INTEGRA LIFESCIENCES HOLDINGS CORP (Form: 10-Q, Received: 10/26/2017 16:25:11)
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, 2017
or
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, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company,” and "emerging growth 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
 
 
 
 
Emerging growth company
o
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   o     No   ý
The number of shares of the registrant’s Common Stock, $0.01 par value, outstanding as of October 24, 2017 was 78,477,437 .



Table of Contents

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
INDEX
 

 
Page
Number
 
 
 
 
 
Condensed Consolidated Statements of Operations and Comprehensive Income for the three and nine months ended September 30, 2017 and 2016 (Unaudited)
 
 
Condensed Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016 (Unaudited)
 
 
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2017 and 2016 (Unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 5. Other Information
 
 
 
 
 
 
 
 
 
 
 
 
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,
 
2017
 
2016
 
2017
 
2016
Total revenue, net
$
278,834

 
$
250,332

 
$
819,634

 
$
736,411

Costs and expenses:
 
 
 
 
 
 

Cost of goods sold
101,757

 
89,329

 
287,340

 
263,667

Research and development
15,034

 
15,124

 
46,275

 
44,254

Selling, general and administrative
145,945

 
112,317

 
433,457

 
343,510

Intangible asset amortization
5,456

 
3,467

 
14,976

 
10,410

Total costs and expenses
268,192

 
220,237

 
782,048

 
661,841

Operating income
10,642

 
30,095

 
37,586

 
74,570

Interest income
89

 
2

 
160

 
14

Interest expense
(6,761
)
 
(6,295
)
 
(18,073
)
 
(19,255
)
Other (expense) income, net
(735
)
 
1,192

 
(3,691
)
 
(398
)
Income before income taxes
3,235

 
24,994

 
15,982

 
54,931

Income tax expense (benefit)
76

 
4,850

 
(4,406
)
 
8,615

Net income
$
3,159

 
$
20,144

 
$
20,388

 
$
46,316

 
 
 
 
 
 
 
 
Net income per share
 
 
 
 
 
 
 
Basic
$
0.04

 
$
0.27

 
$
0.27

 
$
0.62

Diluted
$
0.04

 
$
0.25

 
$
0.26

 
$
0.59

 
 
 
 
 
 
 
 
Weighted average common shares outstanding (See Note 10):
 
 
 
 
 
 
 
Basic
78,186

 
74,534

 
76,387

 
74,286

Diluted
79,455

 
81,032

 
78,973

 
78,804

Comprehensive income (See Note 11)
$
13,534

 
$
23,410

 
$
53,759

 
$
53,908



The accompanying unaudited 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, except per share amount)
 
 
September 30, 2017
 
December 31, 2016
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
481,943

 
$
102,055

 Trade accounts receivable, net of allowances of $6,969 and $6,319
171,126

 
148,186

Inventories, net
232,340

 
217,263

Prepaid expenses and other current assets
59,534

 
27,666

  Total current assets
944,943

 
495,170

Property, plant and equipment, net
232,241

 
222,369

Intangible assets, net
634,052

 
561,175

Goodwill
587,943

 
510,571

Deferred tax assets, net
6,351

 
6,935

Other assets
12,657

 
11,734

Total assets
$
2,418,187

 
$
1,807,954

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Short-term portion of borrowings under senior credit facility
$
18,750

 
$

Accounts payable, trade
40,740

 
29,057

Deferred revenue
7,668

 
6,812

Accrued compensation
59,621

 
52,762

Accrued expenses and other current liabilities
83,455

 
34,970

  Total current liabilities
210,234

 
123,601

Long-term borrowings under senior credit facility
1,152,633

 
665,000

Deferred tax liabilities
128,628

 
148,941

Other liabilities
13,576

 
30,745

Total liabilities
1,505,071

 
968,287

Commitments and contingencies

 

Stockholders’ equity:
 
 
 
Preferred stock; no par value; 15,000 authorized shares; none outstanding

 

Common stock; $0.01 par value; 240,000 authorized shares; 81,301 and 77,666 issued at September 30, 2017 and December 31, 2016, respectively
813

 
777

Additional paid-in capital
817,071

 
798,652

Treasury stock, at cost; 2,916 shares and 2,946 shares at September 30, 2017 and December 31, 2016, respectively
(121,816
)
 
(123,051
)
Accumulated other comprehensive loss
(23,783
)
 
(57,154
)
Retained earnings
240,831

 
220,443

Total stockholders’ equity
913,116

 
839,667

Total liabilities and stockholders’ equity
$
2,418,187

 
$
1,807,954


The accompanying unaudited 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,
 
2017
 
2016
 
 
 
 
OPERATING ACTIVITIES:
 
