INTEGRA LIFESCIENCES HOLDINGS CORP (Form: 10-Q, Received: 10/30/2013 17:31:39)
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
FORM 10-Q
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to              
COMMISSION FILE NO. 0-26224
 
INTEGRA LIFESCIENCES HOLDINGS CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
DELAWARE
 
51-0317849
(STATE OR OTHER JURISDICTION OF
INCORPORATION OR ORGANIZATION)
 
(I.R.S. EMPLOYER
IDENTIFICATION NO.)
 
 
311 ENTERPRISE DRIVE
PLAINSBORO, NEW JERSEY
 
08536
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
 
(ZIP CODE)
REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (609) 275-0500
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x     No   o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   x     No   o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
x
Accelerated filer
o
 
 
 
 
Non-accelerated filer
o   (Do not check if a smaller reporting company)
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   o     No   ý
The number of shares of the registrant’s Common Stock, $0.01 par value, outstanding as of October 28, 2013 was 28,113,418 .



Table of Contents

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
INDEX
 
 
Page
Number
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 5. Other Information
 
 
 
 
 
 
Exhibit 10.1
 
Exhibit 10.2
 
Exhibit 10.3
 
Exhibit 10.4
 
Exhibit 31.1
 
Exhibit 31.2
 
Exhibit 32.1
 
Exhibit 32.2
 
Exhibit 99.1
 
EX-101 INSTANCE DOCUMENT
 
EX-101 SCHEMA DOCUMENT
 
EX-101 CALCULATION LINKBASE DOCUMENT
 
EX-101 DEFINITION LINKBASE DOCUMENT
 
EX-101 LABELS LINKBASE DOCUMENT
 
EX-101 PRESENTATION LINKBASE DOCUMENT
 



Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME
(UNAUDITED)
(In thousands, except per share amounts)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
Total revenue, net
$
213,246

 
$
210,084

 
$
615,445

 
$
616,439

Costs and Expenses:
 
 
 
 
 
 
 
Cost of goods sold
84,101

 
79,548

 
247,437

 
232,497

Research and development
13,052

 
13,105

 
37,577

 
38,148

Selling, general and administrative
95,933

 
93,077

 
295,713

 
276,585

Intangible asset amortization
3,036

 
4,618

 
9,660

 
13,985

Goodwill impairment charge
46,738

 

 
46,738

 

Total costs and expenses
242,860

 
190,348

 
637,125

 
561,215

Operating income
(29,614
)
 
19,736

 
(21,680
)
 
55,224

Interest income
38

 
100

 
390

 
893

Interest expense
(5,316
)
 
(5,549
)
 
(15,081
)
 
(20,581
)
Other income (expense), net
(263
)
 
(31
)
 
(1,544
)
 
(118
)
Income (loss) before income taxes
(35,155
)
 
14,256

 
(37,915
)
 
35,418

Income tax (benefit) expense
(6,605
)
 
1,045

 
(8,755
)
 
7,000

Net income (loss)
$
(28,550
)
 
$
13,211

 
$
(29,160
)
 
$
28,418

Basic net income per common share
$
(1.02
)
 
$
0.46

 
$
(1.05
)
 
$
1.00

Diluted net income per common share
$
(1.02
)
 
$
0.46

 
$
(1.05
)
 
$
0.99

Weighted average common shares outstanding (See Note 11):
 
 
 
 
 
 
 
Basic
27,896

 
28,446

 
27,855

 
28,403

Diluted
27,896

 
28,777

 
27,855

 
28,629

Comprehensive income (loss) (See Note 12)
$
(19,860
)
 
$
17,106

 
$
(25,076
)
 
$
28,016


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

3

Table of Contents

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(In thousands)
 
 
September 30,
2013
 
December 31,
2012
ASSETS
 
 
 
Current Assets:
 
 
 
Cash and cash equivalents
$
118,868

 
$
96,938

Trade accounts receivable, net of allowances of $8,159 and $7,221
113,538

 
114,916

Inventories, net
207,389

 
171,806

Deferred tax assets
40,049

 
39,100

Prepaid expenses and other current assets
30,739

 
30,291

Total current assets
510,583

 
453,051

Property, plant and equipment, net
192,724

 
177,898

Intangible assets, net
202,410

 
212,267

Goodwill
248,824

 
294,067

Deferred tax assets
19,545

 
15,957

Other assets
9,986

 
10,359

Total assets
$
1,184,072

 
$
1,163,599

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current Liabilities:
 
 
 
Accounts payable, trade
$
54,466

 
$
36,742

Deferred revenue
4,474

 
3,505

Accrued compensation
28,520

 
34,914

Accrued expenses and other current liabilities
34,818

 
31,768

Total current liabilities
122,278

 
106,929

Long-term borrowings under senior credit facility
341,875

 
321,875

Long-term convertible securities
203,265

 
197,672

Deferred tax liabilities
5,154

 
5,393

Other liabilities
12,023

 
13,955

Total liabilities
$
684,595

 
$
645,824

Commitments and contingencies

 

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


 


Common stock; $0.01 par value; 60,000 authorized shares; 36,972 and 36,852 issued at September 30, 2013 and December 31, 2012, respectively
370

 
369

Additional paid-in capital
594,078

 
587,301

Treasury stock, at cost; 8,903 shares at September 30, 2013 and December 31, 2012
(367,121
)
 
(367,121
)
Accumulated other comprehensive (loss)
(713
)
 
(4,797
)
Retained earnings
272,863

 
302,023

Total stockholders’ equity
$
499,477

 
$
517,775

Total liabilities and stockholders’ equity
$
1,184,072

 
$
1,163,599


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

4

Table of Contents

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(In thousands)
 
 
Nine Months Ended September 30,
 
2013
 
2012
OPERATING ACTIVITIES:
 
 
 
Net income (loss)
$
(29,160
)
 
$
28,418

Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Depreciation and amortization
35,695

 
39,122

Non-cash impairment charges
46,738

 

Deferred income tax (benefit) provision
(7,238
)
 
(3,184
)
Amortization of debt issuance costs
1,707

 
2,103

Non-cash interest expense
4,865

 
8,284

Payment of accreted interest

 
(30,617
)
Loss on disposal of property and equipment
1,816

 
807

Share-based compensation
7,594

 
6,632

Excess tax benefits from stock-based compensation arrangements
(140
)
 
(432
)
Changes in assets and liabilities, net of business acquisitions:
 
 
 
Accounts receivable
1,440

 
(1,333
)
Inventories
(34,855
)
 
1,080

Prepaid expenses and other current assets
(282
)
 
8,148

Other non-current assets
(515
)
 
(877
)
Accounts payable, accrued expenses and other current liabilities
14,185

 
6,528

Deferred revenue
986

 
(913
)
Other non-current liabilities
(1,264
)
 
(1,263
)
Net cash provided by operating activities
$
41,572

 
$
62,503

INVESTING ACTIVITIES:
 
 
 
Purchases of property and equipment
(37,722
)
 
(44,359
)
Sales of property and equipment
533

 

Cash used in business acquisition, net of cash acquired
(2,980
)
 
(2,177
)
Purchases of short-term investments

 
(67,907
)
Maturities of short-term investments

 
64,940

Net cash used in investing activities
$
(40,169
)
 
$
(49,503
)
FINANCING ACTIVITIES:
 
 
 
Borrowings under senior credit facility
30,000

 
155,000

Repayments under senior credit facility
(10,000
)
 
(12,812
)
Payment of liability component of convertible notes

 
(134,383
)
Payment of debt issuance costs
(1,053
)
 

Proceeds from exercised stock options
420

 
696

Excess tax benefits from stock-based compensation arrangements
140

 
432

Net cash provided by (used in) financing activities
$
19,507

 
$
8,933

Effect of exchange rate changes on cash and cash equivalents
1,020

 
2,977

Net change in cash and cash equivalents
21,930

 
24,910

Cash and cash equivalents at beginning of period
96,938

 
100,808

Cash and cash equivalents at end of period
$
118,868

 
$
125,718

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

5

Table of Contents

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION
General
The terms “we,” “our,” “us,” “Company” and “Integra” refer to Integra LifeSciences Holdings Corporation, a Delaware corporation, and its subsidiaries unless the context suggests otherwise.
In the opinion of management, the September 30, 2013 unaudited condensed consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of the financial position, results of operations and cash flows of the Company. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements for the year ended December 31, 2012 included in the Company’s Annual Report on Form 10-K. The December 31, 2012 consolidated balance sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States. Operating results for the three and nine -month periods ended September 30, 2013 are not necessarily indicative of the results to be expected for the entire year.
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent liabilities, and the reported amounts of revenues and expenses. Significant estimates affecting amounts reported or disclosed in the consolidated financial statements include allowances for doubtful accounts receivable and sales returns and allowances, net realizable value of inventories, valuation of intangible assets including in-process research and development, amortization periods for acquired intangible assets, discount rates and estimated projected cash flows used to value and test impairments of long-lived assets and goodwill, estimates of projected cash flows and depreciation and amortization periods for long-lived assets, computation of taxes, valuation allowances recorded against deferred tax assets, the valuation of stock-based compensation, valuation of pension assets and liabilities, valuation of derivative instruments, valuation of the equity component of convertible debt instruments, valuation of contingent liabilities, the fair value of debt instruments and loss contingencies. These estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the current circumstances. Actual results could differ from these estimates.
Certain amounts from the prior year’s financial statements have been reclassified in order to conform to the current year’s presentation.    
Recently Issued Accounting Standards
On July 17, 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2013-10, Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes. The revised standard allows entities to now use the Federal Funds Effective Swap Rate (which is the Overnight Index Swap Rate, or OIS rate, in the U.S.) as a benchmark interest rate for hedge accounting purposes under U.S. Generally Accepted Accounting Principles (GAAP). Previously, only U.S. Treasury and London Interbank Offered Rate (LIBOR) rates could be used as benchmark interest rates in hedge accounting. In issuing the new guidance, which became effective July 17, 2013, the FASB responded to an increase in demand for hedging exposures to the OIS rate, driven partly by regulations that require collateralization and central clearing of over-the-counter derivatives. The guidance allows entities to develop new hedging strategies but does not resolve ineffectiveness issues that arise in existing LIBOR hedges when the OIS rate is used to discount future cash flows. The standard adoption did not have a material impact on the Company's financial statements.
On July 18, 2013, the FASB issued Accounting Standards Update No. 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. This updated guidance requires an unrecognized tax benefit to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, similar tax loss, or a tax credit carryforward. To the extent the tax benefit is not available at the reporting date under the governing tax law or if the entity does not intend to use the deferred tax asset for such purpose, the unrecognized tax benefit should be presented as a liability and not combined with deferred tax assets. The ASU 2013-11 is effective for fiscal years and interim periods within those years beginning after December 15, 2013 for public entities. Early adoption is permitted. The amendments are to be applied to all unrecognized tax benefits that exist as of the effective date and

6

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

may be applied retrospectively to each prior reporting period presented. The Company is in the process of evaluating the impact of this standard, but does not believe its adoption will have a material impact on the Company's financial statements.

