9 % 35.0 % 32.2 % 30.2 % Net income $ 12,348 $ 9,752 $ 2,596 27 % $ 27,270 $ 15,415 $ 25,729 167 % Net margin 7.2 % 5.7 % 7.9 % 4.8 % Diluted earnings per share $ 0.48 $ 0.39 $ 0.09 23 % $ 1.06 $ 0.62 $ 0.44 71 % Greatbatch Medical Sales Total Greatbatch Medical sales for the second quarter of 2014 were consistent with the prior year period. However, for the first six months of 2014, Greatbatch Medical sales increased 8% over the comparable 2013 period. The most significant contributors to these variances were as follows: Cardiac and neuromodulation sales for the second quarter 2014 decreased 4% over the prior year period. This decrease was primarily a result of the timing of shipments of customer orders, as well as the initial end of life impact for two legacy products. However, for the first six months of 2014, cardiac and neuromodulation sales increased 9% due to the timing of customer product launches and inventory replenishments. Although sales from this product line may vary significantly in the short-term, over the long-term we expect our new business opportunities will offset these end of product life impacts. When coupled with the continued success of products that our customers have in the marketplace, we believe we are well-positioned to grow our cardiac and neuromodulation product line.

- 33 --------------------------------------------------------------------------------- Table of Contents Orthopaedic sales for the second quarter and first six months of 2014 increased 17% and 20%, respectively, in comparison to the prior year periods. For the second quarter and first six months of 2014, foreign currency exchange rate fluctuations increased sales by approximately $1.5 million and $ $2.5 million, respectively, in comparison to the prior year. On an organic constant currency basis, our orthopaedic product line sales increased 12% and 16% in comparison to the prior year second quarter and year-to-date periods, respectively. These increases were across all of our orthopaedic products and were primarily due to our sales force productivity, marketing efforts and market growth. We believe that for the year, orthopaedics revenue growth will be in the high single to low double digit range.

Portable medical sales for the second quarter and first six months of 2014 decreased 24% and 12%, respectively, in comparison to the prior year periods. We are refocusing our product line offerings in the portable medical space to products that have higher profitability. Correspondingly, we have discontinued or reduced volumes in certain of our lower margin products, which is expected to negatively impact our sales for the remainder of 2014. As part of our investment in capacity and capabilities and to better align our resources to meet our customers' needs, during the second quarter of 2014, we announced plans to transfer our portable medical operations into a new facility located in Tijuana, Mexico. We remain optimistic about this product line and continue to see our pipeline of customer opportunities grow.

Vascular sales for the second quarter and first six months of 2014 increased 25% and 24%, respectively, in comparison to the prior year periods. These increases reflect the continued adoption of our medical device products and the relaunch of a vascular medical device near the end of 2013 which, as previously communicated, was voluntarily recalled in the fourth quarter of 2012. We anticipate continued strength in our vascular product line for the remainder of the year.

Second quarter and year-to-date 2014 sales from our EME product line benefited from strong growth in energy sales due to market and market share growth.

Partially offsetting this growth was declines in sales to the military and environmental markets primarily due to the timing of orders from our customers.

QiG Sales QiG revenue for the first two quarters of 2014 includes sales of neural interface technology, components and systems to the neuroscience and clinical markets and remained relatively consistent with the prior year.

Gross Profit Changes to gross profit as a percentage of sales from the prior year were due to the following: Change From Prior Year Three Six Months Months Performance-based compensation(a) 0.7 % - % Production efficiencies, volume and mix(b) 1.2 % 1.5 % Price(c) (1.3 )% (1.2 )% Total percentage point change to gross profit as a percentage of sales 0.6 % 0.3 % (a) Amount represents the change in performance-based compensation versus the prior year period and is recorded based upon the actual results achieved.

(b) Our gross profit percentage benefited from production efficiencies gained at our manufacturing facilities as a result of our various lean and supply chain initiatives, as well as higher production volumes due to increased sales.

Additionally, our gross profit percentage benefited from increased sales of higher margin products in comparison to the prior year.

