INTEGRA LIFESCIENCES HOLDINGS CORP (Form: 10-Q, Received: 11/07/2014 11:46:43)

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, 2014
 
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 November 5, 2014 was 32,788,086 .



Table of Contents

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
INDEX
 

 
Page
Number
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 5. Other Information
 
 
 
 
 
 
Exhibit 31.1
 
Exhibit 31.2
 
Exhibit 32.1
 
Exhibit 32.2
 
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,
 
2014
 
2013
 
2014
 
2013
 
 
 
(As adjusted)*
 
 
 
(As adjusted)*
Total revenue, net
$
229,719

 
$
213,246

 
$
676,129

 
$
615,445

Costs and expenses:
 
 
 
 
 
 
 
Cost of goods sold
85,974

 
81,767

 
255,333

 
243,208

Research and development
13,127

 
13,052

 
39,439

 
37,577

Selling, general and administrative
109,896

 
99,794

 
333,487

 
306,037

Intangible asset amortization
2,995

 
3,036

 
9,013

 
9,660

   Goodwill impairment charge

 
46,738

 

 
46,738

Total costs and expenses
211,992

 
244,387

 
637,272

 
643,220

Operating income (loss)
17,727

 
(31,141
)
 
38,857

 
(27,775
)
Interest income
25

 
38

 
145

 
390

Interest expense
(5,916
)
 
(5,316
)
 
(16,440
)
 
(15,081
)
Other income (expense), net
(293
)
 
(263
)
 
142

 
(1,544
)
Income (loss) before income taxes
11,543

 
(36,682
)
 
22,704

 
(44,010
)
Income tax expense (benefit)
1,736

 
(6,352
)
 
5,866

 
(9,172
)
Net income (loss)
$
9,807

 
$
(30,330
)
 
$
16,838

 
$
(34,838
)
Basic net income (loss) per common share
$
0.30

 
$
(1.09
)
 
$
0.52

 
$
(1.25
)
Diluted net income (loss) per common share
$
0.30

 
$
(1.09
)
 
$
0.51

 
$
(1.25
)
Weighted average common shares outstanding (See Note 10):
 
 
 
 
 
 
 
Basic
32,450

 
27,896

 
32,374

 
27,855

Diluted
32,906

 
27,896

 
32,844

 
27,855

Comprehensive income (loss) (See Note 11)
$
(6,364
)
 
$
(21,640
)
 
$
1,593

 
$
(30,754
)

* See Note 1 of these condensed consolidated financial statements for discussion of the impact of the change in accounting for the medical device excise tax.

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, 2014
 
December 31, 2013
 
 
 
(As adjusted)*
 
 
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
140,231

 
$
120,614

Trade accounts receivable, net of allowances of $5,161 and $6,194
120,741

 
118,145

Inventories, net
230,455

 
206,919

Deferred tax assets
44,276

 
48,616

Prepaid expenses and other current assets
26,886

 
26,858

  Total current assets
562,589

 
521,152

Property, plant and equipment, net
203,882

 
200,310

Intangible assets, net
413,906

 
197,163

Goodwill
349,574

 
249,764

Deferred tax assets
6,259

 
15,412

Other assets
9,524

 
8,338

Total assets
$
1,545,734

 
$
1,192,139

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable, trade
$
45,935

 
$
50,752

Deferred revenue
5,183

 
4,197

Accrued compensation
36,957

 
28,079

Accrued expenses and other current liabilities
40,173

 
36,354

Borrowings under senior credit facility
1,875

 

  Total current liabilities
130,123

 
119,382

Long-term borrowings under senior credit facility
410,000

 
186,875

Long-term convertible securities
211,095

 
205,182

Deferred tax liabilities
76,782

 
2,083

Other liabilities
31,756

 
12,527

Total liabilities
859,756

 
526,049

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; 41,453 and 41,042 issued at September 30, 2014 and December 31, 2013, respectively
415

 
410

Additional paid-in capital
769,208

 
750,918

Treasury stock, at cost; 8,903 shares at September 30, 2014 and December 31, 2013
(367,121
)
 
(367,121
)
Accumulated other comprehensive income (loss)
(14,318
)
 
927

Retained earnings
297,794

 
280,956

Total stockholders’ equity
685,978

 
666,090

Total liabilities and stockholders’ equity
$
1,545,734

 
$
1,192,139


* See Note 1 of these condensed consolidated financial statements for discussion of the impact of the change in accounting for the medical device excise tax.

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

4

Table of Contents

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(In thousands)
 
 
Nine Months Ended September 30,
 
2014
 
2013
 
 
 
(As adjusted)*
 
 
 
 
OPERATING ACTIVITIES:
 
 
 
Net income (loss)
$
16,838

 
$
(34,838
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Depreciation and amortization
45,105

 
35,695

Non-cash impairment charges
600

 
46,738

Deferred income tax (benefit)
(1,510
)
 
(7,238
)
Amortization of debt issuance costs
2,060

 
1,707

Non-cash interest expense
5,256

 
4,865

Loss on disposal of property and equipment
505

 
1,816

(Gain) from change in fair value of contingent consideration
(878
)
 

Share-based compensation
11,688

 
7,594

Excess tax benefits from stock-based compensation arrangements
(1,207
)
 
(140
)
Changes in assets and liabilities, net of business acquisitions:
 
 
 
Accounts receivable
(3,847
)
 
1,440

Inventories
(26,648
)
 
(28,765
)
Prepaid expenses and other current assets
6,628

 
(694
)
Other non-current assets
(437
)
 
(515
)
Accounts payable, accrued expenses and other current liabilities
8,794

 
14,185

Deferred revenue
1,069

 
986

Other non-current liabilities
(5,310
)
 
(1,264
)
Net cash provided by operating activities
58,706

 
41,572

INVESTING ACTIVITIES:
 
 
 
Purchases of property and equipment
(29,466
)
 
(37,722
)
Sales of property and equipment

 
533

Cash used for business acquisition, net of cash acquired
(235,000
)
 
(2,980
)
Net cash used in investing activities
(264,466
)
 
(40,169
)
FINANCING ACTIVITIES:
 
 
 
Borrowings under senior credit facility
385,000

 
30,000

Repayments under senior credit facility
(160,000
)
 
(10,000
)
Payment of debt issuance costs
(3,110
)
 
(1,053
)
Principal payments under capital lease obligations
(370
)
 

Proceeds from exercised stock options
8,317

 
420

Excess tax benefits from stock-based compensation arrangements
1,207

 
140

Net cash provided by financing activities
231,044

 
19,507

Effect of exchange rate changes on cash and cash equivalents
(5,667
)
 
1,020

Net change in cash and cash equivalents
19,617

 
21,930

Cash and cash equivalents at beginning of period
120,614

 
96,938

Cash and cash equivalents at end of period
$
140,231

 
$
118,868

* See Note 1 of these condensed consolidated financial statements for discussion of the impact of the change in accounting for the medical device excise tax.

5

Table of Contents

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

6

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, 2014 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, 2013 included in the Company’s Current Report on Form 8-K dated June 16, 2014, which was filed with the Securities and Exchange Commission on June 20, 2014. The December 31, 2013 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, 2014 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.

Change in Accounting Principle

In the first quarter of 2014, the Company changed its method of accounting for the medical device excise tax (“MDET”). Prior to the change the Company recorded the MDET in inventory at the time of the first sale in the United States and then recognized the MDET in cost of goods sold when the medical device was sold to the ultimate customer. Under the new method, the MDET will be recorded in selling, general and administrative expenses in the period the first sale occurs in the United States, which could be an intercompany sale.

The Company believes that this change in accounting principle is preferable as the new method provides a better comparison with the Company's peers, the majority of which expense the MDET at the time of the first sale in the United States.