2. BUSINESS ACQUISITIONS
Tarsus Medical, Inc.
On January 24, 2013, the Company acquired all outstanding preferred and common stock of Tarsus Medical, Inc. for a total of $4.7 million consisting of $2.8 million in cash (less cash acquired) and contingent consideration with an estimated acquisition date fair value of approximately $1.6 million . The potential maximum undiscounted contingent consideration consists of the first milestone payment of up to $1.5 million and the second payment of up to $11.5 million . These payments are based on reaching certain sales of acquired products. Tarsus Medical, Inc. is a podiatry device company addressing clinical needs associated with diseases and injuries of the foot and ankle.
The following summarizes the final allocation of the purchase price based on fair value of the assets acquired and liabilities assumed:
 
Final
Purchase Price
Allocation
 
 
 
(Dollars in thousands)
 
 
Cash
$
85

 
 
Prepaid expenses
13

 
 
Intangible assets
 
 
Wtd. Avg. Life:
Technology
5,040

 
10 - 14 years
In-process research and development
340

 
Indefinite
Deferred tax asset - long term
1,334

 
 
Goodwill
116

 
 
Total assets acquired
6,928

 
 
Accounts payable and other liabilities
111

 
 
Deferred tax liability
2,152

 
 
Net assets acquired
$
4,665

 
 

Management determined the preliminary fair value of net assets acquired during the first quarter of 2013 and finalized the working capital adjustment in the second quarter of 2013. The Company accounts for the contingent consideration by recording its fair value as a liability on the date of the acquisition. The contingent consideration is re-measured to fair value at each reporting date until the contingency is resolved. Changes in fair value of the contingent consideration are recognized in earnings. Accordingly, on January 24, 2013 the Company recorded $1.6 million representing the initial fair value estimate of the contingent consideration that will be earned through December 31, 2015. At September 30, 2013 there was no change in the fair value of the contingent consideration. The fair value of this liability is based on future sales projections of the Tarsus Medical product under various potential scenarios and weighting the probability of these outcomes for the period ended December 31, 2015. At the date of the acquisition, the first milestone cash flow projection was discounted using a rate of 4.3% based on an estimated after tax cost of debt; the second milestone cash flow projection was discounted using a weighted average cost of capital of 16.5% . These fair value measurements were based on significant inputs not observed in the market and thus represented a Level 3 measurement.
The goodwill recorded in connection with this acquisition is based on (i) expected cost savings, operating synergies and other benefits expected to result from the combined operations, (ii) the value of the going-concern element of Tarsus’ existing business (that is, the higher rate of return on the assembled net assets versus if the Company had acquired all of the net assets separately), and (iii) intangible assets that do not qualify for separate recognition such as Tarsus’ assembled workforce. The goodwill acquired will not be deductible for tax purposes.
The impact of the Tarsus acquisition is not material to the consolidated operating results of the Company; therefore, the pro-forma impact of the acquisition has not been presented.

7

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)


3. INVENTORIES
Inventories, net consisted of the following:
 
 
September 30,
2013
 
December 31,
2012
 
(In thousands)
Finished goods
$
126,891

 
$
102,401

Work-in process
47,059

 
39,944

Raw materials
33,439

 
29,461

 
$
207,389

 
$
171,806


The finished goods inventory includes $6.1 million of capitalized medical device excise tax at September 30, 2013 .

4. GOODWILL AND OTHER INTANGIBLE ASSETS

The Company reviews goodwill for impairment annually during its third quarter and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. The Company performed its most recent annual assessment on July 31, 2013 which resulted in a non-cash goodwill impairment charge of $46.7 million for its U.S. Spine reporting unit, which is a part of the U.S. Spine and Other reportable segment.

As previously disclosed, the Company has monitored its U.S. Spine business and disclosed that it was at risk for impairment. In the third quarter, during the course of the annual strategic planning process, the Company determined that both the actual and expected income and cash flows for the U.S. Spine reporting unit are projected to be substantially lower than forecasts, and the U.S. spine market recovery may take longer than originally forecasted, including the current expectation of future significant negative pricing pressures. Factors that contributed to the impairment of the U.S. Spine reporting unit include broader market issues as well as company-specific issues. Company-specific issues have included turnover of some distributors, significant delays in new product introductions and other operational issues that negatively impacted and decreased projected revenues by a material amount. As a result, the Company lowered its expectations of recovery in the U.S. market and its related impact on the U.S. Spine reporting unit. This revised outlook resulted in a reduction of the U.S. Spine forecasts of the sales, operating income and cash flows expected in 2014 and beyond and consequently, resulted in an impairment charge.

To derive the fair value of the reporting units, as required in step one of the impairment test, the Company used the income approach, specifically the discounted cash flow ("DCF") method, which incorporates significant estimates and assumptions made by management which, by their nature, are characterized by uncertainty. Inputs used to fair value the Company's reporting units are considered Level 3 inputs of the fair value hierarchy. For Level 3 measurements, significant increases or decreases in long-term growth rates or discount rates in isolation or in combination could result in a significantly lower or higher fair value measurement. The key assumptions impacting the valuation included:

The Company's financial projections for its reporting units, which are based on management's assessment of regional and macroeconomic variables, industry trends and market opportunities, and the Company's strategic objectives and future growth plans.
The projected terminal value for each reporting unit, which represents the present value of projected cash flows beyond the last period in the discounted cash flow analysis.  The terminal value reflects the Company's assumptions related to long-term growth rates and profitability, which are based on several factors, including local and macroeconomic variables, market opportunities, and future growth plans.
The discount rate used to measure the present value of the projected future cash flows is set using a weighted-average cost of capital method that considers market and industry data as well as the Company's specific risk factors that are likely to be considered by a market participant.  The weighted-average cost of capital is the Company's estimate of the overall after-tax rate of return required by equity and debt holders of a business enterprise.

Based on the results of step one of the impairment test, the Company determined that the carrying value of the U.S. Spine reporting unit exceeded its respective fair value, and accordingly, the Company proceeded to step two of the impairment test.

In the second step, the Company assigned the reporting unit's fair value to all of its assets and liabilities, including any unrecognized intangible assets, in a hypothetical analysis that calculates the implied fair value of goodwill in the same manner as if the reporting unit were being acquired in a business combination. If the implied fair value of the reporting unit's goodwill

8

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

is less than the carrying value, the difference is recorded as an impairment charge. This allocation process was performed only for the purposes of measuring the goodwill impairment and not to adjust the carrying values of the recognized tangible assets and liabilities. Step two of the impairment was initiated, but due to the time necessary to complete the analysis, has not been completed. The Company recorded its estimate of the goodwill impairment charge of $46.7 million , which represents the remaining goodwill balance in the U.S. Spine reporting unit. The Company expects to finalize the step two analysis in the fourth quarter of 2013. Any adjustment, which the Company does not expect to be material to the impairment charge, would be recorded in the Condensed Consolidated Statement of Operations and Comprehensive Income in that period. Only $5.5 million of the goodwill impairment charge was deductible for tax purposes.
Changes in the carrying amount of goodwill for the nine months ended September 30, 2013 were as follows:
 
 
U.S.
Neurosurgery
 
U.S.
Instruments
 
U.S.
Extremities
 
U.S.
Spine
and
Other
 
International
 
Total
 
(In thousands)
Goodwill, gross
$
94,312

 
$
57,514

 
$
60,353

 
$
56,219

 
$
25,669

 
$
294,067

Accumulated impairment losses


 


 


 


 


 


Goodwill at December 31, 2012
94,312

 
57,514

 
60,353

 
56,219

 
25,669

 
294,067

Tarsus Medical, Inc. acquisition


 


 
180

 


 


 
180

Goodwill impairment charge

 

 

 
(46,738
)
 

 
(46,738
)
Foreign currency translation
494

 
300

 
316

 
70

 
135

 
1,315

Balance at September 30, 2013
$
94,806

 
$
57,814

 
$
60,849

 
$
9,551

 
$
25,804

 
$
248,824


Prior to performing the annual goodwill impairment tests for the U.S. Spine reporting unit, the Company tested long-lived assets to be held and used by this reporting unit for impairment on an undiscounted cash flow basis. Based on the results of this testing, there was no impairment of the Company's long-lived assets to be held and used.
The components of the Company’s identifiable intangible assets were as follows:
 
 
Weighted
Average
Life
September 30, 2013
 
Weighted
Average
Life
December 31, 2012
 
Cost
 
Accumulated
Amortization
 
Net
 
Cost
 
Accumulated
Amortization
 
Net
 
(Dollars in thousands)
Completed technology
12 years
$
80,835

 
$
(43,512
)
 
$
37,323

 
12 years
$
75,692

 
$
(38,402
)
 
$
37,290

Customer relationships
12 years
146,914

 
(77,361
)
 
69,553

 
12 years
147,690

 
(70,005
)
 
77,685

Trademarks/brand names
31 years
33,750

 
(15,516
)
 
18,234

 
31 years
33,807

 
(15,034
)
 
18,773

Trademarks/brand names
Indefinite
48,484

 

 
48,484

 
Indefinite
48,484

 

 
48,484

Supplier relationships
27 years
34,721

 
(8,933
)
 
25,788

 
27 years
34,721

 
(7,817
)
 
26,904

All other  (1)
4 years
4,830

 
(1,802
)
 
3,028

 
4 years
4,519

 
(1,388
)
 
3,131

 
 
$
349,534

 
$
(147,124
)
 
$
202,410

 
 
$
344,913

 
$
(132,646
)
 
$
212,267

 
(1)  
At September 30, 2013 and December 31, 2012 , all other included in-process research and development of $2.1 million and $1.7 million , respectively, which was indefinite-lived.
Based on quarter-end exchange rates, annual amortization expense is expected to approximate $19.4 million in 2013, $18.4 million in 2014, $16.6 million in 2015, $14.3 million in 2016 and $12.5 million in 2017. Identifiable intangible assets are initially recorded at fair market value at the time of acquisition using an income or cost approach.