(c) Our gross profit percentage was negatively impacted by contractual price concessions to our larger OEM customers, which were given in exchange for long-term contracts and volume commitments.

Over the long-term, we expect to see gross margin improvements as we leverage our organic growth across our manufacturing footprint and realize the benefit of the various productivity improvement initiatives that are being implemented (See "Cost Savings and Consolidation Efforts" section of this Item). Additionally, we expect our gross margin to improve as more system and device level products are introduced, which typically earn a higher margin.

- 34 --------------------------------------------------------------------------------- Table of Contents SG&A Expenses Changes to SG&A expenses from the prior year were due to the following (in thousands): Change From Prior Year Three Six Months MonthsSelling and marketing(a) $ 1,469 $ 2,450 Performance-based compensation(b) (978 ) (200 ) Legal fees(c) 1,024 1,267 G&A personnel costs(d) (1,426 ) (2,157 ) Other (460 ) (68 ) Net increase (decrease) in SG&A $ (371 ) $ 1,292 (a) Amount represents the incremental SG&A expenses related to our strategic initiative to increase selling and marketing resources to drive core business growth and sustain a pipeline in order to achieve our 5% or better organic revenue growth performance goal.

(b) Amount represents the change in performance-based compensation versus the prior year period and is recorded based upon the actual results achieved.

(c) Amount represents the increase in legal costs compared to the prior year period and includes higher patent related costs, as well as other corporate initiatives.

(d) Amount represents lower G&A personnel costs incurred during 2014 in comparison to the prior year and is primarily a result of our various consolidation initiatives including our operating unit realignment that occurred during the second half of 2013.

RD&E Expenses, Net Net RD&E costs are comprised of the following (in thousands): Three Months Ended Six Months Ended July 4, 2014 June 28, 2013 July 4, 2014 June 28, 2013 Research, development, and engineering costs $ 15,075 $ 16,053 $ 30,534 $ 30,346 Less cost reimbursements (2,282 ) (1,956 ) (4,210 ) (5,169 ) Total RD&E, net $ 12,793 $ 14,097 $ 26,324 $ 25,177 Net RD&E for the 2014 second quarter decreased $1.3 million versus the comparable 2013 period and increased $1.1 million for the year-to-date period.

The decrease for the second quarter was primarily attributable to lower DVT costs incurred in connection with the development of our SCS system. The remainder of the decrease results from an increase in customer cost reimbursements compared to the prior year of $0.3 million, due to the timing of achievement of milestones on various projects, as well as lower performance-based compensation. The increase for the year-to-date period was primarily attributed to a decrease in customer costs reimbursements compared to the prior year. Additionally, lower DVT costs were offset by higher costs incurred in connection with the development of our next generation cardiac products (i.e. batteries, capacitors, filtered feedthoughs).

In total, net medical device costs incurred by our QiG segment were $6.2 million for the second quarter 2014 ($12.1 million year-to-date), compared to $7.4 million for the respective 2013 period ($14.7 million year-to-date). Our lower expenses reflect a decrease in DVT costs incurred in connection with the development of our SCS system to treat chronic intractable pain of the trunk and/or limbs from $1.2 million for the 2013 second quarter ($3.0 million year-to-date) to $0.5 million for the 2014 second quarter ($1.2 million year-to-date). QiG's medical device technology investment is primarily focused on successfully commercializing Algovita and selective opportunities that leverage the strengths of Greatbatch Medical to drive sustainable growth.

- 35 --------------------------------------------------------------------------------- Table of Contents Other Operating Expenses, Net Other operating expenses, net is comprised of the following (in thousands): Three Months Ended Six Months Ended July 4, 2014 June 28, 2013 July 4, 2014 June 28, 2013 2014 investments in capacity and capabilities (a) 2,166 - 2,218 - 2013 operating unit realignment(a) 32 852 1,035 852 Orthopaedic facility optimization(a) 1,187 2,667 36 5,303 Medical device facility optimization(a) - 125 11 230 ERP system upgrade (income) costs(a) (10 ) 64 (82 ) 385 Acquisition and integration (income) costs(b) 47 71 (381 ) 182 Asset dispositions, severance and other(c) 839 43 1,210 108 Total other operating expenses, net $ 4,261 $ 3,822 $ 4,047 $ 7,060 (a) Refer to "Cost Savings and Consolidation Initiatives" section of this Item and Note 8 "Other Operating Expenses, Net" of the Notes to the Condensed Consolidated Financial Statements contained in Item 1 of this report for disclosures related to the timing and level of remaining expenditures for these initiatives.