 
 
Net income
$
20,388

 
$
46,316

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
62,281

 
54,353

Non-cash impairment charges
3,290

 

Deferred income tax
(935
)
 
(2,919
)
Amortization of debt issuance costs
1,178

 
1,623

Non-cash interest expense

 
6,300

Realized loss on sale of short-term investment
2,287

 

Loss on disposal of property and equipment
443

 
1,046

Change in fair value of contingent consideration and other
(2,773
)
 
81

Share-based compensation
16,359

 
12,773

Changes in assets and liabilities, net of business acquisitions:
 
 
 
Accounts receivable
(9,861
)
 
(8,100
)
Inventories
(862
)
 
(9,061
)
Prepaid expenses and other current assets
(14,691
)
 
1,051

Other non-current assets
(1,977
)
 
(552
)
Accounts payable, accrued expenses and other current liabilities
24,021

 
5,831

Deferred revenue
1,405

 
1,381

Other non-current liabilities
2,442

 
(247
)
Net cash provided by operating activities
102,995

 
109,876

INVESTING ACTIVITIES:
 
 
 
Purchases of property and equipment
(29,806
)
 
(26,136
)
Proceeds from sale of short-term investments
16,951

 

Proceeds from note receivable
483

 

Proceeds from sale of property and equipment
157

 
266

Cash used in business acquisition, net of cash acquired
(225,552
)
 

Cash received from business acquisition purchase price adjustment

 
225

Change in restricted cash

 
4,165

Net cash used in investing activities
(237,767
)
 
(21,480
)
FINANCING ACTIVITIES:
 
 
 
Borrowings under senior credit facility
571,383

 
15,000

Repayments under senior credit facility
(65,000
)
 
(48,750
)
Net cash paid for contingent consideration
(4,661
)
 

Principal payments under capital lease obligations

 
(487
)
Proceeds from exercised stock options
9,774

 
9,925

Cash taxes paid in net equity settlement
(6,763
)
 
(4,567
)
Net cash provided by (used in) financing activities
504,733

 
(28,879
)
Effect of exchange rate changes on cash and cash equivalents
9,927

 
(51
)
Net increase in cash and cash equivalents
379,888

 
59,466

Cash and cash equivalents at beginning of period
102,055

 
48,132

Cash and cash equivalents at end of period
$
481,943

 
$
107,598


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

5

Table of Contents

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

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, 2017 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, 2016 included in the Company’s Annual Report on Form 10-K. The December 31, 2016 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, 2017 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 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.
Amendment to the Certificate of Incorporation and Stock Split
On October 25, 2016, the Board of Directors recommended, subject to stockholder approval, an Amendment to the Company’s Certificate of Incorporation (the “Amendment”) to increase the number of authorized shares of common stock from 60.0 million shares to 240.0 million shares with $0.01 per share par value, for the purpose of, among other things, effecting a two-for-one stock split. The stockholders approved the Amendment at its special meeting of stockholders on December 21, 2016, and the Company subsequently filed a certificate of amendment to its Amended and Restated Certificate of Incorporation to effect the increase in the number of authorized shares of common stock and the two-for-one-stock split. Stockholders of record, as of the close of market on December 21, 2016, became entitled to receive one additional share of common stock for each share held. The shares were distributed on January 3, 2017. No fractional shares of common stock were issued as a result of the stock split. The adjusted stock price was reflected on the NASDAQ stock market beginning on January 4, 2017.
The shares of common stock retain a par value of $0.01 per share. Accordingly, the stockholders' equity reflects the stock split by reclassifying from "additional paid-in capital" to "common stock" an amount equal to the par value of the increased shares resulting from the stock split. All share and per share amounts of common stock contained in the Company's financial statements have been restated for all periods to give retroactive effect to the stock split.
Johnson & Johnson's Codman Neurosurgery Business
On February 14, 2017, the Company entered into a binding offer letter (the “Offer Letter”) with DePuy Synthes, Inc., a Delaware corporation (“DePuy Synthes”), a wholly-owned subsidiary of Johnson & Johnson, pursuant to which Integra made a binding offer to acquire certain assets, and assume certain liabilities, of Johnson & Johnson’s Codman neurosurgery business (the “Codman Acquisition”). The assets and liabilities subject to the proposed Codman Acquisition relate to the research, development, manufacture, marketing, distribution and sale of certain products used in connection with neurosurgery procedures. The purchase price for the Codman Acquisition is $1.014 billion , subject to adjustments set forth in the Purchase Agreement (as defined below) relating to the book value of inventory transferred to the Company at the closing of the Codman Acquisition, the book value of certain inventory retained by DePuy Synthes and the amount of certain prepaid taxes.