9

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

5. DEBT
Amended and Restated Senior Credit Agreement
On August 10, 2010, the Company entered into an amended and restated credit agreement with a syndicate of lending banks (the “Senior Credit Facility”). The Company amended the Senior Credit Facility on June 8, 2011, and further amended it on May 11, 2012 and June 21, 2013.
The June 8, 2011 amendment:
i.
increased the revolving credit component from $450 million to $600 million and eliminated the $150 million term loan component that existed under the original amended and restated credit agreement;
ii.
allows the Company to further increase the size of the revolving credit component by an aggregate of $200 million with additional commitments;
iii.
provides the Company with decreased borrowing rates and annual commitment fees, and provides more favorable financial covenants; and
iv.
extended the maturity date from August 10, 2015 to June 8, 2016 .
On May 11, 2012, the Company entered into another amendment to the Senior Credit Facility (the “2012 Amendment”). The 2012 Amendment modified certain financial and negative covenants. The 2012 Amendment provides that the Company’s Maximum Consolidated Total Leverage Ratio (a measure of net debt to consolidated EBITDA, in each case as defined in the Senior Credit Facility, as amended) during any consecutive four quarter period should not be greater than 3.75 to 1.00 during any such period ending on December 31, 2013 (instead of March 31, 2012). In addition, when calculating consolidated EBITDA for any period, the 2012 Amendment permits the addition of certain costs and expenses in the calculation of consolidated net income for such period, to the extent deducted in the calculation of consolidated net income.
On June 21, 2013, the Company entered into a second amendment to the Senior Credit Facility (the “2013 Amendment”). The 2013 Amendment modified certain financial and negative covenants and increased the Company’s Maximum Consolidated Total Leverage Ratio (a measure of net debt to consolidated EBITDA, in each case as defined in the Senior Credit Facility, as amended) to 4.25 through June 30, 2014, with a step-down to 4.00 through March 31, 2015, and then with another step-down to 3.75 thereafter. In addition, when calculating consolidated EBITDA for any period, the 2013 Amendment permits the addition of certain costs and expenses in the calculation of consolidated net income for such period, to the extent deducted in the calculation of consolidated net income. The effect of the 2013 Amendment is to increase the ability of the Company to borrow under the Senior Credit Facility during the affected periods. The Company capitalized $1.1 million of incremental financing costs in connection with the 2013 Amendment, which will be amortized through the maturity date of the Senior Credit Facility.
The Senior Credit Facility is collateralized by substantially all of the assets of the Company’s U.S. subsidiaries, excluding intangible assets. The Senior Credit Facility is subject to various financial and negative covenants and at September 30, 2013 , the Company was in compliance with all such covenants.
Borrowings under the Senior Credit Facility currently bear interest, at the Company’s option, at a rate equal to (i) the Eurodollar Rate (as defined in the Senior Credit Facility, which definition has not changed) in effect from time to time plus the applicable rate (ranging from 1.00% to 1.75% ) or (ii) the highest of (x) the weighted average overnight Federal funds rate, as published by the Federal Reserve Bank of New York, plus 0.5% , (y) the prime lending rate of Bank of America, N.A. or (z)  the one-month Eurodollar Rate plus 1.0% . The applicable rates are based on the Company’s consolidated total leverage ratio (defined as the ratio of (a) consolidated funded indebtedness less cash in excess of $40 million that is not subject to any restriction of the use or investment thereof to (b) consolidated EBITDA) at the time of the applicable borrowing.
The Company also pays an annual commitment fee (ranging from 0.15% to 0.30% , based on the Company’s consolidated total leverage ratio) on the daily amount by which the revolving credit facility exceeds the outstanding loans and letters of credit under the credit facility.
At September 30, 2013 and December 31, 2012 , there was $341.9 million and $321.9 million outstanding under the Senior Credit Facility at a weighted average interest rate of 1.9% and 1.8% , respectively. At September 30, 2013 , there was approximately $258.1 million available for borrowing under the Senior Credit Facility. The fair value of outstanding borrowings under the Senior Credit Facility at September 30, 2013 was approximately $337.0 million . The fair value of the Senior Credit Facility was determined by using a discounted cash flow model based on current market interest rates available to the Company. These inputs are corroborated by observable market data for similar liabilities and therefore classified within Level 2 of the fair value hierarchy. Level 2 inputs represent inputs that are observable for the asset or liability, either directly or indirectly and are other than active market observable inputs that reflect unadjusted quoted prices for identical assets or

10

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

liabilities. The Company considers the balance to be long-term in nature based on its current intent and ability to repay the borrowing outside of the next twelve-month period.
2016 Convertible Senior Notes
On June 15, 2011, the Company issued $230.0 million aggregate principal amount of its 1.625% Convertible Senior Notes due in 2016 (the “2016 Notes”). The 2016 Notes mature on December 15, 2016, and bear interest at a rate of 1.625%  per annum payable semi-annually in arrears on December 15 and June 15 of each year. The portion of the debt proceeds that was classified as equity at the time of the offering was $43.2 million , an equivalent of that amount is being amortized to interest expense using the effective interest method through December 2016. The effective interest rate implicit in the liability component is 5.6% .
At September 30, 2013 , the carrying amount of the liability component was $203.3 million , the remaining unamortized discount was $26.7 million , and the principal amount outstanding was $230.0 million . The fair value of the 2016 Notes at September 30, 2013 was approximately $237.6 million . At December 31, 2012 , the carrying amount of the liability component was $197.7 million , the remaining unamortized discount was $32.3 million and the principal amount outstanding was $230.0 million . The fair value of the liability of the 2016 Notes was determined using a discounted cash flow model based on current market interest rates available to the Company. These inputs are corroborated by observable market data for similar liabilities and therefore classified within Level 2.
The 2016 Notes are senior, unsecured obligations of the Company, and are convertible into cash and, if applicable, shares of its common stock based on an initial conversion rate, subject to adjustment of 17.4092 shares per $1,000 principal amount of 2016 Notes (which represents an initial conversion price of approximately $57.44 per share). The Company will satisfy any conversion of the 2016 Notes with cash up to the principal amount of the 2016 Notes pursuant to the net share settlement mechanism set forth in the indenture and, with respect to any excess conversion value, with shares of the Company’s common stock. The 2016 Notes are convertible only in the following circumstances: (1) if the closing sale price of the Company’s common stock exceeds 150% of the conversion price during a period as defined in the indenture; (2) if the average trading price per $1,000 principal amount of the 2016 Notes is less than or equal to 98% of the average conversion value of the 2016 Notes during a period as defined in the indenture; (3) at any time on or after June 15, 2016 ; or (4) if specified corporate transactions occur. The issue price of the 2016 Notes was equal to their face amount, which is also the amount holders are entitled to receive at maturity if the 2016 Notes are not converted. As of September 30, 2013 , none of these conditions existed with respect to the 2016 Notes and as a result, the 2016 Notes are classified as long term.
In connection with the issuance of the 2016 Notes, the Company entered into call transactions and warrant transactions, primarily with affiliates of the initial purchasers of such notes (the “hedge participants”). The initial strike price of the call transaction is approximately $57.44  per share, subject to customary anti-dilution adjustments. The initial strike price of the warrant transaction is approximately $70.05 per share, subject to customary anti-dilution adjustments.
Convertible Note Interest
The interest expense components of the Company’s convertible notes are as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
(In thousands)
2016 Notes:
 
 
 
 
 
 
 
Amortization of the discount on the liability component
$
1,633

 
$
1,788

 
$
4,865

 
$
5,289

Cash interest related to the contractual interest coupon
807

 
934

 
2,438

 
2,803

Total
$
2,440

 
$
2,722

 
$
7,303

 
$
8,092

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

 
$

 
$

 
$
2,995

Cash interest related to the contractual interest coupon

 

 

 
1,633

Total
$

 
$

 
$

 
$
4,628


6. DERIVATIVE INSTRUMENTS
Interest Rate Hedging
The Company’s interest rate risk relates to U.S. dollar denominated variable LIBOR interest rate borrowings. The Company uses an interest rate swap derivative instrument entered into on August 10, 2010 with an effective date of December 31, 2010 to

11

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

manage its earnings and cash flow exposure to changes in interest rates by converting a portion of its floating-rate debt into fixed-rate debt beginning on December 31, 2010. This interest rate swap expires on August 10, 2015 .
The Company designates this derivative instrument as a cash flow hedge. The Company records the effective portion of any change in the fair value of a derivative instrument designated as a cash flow hedge as unrealized gains or losses in accumulated other comprehensive income (“AOCI”), net of tax, until the hedged item affects earnings, at which point the effective portion of any gain or loss will be reclassified to earnings. If the hedged cash flow does not occur, or if it becomes probable that it will not occur, the Company will reclassify the amount of any gain or loss on the related cash flow hedge to interest expense at that time.
The Company expects that approximately $1.7 million of pre-tax losses recorded as net in AOCI related to the interest rate hedge could be reclassified to earnings within the next twelve months.
Foreign Currency Hedging
From time to time the Company enters into foreign currency hedge contracts intended to protect the U.S. dollar value of certain forecasted foreign currency denominated transactions. The Company records the effective portion of any change in the fair value of foreign currency cash flow hedges in AOCI, net of tax, until the hedged item affects earnings. Once the related hedged item affects earnings, the Company reclassifies the effective portion of any related unrealized gain or loss on the foreign currency cash flow hedge to earnings. If the hedged forecasted transaction does not occur, or if it becomes probable that it will not occur, the Company will reclassify the amount of any gain or loss on the related cash flow hedge to earnings at that time.
The success of the Company’s hedging program depends, in part, on forecasts of certain activity denominated in euros. The Company may experience unanticipated currency exchange gains or losses to the extent that there are differences between forecasted and actual activity during periods of currency volatility. In addition, changes in currency exchange rates related to any unhedged transactions may affect its earnings and cash flows.