The medical device excise tax applies to sales beginning January 1, 2013; therefore, this change affected only 2013 financial results. The cumulative effect of the change in the prior year is included in retained earnings as of December 31, 2013. We have revised the comparative results for the three- and nine-month periods ended September 30, 2013 to reflect the retrospective application of the change in accounting principle had the new method been in effect for all periods, as follows:
  


7

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

Condensed Consolidated Statements of Operations and Comprehensive Income:
 
Three Months Ended September 30, 2013
 
Nine Months Ended September 30, 2013
 
Originally
 
 
 
As
 
Originally
 
 
 
As
 
Reported
 
Adjustments
 
Adjusted
 
Reported
 
Adjustments
 
Adjusted
 
(In thousands, except per share amounts)
Cost of goods sold
$
84,101

 
$
(2,334
)
 
$
81,767

 
$
247,437

 
$
(4,229
)
 
$
243,208

Selling, general and administrative
95,933

 
3,861

 
99,794

 
295,713

 
10,324

 
306,037

Income tax expense (benefit)
(6,605
)
 
253

 
(6,352
)
 
(8,755
)
 
(417
)
 
(9,172
)
Net income (loss)
(28,550
)
 
(1,780
)
 
(30,330
)
 
(29,160
)
 
(5,678
)
 
(34,838
)
Basic net income (loss) per common share
$
(1.02
)
 
 

 
$
(1.09
)
 
$
(1.05
)
 
 

 
$
(1.25
)
Diluted net income (loss) per common share
(1.02
)
 
 

 
(1.09
)
 
(1.05
)
 
 

 
(1.25
)
Comprehensive income (loss)
$
(19,860
)
 
$
(1,780
)
 
$
(21,640
)
 
$
(25,076
)
 
$
(5,678
)
 
$
(30,754
)


Condensed Consolidated Balance Sheets:
 
December 31, 2013
 
Originally
 
 
 
As
 
Reported
 
Adjustments
 
Adjusted
 
(In thousands)
Inventories
$
213,431

 
$
(6,512
)
 
$
206,919

Deferred tax assets - current
46,300

 
2,316

 
48,616

Prepaid expenses and other current assets
26,752

 
106

 
26,858

Retained earnings
285,046

 
(4,090
)
 
280,956



Condensed Consolidated Statements of Cash Flows:
 
Nine Months Ended September 30, 2013
 
Originally
 
 
 
As
 
Reported
 
Adjustments
 
Adjusted
 
(In thousands)
Net income (loss)
$
(29,160
)
 
$
(5,678
)
 
$
(34,838
)
Inventories
(34,855
)
 
6,090

 
(28,765
)
Prepaid and other current assets
(282
)
 
(412
)
 
(694
)

Realignment of Segment Revenues
In the first quarter of 2014 the Company realigned certain products between operating segments. The Company did not change its management structure and has determined that the Company still has the same five reportable segments. The impact of this immaterial change on all periods presented is that (i) the revenues and segment profit of the U.S. Extremities segment is lower, and U.S. Instruments and U.S. Spine and Other segments are higher, and (ii) the global revenues of the Orthopedics product category is lower and the Instruments product category is higher. These changes have been reflected in all periods presented. There has been no change in the Company's net revenues reported.
Recently Issued Accounting Standards
In July 2013, the FASB issued ASU 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. This ASU is effective for fiscal years and interim periods within those years beginning after December 15, 2013 for public entities and early adoption is permitted. The amendments are to be applied

8

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

to all unrecognized tax benefits that exist as of the effective date and may be applied retrospectively to each prior reporting period presented. The standard adoption did not have a material impact on the Company's financial statements.
In April 2014, the FASB issued amendments to guidance for reporting discontinued operations and disposals of components of an entity. The amended guidance requires that a disposal representing a strategic shift that has (or will have) a major effect on an entity’s financial results or a business activity classified as held for sale should be reported as discontinued operations. The amendments also expand the disclosure requirements for discontinued operations and add new disclosures for individually significant dispositions that do not qualify as discontinued operations. The amendments are effective prospectively for fiscal years, and interim reporting periods within those years, beginning after December 15, 2014 (early adoption is permitted only for disposals that have not been previously reported). The implementation of the amended guidance is not expected to have a material impact on our consolidated financial position or results of operations.

In May 2014, the FASB issued Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) . The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should: 1) identify the contract(s) with a customer, 2) identify the performance obligations in the contract, 3) determine the transaction price, 4) allocate the transaction price to the performance obligations in the contract, and 5) recognize revenue when (or as) the entity satisfies a performance obligation. This update is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, and early adoption is not permitted. The Company is in the process of evaluating the impact of this standard on its financial statements.

In June 2014, the FASB issued Update No. 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (Topic 718). The amendments require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in Topic 718 as it relates to awards with performance conditions that affect vesting to account for such awards. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The requisite service period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. This update is effective for annual reporting periods beginning after December 15, 2015, including interim periods within that reporting period, and early adoption is permitted. The implementation of the amended guidance is not expected to have a material impact on our consolidated financial position or results of operations.
There are no other recently issued accounting pronouncements that are expected to have a material effect on our financial position, results of operations or cash flows.

2. BUSINESS ACQUISITIONS
Confluent Surgical, Inc.
On January 15, 2014, the Company acquired all outstanding shares of Confluent Surgical, Inc., ("Confluent Surgical") - including its surgical sealant and adhesion barrier product lines - from Covidien Group S.a.r.l, ("Covidien") for an aggregate purchase price of $255.9 million . The purchase price is comprised of an initial cash payment to Covidien of $231.0 million upon the closing of the transaction, a separate prepayment of $4.0 million made under a transitional supply agreement with an affiliate of Covidien, and contingent consideration with an acquisition date fair value of $20.9 million . The potential maximum undiscounted contingent consideration of $30.0 million consists of $25.0 million upon obtaining certain U.S. governmental approvals and $5.0 million upon obtaining certain European governmental approvals, both related to the completion of the transition of the Confluent Surgical business.
The transitional supply agreement secures the supply of the acquired products from an affiliate of Covidien until the earlier of (i) the time that the transition of the Confluent Surgical business as discussed above is complete, or (ii) the fifth anniversary of the effective date of the agreement (the agreement also contains an option to extend for another two years by providing written notice at least 180 days prior to the end of the initial five-year period). This agreement contains financial incentives to the affiliate of Covidien for the timely supply of products each fiscal quarter through the third anniversary of the agreement. The prices paid under the supply agreement are essentially flat through the third anniversary of the agreement, and then increase significantly each of the following three years. The Company also entered into a transition services agreement with an affiliate of Covidien at the closing for services such as customer service, accounting and information technology management, clinical and regulatory affairs, manufacturing transition services, and other functions.

9

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

This acquisition complements the Company's global neurosurgery growth strategy aimed at providing a broader set of solutions for surgical procedures in the head.
The Company adjusted the preliminary purchase price allocation during the quarter ended June 30, 2014 to reduce deferred tax liabilities by $12.4 million . This adjustment offset goodwill and was the result of the Company analyzing and revising its tax positions in certain jurisdictions. The purchase price allocation is preliminary because the Company has not yet completed the final analysis of the tax accounts. The following summarizes the preliminary allocation of the purchase price as of September 30, 2014 based on the fair value of the assets acquired and liabilities assumed:

 
Preliminary
Purchase Price
Allocation
 
 
(Dollars in thousands)
 
Inventory deposit
$
4,000

 
Fixed assets
438

 
Intangible assets:


Wtd. Avg. Life
  Technology product rights
239,800

20 years
  Other
400

Less than 1 year
Deferred tax assets - long term
12

 
Goodwill
105,331

 
       Total assets acquired
349,981

 
Contingent supply liability
5,891

 
Other
731

 
Deferred tax liabilities - long term
87,464

 
       Net assets acquired
$
255,895

 
Subsequent to the acquisition date, a regulatory event occurred that resulted in the full-impairment of one of the acquired technology product rights of $0.6 million . This event was not known, or knowable, at the time of the acquisition and therefore the impairment has been included in the Company's cost of sales.
The Company accounted for the contingent supply liability by recording its fair value as a liability on the date of the acquisition based on a discounted cash-flow model. This contingent supply liability relates to contractual quarterly incentive payments that will be made to an affiliate of Covidien if certain supply minimums under the transitional supply agreement are met.
The Company accounted for the contingent consideration by recording its fair value as a liability on the date of the acquisition. The contingent consideration relates to the Company's obtaining certain U.S. and European regulatory approvals. At the date of the acquisition, both of these milestones were valued using a discount rate of 2.2% , which is equivalent to the cost of debt for the estimated time horizon, and an overall probability of occurring of 95% . Accordingly, on January 15, 2014 the Company recorded a $20.9 million liability representing the initial fair value estimate of the probability weighted contingent consideration that management believes will be paid between early 2017 and late 2018. Depending on the expected timing of the estimated payments, the acquisition date fair value of the probability adjusted payments could have been $0.3 million higher or $0.4 million lower. These fair value measurements were based on significant inputs not observed in the market and thus represented a Level 3 measurement. The contingent consideration is re-measured to fair value at each reporting date until the contingency is resolved, and those changes in fair value are recognized in earnings.
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 Confluent Surgical's 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 Confluent Surgical's assembled workforce. The goodwill acquired will not be deductible for tax purposes.
Contingent consideration
The fair value of contingent consideration during the nine -months ended September 30, 2014 was (i) increased to reflect current period acquisitions, and the change in the time value of money during the period, and (ii) decreased because the Company believes that it is no longer probable that it will reach certain sales-based milestone targets. A reconciliation of the opening balances to the closing balances of these Level 3 measurements is as follows (in thousands):