6

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

Pursuant to the terms of the Offer Letter, following the conclusion of certain statutory information or consultation processes in connection with the Codman Acquisition by the employees of DePuy Synthes and its affiliates in France, Switzerland, and Germany, on May 11, 2017, DePuy Synthes accepted the Company’s offer and countersigned the Asset Purchase Agreement (the “Purchase Agreement”) with respect to the Codman Acquisition, previously executed by the Company. On October 2, 2017, the Company completed the Codman Acquisition. See Note 14 - Subsequent Events.
Assets and Liabilities Held for Sale
The Company considers assets and liabilities to be held for sale when management approves and commits to a formal plan to actively market the assets and liabilities for sale, the assets and liabilities are available for immediate sale in their present condition, an active program to locate a buyer and other actions required to complete the sale have been initiated, the sale of the assets and liabilities are expected to be completed within one year, the assets and liabilities are being actively marketed for sale at a price that is reasonable in relation to its current fair value and it is unlikely that significant changes will be made to the plan. Upon designation of the assets and liabilities as held for sale, the Company records the assets at the lower of their carrying value or their estimated fair value, less estimated costs to sell. Assets held for sale are not depreciated. Any loss resulting from this measurement is recognized in the period in which the held for sale criteria are met and gains are not recognized until the date of sale. The Company assesses the fair value of assets held for sale less any costs to sell each reporting period it remains classified as held for sale and reports any reduction in fair value as an adjustment to the carrying value of the assets held for sale.
To facilitate the Company’s planned acquisition of the Codman Neurosurgery Business, the Company identified certain assets and liabilities related to the Camino® Intracranial Pressure monitoring product line within its Specialty Surgical Solutions segment as Assets and Liabilities Held for Sale as of June 30, 2017 when all of the criteria above were met. On August 31, 2017, the Company identified additional assets and liabilities related to the Company's U.S. rights to the fixed pressure shunts product line within its Special Surgical Solutions segment as Assets and Liabilities Held for Sale.

Assets and liabilities held for sale consisted of the following as of September 30, 2017 (amounts in thousands):
Inventories
$
7,957

Property, plant and equipment, net
883

Goodwill
2,861

Total assets held for sale
$
11,701

 
 
Deferred revenue
$
909

Accrued compensation
197

Total liabilities held for sale
$
1,106


Goodwill was allocated to the assets and liabilities held for sale using the relative fair value method. Assets held for sale were included in prepaid expenses and other current assets and liabilities held for sale were included in accrued expenses and other current liabilities in the consolidated balance sheet. The Company recognized no losses in its consolidated statement of operations for the three and nine months ended September 30, 2017 .
On September 8, 2017, the Company and certain of its subsidiaries entered into an asset purchase agreement (the “Divestiture Agreement”) with Natus Medical Incorporated (“Natus”), pursuant to which the Company agreed to divest its Camino Intracranial Pressure monitoring and the U.S. rights to its fixed pressure shunts businesses together with certain neurosurgery assets acquired as part of the Codman Acquisition (the “Divestiture”). The Divestiture Agreement was entered into in connection with the review of the Codman Acquisition by the Federal Trade Commission and the antitrust authority of Spain. The Divestiture was completed on October 6, 2017. See Note 14 - Subsequent Events.
Recently Issued Accounting Standards
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 will become effective for all annual periods and interim reporting periods beginning after December 15, 2017.