Counterparty Credit Risk

The Company manages its concentration of counterparty credit risk on its derivative instruments by limiting acceptable counterparties to a group of major financial institutions with investment grade credit ratings, and by actively monitoring their credit ratings and outstanding positions on an ongoing basis. Therefore, the Company considers the credit risk of the counterparties to be low. Furthermore, none of the Company’s derivative transactions are subject to collateral or other security arrangements, and none contain provisions that depend upon the Company’s credit ratings from any credit rating agency.
Fair Value of Derivative Instruments
The Company has classified all of its derivative instruments within Level 2 of the fair value hierarchy because observable inputs are available for substantially the full term of the derivative instruments. The fair value of the foreign currency forward exchange contracts related to inventory purchases is determined by comparing the forward rate as of the period end and the settlement rate specified in each contract. The fair value of the interest rate swaps was developed using a market approach based on publicly available market yield curves and the terms of the related swap. The Company performs ongoing assessments of counterparty credit risk.
The following table summarizes the fair value and presentation in the condensed consolidated balance sheets for derivatives designated as hedging instruments as of September 30, 2013 and December 31, 2012 :
 
 
Fair Value as of
 
Notional Amount as of
Location on Balance Sheet (1) :
September 30,
2013
 
December 31,
2012
 
September 30,
2013
 
December 31,
2012
 
(In thousands)
Derivatives designated as hedges — Liabilities:
 
 
 
 
 
 
 
Interest rate swap — Accrued expenses and other current liabilities (2)
1,731

 
1,888

 
 
 
 
Interest rate swap — Other liabilities  (2)
1,075

 
2,238

 
 
 
 
Total Derivatives designated as hedges — Liabilities
$
2,806

 
$
4,126

 
 
 
 
 
(1)  
The Company classifies derivative assets and liabilities as current based on the cash flows expected to be incurred within the following 12 months.

12

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(2)  
At September 30, 2013 and December 31, 2012 , the notional amount related to the Company’s sole interest rate swap was $116.3 million and $127.5 million , respectively. In the next twelve months, the Company expects to reduce the notional amount by $15.0 million .

The following presents the effect of derivative instruments designated as cash flow hedges on the accompanying consolidated statements of operations during the three and nine months ended September 30, 2013 and 2012 :
 
 
Balance in AOCI
Beginning of
Quarter
 
Amount of
Gain (Loss)
Recognized in
AOCI-
Effective Portion
 
Amount of Gain (Loss)
Reclassified from
AOCI into
Earnings-Effective
Portion
 
Balance in AOCI
End of Quarter
 
Location in
Statements of
Operations
 
(In thousands)
Three Months Ended September 30, 2013
 
 
 
 
 
 
 
 
 
Forward currency forward contracts
$
162

 
$
(19
)
 
$
110

 
$
33

 
Costs of goods sold
Interest rate swap
(3,030
)
 
(258
)
 
(483
)
 
(2,805
)
 
Interest (expense)
 
$
(2,868
)
 
$
(277
)
 
$
(373
)
 
$
(2,772
)
 
 
Three Months Ended September 30, 2012
 
 
 
 
 
 
 
 
 
Forward currency forward contracts
$
(176
)
 
$
(9
)
 
$
(6
)
 
$
(179
)
 
Costs of goods sold
Interest rate swap
(4,374
)
 
(744
)
 
(476
)
 
(4,642
)
 
Interest (expense)
 
$
(4,550
)
 
$
(753
)
 
$
(482
)
 
$
(4,821
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance in AOCI
Beginning of
Year
 
Amount of
Gain (Loss)
Recognized in
AOCI-
Effective Portion
 
Amount of Gain (Loss)
Reclassified from
AOCI into
Earnings-Effective
Portion
 
Balance in AOCI
End of Quarter
 
Location in
Statements of
Operations
 
(In thousands)
Nine Months Ended September 30, 2013
 
 
 
 
 
 
 
 
 
Forward currency forward contracts
$
(34
)
 
$
142

 
$
75

 
$
33

 
Cost of goods sold
Interest rate swap
(4,125
)
 
(159
)
 
(1,479
)
 
(2,805
)
 
Interest (expense)
 
$
(4,159
)
 
$
(17
)
 
$
(1,404
)
 
$
(2,772
)
 
 
Nine Months Ended September 30, 2012
 
 
 
 
 
 
 
 
 
Forward currency forward contracts
$
(216
)
 
$
(140
)
 
$
(177
)
 
$
(179
)
 
Cost of goods sold
Interest rate swap
(4,092
)
 
(1,952
)
 
(1,402
)
 
(4,642
)
 
Interest (expense)
 
$
(4,308
)
 
$
(2,092
)
 
$
(1,579
)
 
$
(4,821
)
 
 

The Company recognized no gains or losses resulting from ineffectiveness of cash flow hedges during the three and nine months ended September 30, 2013 and 2012 .

7. STOCK-BASED COMPENSATION
As of September 30, 2013 , the Company had stock options, restricted stock awards, performance stock awards, contract stock awards and restricted stock unit awards outstanding under three plans, the 2000 Equity Incentive Plan (the “2000 Plan”), the 2001 Equity Incentive Plan (the “2001 Plan”), and the 2003 Equity Incentive Plan (the “2003 Plan,” and collectively, the “Plans”).
Stock options issued under the Plans become exercisable over specified periods, generally within four years from the date of grant for officers and directors, and generally expire from six to ten years for directors and certain executive officers. Restricted stock issued under the Plans vests over specified periods, generally three years after the date of grant. The vesting of performance stock, issued under the Plans, is subject to service and performance conditions.

13

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Stock Options
There were 32,468 stock options granted during the nine months ended September 30, 2013 . As of September 30, 2013 , there were approximately $1.5 million of total unrecognized compensation costs related to unvested stock options. These costs are expected to be recognized over a weighted-average period of approximately one year, six months .
Awards of Restricted Stock, Performance Stock and Contract Stock
Performance stock, restricted stock and contract stock awards generally have requisite service periods of three years. Performance stock awards are subject to graded vesting conditions and the Company expenses their fair value over the requisite service period. The Company expenses the fair value of restricted stock and contract stock awards on a straight-line basis over the vesting period or requisite service period, whichever is shorter. The Company granted approximately 181,000 restricted stock awards/stock units and 55,000 performance shares during the nine months ended September 30, 2013 . As of September 30, 2013 , there were approximately $13.8 million of total unrecognized compensation costs related to these unvested awards. The Company expects to recognize these costs over a weighted-average period of approximately two years .
The Company has no formal policy related to the repurchase of shares for the purpose of satisfying stock-based compensation obligations.
The Company also maintains an Employee Stock Purchase Plan (the “ESPP”), which provides eligible employees with the opportunity to acquire shares of common stock at periodic intervals by means of accumulated payroll deductions. The ESPP is a non-compensatory plan based on its terms.

8. TREASURY STOCK

On October 23, 2012, the Company's Board of Directors authorized a repurchase of up to $75.0 million of its outstanding common stock through December 2014. The Company has not repurchased any of its outstanding shares of common stock during the three and nine month periods ended September 30, 2013 and 2012.
As of September 30, 2013 , there remained $75.0 million available for repurchases under this authorization.

9. RETIREMENT BENEFIT PLANS
The Company maintains defined benefit pension plans that cover employees in its manufacturing plants located in Andover, United Kingdom (the “UK Plan”) and Tuttlingen, Germany (the “Germany Plan”). The Company closed the Tuttlingen, Germany plant in December 2005. The Company did not terminate the Germany Plan, and the Company remains obligated for the accrued pension benefits related to this plan. Effective March 31, 2011, the Company froze the benefits due to the participants of the UK Plan in their entirety; this curtailment resulted in a $0.3 million reduction in the projected benefit obligations which the Company recorded on that date. The plans cover certain current and former employees.
Net periodic benefit costs for the Company’s defined benefit pension plans included the following amounts:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
(In thousands)
Service cost
$

 
$
6

 
$

 
$
19

Interest cost
137

 
157

 
410

 
478

Return on plan assets
(100
)
 
(142
)
 
(300
)
 
(432
)
Net period benefit cost
$
37

 
$
21

 
$
110

 
$
65


The Company made $0.7 million and $0.6 million of contributions to its defined benefit pension plans during the nine months ended September 30, 2013 and 2012 , respectively.


14

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

10. INCOME TAXES
The following table provides a summary of the Company’s effective tax rate:
 
 
Three Months Ended September 30,
 
2013
 
2012
Reported tax rate
18.8
%
 
7.3
%
 
Nine Months Ended September 30,
 
2013
 
2012
Reported tax rate
23.1
%
 
19.8
%

The Company’s effective income tax rates for the three months ended September 30, 2013 and 2012 were 18.8% and 7.3% , respectively. For the three months ended September 30, 2013 , the increase in the income tax rate compared to the same period in 2012 was primarily the goodwill impairment charge as only a portion of the impairment charge was deductible for tax and lower income within the U.S.-based operations relative to foreign operations, which created a favorable effect on the effective tax rate. The Company also recorded a benefit of $2.3 million for the release of uncertain tax positions and related interest due to the expiration of the statute of limitations, which is offset by an expense of $0.2 million due to additional U.S. tax contingency reserves.

The Company's effective income tax rates for the nine months ended September 30, 2013 and 2012 were 23.1% and 19.8% , respectively. For the nine months ended September 30, 2013 , the increase in the income tax rate compared to the same period in 2012 primarily resulted from the tax impact of the goodwill impairment and the release of uncertain tax positions.

The Company expects its effective income tax rate for the full year to be approximately 36.3% resulting largely from the income tax impact associated with the goodwill impairment, offset with foreign earnings taxed at lower tax rates, as well as the expected release of tax contingency reserves. This estimate could be revised in the future as additional information is presented to the Company.