(b) During 2014 and 2013, we recognized (income) costs related to the integration of Micro Power Electronics, Inc. and NeuroNexus. These expenses (income) were primarily for retention bonuses, travel costs in connection with integration efforts, training, severance, and the change in fair value of the contingent consideration recorded in connection with the NeuroNexus acquisition. Refer to Note 13 "Fair Value Measurements" of the Notes to the Condensed Consolidated Financial Statements contained in Item 1 of this report for disclosures related to the change in fair value of the contingent consideration.

(c) During 2014 and 2013, we recorded charges in connection with various asset disposals and write-downs. Additionally, during 2014 we recorded charges as a result of various tax planning initiatives in connection with our business reorganization to align our contract manufacturing operations, which is expected to produce tax savings over the long-term. Costs incurred primarily relate to consulting and IT development, and are expected to be completed during the second half of 2014.

Other operating expenses, net is expected to be approximately $12 million to $15 million for 2014.

Interest Expense Interest expense for the second quarter and first six months of 2014 decreased $0.4 million and $6.3 million, respectively, in comparison to the prior year periods. This decrease was primarily due to the elimination of discount amortization expense in 2014 as a result of the repayment of our convertible subordinated notes during the first quarter of 2013. Additionally, interest expense was lower for the 2014 periods in comparison to 2013 due to lower outstanding debt balances, as well as lower interest rates paid on outstanding debt.

Other (Income) Expense, Net Other (income) expense, net decreased $0.3 million and $1.3 million, respectively, for the 2014 second quarter and year-to-date periods in comparison to 2013. This year-to-date decrease is primarily due to $0.8 million of income realized on our cost and equity method investments during the first quarter of 2014. Other (income) expense, net also 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 financial results.

Provision for Income Taxes The 2014 second quarter GAAP effective tax rate was 31.9% compared to 35.0% for the same period of 2013. This decrease was primarily attributable to higher income in lower tax rate jurisdictions partially offset by a lower Federal R&D tax credit, which has not yet been extended for 2014. Including the impact of what the forecasted R&D tax credit would be for 2014 if enacted, the effective tax rate decreased to 29.7% for the second quarter of 2014 compared to 35.0% for the 2013 second quarter, primarily due to higher income in lower tax rate jurisdictions.

The higher GAAP effective tax rate of 32.2% for the first six months of 2014 in comparison to 30.2% for 2013 was primarily due to the R&D tax credit recognized in 2013 for fiscal year 2013 as well as the R&D tax credit recognized in the first quarter of 2013 relating to 2012 due to the enactment of that legislation, retroactive to the beginning of 2012, in that period. Including the impact of what the forecasted R&D tax credit would be for 2014 if enacted, and excluding the 2012 R&D tax credit - 36 --------------------------------------------------------------------------------- Table of Contents recognized in 2013, the effective tax rate decreased to 30.2% for the first six months of 2014 compared to 37.0% for the comparable 2013 period, primarily due to higher income in lower tax rate jurisdictions.

We currently expect our 2014 annual GAAP and adjusted effective tax rate to be in the range of 32% to 34%. This current expected GAAP effective tax rate for 2014 does not include the benefit of the U.S. R&D tax credit. If reinstated, our 2014 GAAP effective tax rate is expected to be 30% to 32%. We expect there to be continued volatility of this effective tax rate due to several factors, including changes in the mix of pre-tax income and the jurisdictions to which it relates, changes in tax laws and foreign tax holidays, business reorganizations, settlements with taxing authorities and foreign currency fluctuations. We currently have various tax planning initiatives in place that are aimed at reducing our effective tax rate over the long-term.