7

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

The Company will adopt this standard on January 1, 2018. The Company expects to apply the full retrospective method of adoption. The Company is progressing with the implementation and continues to evaluate the impact of the standard’s revenue recognition model on business processes, accounting systems, controls and financial statement disclosures. The Company has reviewed a sample of contracts with customers and does not expect the adoption of Accounting Standard Update ("ASU") 2014-09 to have a material impact on the amount or timing of revenues recognized. That said, the Company’s initial conclusion could change as the implementation is finalized.
In July 2015, the FASB issued Update No. 2015-11, Simplifying the Measurement of Inventory . The amendment requires an entity to measure inventory that is within the scope of this amendment at the lower of cost and net realizable value. Existing impairment models will continue to be used for inventories that are accounted for using the last-in first-out (“LIFO”) method. The ASU requires prospective adoption for inventory measurements for fiscal years beginning after December 15, 2016 and interim periods within those fiscal years for public business entities. Early adoption was permitted. The Company adopted ASU 2015-11 as of January 1, 2017 on a prospective basis, and there was no significant impact of this guidance on its consolidated financial statements.
In February 2016, the FASB issued Update No. 2016-02, Leases (Topic 842) . Under current accounting guidance, an entity is not required to report operating leases on the balance sheet. The amendment requires that lessees recognize virtually all of their leases on the balance sheet by recording a right-of-use asset and lease liability (other than leases that meet the definition of a "short-term lease"). This update will become effective for all annual periods and interim reporting periods beginning after December 15, 2018. The new standard must be adopted using a modified retrospective transition. Early adoption is permitted. The Company is in the process of evaluating the impact of this standard on its financial statements.
In August 2016, the FASB issued Update No. 2016-15, Classification of Certain Cash Receipts and Cash Payments . The guidance addresses the classification of cash flows related to debt repayment or extinguishment costs, settlement of zero-coupon debt instruments or debt instruments with coupon rates that are insignificant in relation to the effective interest rate of the borrowing, contingent consideration payments made after business combination, proceeds from the settlement of insurance claims and corporate-owned life insurance, distribution received from equity method investees and beneficial interest in securitization transaction. This update will become effective for all annual periods and interim reporting periods beginning after December 15, 2017. Early adoption is permitted. The Company does not expect the adoption of ASU 2016-15 to have a material impact on its consolidated financial statements.
In October 2016, the FASB issued Update No. 2016-16, Intra-Entity Transfers of Assets Other Than Inventory. The guidance requires the income tax consequences of intra-entity transfers of assets other than inventory to be recognized as current period income tax expense or benefit and removes the requirement to defer and amortize the consolidated tax consequences of intra-entity transfers. The new standard will be effective for all annual periods beginning after December 15, 2017. The Company does not expect the adoption of ASU 2016-16 to have a material impact on its consolidated financial statements.
In January 2017, the FASB issued Update No. 2017-01, Business Combinations . The standard provides guidance for evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The guidance provides a screen to determine when an integrated set of assets and activities (a “set”) does not qualify to be a business. The screen requires that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in an identifiable asset or a group of similar identifiable assets, the set of assets and activities is not a business. If the screen is not met, the guidance requires a set of assets and activities to be considered a business and to include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create outputs and removes the evaluation as to whether a market participant could replace the missing elements. The new standard will be effective for all annual periods beginning after December 15, 2017. Early adoption is permitted. The Company elected to early adopt ASU 2017-01 effective January 1, 2017. The implementation of the amended guidance did not have any material impact on the Company's consolidated financial statements.
In January 2017, the FASB issued Update 2017-04, Simplifying the Test for Goodwill Impairment . The standard eliminates the second step in the goodwill impairment test, which requires an entity to determine the implied fair value of the reporting unit’s goodwill. Instead, an entity should recognize an impairment loss if the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, with the impairment loss not to exceed the amount of goodwill allocated to the reporting unit. The standard is effective for annual and interim goodwill impairment tests conducted in fiscal years beginning after December 15, 2019. Early adoption is permitted. The Company elected to early adopt ASU 2017-04 effective January 1, 2017 and applied the new guidance in its annual assessment in the third quarter of 2017. The Company performed its annual goodwill impairment assessment as of July 31, 2017. The Company elected to perform a qualitative analysis for its reporting units. The Company determined, after performing the qualitative analysis, that there was no evidence that it is more likely than not that the fair value of any identified reporting unit was less than the carrying amount, and therefore, it was not necessary to perform quantitative analysis for any reporting units.


8

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

In May 2017, the FASB issued ASU 2017-09, Stock Compensation (Topic 718): Scope of Modification Accounting . The update to provide clarity and reduce both (1) diversity in practice and (2) cost and complexity when applying the guidance in Topic 718, Compensation-Stock Compensation, to a change to the terms or conditions of a share-based payment award. The new standard will be effective for all annual periods beginning after December 15, 2017. Early adoption is permitted. The Company does not expect the adoption of ASU 2017-09 to have a material impact on its consolidated financial statements.

In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities . This update amends the hedge accounting rules to simplify the application of hedge accounting guidance and better portray the economic results of risk management activities in the financial statements. The guidance expands the ability to hedge nonfinancial and financial risk components, reduces complexity in fair value hedges of interest rate risk, eliminates the requirement to separately measure and report hedge ineffectiveness, as well as eases certain hedge effectiveness assessment requirements. This update will become effective for all annual periods and interim reporting periods beginning after December 15, 2018. Early adoption is permitted. The Company is in the process of evaluating the impact of this standard on its financial statements.
There are no other recently issued accounting pronouncements that are expected to have a material effect on the Company's financial position, results of operations or cash flows.