11. NET INCOME (LOSS) PER SHARE
Basic and diluted net income per share was as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
(In thousands, except per share amounts)
Basic net income per share:
 
 
 
 
 
 
 
Net income (loss)
$
(28,550
)
 
$
13,211

 
$
(29,160
)
 
$
28,418

Weighted average common shares outstanding
27,896

 
28,446

 
27,855

 
28,403

Basic net income per common share
$
(1.02
)
 
$
0.46

 
$
(1.05
)
 
$
1.00

Diluted net income per share:
 
 
 
 
 
 
 
Net income (loss)
$
(28,550
)
 
$
13,211

 
$
(29,160
)
 
$
28,418

Weighted average common shares outstanding — Basic
27,896

 
28,446

 
27,855

 
28,403

Effect of dilutive securities:
 
 
 
 
 
 
 
Stock options and restricted stock

 
331

 

 
226

Weighted average common shares for diluted earnings per share
27,896

 
28,777

 
27,855

 
28,629

Diluted net income per common share
$
(1.02
)
 
$
0.46

 
$
(1.05
)
 
$
0.99


At September 30, 2013 and 2012 , the Company had 1.7 million of outstanding stock options. The Company also has warrants outstanding relating to its 2016 Notes at September 30, 2013 and 2012 . Stock options, restricted stock and warrants are included in the diluted earnings per share calculation using the treasury stock method, unless the effect of including the stock options would be anti-dilutive. For the three and nine months ended September 30, 2013 all stock options, restricted stock and warrants were excluded in the diluted earnings per share calculation using the treasury stock method because of their anti-

15

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

dilutive effect. For the three and nine months ended September 30, 2012, 1.0 million and 1.2 million of anti-dilutive stock options, respectively, were excluded from the diluted earnings per share calculation.

12. COMPREHENSIVE (LOSS) INCOME
Comprehensive (loss) income was as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
(In thousands)
Net (loss) income
$
(28,550
)
 
$
13,211

 
$
(29,160
)
 
$
28,418

Foreign currency translation adjustment
8,711

 
4,051

 
3,288

 
(106
)
Change in unrealized gain on derivatives, net of tax
47

 
(154
)
 
794

 
(290
)
Pension liability adjustment, net of tax
(68
)
 
(2
)
 
2

 
(6
)
Comprehensive (loss) income
$
(19,860
)
 
$
17,106

 
$
(25,076
)
 
$
28,016


Changes in Accumulated Other Comprehensive (Loss) Income by component between December 31, 2012 and September 30, 2013 are presented in the table below, net of tax:
 
 
Gains and Losses on Cash Flow Hedges
 
Defined Benefit Pension Items
 
Foreign Currency Items
 
Total
 
 
(In thousands)
Beginning balance
 
$
(2,373
)
 
$
(1,154
)
 
$
(1,270
)
 
$
(4,797
)
Other comprehensive income before reclassifications
 
(6
)
 
70

 
3,288

 
3,352

Amounts reclassified from accumulated other comprehensive income
 
(800
)
 
68

 

 
(732)
Net current-period other comprehensive income (loss)
 
794

 
2

 
3,288

 
4,084

Ending balance
 
$
(1,579
)
 
$
(1,152
)
 
$
2,018

 
$
(713
)

The reclassification adjustments out of Accumulated Other Comprehensive (Loss) Income during the three and nine months ended September 30, 2013 were as follows:
Three Months Ended September 30, 2013
Details about Accumulated Other Comprehensive Income Components
 
Amount Reclassified from Accumulated Other Comprehensive Income
 
Affected Line Item in the Statement where Net Income (loss) is Presented
 
 
(In thousands)
 
 
Gains and losses on cash flow hedges
 
 
 
 
Interest rate swap
 
$
(483
)
 
Interest (expense)
Foreign currency forwards
 
110

 
Cost of goods sold
 
 
(373
)
 
Total before tax
 
 
160

 
Tax (expense) or benefit
 
 
$
(213
)
 
Net of tax


16

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Nine Months Ended September 30, 2013
Details about Accumulated Other Comprehensive Income Components
 
Amount Reclassified from Accumulated Other Comprehensive Income
 
Affected Line Item in the Statement where Net Income (loss) is Presented
 
 
(In thousands)
 
 
Gains and losses on cash flow hedges
 
 
 
 
Interest rate swap
 
$
(1,479
)
 
Interest (expense)
Foreign currency forwards
 
75

 
Cost of goods sold
 
 
(1,404
)
 
Total before tax
 
 
604

 
Tax (expense) or benefit
 
 
$
(800
)
 
Net of tax

13. SEGMENT AND GEOGRAPHIC INFORMATION

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

The operating results of the various reportable segments as presented are not comparable to one another because (i) certain operating segments are more dependent than others on corporate functions for unallocated general and administrative and/or operational manufacturing functions, and (ii) the Company does not allocate certain manufacturing costs and general and administrative costs to the operating segment results.

17

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Net sales and profit by reportable segment for the three and nine months ended September 30, 2013 and 2012 are as follows:
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2013
 
2012
 
2013
 
2012
 
 
(In thousands)
Segment Net Sales
 
 
 
 
 
 
 
 
U.S. Neurosurgery
 
$
45,114

 
$
43,269

 
$
125,877

 
$
125,776

U.S. Instruments
 
41,798

 
41,469

 
118,737

 
120,732

U.S. Extremities
 
33,541

 
32,961

 
98,440

 
91,596

U.S. Spine and Other
 
46,904

 
49,188

 
133,414

 
142,821

International
 
45,889

 
43,197

 
138,977

 
135,514

Total revenues
 
$
213,246

 
$
210,084

 
$
615,445

 
$
616,439

Segment Profit
 
 
 
 
 
 
 
 
U.S. Neurosurgery
 
$
23,080

 
$
23,201

 
$
59,770

 
$
66,247

U.S. Instruments
 
12,654

 
11,811

 
33,172

 
33,860

U.S. Extremities
 
14,570

 
14,996

 
38,529

 
37,484

U.S. Spine and Other
 
(31,437
)
 
14,771

 
(5,970
)
 
42,166

International
 
14,693

 
14,550

 
41,697

 
45,456

Segment profit
 
33,560

 
79,329

 
167,198

 
225,213

Amortization
 
(3,036
)
 
(4,618)

 
(9,660)

 
(13,985)

Corporate and other
 
(60,138
)
 
(54,975
)
 
(179,218
)
 
(156,004
)
Operating (loss) income
 
$
(29,614
)
 
$
19,736

 
$
(21,680
)
 
$
55,224

The segment profits for the U.S. Instruments segment and Corporate and Other for the three and nine months ended September 30, 2012 have been revised.
Revenue by major product category consisted of the following:  
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
(In thousands)
Orthopedics
$
93,331

 
$
94,186

 
$
275,025

 
$
276,033

Neurosurgery
72,639

 
69,667

 
204,283

 
203,499

Instruments
47,276

 
46,231

 
136,137

 
136,907

Total Revenues
$
213,246

 
$
210,084

 
$
615,445

 
$
616,439


The Company attributes revenues to geographic areas based on the location of the customer. There are certain revenues that the various U.S. segments manage that are generated from non-U.S. customers and therefore are included in Europe and the Rest of World revenues below. Total revenue by major geographic area consisted of the following:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
(In thousands)
United States
$
166,555

 
$
165,930

 
$
473,740

 
$
478,087

Europe
21,543

 
20,351

 
68,936

 
66,903

Rest of World
25,148

 
23,803

 
72,769

 
71,449

Total Revenues
$
213,246

 
$
210,084

 
$
615,445

 
$
616,439



18

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)


14. COMMITMENTS AND CONTINGENCIES
In consideration for certain technology, manufacturing, distribution, and selling rights and licenses granted to the Company, the Company has agreed to pay royalties on sales of certain products that we sell. The royalty payments that the Company made under these agreements were not significant for any of the periods presented.
The Company is subject to various claims, lawsuits and proceedings in the ordinary course of the Company's business, including claims by current or former employees, distributors and competitors and with respect to its products and product liability claims, lawsuits and proceedings, some of which have been settled by the Company. In the opinion of management, such claims are either adequately covered by insurance or otherwise indemnified, or are not expected, individually or in the aggregate, to result in a material adverse effect on our financial condition. However, it is possible that the Company's results of operations, financial position and cash flows in a particular period could be materially affected by these contingencies.
On June 6, 2012, the Company was contacted by the United States Attorney's Office for the District of New Jersey regarding the activities of sales representatives in a single region within our Extremities Reconstruction division. The U.S. Attorney's Office is investigating the activities of three sales representatives, one of whom was a supervisor until terminated by the Company for failure to cooperate with this investigation.  The activities at issue pertain to alleged improper billing of products for extremities indications. The Company is cooperating with the United States Attorney's Office on a voluntary basis and is not a subject or target of an investigation at this time.
The Company accrues for loss contingencies when it is deemed probable that a loss has been incurred and that loss is estimable. The amounts accrued are based on the full amount of the estimated loss before considering insurance proceeds, and do not include an estimate for legal fees expected to be incurred in connection with the loss contingency. The Company consistently accrues legal fees expected to be incurred in connection with loss contingencies as those fees are incurred by outside counsel as a period cost.

15. SUBSEQUENT EVENTS
On October 25, 2013, the Company, entered into a stock purchase agreement (the "Purchase Agreement") with Covidien Group S.a.r.l, a Luxembourg company ("Covidien"), for the acquisition by the Company of Confluent Surgical, Inc., a Delaware corporation ("Confluent Surgical") including its surgical sealant and adhesion barrier product lines. Pursuant to the Purchase Agreement, the Company will acquire all of the capital stock of Confluent Surgical.
Under the terms of the Purchase Agreement, the Company will pay Covidien an initial cash payment of $231.0 million upon the closing of the transaction and at that time make a prepayment of $4.0 million under a transitional supply agreement with an affiliate of Covidien. In addition, the Company may pay Covidien up to $30.0 million following the closing, contingent upon obtaining certain U.S. and European governmental approvals related to the completion of the transition of the Confluent Surgical business and the timely supply of products under the transitional supply agreement. The Company will also enter into a transition services agreement with an affiliate of Covidien at the closing. This acquisition complements Integra's global neurosurgery growth strategy aimed at providing a broader set of solutions for surgical procedures in the head. Since the acquisition occurred subsequent to September 30, 2013, the acquisition is not included in the results of operations for any of the periods presented.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the related notes thereto appearing elsewhere in this report and our consolidated financial statements for the year ended December 31, 2012 included in our Annual Report on Form 10-K.
We have made statements in this report which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). These forward-looking statements are subject to a number of risks, uncertainties and assumptions about the Company. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those set forth above under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2012 and under the heading "Risk Factors" in this report. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
You can identify these forward-looking statements by forward-looking words such as “believe,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should,” “would” and similar expressions in this report.