10

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

 

Location in Statement of Operations
Balance as of January 1, 2014
$
1,227


Contingent consideration from Confluent Surgical acquisition
20,895


Loss/(gain) from increase/(decrease) in fair value of contingent consideration liabilities
(878
)
Selling, general and administrative
Fair value at September 30, 2014
$
21,244


The entire contingent consideration balance was included in Other liabilities at September 30, 2014 and December 31, 2013 .

Pro Forma Results
The following unaudited pro forma financial information summarizes the results of operations for the three and nine months ended September 30, 2013 as if the Confluent Surgical acquisition completed by the Company during 2014 had been completed as of January 1, 2013 . The pro forma results are based upon certain assumptions and estimates, and they give effect to actual operating results prior to the acquisition and adjustments to reflect (i) the change in interest expense, depreciation expense, and intangible asset amortization, (ii) certain external expenses related to the acquisition as if they were incurred on January 1, 2013 that will not be recurring in the post-acquisition periods, and (iii) income taxes on the aforementioned adjustments at the Company’s statutory rate. No effect has been given to other cost reductions or operating synergies. As a result, these pro forma results do not necessarily represent results that would have occurred if the acquisition had taken place on the basis assumed above, nor are they indicative of the results of future combined operations.
The pro forma impact of the Confluent Surgical pre-acquisition results were not material to the 2014 consolidated operating results of the Company; therefore the pro forma impact on the 2014 results of the Company has not been presented below. The pro forma results below also incorporate the impact of the change in accounting for the MDET on the 2013 results which is discussed in Note 1.
 
Three Months Ended September 30, 2013
 
Nine Months Ended September 30, 2013
 
(In thousands)
Total revenue
$
229,645

 
$
664,642

Net income (loss)
$
(28,324
)
 
$
(30,356
)


3. INVENTORIES
Inventories, net consisted of the following:
 
 
September 30, 2014
 
December 31, 2013
 
(In thousands)
 
 
 
(As adjusted)*
Finished goods
$
142,342

 
$
123,786

Work in process
50,864

 
47,403

Raw materials
37,249

 
35,730

 
$
230,455

 
$
206,919


* See Note 1 of these condensed consolidated financial statements for discussion of the impact of the change in accounting for the medical device excise tax.


4. GOODWILL AND OTHER INTANGIBLE ASSETS

The Company reviews goodwill for impairment annually as of July 31 and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. In reviewing goodwill for impairment, an Company has the option - for any or all of its reporting units that carry goodwill - to first assess qualitative factors to determine whether the existence of events

11

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

or circumstances leads to a determination that it is more likely than not (i.e. greater than 50%) that the estimated fair value of a reporting unit is less than its carrying amount. If the Company elects to perform a qualitative assessment and determines that an impairment is more likely than not, the Company is then required to perform the two-step quantitative impairment test, otherwise no further analysis is required. The Company also may elect not to perform the qualitative assessment and, instead, proceed directly to step one of the two-step quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether the Company chooses to perform the qualitative assessment or proceeds directly to the two-step quantitative impairment test. The most recent two-step quantitative impairment test completed for each reporting unit was as of July 31, 2013 (the "Base Valuation"), which resulted in the full impairment of goodwill held by the U.S. Spine reporting unit. At July 31, 2014 the following reporting units carried goodwill: U.S. Neurosurgery, U.S. Instruments, U.S. Extremities, Private Label, EMEA and LAPAC.
At July 31, 2014, management performed a comprehensive analysis of various events and circumstances (i.e. factors) that would likely affect the estimated fair value of all of its reporting units that carried goodwill at that date, and whether those factors would have a positive or negative impact on the fair value of the reporting unit when compared to the Base Valuation. Management considered Company-wide factors such as, but not limited to (i) macroeconomic conditions, (ii) industry conditions, (iii) the Company's overall financial prospects and market capitalization, (iv) the competitive environment, (v) regulatory and political developments, and (vi) any changes in the Company's weighted average cost of capital ("WACC"). Management also considered reporting unit specific factors such as, but not limited to (i) changes in the market for products and services, (ii) strategic business changes, (iii) reporting unit financial performance, (iv) management's most recent prospective revenue estimates, (v) the prospective cost burden of the reporting units, (vi) changes in a reporting unit's management, (vii) how any change in the Company's WACC above might impact the reporting unit specific WACC, and (viii) the suitability of the risk premiums on the reporting unit specific WACC. These factors are then classified by the type of impact they would have on the estimated fair value using positive, neutral, and adverse categories based on current business conditions. The Company then performs an assessment of the level of impact that a particular factor would have on the estimated fair value using high, medium, and low weighting. Finally, management considered all of the factors above in the context of the results of the Base Valuation, and whether it is more likely than not that the carrying value of any of the reporting units that have goodwill exceeds their individual fair value.
Management concluded that at July 31, 2014, based on the totality of information available for each reporting unit that carried goodwill, it was more likely than not that the estimated fair values of the U.S. Neurosurgery, U.S. Extremities, Private Label, EMEA and LAPAC reporting units were greater than their carrying values, and as such, no further analysis was required for those reporting units. The Company proceeded to step one of the quantitative goodwill impairment test for the U.S. Instruments reporting unit, primarily as a result of recent declines in that reporting unit's revenues.
To derive the fair value of the U.S. Instruments reporting unit, 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 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 reporting unit's financial projections, 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 the 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.
The Company determined, after performing the Step-1 fair value analysis above, that the U.S. Instruments reporting unit's fair value was in excess of its carrying value; therefore, it was not necessary to proceed to Step-2 of the goodwill impairment test for the U.S. Instruments reporting unit.

12

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

Changes in the carrying amount of goodwill for the nine months ended September 30, 2014 were as follows:
 
 
U.S.
Neurosurgery
 
U.S.
Instruments
 
U.S.
Extremities
 
U.S.
Spine
and
Other
 
International
 
Total
 
(In thousands)
Goodwill, gross
$
95,165

 
$
58,033

 
$
61,079

 
$
56,325

 
$
25,900

 
$
296,502

Accumulated impairment losses

 

 

 
(46,738
)
 

 
(46,738
)
Goodwill at December 31, 2013
95,165

 
58,033

 
61,079

 
9,587

 
25,900

 
249,764

Confluent Surgical acquisition
95,373

 

 

 

 
9,958

 
105,331

Foreign currency translation
(2,966
)
 
(901
)
 
(948
)
 
(149
)
 
(557
)
 
(5,521
)
Goodwill at September 30, 2014
$
187,572

 
$
57,132

 
$
60,131

 
$
9,438

 
$
35,301

 
$
349,574

The components of the Company’s identifiable intangible assets were as follows:
 
 
September 30, 2014
 
Weighted
Average
Life
 
Cost
 
Accumulated
Amortization
 
Net
 
(Dollars in thousands)
Completed technology
18 years
 
$
320,270

 
$
(58,458
)
 
$
261,812

Customer relationships
12 years
 
145,658

 
(85,762
)
 
59,896

Trademarks/brand names
31 years
 
33,316

 
(15,766
)
 
17,550

Trademarks/brand names
Indefinite
 
48,484

 

 
48,484

Supplier relationships
27 years
 
34,721

 
(10,452
)
 
24,269

All other  (1)
4 years
 
4,620

 
(2,725
)
 
1,895

 
 