2. BUSINESS ACQUISITION
TGX Medical
On April 4, 2017, the Company entered into a Membership Interest Purchase Agreement (the "Purchase Agreement"), by and among the Company, MCF I LP THX Medical System LLC Holdings, Inc., Terragraphix, Inc. and TGX Medical Systems, LLC (collectively, "TGX Medical"). Pursuant to the Purchase Agreement, the Company purchased all issued and outstanding membership interests in TGX Medical for $5.4 million , including a $0.1 million adjustment made in the third quarter of 2017 related to additional closing costs incurred by TGX Medical.
TGX Medical designs, develops and markets software solutions that track surgical instruments from the operating room, through sterilization to storage, which helps ensure that the instruments have been properly cleaned, assembled and maintained. TGX Medical’s customers are located in the U.S. and Canada.
The Company recorded revenue for TGX Medical of approximately $0.2 million and $0.4 million in the condensed consolidated statements of operations and comprehensive income for three and nine months ended September 30, 2017 , respectively. The net income or loss attributable to this acquisition cannot be identified on a stand-alone basis because it is in the process of being integrated into the Company's operations.
The following summarizes the preliminary allocation of the purchase price as of September 30, 2017 based on the fair value of the assets acquired and liabilities assumed:
 
Preliminary Purchase Price
Allocation
 
 
(Dollars in thousands)

 
Cash and cash equivalents
$
49

 
Accounts receivables
279

 
Property, plant and equipment
3

 
Intangible assets:
 
Wtd. Avg. Life:

Completed technology
4,707

13 Years
Goodwill
641

 
Total assets acquired
5,679

 
Accounts payable
13

 
Accrued expenses and other current liabilities
65

 
Other liabilities
234

 
Net assets acquired
$
5,367

 
Goodwill was allocated to the Special Surgical Solutions segment. Goodwill is the excess of the consideration transferred over the net assets recognized and represents the expected revenue and cost synergies of the combined company and assembled workforce. Goodwill recognized as a result of the acquisition is not deductible for income tax purposes.


9

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

Derma Sciences
On February 24, 2017, the Company executed the Agreement and Plan of Merger (the "Merger Agreement") under which the Company acquired all of the outstanding shares of Derma Sciences, Inc., a Delaware corporation ("Derma Sciences") for an aggregate purchase price of approximately $210.8 million , including payment of certain of Derma Sciences' closing expenses and settlement of stock-based compensation plans of $4.8 million and $4.3 million , respectively. The purchase price consisted of a cash payment to the former shareholders of Derma Sciences of approximately $201.7 million upon the closing of the transaction.
Derma Sciences is a tissue regeneration company focused on advanced wound and burn care that offers products to help manage chronic and hard-to-heal wounds, especially those resulting from diabetes and poor vascular functioning.
The Company recorded revenue for Derma Sciences of approximately $24.1 million and $58.4 million in the condensed consolidated statements of operations and comprehensive income for the three and nine months ended September 30, 2017 , respectively. The net income or loss attributable to this acquisition cannot be identified on a stand-alone basis because it has been integrated into the Company's operations.
The following summarizes the preliminary allocation of the purchase price as of September 30, 2017 based on the fair value of the assets acquired and liabilities assumed:
 
 Preliminary Purchase Price
Allocation
 
 
(Dollars in thousands)
 
Cash and cash equivalents
$
16,512

 
Short-term investments
19,238

 
Accounts receivable
8,949

 
Inventory
17,977

 
Prepaid expenses and other current assets
4,369

 
Property, plant and equipment
4,311

 
Intangible assets:
 
Wtd. Avg. Life:
Customer relationship
78,300

14 years
Trademarks/brand names
13,500

15 years
Completed technology
11,600

14 years
Non-compete agreement
280

1 year
Goodwill
70,424

 
Deferred tax assets
17,865

 
Other assets
101

 
Total assets acquired
263,426

 
Accounts payable
4,560

 
Accrued expenses and other current liabilities
7,409

 
Contingent liability
37,174

 
Other liabilities
3,805

 
     Net assets acquired
$
210,478

 
Goodwill was allocated to the Orthopedics and Tissue Technologies segment. Goodwill is the excess of the consideration transferred over the net assets recognized and represents the expected revenue and cost synergies of the combined company and assembled workforce. Goodwill recognized as a result of the acquisition is not deductible for income tax purposes.
In the second quarter of 2017, the Company adjusted its preliminary purchase price allocation of other liabilities by $1.7 million because of additional liabilities for sales and use tax, employment tax and unclaimed property. In the third quarter of 2017, the Company adjusted the purchase price and goodwill by $0.3 million , as a result of cash received from escrow related to the acquisition of BioD LLC ("BioD") by Derma Sciences. BioD is a wholly owned subsidiary of Derma Sciences.