GENERAL

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Integra is a world leader in medical devices focused on limiting uncertainty for surgeons so they can concentrate on providing the best patient care. Integra provides customers with clinically relevant, innovative and cost-effective products that improve the quality of life for patients. We focus on cranial and spinal procedures, small bone and joint injuries, the repair and reconstruction of soft tissue, and instruments for surgery.
We manage our business through a combination of product groups and geography, and accordingly, we report our financial results under five reportable segments - U.S. Instruments, U.S. Neurosurgery, U.S. Extremities, U.S. Spine and Other (which consists of our U.S. Spine and Private Label businesses) and International.
We present revenues in the following three product categories: Orthopedics, Neurosurgery and Instruments. Our orthopedics product group includes specialty metal implants for surgery of the extremities, shoulder and spine, orthobiologics products for repair and grafting of bone, dermal regeneration products and tissue-engineered wound dressings and nerve and tendon repair products. Our neurosurgery product group includes, among other things, dural grafts that are indicated for the repair of the dura mater, ultrasonic surgery systems for tissue ablation, cranial stabilization and brain retraction systems, systems for measurement of various brain parameters and devices used to gain access to the cranial cavity and to drain excess cerebrospinal fluid from the ventricles of the brain. Our instruments product group includes a wide range of specialty and general surgical and dental instruments and surgical lighting for sale to hospitals, outpatient surgery centers, and physician, veterinarian and dental practices.
We manufacture many of our products in plants located in the United States, Puerto Rico, France, Germany, Ireland, the United Kingdom and Mexico. We also source most of our handheld surgical instruments and specialty metal and pyrocarbon implants through specialized third-party vendors.
In the United States, we have several sales channels. We sell orthopedics products through a large direct sales organization and through specialty distributors focused on their respective surgical specialties. Neurosurgery products are sold through directly employed sales representatives. Instruments products are sold through two sales channels, both directly and through distributors and wholesalers, depending on the customer call point. We sell in the international markets through a combination of a direct sales organization and distributors.
We also market certain products through strategic partners in the United States.
Our objective is to become a multi-billion dollar diversified global medical technology company that (i) helps patients by limiting uncertainty for medical professionals and (ii) is a high-quality investment for shareholders. We will achieve these goals by delivering on our Brand Promises to our customers worldwide and by becoming a top player in all markets in which we compete. Our strategy includes the following key elements: geographic expansion, disciplined focus and execution, global quality assurance and acquiring or in-licensing products that fit existing sales channels, margin expansion and leveraging platform synergies.
We aim to achieve growth in our revenues while maintaining strong financial results. While we pay attention to any meaningful trend in our financial results, we pay particular attention to measurements that are indicative of long-term profitable growth. These measurements include (1) revenue growth (including internal growth and by acquisitions), (2) gross margins on total revenues, (3) operating margins (which we aim to expand as we leverage our existing infrastructure and improve our quality systems), (4) earnings before interest, taxes, depreciation, and amortization, and (5) earnings per diluted share of common stock.
We believe that we are particularly effective in the following aspects of our business:
Regenerative Medicine Platform . We have developed numerous product lines through our proprietary collagen matrix and demineralized bone matrix technologies that are sold through every one of our sales channels.
Diversification and Platform Synergies . Each of our three selling platforms contributes a different strength to our core business. Orthopedics enables us to grow our top line and increase gross margins. Neurosurgery provides stable growth as a market with few elective procedures. The Instruments business has a strong capacity to generate cash flows. We have unique synergies among these platforms, such as our regenerative medicine technology, instrument sourcing capabilities, Group Purchasing Organization (“GPO”) contract management and recent enterprise selling platform.
Unique Sales Footprint . Our sales footprint provides us with a unique set of customer call-points and synergies. Each of our sales channels can benefit from the GPO and Integrated Delivery Network (“IDN”) relationships that our Instruments group currently manages. We have market-leading products for neurosurgeons, many of whom also perform spine surgeries, and we have yet to fully leverage those relationships to sell our spine products. We also have

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clinical expertise across all of our channels in the United States, and have an opportunity to expand and leverage this expertise in markets worldwide.
Ability to Change and Adapt . Our corporate culture is truly what enables us to adapt and reinvent ourselves. We have demonstrated that we can quickly and profitably integrate new products and businesses. This core strength has made it possible for us to grow over the years, and is key to our ability to grow into a multi-billion dollar company.

RESULTS OF OPERATIONS
Executive Summary
Net loss for the three months ended September 30, 2013 , was $28.6 million , or $1.02 per diluted share as compared with net income of $13.2 million or $0.46 per diluted share for the three months ended September 30, 2012 .
Net loss for the nine months ended September 30, 2013 was $29.2 million , or $1.05 per diluted share as compared with net income of $28.4 million or $0.99 per diluted share for the nine months ended September 30, 2012 .
The results of operations for the three and nine months ended September 30, 2013 were adversely affected by a voluntary recall of certain collagen-based products manufactured in our Añasco, Puerto Rico facility and the impairment of our U.S. Spine reporting unit goodwill. We incurred higher selling, general and administrative headcount expenses, increased consulting fees and expenses incurred in connection with the implementation of our global ERP system. The effects of the increased expenses noted above were partially offset by a $4.9 million and $2.2 million decrease in our interest expense as a result of the June 2012 repayment of our 2012 Notes and capitalization of a portion of our interest expense into the cost of our capital projects, respectively.
Income before taxes includes the following special charges:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
(In thousands)
 
(In thousands)
Global ERP implementation charges
$
4,950

 
$
4,821

 
$
18,715

 
$
12,097

Facility optimization charges
1,360

 
2,861

 
7,030

 
7,481

Manufacturing facility remediation costs
2,761

 
3,788

 
7,849

 
7,193

Certain expenses associated with product recalls

 

 
1,444

 

Certain employee termination charges
30

 
638

 
30

 
1,139

Discontinued product lines charges

 
223

 

 
1,058

Acquisition-related charges
319

 
602

 
993

 
2,323

Impairment charges
46,738

 

 
46,738

 
141

Convertible debt non-cash interest
1,633

 
1,787

 
4,865

 
8,284

Total
$
57,791

 
$
14,720

 
$
87,664

 
$
39,716


The items reported above are reflected in the condensed consolidated statements of operations as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
(In thousands)
 
(In thousands)
Cost of goods sold
$
4,050

 
$
5,661

 
$
12,922

 
$
13,890

Selling, general and administrative
5,370

 
7,272

 
23,139

 
17,542

Goodwill impairment charge
46,738

 

 
46,738

 

Interest expense
1,633

 
1,787

 
4,865

 
8,284

Total
$
57,791

 
$
14,720

 
$
87,664

 
$
39,716


We typically define special charges as items for which the amounts and/or timing of such expenses may vary significantly from period to period, depending upon our acquisition, integration and restructuring activities, and for which the amounts are non-cash in nature, or for which the amounts are not expected to recur at the same magnitude as we implement certain tax planning

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strategies. We believe that given our ongoing strategy of seeking acquisitions, our continuing focus on rationalizing our existing manufacturing and distribution infrastructure and our continuing review of various product lines in relation to our current business strategy, certain of the special charges discussed above could recur with similar materiality in the future. In 2010 we began investing significant resources in the global implementation of a single enterprise resource planning system. We began capitalizing certain costs for the project starting in 2011.
We believe that the separate identification of these special charges provides important supplemental information to investors regarding financial and business trends relating to our financial condition and results of operations. Investors may find this information useful in assessing comparability of our operating performance from period to period, the business model objectives that management has established, and other companies in our industry. We provide this information to investors so that they can analyze our operating results in the same way that management does and to use this information in their assessment of our core business and valuation of Integra.
Update on Remediation Activities
Remediation activities in our regenerative medicine facility in Plainsboro, New Jersey affected revenues and gross margin in the first three quarters of 2013. We received a warning letter from the FDA in December 2011, related to quality systems and compliance issues at that plant. The letter resulted from an inspection held at that facility in August 2011, and did not identify any new observations that were not provided in the Form 483 that followed the inspection. The warning letter did not restrict our ability to manufacture or ship products, nor did it require the recall of any product. In June and July 2012, the FDA again inspected the regenerative medicine facility. The second inspection closed out on July 30, 2012 and a FDA Form 483 Inspectional Observations was issued. On July 16, 2013, the FDA began an inspection of the Plainsboro facility and focused primarily on the issues raised in the warning letter and in previous inspections of the Plainsboro facility. At the conclusion of the inspection, the FDA found that the Company had addressed the issues raised in the warning letter and previous inspectional observations, and it issued no other inspectional observations. In reaching this conclusion, the FDA determined that the Company’s remediation activities were effective and its quality management system was adequate and the warning letter was closed out effective September 24, 2013.

The FDA inspected our neurosurgery manufacturing facility in Andover, England in June 2012.  Subsequently, on November 5, 2012, we received a warning letter from the FDA dated November 1, 2012 related to quality systems issues at that facility.  The warning letter identified violations related to corrective and preventative actions, process validations, internal quality audits, and internal review of the suitability and effectiveness of the quality system at defined intervals.  We filed the FDA warning letter as an exhibit to a Current Report on Form 8-K on November 13, 2012.   Since the conclusion of the FDA inspection in June 2012, we have undertaken significant efforts to remediate the observations that the FDA has made and continue to do so. We have provided the FDA with monthly status reports and are working cooperatively with the FDA to resolve any outstanding issues.

On February 14, 2013, we received a warning letter from the FDA relating to quality systems issues at our manufacturing facility located in Añasco, Puerto Rico. The letter resulted from an inspection conducted at that facility during October and November 2012. On February 15, 2013 we stopped distribution of our collagen products manufactured in the Añasco facility in order to confirm that we had successfully validated all such products and engaged a third-party consultant having appropriate quality system regulations expertise to confirm such validations. On February 22, 2013 the third-party consultant certified the completeness of such validations and we resumed distribution of collagen products from the Añasco, Puerto Rico facility.