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. healthcare 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. The medical device tax, which was effective in 2013, increased our cost of sales by $0.2 million and $0.4 million for the 2014 second quarter and year-to-date periods, respectively.

In the first quarter of 2014, we initiated a voluntary field corrective action for all Standard Offset Cup Impactors after an internal review determined that the sterilization recommendation in the Instructions For Use for the product did not meet requirements for sterility assurance, which has the potential to result in surgical infection. We have validated two sterilization parameters that meet acceptable sterility assurance levels and provided them to affected customers.

We have informed the FDA and other government agencies of this action, which impacts all Standard Offset Cup Impactors manufactured and distributed from 2004 to 2013. Greatbatch has received 2 complaints possibly related to this issue, however no adverse events have been reported. Potential future product complaints or negative regulatory actions with this product or any of our products could harm our operating results or financial condition.

Liquidity and Capital Resources As of (Dollars in thousands) July 4, 2014 January 3, 2014 Cash and cash equivalents $ 51,193 $ 35,465 Working capital $ 232,594 $ 190,731 Current ratio 3.96 3.08 The increase in cash and cash equivalents from the end of 2013 was primarily due to a higher level of operating income, which generated $26.5 million in net cash provided by operating activities. This also contributed to the higher level of working capital and the increase in current ratio from the end of 2013. Of the $51.2 million of cash on hand as of July 4, 2014, $11.7 million is being held at our foreign subsidiaries and is considered permanently reinvested.

Credit Facility - We have a credit facility (the "Credit Facility"), which consists of a $300 million revolving line of credit (the "Revolving Credit Facility"), a $200 million term loan (the "Term Loan"), a $15 million letter of credit subfacility, and a $15 million swingline subfacility. The Revolving Credit Facility can be increased by $200 million upon our request and approval by the lenders. The Revolving Credit Facility has a maturity date of September 20, 2018, which may be extended to September 20, 2019 upon notice by us and subject to certain conditions. The principal of the Term Loan is payable in quarterly installments as specified in the Credit Facility until its maturity date of September 20, 2019 when the unpaid balance is due in full.

The Credit Facility is supported by a consortium of fifteen banks with no bank controlling more than 18% of the facility. As of July 4, 2014, each bank supporting 98% of the Credit Facility has an S&P credit rating of at least BBB or better, which is considered investment grade. The bank which supports the remaining 2% of the Credit Facility is not currently being rated.

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 July 4, 2014, our ratio of adjusted EBITDA to interest expense, calculated in accordance with our credit agreement, was 28.5 to 1.0, well above the required limit. The Credit Facility also requires us to maintain a total leverage ratio of not greater than 4.5 to 1.0 and not greater than 4.25 to 1.00 after January 2, 2016. As of July 4, 2014, our total leverage ratio, calculated in accordance with our credit agreement, was 1.4 to 1.0, well below the required limit.

- 37 --------------------------------------------------------------------------------- Table of Contents 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 5 "Debt" of the Notes to Condensed Consolidated Financial Statements in Item 1 of this report for a more detailed description of the Credit Facility.

As of July 4, 2014, we had $300 million of borrowing capacity available under the Credit Facility. 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 available borrowing capacity under the Credit Facility provide adequate liquidity to meet our short- and long- term funding needs.

Operating activities - Cash provided by operations for the first six months of 2014 were $26.5 million versus $8.6 million used in operations for the comparable 2013 period. This increase was primarily due to a higher level of operating income in 2014 as compared to 2013, as well as improved working capital management. Additionally, during the second quarter of 2013, the Company paid $11.5 million of estimated tax payments in connection with the retirement of our convertible subordinated notes.