10

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

Short-term Investments
Short-term investments recognized at the acquisition date of Derma Sciences are investments in equity and debt securities including certificates of deposit purchased with an original maturity greater than three months which are deposited in various U.S. financial institutions and are fully insured by the Federal Deposit Insurance Corporation. The Company considers securities with original maturities of greater than 90 days to be available for sale securities. Securities under this classification are recorded at fair value and unrealized gains and losses are recorded within accumulated other comprehensive income. The estimated fair value of the available for sale securities is determined based on quoted market prices. The Company evaluates securities with unrealized losses to determine whether such losses, if any, are other than temporary. Short-term investments are classified as Level 1 in fair value hierarchy. Fair values of short-term investments are determined using the unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the balance sheet date.
In the second quarter of 2017 , the Company sold the acquired short-term investments and recognized a realized loss of $2.3 million included in other expense, net in the consolidated statement of operations.
Deferred Taxes
The acquired deferred taxes of $17.9 million include a deferred tax asset of $39.7 million related to a federal net operating loss which the Company expects to utilize against income in future periods, a deferred tax asset of $15.8 million related to intangibles acquired by Derma Sciences in previous periods, and a deferred tax asset of $0.7 million related to various deferred items, offset by a deferred tax liability of $38.3 million for new intangibles for which the Company will not receive a tax benefit. In second quarter of 2017, the Company increased the preliminary estimated value of deferred tax liability by $1.5 million to reflect the adjustments to preliminary estimated fair values of assets and liabilities acquired.
United States Food and Drug Administration ("FDA") Untitled Letter
On June 22, 2015, the FDA issued an Untitled Letter (the "Untitled Letter") alleging that BioD morselized amniotic membrane based products do not meet the criteria for regulation as human cellular tissue-based products (“HCT/Ps”) solely under Section 361 of the Public Health Service Act and that, as a result, BioD would need a biologics license to lawfully market those morselized products. Since the issuance of the Untitled Letter, BioD and now the Company had and plan to continue discussions with the FDA to communicate its disagreement with the FDA’s assertion that certain products are more than minimally manipulated and therefore do not meet the requirements for HCT/Ps. To date, the FDA has not changed its position that certain of the acquired morselized products are not eligible for marketing solely under Section 361 of the Public Health Service Act. The Company continues to market these products.

On December 22, 2014, the FDA issued for comment “Draft Guidance for Industry and FDA Staff: Minimal Manipulation of Human Cells, Tissues, and Cellular and Tissue-Based Products.” On October 28, 2015, the FDA issued for comment, "Draft Guidance for Industry and FDA Staff: Homologous Use of Human Cells, Tissues, and Cellular and Tissue-Based Products." The FDA held a public hearing on September 12 and 13, 2016 to obtain input on the Homologous Use draft guidance and the Minimal Manipulation draft guidance, as well as other recently issued guidance documents on HCT/Ps.

If the FDA does allow us to continue to market its morselized products without a 510(k) or biologics license either prior to or after finalization of the draft guidance documents, it may impose conditions on marketing, such as labeling restrictions and compliance with current Good Manufacturing Practices. Compliance with these conditions would require significant additional time and cost investments from us. It also is possible that the FDA will not allow us to market any form of a morselized product without a biologics license even prior to finalization of the draft guidance documents and could require us to recall our morselized products. We continue to market these products. The Company continues to monitor the FDA's position on these products. Any potential action of the FDA could have a financial impact on the sales of BioD’s morselized amniotic tissue-based products. Revenues from BioD morselized amniotic material based products for the three and nine months ended September 30, 2017 were less than 1.0% of consolidated revenues.

Contingent Consideration

The Company assumed contingent consideration incurred by Derma Sciences related to its acquisitions of BioD and the intellectual property related to the Medihoney product. The Company accounted for the contingent liabilities by recording their fair value on the date of the acquisition based on a discounted cash-flow model. The contingent liabilities recognized as part of the Derma Sciences acquisition relate to the following:

i.
contractual incentive payments that could be made to former equity owners of BioD if net sales of BioD products exceed a certain amount for the twelve-month periods ending June 30, 2017 and 2018 ("BioD Earnout Payments");