On April 10, 2013, we initiated a voluntary recall of certain products manufactured in our Añasco facility between December 2010 and May 2011 and between November 2012 and March 2013. Specific lots of these products, as described below, were recalled because we identified that there may have been deviations from required processes in their production. We identified through an internal quality assurance review that we may have deviated from a production process during the manufacture of specific lots of collagen products during the periods described. The product lots in question passed all product finished goods testing including endotoxin testing, are sterile, and were tested and accepted for release. However, due to the process deviation, they may have been released with higher levels of endotoxins than permitted by the product specifications. Higher levels of endotoxins may result in a fever in the immediate postoperative period. There have been no reports of patient injuries or other adverse events attributable to the products subject to the recall. We continue to manufacture all such products in our Añasco facility.

We believe that most of the recalled product lots manufactured between December 2010 and May 2011 have already been consumed, and that therefore, the recall of those lots will not have a material financial impact. However, the return of products, manufactured between November 2012 and March 2013, which were substantially sold in the first three months ended March 31, 2013, directly reduced revenues in the nine months ended September 30, 2013 by $3.4 million. As we anticipated, we were

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not able to produce all the affected products quickly enough to meet the demand from customers in the three months ended September 30, 2013 . Such supply shortages resulted in lower revenues in the nine months of 2013. As expected, the recall and supply shortages had a significant impact on the U.S. Neurosurgery, U.S. Spine and Other, and International segments during the nine months of 2013. By the end of the third quarter, the Company had significantly reduced its backorders of products manufactured at the Añasco facility and on a consolidated basis from the level that prevailed at the beginning of the quarter.

The recall applied to limited and specific lots of DuraGen ® Dural Graft Matrix, DuraGen ® Plus Dural Regeneration Matrix, DuraGen ® Suturable Dural Regeneration Matrix, DuraGen XS™ Dural Regeneration Matrix, Layershield ® Adhesion Barrier Matrix, NeuraWrap™ Nerve Protector, NeuraGen ® Nerve Guide, BioMend ® Absorbable Collagen Membrane, OraMem ® Absorbable Collagen Membrane, BioMend ® Extend Absorbable Collagen Membrane, CollaCote ® Absorbable Collagen Wound Dressing for Dental Surgery, CollaTape ® Absorbable Collagen Wound Dressing for Dental Surgery, CollaPlug ® Absorbable Collagen Wound Dressing for Dental Surgery, HeliTape ® Absorbable Collagen Wound Dressing for Dental Surgery, HeliPlug ® Absorbable Collagen Wound Dressing for Dental Surgery, OraTape ® Absorbable Collagen Wound Dressing for Dental Surgery, OraPlug ® Absorbable Collagen Wound Dressing for Dental Surgery, Instat ® Microfibrillar Collagen Hemostat, Helistat ® Absorbable Collagen Hemostatic Sponge (ACS/Helistat), and Helitene ® Absorbable Collagen Hemostatic Agent. The Absorbable Collagen Sponge (ACS) is not a final product, but a component of a product assembled by another company.

We met with the Office of Compliance at the Center for Devices and Radiological Health on March 26, 2013. We presented our plans for both immediate remediation and our corporate plan for the development and implementation of a single Quality System for the entire Company. We have engaged former FDA professionals as third party consultants to work with us on our remediation plans. We also met with the Office of Compliance at the FDA San Juan, Puerto Rico office to discuss the remediation plans at the Añasco, Puerto Rico facility. We have prioritized senior level quality and regulatory staff to address the quality system improvement plans at all of our facilities. On October 24, 2013, the United States Food and Drug Administration began an inspection of the Añasco facility. We do not expect to comment on or otherwise discuss the FDA inspection until after the conclusion of the inspection.

We have undertaken significant efforts to remediate the observations that the FDA has made and have been working on improving and revising our quality systems. During the three and nine months ended September 30, 2013 , we incurred $2.8 million and $7.8 million in remediation activities expenses, respectively, consisting of consulting expenses and other work activities required to complete our remediation activities. For the full year 2013, we expect to spend approximately $8.5 million on our quality systems and remediation activities. We expect to have these activities completed in the last quarter of 2013. We will provide periodic status reports to the FDA and work cooperatively with the agency to resolve any outstanding issues.
Revenues and Gross Margin on Product Revenues
Our revenues and gross margin on product revenues were as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
Segment Net Sales
(In thousands)
 
(In thousands)
U.S. Neurosurgery
$
45,114

 
$
43,269

 
$
125,877

 
$
125,776

U.S. Instruments
41,798

 
41,469

 
118,737

 
120,732

U.S. Extremities
33,541

 
32,961

 
98,440

 
91,596

U.S. Spine and Other
46,904

 
49,188

 
133,414

 
142,821

International *
45,889

 
43,197

 
138,977

 
135,514

Total revenue
213,246

 
210,084

 
615,445

 
616,439

Cost of goods sold
84,101

 
79,548

 
247,437

 
232,497

Gross margin on total revenues
$
129,145

 
$
130,536

 
$
368,008

 
$
383,942

Gross margin as a percentage of total revenues
60.6
%
 
62.1
%
 
59.8
%
 
62.3
%
* The Company attributes revenue to geographic areas based on the location of the customer. There are certain revenues managed by the various U.S. segments above that are generated from non-U.S. customers and therefore included in Europe and the Rest of World revenues.


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Three Months Ended September 30, 2013 as Compared to Three Months Ended September 30, 2012
Revenues and Gross Margin
For the three months ended September 30, 2013 total revenues increased by $ 3.2 million to $213.2 million from $210.1 million for the same period in 2012.
U.S. Neurosurgery revenues were $45.1 million , an increase of 4% from the prior-year period. The increase is primarily attributable to the shipping of nearly all backorders related to our collagen product shortages caused by the first quarter recall. We experienced increases in neuro critical care, cranial stabilization and stereotaxy driven by stronger capital product sales. These increases were partially offset by weaker capital sales in tissue ablation.
U.S. Instruments revenues were $41.8 million , an increase of 1% from the prior-year period. In the quarter, we saw low-single digit growth in our alternate site sales and continued to experience sustained growth in sales of our LED surgical headlamp. In addition, we experienced softness in our acute care sales channel due to fewer large orders for hospital starts and expansions.
U.S. Extremities revenues were $33.5 million , an increase of 2% from the prior-year period. This increase resulted primarily from a strong growth in sales of our upper and lower extremities businesses. Softness in our dermal and wound care products caused by fewer burn incidents reported by our hospital and surgeon customers largely offset the increase.
U.S. Spine and Other revenues, which include our spine hardware, orthobiologics and private label products, were $46.9 million , a 5% decrease from the prior-year period. Our spine hardware product sales continued to lag the overall market.  We saw double-digit growth in our orthobiologics products, led by a strong demand for our Evo3™ products. Sales of our private label products were down from the prior-year period due to the loss of some business to certain customers as related to prolonged recall-related supply shortages.
International segment revenues were $45.9 million , an increase of 6% from the prior-year period. Our sales increases around the world were primarily attributable to a substantial growth in our spine implants and acute care instruments. Foreign currency had a negligible impact on our sales in the current quarter.
In addition, the Company announced in October that it was rationalizing product lines and that certain product revenues were being substantially reduced or eliminated within its Private Label business because Integra's customers found other sources during the supply disruptions earlier this year.
Gross margin decreased 1% to $129.1 million for the three-month period ended September 30, 2013 from $130.5 million for the same period last year. Gross margin as a percentage of total revenue decreased to 60.6% for the third quarter of 2013 from 62.1% for the same period last year. The decrease in gross margin percentage resulted primarily from increased quality costs at our manufacturing facilities and the impact of the manufacturer's excise tax that we capitalize in our inventory and subsequently record in cost of goods sold as these products are sold to third-party customers.
We expect our consolidated gross margin percentage for the full year 2013 to be between 60% and 61%, down compared to 2012. Costs related to the expansion of our regenerative medicine activities, continued downward pressure on our private-label and spine hardware product sales volumes, and the inclusion of the medical device tax will negatively affect our consolidated gross margin.
Operating Expenses
The following is a summary of operating expenses as a percent of total revenues:  

 
Three Months Ended September 30,
 
2013

2012
Research and development
6.1
%

6.2
%
Selling, general and administrative
45.0
%

44.3
%
Intangible asset amortization
1.4
%

2.2
%
Goodwill impairment charge
21.9
%
 
%
Total operating expenses
74.4
%

52.7
%


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Total operating expenses, which consist of research and development expenses, selling, general and administrative expenses, amortization expense and goodwill impairment, increased $48.0 million , or 43% , to $158.8 million in the three months ended September 30, 2013 , compared to $110.8 million in the same period last year.

Research and development expenses in the third quarter of 2013 decreased $0.1 million compared to the same period last year due to lower product development spending. We target full-year 2013 spending on research and development to be approximately 6.0% of total revenues.

Selling, general and administrative expenses in the third quarter of 2013 increased by $2.8 million to $95.9 million compared to $93.1 million in the same period last year. Selling and marketing expenses increased by $2.7 million , primarily resulting from a higher headcount of our sales force in Extremities and Neurosurgery as well as marketing and logistic groups in the United States. General and administrative costs were up $0.1 million , as a result of increases in compensation expenses fully offset by lower consulting costs supporting various projects. 

Amortization expense in the third quarter of 2013 was $3.0 million compared to $4.6 million in the same period last year. The decrease is primarily due to certain intangible assets becoming fully amortized in 2013.

Operating expenses for the third quarter of 2013 also included a goodwill impairment charge of $46.7 million. The goodwill impairment charge is related to our U.S. Spine reporting unit. See Note 4 "Goodwill and Other Intangible Assets" to our condensed consolidated financial statements for further discussion.