 
$
587,069

 
$
(173,163
)
 
$
413,906


 
December 31, 2013
 
Weighted
Average
Life
 
Cost
 
Accumulated
Amortization
 
Net
 
(Dollars in thousands)
Completed technology
12 years
 
$
81,238

 
$
(45,343
)
 
$
35,895

Customer relationships
12 years
 
146,627

 
(79,624
)
 
67,003

Trademarks/brand names
31 years
 
33,703

 
(15,648
)
 
18,055

Trademarks/brand names
Indefinite
 
48,484

 

 
48,484

Supplier relationships
27 years
 
34,721

 
(9,305
)
 
25,416

All other  (1)
5 years
 
4,251

 
(1,941
)
 
2,310

 
 
 
$
349,024

 
$
(151,861
)
 
$
197,163


 
(1)  
At September 30, 2014 and December 31, 2013 , all other included in-process research and development ("IPR&D") of $1.4 million in both periods, which was indefinite-lived.
During the nine months ended September 30, 2014 , the Company recorded an impairment charge of $0.6 million in cost of goods sold related to technology assets acquired from Confluent Surgical that will no longer be sold resulting from a regulatory event that occurred after the acquisition date.
Based on quarter-end exchange rates, annual amortization expense (including amounts reported in cost of product revenues, but excluding any possible future amortization associated with acquired in-process research and development) is expected to approximate $31.2 million in 2014, $28.7 million in 2015, $26.6 million in 2016, $24.5 million in 2017 and $24.1 million in 2018. Identifiable intangible assets are initially recorded at fair market value at the time of acquisition using an income or cost approach.

13

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


5. DEBT
Amended and Restated Senior Credit Agreement
On July 2, 2014 , the Company entered into an amended and restated credit agreement (the "Senior Credit Facility") with a syndicate of lending banks, Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer, Wells Fargo Bank, National Association, as Syndication Agent and HSBC Bank USA, National Association, Royal Bank of Canada, Citizens Bank, National Association, DNB Capital LLC, Credit Agricole-Corporate and Investment Bank and TD Bank, N.A., as Co-Documentation Agents. The Company's Senior Credit Facility was originally amended and restated on August 10, 2010, and that agreement was then amended on June 8, 2011, May 11, 2012, and June 21, 2013, as previously disclosed.
The 2014 amended and restated Senior Credit Facility created an aggregate principal amount of up to $900.0 million available to the Company through the following facilities:
i.
a $750.0 million revolving credit facility (increased from $600.0 million ), which includes a $60.0 million sublimit for the issuance of standby letters of credit and a $60.0 million sublimit for swingline loans, and
ii.
a $150.0 million term loan facility.
The Senior Credit Facility allows the Company to further increase the size of either the revolving credit facility or the term loan facility, or a combination thereof, by an aggregate of $200.0 million with additional commitments. The July 2014 amended and restated Senior Credit Facility extended the maturity date of the prior facility from June 8, 2016 to July 2, 2019.
Borrowings under the Senior Credit Facility bear interest, at the Company’s option, at a rate equal to:
i.
the Eurodollar Rate (as defined in the amendment and restatement) in effect from time to time plus the applicable rate (ranging from 1.00% to 1.75% ), or
ii.
the highest of:
1.
the weighted average overnight Federal funds rate, as published by the Federal Reserve Bank of New York, plus 0.50% , or
2.
the prime lending rate of Bank of America, N.A., or
3.
the one-month Eurodollar Rate plus 1.00% .
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 $40.0 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 will also pay 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.

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, 2014 the Company was in compliance with all such covenants. In connection with the modification of the 2014 amendment and restatement of the Senior Credit Facility the Company capitalized $3.1 million of incremental financing costs, and expensed $0.3 million of previously capitalized financing costs.

On July 2, 2014, the Company borrowed $422.0 million under the Senior Credit Facility consisting of a $150.0 million term loan and $272.0 million under its revolving credit facility. The Company used the funds to repay the balance of its previous Senior Credit Facility. The outstanding borrowings have one, two, three, six months, or, if available, twelve months interest periods.
At September 30, 2014 and December 31, 2013 , there was $261.9 million and $186.9 million outstanding under the revolving credit component of the Senior Credit Facility at a weighted average interest rate of 1.7% and 2.0% , respectively. At September 30, 2014 , there was approximately $488.1 million available for borrowing under the Senior Credit Facility. 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.
At September 30, 2014 there was $150.0 million outstanding under the term loan component of the Senior Credit Facility at a weighted average interest rate of 1.7% . Contractual repayments of the term loan do not begin until September 30, 2015 and are due as follows:

14

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

Year Ended December 31,
 
Principal Repayment
 
 
(In thousands)
2015
 
$
3,750

2016
 
9,375

2017
 
13,125

2018
 
15,000

2019
 
108,750

 
 
$
150,000

The fair value of outstanding borrowings of the Senior Credit Facility's revolving credit facility and term loan components at September 30, 2014 was approximately $241.4 million and $139.1 million , respectively. These fair values were 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 liabilities.
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, 2014 , the carrying amount of the liability component was $211.1 million , the remaining unamortized discount was $18.9 million , and the principal amount outstanding was $230.0 million . The fair value of the 2016 Notes at September 30, 2014 was approximately $247.7 million . At December 31, 2013 , the carrying amount of the liability component was $205.2 million , the remaining unamortized discount was $24.8 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, 2014 , 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.

15

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

Convertible Note Interest
The interest expense components of the Company’s convertible notes are as follows (net of capitalized interest amounts):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
(In thousands)
2016 Notes:
 
 
 
 
 
 
 
Amortization of the discount on the liability component
$
1,822

 
$
1,633

 
$
5,256

 
$
4,865

Cash interest related to the contractual interest coupon
853

 
807

 
2,491

 
2,438

Total
$
2,675

 
$
2,440

 
$
7,747

 
$
7,303


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 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 $1.3 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.

16

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

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 for derivatives designated as hedging instruments in the condensed consolidated balance sheets as of September 30, 2014 and December 31, 2013 :
 
 
 
Fair Value as of
Location on Balance Sheet (1) :
 
September 30, 2014
 
December 31, 2013
 
 
(In thousands)
Derivatives designated as hedges — Liabilities:
 
 
 
 
Interest rate swap — Accrued expenses and other current liabilities (2)
 
$
1,289

 
$
1,676

Interest rate swap — Other liabilities  (2)
 

 
763

Total Derivatives designated as hedges — Liabilities
 
$
1,289

 
$
2,439

 
(1)  
The Company classifies derivative assets and liabilities as current based on the cash flows expected to be incurred within the following 12 months.
(2)  
At September 30, 2014 and December 31, 2013 , the notional amount related to the Company’s sole interest rate swap was $101.3 million and $112.5 million , respectively. In the next twelve months, the Company expects to reduce the notional amount by the entire $101.3 million .

The following presents the effect of derivative instruments designated as cash flow hedges on the accompanying condensed consolidated statements of operations during the three and nine months ended September 30, 2014 and 2013 :
 
 
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, 2014
 
 
 
 
 
 
 
 
 
Interest rate swap
$
(1,713
)
 
$
(9
)
 
$
(433
)
 
$
(1,289
)
 
Interest (expense)
Three Months Ended September 30, 2013
 
 
 
 
 
 
 
 
 
Forward currency forward contracts
$
162

 
$
(19
)
 
$
110

 
$
33

 
Cost of goods sold
Interest rate swap
(3,030
)
 
(258
)
 
(483
)
 
(2,805
)
 
Interest (expense)
 
$
(2,868
)
 
$
(277
)
 
$
(373
)
 
$
(2,772
)
 
 



17

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

 
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, 2014
 
 
 
 
 
 
 
 
 
Interest rate swap
(2,439
)
 
(179
)
 
(1,329
)
 
(1,289
)
 
Interest (expense)
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
)
 
 


The Company recognized no gains or losses resulting from ineffectiveness of cash flow hedges during the nine months ended September 30, 2014 and 2013 .

7. STOCK-BASED COMPENSATION
As of September 30, 2014 , the Company had stock options, restricted stock awards, performance stock units, 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, directors, and employees, and generally expire six years from the grant date for employees, and 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.

Stock Options

As of September 30, 2014 , there were approximately $1.7 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 two years . There were approximately 80,991 stock options granted during the nine months ended September 30, 2014 .