11

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

ii.
a contractual incentive payment that could be made to the former equity owners if there has been no specific enforcement action or notice by the FDA against the specific BioD products as a result of the Untitled Letter for a certain period after closing as defined by the agreement ("Product Payment"); and
iii.
contractual incentive payments that could be made to the former owner of the intellectual property relating to the Medihoney product line, if net sales of Medihoney products exceed certain amounts defined in the agreement between Derma Sciences and the former owner of the intellectual property of Medihoney for any twelve-month period ("Medihoney Earnout Payments").
At the date of the acquisition, net sales used in estimating the BioD Earnout Payments is based on the weighted average of different possible scenarios using revenue volatility of 13.5% . The BioD Earnout Payments were valued using a discount rate of 3.0% . The maximum payout related to the BioD Earnout Payments is $26.5 million . The estimated fair value as of February 24, 2017 was $9.1 million . In August 2017, the Company paid $4.8 million for the twelve-month period ending June 30, 2017 component of the BioD Earnout Payments. As of September 30, 2017 , the estimated fair value of the remaining portion of the BioD Earnout Payments is $2.1 million .
At the date of acquisition, the Company estimated that the probability of the Product Payment was 98.0% and valued it at a discount rate of 2.5% . The maximum payout related to the Product Payment is $29.7 million . The estimated fair value as of February 24, 2017 was $26.8 million . In the second quarter of 2017, the Company adjusted the preliminary estimated fair value to increase the Product Payment by $0.9 million related to additional products that should have been included in the preliminary estimate based on the Merger Agreement. On May 25, 2017, the Company made full payment for the Product Payment of $26.6 million . The payment was included in cash used in business acquisition, net of cash acquired within investing activities in the condensed consolidated statements of cash flows since the payment was made shortly after the acquisition.
At the date of the acquisition, net sales used in estimating the Medihoney Earnout Payments is based on the weighted average of different possible scenarios using revenue volatility of 27.5% . The Medihoney Earnout Payments were valued using a discount rate of 4.5% . The maximum payout related to the Medihoney Earnout Payments is $5.0 million . The estimated fair value as of February 24, 2017 and September 30, 2017 was $1.4 million .
These fair value measurements were based on significant inputs not observed in the market and thus represented a Level 3 measurement. The contingent considerations are re-measured to fair value at each reporting date until the contingency is resolved, and those changes in fair value are recognized in earnings. Depending on the expected timing of the estimated payments, the acquisition date fair values and subsequent remeasurement could be different.
Pro Forma Results
The following unaudited pro forma financial information summarizes the results of operations for the three months ended September 30, 2016 and for the nine months ended September 30, 2017 and 2016 as if the acquisitions had been completed as of the beginning of the prior year. 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 and intangible asset amortization, (ii) certain external expenses related to the acquisition as if they were incurred on January 1 of the year prior to the acquisition that will not be recurring in the post-acquisition periods, which includes $2.9 million incurred by Derma Sciences prior to acquisition and $12.5 million incurred by Integra, 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.
 
Three Months Ended September 30, 2016
 
Nine Months Ended September 30,
 
 
2017
 
2016
 
(In thousands, except per share amounts)
Total revenue
$
272,427

 
$
832,710

 
$
792,672

Net income
$
18,318

 
$
24,091

 
$
32,180

Basic income per share
$
0.25

 
$
0.32

 
$
0.43



12

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

3. INVENTORIES
Inventories, net consisted of the following:
 
September 30, 2017
 
December 31, 2016
 
(In thousands)
Finished goods
$
136,729

 
$
127,973

Work in process
47,257

 
50,043

Raw materials
48,354

 
39,247

 
$
232,340

 
$
217,263



4. GOODWILL AND OTHER INTANGIBLE ASSETS

Changes in the carrying amount of goodwill for the nine -month period ended September 30, 2017 were as follows:
 
Specialty
Surgical
Solutions
 
Orthopedics and
Tissue Technologies
 
Total
 
(In thousands)
Goodwill at December 31, 2016
$
284,358

 
$
226,213

 
$
510,571

Derma Sciences acquisition

 
70,424

 
70,424

TGX Medical acquisition
641

 

 
641

Transfer to assets held for sale
(2,861
)
 

 
(2,861
)
Foreign currency translation
4,400

 
4,768

 
9,168

Balance, September 30, 2017
$
286,538

 
$
301,405

 
$
587,943


The components of the Company’s identifiable intangible assets were as follows:
 
September 30, 2017
 
Weighted
Average
Life
 
Cost
 
Accumulated
Amortization
 
Net
 
(Dollars in thousands)
Completed technology
17 years
 
$
492,380

 
$
(114,996
)
 
$
377,384

Customer relationships
13 years
 
234,020

 
(88,944
)
 
145,076

Trademarks/brand names
28 years
 
105,690

 
(22,336
)
 
83,354

Supplier relationships
27 years
 
34,721

 
(14,735
)
 
19,986

All other  (1)
5 years
 
11,675

 
(3,423
)
 
8,252

 
 
 
$
878,486

 
$
(244,434
)
 
$
634,052


13

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


 
December 31, 2016
 
Weighted
Average
Life
 
Cost
 
Accumulated
Amortization
 
Net
 
(Dollars in thousands)
Completed technology
17 years
 
$
479,964

 
$
(94,991
)
 
$
384,973

Customer relationships
12 years
 
152,335

 
(77,005
)
 
75,330

Trademarks/brand names
30 years
 
90,507

 
(19,158
)
 
71,349

Supplier relationships
27 years
 
34,721

 
(13,664
)
 
21,057

All other  (1)
5 years
 
10,806

 
(2,340
)
 
8,466

 
 
 
$
768,333

 
$
(207,158
)
 
$
561,175

 
(1)  
At September 30, 2017 and December 31, 2016 , all other included in-process research and development ("IPR&D") of $1.0 million in both periods, which was indefinite-lived.