Non-Operating Income and Expenses
The following is a summary of non-operating income and expenses:
 
 
Three Months Ended September 30,
 
2013
 
2012
 
(In thousands)
Interest income
$
38

 
$
100

Interest expense
(5,316
)
 
(5,549
)
Other income (expense)
(263
)
 
(31
)

Interest Income and Interest Expense
Interest expense in the three months ended September 30, 2013 decreased by $0.2 million primarily as a result of capitalizing $0.8 million of interest expense on our qualified construction in progress balances. This amount was offset by an additional $0.3 million of higher interest because of increased borrowing on our revolving line of credit. Our reported interest expense for the three-month periods ended September 30, 2013 and 2012 includes non-cash interest related to the accounting for convertible securities of $1.6 million and $1.8 million , respectively.
Other Income (Expense)
Other expense for the third quarter of 2013 was primarily attributable to foreign exchange losses on intercompany balances.
Income Taxes
 
 
Three Months Ended September 30,
 
2013
 
2012
 
(In thousands)
Income before income taxes
$
(35,155
)
 
$
14,256

Income tax (benefit) expense
(6,605
)
 
1,045

Effective tax rate
18.8
%
 
7.3
%

Our effective income tax rates for the three months ended September 30, 2013 and 2012 were 18.8% and 7.3% , respectively. For the three months ended September 30, 2013 , the increase in the income tax rate compared to the same period in 2012 was primarily the result of the goodwill impairment charge as only a portion of the impairment charge was deductible for tax and a lower income within our U.S.-based operations relative to foreign operations, which created a favorable effect on our effective

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tax rate. Also, in the current quarter, we recorded a benefit of $2.3 million for the release of uncertain tax positions and related interest due to the expiration of the statute of limitations, which is offset by an expense of $0.2 million due to additional U.S. tax contingency reserves.

In September 2013, the Internal Revenue Service released final tangible property regulations regarding the deduction and capitalization of expenditures related to tangible property. Also released were proposed regulations regarding dispositions of tangible property. The regulations are effective beginning January 1, 2014, however, early adoption is allowed. The Company does not believe the regulations will have a material impact on the Company's financial statements when they are adopted.

We expect our effective income tax rate for the full year to be approximately 36.3% resulting largely from the income tax impact associated with the goodwill impairment, offset with foreign earnings taxed at lower tax rates, as well as the expected release of tax contingency reserves. This estimate could be revised in the future as additional information is presented to the Company.

The effective tax rate may vary from period to period depending on, among other factors, the geographic and business mix of taxable earnings and losses, tax planning and settlements with the various taxing authorities. We consider these factors and others, including our history of generating taxable earnings, in assessing our ability to realize deferred tax assets on a quarterly basis.
While it is often difficult to predict the final outcome or the timing of resolution of any particular matter with the various Federal, state and foreign tax authorities, we believe that our reserves reflect the most probable outcome of known tax contingencies. Settlement of any particular issue would usually require the use of cash. Favorable resolution would be recognized as a reduction to our annual effective tax rate in the year of resolution. The tax reserves are presented in the balance sheet within other liabilities, except for amounts relating to items we expect to pay in the coming year which are classified as current income taxes payable.
Nine Months Ended September 30, 2013 as Compared to Nine Months Ended September 30, 2012

Revenues and Gross Margin
For the nine-month period ended September 30, 2013 , total revenues decreased by $1.0 million to $615.4 million from $616.4 million during the prior-year period.

Our total revenues for the nine-month period ended September 30, 2013 , were negatively affected by our voluntary recall of certain products manufactured in our Añasco, Puerto Rico facility, including DuraGen® Dural Graft Matrix products.
U.S. Neurosurgery revenues were $125.9 million , in line with prior year. Capital sales were up mid-single digits as we saw growth in our critical care, cranial stabilization and stereotaxy lines.  These increases were offset by decreases in sales of our collagen products resulting from their lack of availability because of the recall.
U.S. Instruments revenues were $118.7 million , a decrease of 2% from the prior year. We experienced lower sales of our legacy lighting products due to some product discontinuation and conversion of the legacy xenon lighting products to LED lighting. There was softness in our alternate site sales due to pricing pressures and product discontinuation of some of our lower margin products.
U.S. Extremities revenues were $98.4 million , an increase of 7% from the prior year. This growth resulted from low-double digit growth in both our upper and lower extremities businesses, driven by new product introductions, including pyrocarbon implants. Sales of our dermal and wound care products were up high-single digits.
U.S. Spine and Other revenues, which include our spine hardware, orthobiologics and private label products, were $133.4 million , a decrease of 7% from the prior year. In addition to general market softness and pricing pressure, our spine hardware product sales declined more than the market because of poor execution in the business and some distributor turnover.  Orthobiologics sales increased low-single digits and were affected by backorders in collagen ceramic bone void fillers in the first half of 2013.  Our supplies returned to normal levels by the end of the third quarter.  Sales growth in the rest of the portfolio offset much of this decrease, and demand for the overall orthobiologics line remains strong. Sales of our private label products were down significantly from the prior-year period due to the loss of some business to certain customers as related to the recall-related supply shortages.
International segment revenues were $139.0 million , an increase of 3% from prior year. Our sales around the world were affected by the recall of our collagen products and backorders on these recalled products, however, we cleared most of our backorders in the third quarter of 2013. We saw growth in our spine implants and dermal and wound businesses with several

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new product introductions and increasing product coverage in direct and indirect channels. We experienced some growth in Asia-Pacific and Latin America markets for our duraplasty products. Foreign currency unfavorably impacted our sales by $0.2 million.
Gross margin decreased 4% to $368.0 million for the nine-month period ended September 30, 2013 from $383.9 million for the same period last year. Gross margin as a percentage of total revenue decreased to 59.8% for the nine months of 2013 from 62.3% for the same period last year. The decrease in gross margin percentage resulted primarily from increases in reserves related to inventory associated with the recall and increased quality costs at our manufacturing facilities. Finally, in January, we began paying the manufacturer's excise tax imposed on the first sale of certain medical devices in the United States. We elected to capitalize the excise tax in inventory and subsequently record in cost of goods sold as these products are sold to third-party customers, which had the impact of decreasing our gross margin by 0.7%.
Operating Expenses
The following is a summary of operating expenses as a percent of total revenues:
 
 
Nine Months Ended September 30,
 
2013
 
2012
Research and development
6.1
%
 
6.2
%
Selling, general and administrative
48.0
%
 
44.9
%
Intangible asset amortization
1.6
%
 
2.3
%
Goodwill impairment charge
7.6
%
 
%
Total operating expenses
63.3
%
 
53.4
%

Total operating expenses, which consist of research and development expenses, selling, general and administrative expenses, amortization expense and goodwill impairment, increased $61.0 million , or 19% , to $389.7 million in the nine months of 2013, compared to $328.7 million in the same period last year.
Research and development expenses in the nine months of 2013 decreased slightly compared to the same period last year due to lower spending on product development.
Selling, general and administrative expenses in the nine months of 2013 increased by $19.1 million to $295.7 million compared to $276.6 million in the same period last year. Selling and marketing expenses increased by $11.1 million primarily resulting from higher headcount. Additionally, U.S. Extremities' commission costs were higher as a result of increases in revenue.  General and administrative costs were up $8.0 million primarily because of higher headcount, increased expenses incurred in connection with the implementation of our global ERP system, and consulting costs to support various strategic projects. 
Amortization expense in the nine months of 2013 decreased by $4.3 million to $9.7 million , compared to $14.0 million in the same period last year. The decrease is primarily due to certain intangible assets becoming fully amortized in the first half of 2013.

Operating expenses for the nine months of 2013 also included a goodwill impairment charge of $46.7 million. The goodwill impairment charge is related to our U.S. Spine reporting unit. See Note 4 "Goodwill and Other Intangible Assets" to our condensed consolidated financial statements for further discussion.
Non-Operating Income and Expenses
The following is a summary of non-operating income and expenses:
 
 
Nine Months Ended September 30,
 
2013
 
2012
 
(In thousands)
Interest income
$
390

 
$
893

Interest expense
(15,081
)
 
(20,581
)
Other income (expense)
(1,544
)
 
(118
)



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Interest Income and Interest Expense
Interest income decreased in the nine-month period ended September 30, 2013 because the Company no longer holds any short-term investments in time deposit accounts held outside the United States as it did in the prior year period.
Interest expense in the nine-month period ended September 30, 2013 decreased by $5.5 million primarily as a result of the June 2012 repayment of our 2012 Senior Convertible Notes, which decreased our interest expense by $4.9 million. In addition, we capitalized $2.2 million of interest expense on our qualified construction in progress balances in 2013. This amount was offset by an additional $1.2 million of higher interest because of increased borrowing on our revolving line of credit. Furthermore, the amount of our 2016 Notes discount amortization increased by $0.3 million as expected when using the effective interest method for its amortization in the nine month period ended September 30, 2012 . Our reported interest expense for the nine-month periods ended September 30, 2013 and 2012 includes non-cash interest related to the accounting for convertible securities of $4.9 million and $8.3 million , respectively.
Other Income (Expense)
Other expenses of $1.5 million in 2013 were primarily attributable to a write off of $1.5 million for a capital expenditure project not placed into service and by foreign exchange losses on intercompany balances.
Income Taxes
 
 
Nine Months Ended September 30,
 
2013
 
2012
 
(In thousands)
(Loss) income before income taxes
$
(37,915
)
 
$
35,418

Income tax (benefit) expense
(8,755
)
 
7,000

Effective tax rate
23.1
%
 
19.8
%

The Company's effective income tax rates for the nine months ended September 30, 2013 and 2012 were 23.1% and 19.8% , respectively. For the nine months ended September 30, 2013, the increase in the income tax rate compared to the same period in 2012 primarily resulted from the tax impact of the goodwill impairment as only a portion of the impairment charge was deductible for tax and the release of uncertain tax positions.
The effective tax rate may vary from period to period depending on, among other factors, the geographic and business mix of taxable earnings and losses, tax planning and settlements with the various taxing authorities. We consider these factors and others, including our history of generating taxable earnings, in assessing our ability to realize deferred tax assets on a quarterly basis.
While it is often difficult to predict the final outcome or the timing of resolution of any particular matter with the various Federal, state and foreign tax authorities, we believe that our reserves reflect the most probable outcome of known tax contingencies. Settlement of any particular issue would usually require the use of cash. Favorable resolution would be recognized as a reduction to our annual effective tax rate in the year of resolution. The tax reserves are presented in the balance sheet within other liabilities, except for amounts relating to items it expects to pay in the coming year which are classified as current income taxes payable.
We expect our effective income tax rate for the full year to be approximately 36.3% .

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GEOGRAPHIC PRODUCT REVENUES AND OPERATIONS
We attribute revenues to geographic areas based on the location of the customer. There are certain revenues that the various U.S. segments manage that are generated from non-U.S. customers and therefore included in Europe and the Rest of World revenues below – these revenues are not significant. Total revenue by major geographic area consisted of the following:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
(In thousands)
 
(In thousands)
United States
$
166,555

 
$
165,930