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 units 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. As of September 30, 2014 , there were approximately $14.7 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 granted 255,407 restricted stock awards/stock units and 90,025 performance shares during the nine months ended September 30, 2014 .

During the three months ended June 30, 2014, the Company recorded an incremental stock compensation expense of $3.0 million in connection with the accelerated vesting of grants due to the amendment of an executive employment contract. The expense, which was comprised of both restricted shares and performance shares, was measured based on the difference between (i) the fair value of the awards on the date of modification and (ii) previously recognized compensation expense for such awards. The expense related to the acceleration of performance stock, included in the compensation expense amount above, was recorded in its entirety on the date of modification as the Company believes the performance obligation will be satisfied.
The Company has no formal policy related to the repurchase of shares for the purpose of satisfying stock-based compensation obligations.

18

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

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 plan 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 nine month periods ended September 30, 2014 and 2013 . As of September 30, 2014 , there remained $75.0 million available for repurchases under this authorization.

See Note 14 - Subsequent Events regarding changes to this share repurchase plan made after September 30, 2014 .

9. INCOME TAXES
The following table provides a summary of the Company’s effective tax rate:  
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
 
 
(As adjusted)*
 
 
 
(As adjusted)*
 
 
 
 
 
 
 
 
Reported tax rate
15.0
%
 
17.3
%
 
25.8
%
 
20.8
%

* See Note 1 of these condensed consolidated financial statements for discussion of the impact of the change in accounting for the medical device excise tax.

The Company’s effective income tax rates for the three months ended September 30, 2014 and 2013 were 15.0% and 17.3% , respectively. The primary drivers of the overall tax rate for the three months ended September 30, 2014 were a tax benefit of $1.6 million that was recognized for the release of uncertain tax positions due to the expiration of statute of limitations, partially offset by an expense of $0.5 million relating to a state income tax audit settlement and an expense of $0.3 million relating to foreign returns filed during the quarter. The primary drivers of the overall tax rate for the three months ended September 30, 2013 were the goodwill impairment charge that was partially deductible for tax purposes, partially offset by 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.

The Company's effective income tax rates for the nine months ended September 30, 2014 and 2013 were 25.8% and 20.8% , respectively. The primary drivers of the income tax rate for the nine months ended September 30, 2014 were an expense of $1.2 million relating to state income tax audit settlements, an expense of $0.4 million for a foreign income tax audit settlement, and an expense of $0.3 million from a change in state filing positions; offset by a benefit of $2.0 million for the release of uncertain tax positions and related interest due to the expiration of statute of limitations. The primary drivers of the income tax rate for the nine months ended September 30, 2013 were a benefit of $3.5 million for the release of uncertain tax positions, a benefit of $0.5 million relating to the granting of Irish research credits for 2011 and 2012, and a benefit of $0.9 million due to the extension of the Federal research credit, enacted through the American Taxpayer Relief Act. These benefits in 2013 were recorded against a book loss, relating primarily to goodwill impairment; accordingly, they had the effect of increasing the effective tax rate in that period.

The Company expects its effective income tax rate for the full year to be approximately 23% to 24% , resulting largely from the release of uncertain tax positions, domestic and foreign audit settlements, as well as the jurisdictional mix of pretax income in U.S.-based operations relative to foreign operations. This estimate could be revised in the future as additional information is presented to the Company.

19

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


10. NET INCOME (LOSS) PER SHARE
Basic and diluted net income (loss) per share was as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
(In thousands, except per share amounts)
 
 
 
(As adjusted)*
 
 
 
(As adjusted)*
Basic net income (loss) per share:
 
 
 
 
 
 
 
Net income (loss)
$
9,807

 
$
(30,330
)
 
$
16,838

 
$
(34,838
)
Weighted average common shares outstanding
32,450

 
27,896

 
32,374

 
27,855

Basic net income (loss) per common share
$
0.30

 
$
(1.09
)
 
$
0.52

 
$
(1.25
)
 
 
 
 
 
 
 
 
Diluted net income (loss) per share:
 
 
 
 
 
 
 
Net income (loss)
$
9,807

 
$
(30,330
)
 
$
16,838

 
$
(34,838
)
 
 
 
 
 
 
 
 
Weighted average common shares outstanding — Basic
32,450

 
27,896

 
32,374

 
27,855

Effect of dilutive securities:
 
 
 
 
 
 
 
Stock options and restricted stock
456

 

 
470

 

Weighted average common shares for diluted earnings per share
32,906

 
27,896

 
32,844

 
27,855

Diluted net income (loss) per common share
$
0.30

 
$
(1.09
)
 
$
0.51

 
$
(1.25
)

* See Note 1 of these condensed consolidated financial statements for discussion of the impact of the change in accounting for the medical device excise tax.

At September 30, 2014 and 2013 , the Company had 1.4 million and 1.7 million of outstanding stock options, respectively. The Company also has warrants outstanding relating to its 2016 Notes at September 30, 2014 and 2013 and the Company's 2016 Notes are convertible to common shares in certain circumstances (see Note 5). Stock options, restricted stock, warrants and the excess conversion value of the 2016 Notes are included in the diluted earnings per share calculation using the treasury stock method, unless the effect of including such items would be anti-dilutive.

For the three months ended September 30, 2014 and 2013, 0.2 million of anti-dilutive stock options were excluded from the diluted earnings per share calculation. For the nine months ended September 30, 2014, 0.2 million of anti-dilutive stock options were excluded. For the three and nine months ended September 30, 2013, all stock options, and all restricted stock were excluded from the diluted earnings per share calculation using the treasury stock method because of their anti-dilutive effect. The effect of outstanding warrants were anti-dilutive because the strike price of the warrants exceeded the Company’s average stock price for the periods, and the potential excess conversion value of the 2016 Notes were anti-dilutive because the conversion price exceeded the Company's stock price; therefore, these amounts have been excluded from the diluted earnings per share calculation in all periods presented.


20

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

11. COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) was as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
(In thousands)
 
 
 
(As adjusted)*
 
 
 
(As adjusted)*
Net income (loss)
$
9,807

 
$
(30,330
)
 
$
16,838

 
$
(34,838
)
Foreign currency translation adjustment
(16,537
)
 
8,711

 
(15,952
)
 
3,288

Change in unrealized gain on derivatives, net of tax
241

 
47

 
655

 
794

Pension liability adjustment, net of tax
125

 
(68
)
 
52

 
2

Comprehensive income (loss)
$
(6,364
)
 
$
(21,640
)
 
$
1,593

 
$
(30,754
)

* See Note 1 of these condensed consolidated financial statements for discussion of the impact of the change in accounting for the medical device excise tax.

Changes in Accumulated Other Comprehensive Income (Loss) by component between December 31, 2013 and September 30, 2014 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
 
$
(1,390
)
 
$
(2,287
)
 
$
4,604

 
$
927

Other comprehensive income (loss) before reclassifications
 
(102
)
 
52

 
(15,952
)
 
(16,002
)
Amounts reclassified from accumulated other comprehensive income
 
757

 

 

 
757
Net current-period other comprehensive income (loss)
 
655

 
52

 
(15,952
)
 
(15,245
)
Ending balance
 
$
(735
)
 
$
(2,235
)
 
$
(11,348
)
 
$
(14,318
)


21

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

The reclassification adjustments out of Accumulated Other Comprehensive Income (Loss) during the three and nine months ended September 30, 2014 were as follows:
Three Months Ended September 30, 2014
Details about Accumulated Other Comprehensive Income (Loss) Components
 
Amount Reclassified from Accumulated Other Comprehensive Income (Loss)
 
Affected Line Item in the Statement where Net Income (Loss) is Presented
 
 
(In thousands)
 
 
Gains and losses on cash flow hedges
 
 
 
 
Interest rate swap
 
$
(433
)
 
Interest (expense)
 
 
192

 
Tax (expense) or benefit
 
 
$
(241
)
 
Net of tax
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2014
Details about Accumulated Other Comprehensive Income (Loss) Components
 
Amount Reclassified from Accumulated Other Comprehensive Income (Loss)
 
Affected Line Item in the Statement where Net Income (Loss) is Presented
 
 
(In thousands)
 
 
Gains and losses on cash flow hedges
 
 
 