Investing activities - Net cash used in investing activities for the first six months of 2014 were $9.8 million. This includes $12.0 million of cash used for the purchase of property, plant and equipment to support normal operations, partially offset by a $2.7 million contingent payment received in 2014 in connection with the sale of certain non-core Swiss orthopaedic product lines, which closed during the first quarter of 2013. Our current expectation is that capital spending for the full year of 2014 will be in the range of $25 million to $35 million, of which approximately half is discretionary in nature. We anticipate that cash on hand, cash flow from operations and available borrowing capacity 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. On August 12, 2014, we purchased all of the outstanding common stock of Centro de Construcción de Cardioestimuladores del Uruguay("CCC"), headquartered in Montevideo, Uruguay. The aggregate purchase price of $18.0 million, plus a working capital adjustment, was funded with cash on hand.

Financing activities - Net cash used in financing activities for the first six months of 2014 were $0.8 million compared to cash provided of $8.1 million in the comparable 2013 period. This cash outflow is the result of $5.0 million of principal payments on long-term debt and a net $1.1 million cash outflow from other financing activities. This activity was offset by $5.4 million of cash received from the exercise of stock options during the first six months of 2014.

Capital Structure - As of July 4, 2014, our capital structure consisted of $192.5 million of debt under our Term Loan and 24.9 million shares of common stock outstanding. Additionally, we had $51.2 million in cash and cash equivalents. If necessary, we currently have access to $300 million under our Revolving Credit Facility and are authorized to issue 100 million shares of common stock and 100 million shares of preferred stock. 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, including our Credit Facility, 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.

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 Condensed Consolidated Financial Statements. Based upon this review, except as noted in Note 15 "Impact of Recently Issued Accounting Standards" of the Notes to the Condensed Consolidated Financial Statements in Item 1 of this report, we do not expect any of the recently issued accounting pronouncements, which have not already been adopted, to have a material impact on our Condensed Consolidated Financial Statements.

Contractual Obligations A table of our contractual obligations as of January 3, 2014 was included in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report on Form 10-K for the fiscal year ended January 3, 2014. There have been no significant changes to our contractual obligations during the six months ended July 4, 2014.

- 38 --------------------------------------------------------------------------------- Table of Contents Forward-Looking Statements Some of the statements contained in this report and other written and oral statements made from time to time by us and our representatives are not statements of historical or current fact. As such, they are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We have based these forward-looking statements on our current expectations, which are subject to known and unknown risks, uncertainties and assumptions. They include statements relating to: • future sales, expenses and profitability; • the future development and expected growth of our business and industry; • our ability to successfully execute our business model and our business strategy; • our ability to identify trends within our markets and to offer products and services that meet the changing needs of those markets; and • projected capital expenditures.

You can identify forward-looking statements by terminology such as "may," "will," "should," "could," "expects," "intends," "plans," "anticipates," "believes," "estimates," "predicts," "potential," or "continue," or variations or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially from those suggested by these forward-looking statements. In evaluating these statements and our prospects generally, you should carefully consider the factors set forth below. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary factors and to others contained throughout this report. We are under no duty to update any of the forward-looking statements after the date of this report or to conform these statements to actual results.

Although it is not possible to create a comprehensive list of all factors that may cause actual results to differ from the results expressed or implied by our forward-looking statements or that may affect our future results, some of these factors include the following: our dependence upon a limited number of customers; customer ordering patterns; product obsolescence; our inability to market current or future products; pricing pressure from customers; our ability to timely and successfully implement cost reduction and plant consolidation initiatives; our reliance on third party suppliers for raw materials, products and subcomponents; fluctuating operating results; our inability to maintain high quality standards for our products; challenges to our intellectual property rights; product liability claims; product field actions or recalls; our inability to successfully consummate and integrate acquisitions and to realize synergies and to operate these acquired businesses in accordance with expectations; our unsuccessful expansion into new markets; our failure to develop new products including system and device products; our inability to obtain licenses to key technology; regulatory changes or consolidation in the healthcare industry; global economic factors including currency exchange rates and interest rates; the resolution of various legal actions brought against the Company; and other risks and uncertainties that arise from time to time as described in the Company's Annual Report on Form 10-K and other periodic filings with the SEC.

[ Back To TMCnet.com's Homepage ]