 
Interest rate swap
 
$
(1,328
)
 
Interest (expense)
 
 
571

 
Tax (expense) or benefit
 
 
$
(757
)
 
Net of tax


12. 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 and a description of their activities are described below:

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, information systems, 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. Net sales and profit by reportable segment for the three and nine months ended September 30, 2014 and 2013 are as follows:

22

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

 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
 
 
(In thousands)
 
 
 
 
(As adjusted)*
 
 
 
(As adjusted)*
Segment Net Sales
 
 
 
 
 
 
 
 
U.S. Neurosurgery
 
$
62,323

 
$
45,114

 
$
177,265

 
$
125,877

U.S. Instruments
 
39,853

 
43,004

 
116,078

 
121,900

U.S. Extremities
 
36,746

 
31,831

 
103,083

 
93,802

U.S. Spine and Other
 
42,015

 
47,408

 
128,168

 
134,889

International
 
48,782

 
45,889

 
151,535

 
138,977

Total revenues
 
$
229,719

 
$
213,246

 
$
676,129

 
$
615,445

Segment Profit
 
 
 
 
 
 
 
 
U.S. Neurosurgery
 
$
35,889

 
$
23,080

 
$
94,247

 
$
59,770

U.S. Instruments
 
12,416

 
13,713

 
34,728

 
35,963

U.S. Extremities
 
14,983

 
13,117

 
40,907

 
34,613

U.S. Spine and Other
 
13,108

 
(31,043
)
 
39,801

 
(4,844
)
International
 
15,170

 
14,693

 
49,549

 
41,697

Segment profit
 
91,566

 
33,560

 
259,232

 
167,199

Amortization
 
(2,995
)
 
(3,036)

 
(9,013)

 
(9,660)

Corporate and other
 
(70,844
)
 
(61,665
)
 
(211,362
)
 
(185,314
)
Operating income (loss)
 
$
17,727

 
$
(31,141
)
 
$
38,857

 
$
(27,775
)
* See Note 1 of these condensed consolidated financial statements for discussion of the impact of the change in accounting for the medical device excise tax.
Certain 2013 segment revenues and the related impact on segment profit above have been reclassified in order to conform with the current year's presentation.
Revenue by major product category consisted of the following:  
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
(In thousands)
Orthopedics
$
91,650

 
$
92,125

 
$
271,958

 
$
271,862

Neurosurgery
92,089

 
72,639

 
269,717

 
204,283

Instruments
45,980

 
48,482

 
134,454

 
139,300

Total Revenues
$
229,719

 
$
213,246

 
$
676,129

 
$
615,445


The Company attributes revenues to geographic areas based on the location of the customer. There are certain revenues managed by the various U.S. segments 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,
 
2014
 
2013
 
2014
 
2013
 
(In thousands)
United States
$
180,101

 
$
166,555

 
$
522,288

 
$
473,740

Europe
23,850

 
21,543

 
75,026

 
68,936

Rest of World
25,768

 
25,148

 
78,815

 
72,769

Total Revenues
$
229,719

 
$
213,246

 
$
676,129

 
$
615,445



23

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


13. 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 was 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 pertained to alleged improper billing of products for extremities indications. On August 12, 2014, the United States Attorney for the District of New Jersey announced that two former Integra sales representatives, one of whom was a supervisor, entered guilty pleas as a result of the investigation. According to the United States Attorney for the District of New Jersey, these individuals acted without the awareness of the Company. The Company cooperated with the U.S. Attorney’s Office on a voluntary basis throughout the investigation and has reimbursed affected customers. The reimbursements were made in historical periods and were not material. The Company was not a subject or target of the investigation, and believes the investigation to now be concluded.
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.

14. SUBSEQUENT EVENTS

Acquisition of MicroFrance
On October 27, 2014 , the Company completed a stock and asset purchase agreement (the “Purchase Agreement”) with Medtronic, Inc. (“Medtronic”), a Minnesota corporation and Medtronic Xomed Instrumentation, SAS (“MicroFrance”), a French corporation and an indirect wholly-owned subsidiary of Medtronic, for the acquisition by the Company of all of the capital stock of MicroFrance and certain assets of Medtronic and its affiliates related to MicroFrance’s business.
MicroFrance is engaged in the business of developing, manufacturing, marketing and distributing reusable handheld surgical instrument products, which are specialized for ear, nose and throat and laparoscopic procedures and providing related services.
Under the terms of the Purchase Agreement, the Company paid Medtronic a net purchase price of approximately $60.0 million for the stock and assets acquired subject to a purchase price adjustment for certain working capital changes. The Company also entered into a distribution agreement, an independent sales representative agreement, and a supply agreement with an affiliate of Medtronic at the closing. In addition, the Company entered into a transition services agreement with Medtronic at the closing. The Company has not yet performed the purchase price allocation, and will do so during the fourth quarter.

Share Repurchase Authorization
On October 28, 2014, our Board of Directors terminated the previous share repurchase plan dated October 23, 2012, and authorized a new repurchase of up to $75.0 million of outstanding common stock through December 2016. Shares may be repurchased either in the open market or in privately negotiated transactions.

Spine Business Spinoff and Organizational Changes

On November 3, 2014, the Company announced its plan for 2015 to spinoff its spine business, and realign the remaining business into two global reporting segments.  The spinoff will create a separate, independent medical technology company focused on developing, marketing and selling spine hardware and orthobiologics.  The realignment of the remaining business will result in two globally managed divisions, with one providing Specialty Surgical Solutions and the other Orthopedics and Tissue Technologies.  These moves to align the portfolio are part of a broader strategy to transform the business that includes optimization and accelerating growth.

24

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

 

Spinoff of the Spine Business

Under the proposed plan, the spine business will spinoff from Integra and operate as an independent, publicly held company. The new spine company will have a comprehensive portfolio of spinal hardware solutions, including unique interbody devices, minimally invasive surgery, and deformity, and a top-three orthobiologics offering, including a full range of osteoconductive and osteoinductive solutions utilizing unique demineralized bone, collagen and synthetic matrices.

The spinoff transaction is expected to take the form of a tax-free distribution to Integra shareholders of publicly traded stock in the new spine company. The transaction is expected to be completed within twelve months, subject to certain customary and other conditions, including final approval by the Integra Board of Directors, confirmation of the tax-free nature of the transaction, and the effectiveness of a registration statement that will be filed with the Securities and Exchange Commission, including information about the separation, distribution and related matters. While the Company expects any spinoff transaction to close within twelve months, there can be no assurances regarding the ultimate timing of the transaction or that the transaction will be completed.

The Company expects to incur one-time charges related to the transaction during the reporting periods preceding the separation and does not otherwise expect this to impact the Company's financial results in 2014.

Alignment of Integra Portfolio: Creating the Specialty Surgical Solutions Division

In addition to the above announced separation of the Spine business in a separate publicly traded company, in 2015 the Company plans to realign the remaining business into 2 global reporting segments, Specialty Surgical Solutions and Orthopedics and Tissue Technologies. The new Specialty Surgical Solutions organization will integrate globally what today are the Neurosurgery and Instruments businesses within Integra. Robert T. Davis, Jr., CVP, President, Specialty Surgical Solutions, will lead this newly-created division. The new global Specialty Surgical Solutions division will leverage Integra’s market-leading positions in both neurosurgery and instruments and will open up a larger potential market in which this business can achieve its communicated growth trajectory.

In addition, Mark Augusti, CVP, President, Orthopedics and Tissue Technologies, will also take on global responsibility for that division. Dan Reuvers, CVP, President, International, will continue to run an International region management structure to prioritize and focus Integra’s investments in International markets.

These plans to realign the business have not taken place yet and therefore these proposed changes have not impacted the Company's current segment disclosures. The Company is in the process of determining how this realignment will impact its segment information in 2015.


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, 2013 included in the Company’s Current Report on Form 8-K dated June 16, 2014, which was filed with the Securities and Exchange Commission on June 20, 2014.
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 under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2013 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

25

Table of Contents

Integra is a world leader in medical technology focused on limiting uncertainty for surgeons so that they can concentrate on providing the best patient care. Integra offers innovative solutions in orthopedic extremity surgery, neurosurgery, spine surgery, and reconstructive and general 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 and dural sealants which 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. Most Neurosurgery products are sold through directly employed sales representatives; products acquired in the Confluent Surgical acquisition were initially sold through distributors, and we transitioned those products to our direct sales force in the third quarter of 2014. 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.
We aspire to be a multi-billion dollar diversified global medical technology company that helps patients by limiting uncertainty for medical professionals, and 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 is built around three pillars - optimize, execute and accelerate growth. These three pillars support our strategic initiatives to optimize our infrastructure, to deliver on our commitments through improved planning and communication, and to grow by introducing new products to the market through internal development, expanding geographically, and strategic acquisitions.
Acquisition of Confluent Surgical, Inc.
On January 15, 2014, we acquired all outstanding shares of Confluent Surgical, Inc., ("Confluent Surgical") - including its surgical sealant and adhesion barrier product lines - from Covidien Group S.a.r.l, ("Covidien") for an aggregate purchase price of $255.9 million . The purchase price is comprised of an initial cash payment to Covidien of $231.0 million upon the closing of the transaction, a separate prepayment of $4.0 million made under a transitional supply agreement with an affiliate of Covidien, and contingent consideration with an acquisition date fair value of $20.9 million . The purchase agreement includes a potential maximum undiscounted contingent consideration of $30.0 million which consists of $25.0 million upon obtaining certain U.S. governmental approvals and $5.0 million upon obtaining certain European governmental approvals, both related to the completion of the transition of the Confluent Surgical business.
The transitional supply agreement secures the supply of the acquired products from an affiliate of Covidien until the earlier of (i) the time that the transition of the Confluent Surgical business as discussed above is complete, or (ii) the fifth anniversary of the effective date of the agreement (the agreement also contains an option to extend for another two years by providing written notice at least 180 days prior to the end of the initial five-year period). This agreement contains financial incentives to the affiliate of Covidien for the timely supply of products each fiscal quarter through the third anniversary of the agreement. The prices paid under the supply agreement are essentially flat through the third anniversary of the agreement, and then increase significantly each of the following three years. We also entered into a transition services agreement with an affiliate of Covidien at the closing for services such as customer service, accounting and information technology management, clinical and regulatory affairs, manufacturing transition services, and other functions.
This acquisition complements our global neurosurgery growth strategy aimed at providing a broader set of solutions for surgical procedures in the head.

26

Table of Contents

Change in Accounting Treatment for the Medical Device Excise Tax

In the first quarter of 2014, the Company changed its method of accounting for the medical device excise tax (“MDET”). Prior to the change the Company recorded the MDET in inventory at the time of the first sale in the United States and then recognized the tax in cost of goods sold when the medical device was sold to the ultimate customer. Under the new method, the MDET is recorded in selling, general and administrative expenses in the period the first sale in the United States occurs, which could be an intercompany sale.

The Company believes that this change in accounting principle is preferable as the new method provides a better comparison with the Company's industry peers, the majority of which expense the MDET at the time of the first sale in the United States.

The medical device excise tax applies to sales beginning January 1, 2013; therefore, this change affected only 2013 financial results. The cumulative effect of the change in the prior years is included in retained earnings as of December 31, 2013 and the comparative period for the three- and nine-month periods ended September 30, 2013. The financial impact of this change on 2013 has been incorporated into the amounts presented throughout this Form 10-Q and the impact on the three and nine months ended September 30, 2013 is discussed in detail in Note 1 to the condensed consolidated financial statements. For a full reconciliation of the impact on the 2013 historical quarterly financial results, please refer to the investor presentations on the Investor Relations homepage of Integra's website at investor.integralife.com.

Management Changes

On April 29, 2014, the Board of Directors (the "Board") of the Company appointed Glenn G. Coleman as Corporate Vice President of the Company effective as of May 2, 2014. In addition, on April 29, 2014, the Board of the Company appointed Mr. Coleman as Corporate Vice President, Chief Financial Officer and Principal Accounting Officer, which became effective on May 2, 2014. When Mr. Coleman commenced as Chief Financial Officer, John B. Henneman, III ceased to serve as the Company’s Chief Financial Officer; however, Mr. Henneman continued to serve as Corporate Vice President, Chief Administrative Officer, until his retirement in September 2014. Jerry Corbin ceased to serve as the Company’s Principal Accounting Officer effective May 2, 2014, and continued to serve as Corporate Vice President, Corporate Controller until his retirement in August 2014.

Diabetic Foot Ulcer Clinical Trial

During July 2014, we completed our multicenter clinical trial evaluating the safety and effectiveness of the INTEGRA® Dermal Regeneration Template for the Treatment of Diabetic Foot Ulcers (“the DFU study”), and we are in the process of evaluating all of the data. We are currently preparing submissions in advance of our clinical publication, reimbursement and regulatory strategies. We expect to submit the data from this clinical trial to the Unites States Food and Drug Administration ("FDA") by the end of 2014. In parallel, we will pursue publishing the data in a peer-reviewed journal. An FDA approval, coupled with published data, is the key to securing reimbursement from third-party payors such as the Centers for Medicare and Medicaid Services, and other large private payors. We anticipate commercializing the resulting DFU product mid-2016.

Acquisition of Medtronic’s MicroFrance and Xomed Manual ENT and Laparoscopy Instrumentation Lines
Subsequent to September 30, 2014, on October 27, 2014 , the Company completed a stock and asset purchase agreement (the “Purchase Agreement”) with Medtronic, Inc. (“Medtronic”), a Minnesota corporation and Medtronic Xomed Instrumentation, SAS (“Medtronic MicroFrance”), a French corporation and an indirect wholly-owned subsidiary of Medtronic, for the acquisition by the Company of all of the capital stock of Medtronic MicroFrance and certain assets of Medtronic and its affiliates related to Medtronic MicroFrance’s business (collectively the "MicroFrance Acquisition").
Medtronic MicroFrance is engaged in the business of developing, manufacturing, marketing and distributing reusable handheld surgical instrument products, which are specialized for ear, nose and throat ("ENT") and laparoscopic procedures and providing related services.
Under the terms of the Purchase Agreement, the Company paid Medtronic a net purchase price of approximately $60.0 million for the stock and assets acquired subject to a purchase price adjustment for certain working capital changes. The Company also entered into a distribution agreement, an independent sales representative agreement, and a supply agreement with an affiliate of Medtronic at the closing. In addition, the Company entered into a transition services agreement with Medtronic at the closing. The Company has not yet performed the purchase price allocation, and will do so during the fourth quarter.

Spine Business Spinoff and Organizational Changes


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Subsequent to September 30, 2014, on November 3, 2014, we announced our plan for 2015 to spinoff our spine business, and realign the remaining business into two global reporting segments.  The spinoff will create a separate, independent medical technology company focused on developing, marketing and selling spine hardware and orthobiologics.  The realignment of our remaining business will result in two globally managed divisions, with one providing Specialty Surgical Solutions and the other Orthopedics and Tissue Technologies.  These moves to align the portfolio are part of a broader strategy to transform the business that includes optimization and accelerating growth. 

Spinoff of the Spine Business

Under the proposed plan, the spine business will spinoff from Integra and operate as an independent, publicly held company. The new spine company will have a comprehensive portfolio of spinal hardware solutions, including unique interbody devices, minimally invasive surgery, and deformity, and a top-three orthobiologics offering, including a full range of osteoconductive and osteoinductive solutions utilizing unique demineralized bone, collagen and synthetic matrices.

The spinoff transaction is expected to take the form of a tax-free distribution to Integra shareholders of publicly traded stock in the new spine company. The transaction is expected to be completed within twelve months, subject to certain customary and other conditions, including final approval by the Integra Board of Directors, confirmation of the tax-free nature of the transaction, and the effectiveness of a registration statement that will be filed with the Securities and Exchange Commission, including information about the separation, distribution and related matters. While we expect any spinoff transaction to close within twelve months, there can be no assurances regarding the ultimate timing of the transaction or that the transaction will be completed.

We expect to incur one-time charges related to the transaction during the reporting periods preceding the separation and do not otherwise expect this to impact our financial results in 2014.


Alignment of Integra Portfolio: Creating the Specialty Surgical Solutions Division

In addition to the above announced separation of the Spine business in a separate publicly traded company, in 2015 we plan to realign the remaining business into 2 global reporting segments, Specialty Surgical Solutions and Orthopedics and Tissue Technologies. The new Specialty Surgical Solutions organization will integrate globally what today are the Neurosurgery and Instruments businesses within Integra. Robert T. Davis, Jr., CVP, President, Specialty Surgical Solutions, will lead this newly-created division. The new global Specialty Surgical Solutions division will leverage Integra’s market-leading positions in both neurosurgery and instruments and will open up a larger potential market in which this business can achieve its communicated growth trajectory.

In addition, Mark Augusti, CVP, President, Orthopedics and Tissue Technologies, will also take on global responsibility for that division. Dan Reuvers, CVP, President, International, will continue to run an International region management structure to prioritize and focus Integra’s investments in International markets.

RESULTS OF OPERATIONS
Executive Summary
Net income for the three months ended September 30, 2014 , was $9.8 million , or $0.30 per diluted share as compared with a loss of $30.3 million or $1.09 per diluted share for the three months ended September 30, 2013 .
Net income for the nine months ended September 30, 2014 was $16.8 million , or $0.51 per diluted share as compared with net loss of $34.8 million or $1.25 per diluted share for the nine months ended September 30, 2013 .
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 a non-cash goodwill impairment charge of $46.7 million for our U.S. Spine reporting unit recorded in the quarter ended September 30, 2013. This recall resulted in lost revenues, increased sales reserves, inventory scrap, and costs of remediation at the facility which continued throughout 2013. We resolved the issues relating to the recall by the beginning of the first quarter of 2014, and saw improved margins from DuraSeal revenues; however, the costs associated with closing the Confluent Surgical acquisition and the related integration effort impacted our 2014 financial results.

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Income before taxes includes the following special charges:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
(In thousands)
Global ERP implementation charges
$
4,960

 
$
4,950

 
$
17,976

 
$
18,715

Structural optimization charges
3,490

 
1,360

 
9,203

 
7,030

Manufacturing facility remediation costs
538

 
2,761

 
905

 
7,849

Certain expenses associated with product recalls

 

 

 
1,444

Certain employee severance charges
3,619

 
30

 
8,229

 
30

Discontinued product lines charges
747

 

 
1,460

 

Acquisition-related charges
2,474

 
319

 
7,480

 
993

Impairment charges

 
46,738

 
600

 
46,738

Convertible debt non-cash interest
1,822

 
1,633

 
5,256

 
4,865

  Total
$
17,650

 
$
57,791

 
$
51,109

 
$
87,664


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,
 
2014
 
2013
 
2014
 
2013
 
(In thousands)
Cost of goods sold
$
5,453

 
$
4,050

 
$
12,522

 
$
12,922

Research and development

 

 
500

 

Selling, general and administrative
10,375

 
5,370

 
32,831

 
23,139

Goodwill impairment charge

 
46,738

 

 
46,738

Interest expense
1,822

 
1,633

 
5,256

 
4,865

  Total
$
17,650

 
$
57,791

 
$
51,109

 
$
87,664


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. 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 ("ERP") system. We began capitalizing certain costs for the project starting in 2011 and continued to do so during 2014. We placed the ERP in service across a number of U.S. sites in May of 2014, and at that time we began depreciating the capitalized costs associated with that part of the implementation.
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
The FDA inspected our neurosurgery manufacturing facility in Andover, England in June 2012. On November 5, 2012, we received a warning letter 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. Since the conclusion of the FDA inspection in June 2012, we have remediated the observations that the FDA has made and continue to make further improvements in the quality system. We have received a letter from the FDA on April 28, 2014 stating that the FDA had accepted the Corrective Action Plan which would be verified at an FDA Inspection.

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On February 14, 2013, we received a warning letter from the FDA dated February 13, 2013 relating to quality systems issues at our manufacturing facility located in Añasco, Puerto Rico ("Añasco facility"). 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 facility.
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 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 FDA began an inspection of the Añasco facility. At the end of the inspection on November 26, 2013, the FDA issued a new Form 483 with six additional observations relating to Corrective and Preventative Action (“CAPA”), quality system procedures and instructions, procedures pertaining to complaints, procedures pertaining to checking and maintaining equipment, procedures for finished device acceptance and procedures to prevent contamination of equipment or products. These observations did not impact our ability to manufacture and sell product. On March 4, 2014 we met with the FDA Office of Compliance, San Juan, Puerto Rico District to discuss the Corrective Action and remediation plan at the Añasco facility. We committed to several corporate-wide corrections and additional site corrections at that meeting.
On September 4, 2014, the FDA began a re-inspection of the Añasco facility. This re-inspection focused primarily on the issues raised in the February 2013 Warning Letter and in previous inspections of the Añasco facility relating to quality systems and compliance issues. The inspection was completed on September 30, 2014, and 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.
Over the past several years 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. Our remediation activity expenses during the three and nine months ended September 30, 2014 were $0.5 million and $0.9 million , respectively, and during the three and nine months ended September 30, 2013 , were $2.8 million and $7.8 million , respectively. These costs consist of consulting expenses and other work activities required to complete our remediation activities, and we expect to incur similar types of expenses during the remainder of 2014, albeit at lower spending levels compared to 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,
 
2014
 
2013
 
2014
 
2013
Segment Net Sales
(Dollars in thousands)
U.S. Neurosurgery
$
62,323

 
$
45,114

 
$
177,265

 
$
125,877

U.S. Instruments
39,853

 
43,004

 
116,078

 
121,900

U.S. Extremities
36,746

 
31,831

 
103,083

 
93,802

U.S. Spine and Other
42,015

 
47,408

 
128,168

 
134,889

International *
48,782

 
45,889

 
151,535

 
138,977

Total revenue
229,719

 
213,246

 
676,129

 
615,445

Cost of goods sold
85,974

 
81,767

 
255,333

 
243,208

Gross margin on total revenues
$
143,745

 
$
131,479

 
$
420,796

 
$
372,237

Gross margin as a percentage of total revenues
62.6
%
 
61.7
%
 
62.2
%
 
60.5
%
* 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 Rest of World revenues disclosed in the "Geographic Product Revenues and Operations" section of this document.

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Certain 2013 segment revenues above have been reclassified in order to conform with the current year's presentation.

Three Months Ended September 30, 2014 as Compared to Three Months Ended September 30, 2013
Revenues and Gross Margin
For the three months ended September 30, 2014 total revenues increased by $ 16.5 million to $229.7 million from $213.2 million for the same period in 2013 .
U.S. Neurosurgery revenues were $62.3 million , an increase of 38% from the prior-year period. The increase largely resulted from the impact of the DuraSeal product sales arising out of the Confluent Surgical acquisition, which added $13.9 million in the quarter. We also saw increases from neuro critical care and tissue ablation product lines, which benefited from strong sales of capital equipment in the quarter.
U.S. Instruments revenues were $39.9 million , a decrease of 7% from the prior-year period. The decrease impacted all instrument franchises as hospital spending is still cautious, and as hospitals are beginning to focus more on repairing old instruments versus replacing them. The decrease also resulted from product discontinuances.
U.S. Extremities revenues were $36.7 million , an increase of 15% from the prior-year period. This increase resulted primarily from dermal and wound care franchise, as a result of adding new salespeople and the launch of the Integra Wound Matrix-Thin product, and from our shoulder business as a result of the launch of new shoulder lines and adding new distributors.
U.S. Spine and Other revenues, which include our spine hardware, orthobiologics and private label products, were $42.0 million , a 11% decrease from the prior-year period. Our private label business was a large driver of the decrease because the comparable quarter last year was unusually high as we increased capacity once the backorder from the 2013 recall subsided. Our overall spine business was down 3%, resulting from fewer overall spine procedures partially offset by smaller increases in orthobiologics revenues.
International segment revenues were $48.8 million , an increase of 6% from the prior-year period, spread evenly across both the EMEA and LAPAC divisions. This increase primarily resulted from the incremental impact of DuraSeal product sales, and increased skin and would sales. Foreign currency also reduced our sales by $0.1 million when compared to the same quarter last year. These contributions to increasing sales were largely offset by weak spine sales and product discontinuances.
Gross margin increased to $143.7 million for the three-month period ended September 30, 2014 from $131.5 million for the same period last year. Gross margin as a perce