During the third quarter of 2017, the Company recorded an impairment charge of $3.3 million in cost of goods sold related to completed technology assets acquired from Tarsus Medical, Inc. ("Tarsus Technology"), since the underlying product will no longer be sold. Tarsus Technology was included in the Orthopedic and Tissue Technology segment.
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 be approximately $48.4 million in 2017 , $49.1 million in 2018 , $49.0 million in 2019 , $48.9 million in 2020 , $47.9 million in 2021 , $44.4 million in 2022 and $493.7 million thereafter. Identifiable intangible assets are initially recorded at fair market value at the time of acquisition using an income or cost approach.

5. DEBT
Amended and Restated Senior Credit Agreement

On March 31, 2017 , the Company entered into an amendment ("March 2017 Amendment") to its fourth amended and restated Senior Credit Facility agreement with a syndicate of lending banks and Bank of America, N.A., as Administrative Agent. The March 2017 Amendment increased the aggregate principal amount from $1.5 billion to $2.2 billion available to the Company through the following facilities:
i.
a $500.0 million Term Loan A facility;
ii.
a $700.0 million Term Loan A-1, which will be available in a single drawing on a delayed basis at the time of closing of the Codman Acquisition (see Note 1 - Basis of Presentation ); and
iii.
a $1.0 billion revolving credit facility, which includes a $60.0 million sublimit for the issuance of standby letters of credit and a $60.0 million sublimit for swingline loans.

In connection with the March 2017 Amendment, the Company’s maximum consolidated total leverage ratio in the financial covenants was increased to the following:
Fiscal Quarter
 
Maximum Consolidated Total Leverage Ratio
 
 
 
December 31, 2016 through before the first fiscal quarter after the delayed draw date of Term Loan A-1
 
4.50 : 1.00
First fiscal quarter ended after the delayed draw date of Term Loan A-1 through September 30, 2018
 
5.50 : 1.00
October 1, 2018 through September 30, 2019
 
5.00 : 1.00
October 1, 2019 through September 30, 2020
 
4.50 : 1.00
October 1, 2020 and thereafter
 
4.00 : 1.00


14

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

There was no change in the maturity date, which remains at December 7, 2021.
Borrowings under the Senior Credit Facility bear interest, at the Company’s option, at a rate equal to the following:
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 2.00% ), 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 on the use or investment thereof to (b) consolidated EBITDA, as defined in the fourth amended and restated Senior Credit Facility agreement) at the time of the applicable borrowing.

The Company will pay an annual commitment fee ranging from 0.15% to 0.35% , based on the Company's consolidated total leverage ratio, on the amount available for borrowing under the revolving 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, as of September 30, 2017 , the Company was in compliance with all such covenants. The Company capitalized $1.1 million of incremental financing costs in 2017 in connection with the modifications to the Senior Credit Facility.
At September 30, 2017 and December 31, 2016 , there were $671.4 million and $165.0 million outstanding, respectively, under the revolving credit component of the Senior Credit Facility at a weighted average interest rate of 2.9% and 2.2% , respectively. At September 30, 2017 and December 31, 2016 , there was $500.0 million outstanding under the Term Loan A component of the Senior Credit Facility at a weighted average interest rate of 2.8% and 2.2% , respectively. At September 30, 2017 , there was no outstanding balance under the Term Loan A-1 component of Senior Credit Facility. At September 30, 2017 , there was approximately $1.0 billion available for borrowing under the Senior Credit Facility, including the $700.0 million available under the Term Loan A-1 component. On October 2, 2017, the Company drew $700.0 million from the Term Loan A-1 component to fund a portion of the Codman Acquisition. Refer to Note 14 - Subsequent Events.
The fair value of outstanding borrowings of the Senior Credit Facility's revolving credit facility and Term Loan A components at September 30, 2017 was approximately $658.7 million and $490.0 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.

Letters of credit outstanding as of September 30, 2017 and December 31, 2016 totaled $0.6 million . There were no amounts drawn as of September 30, 2017 .
The Company uses interest rate derivative instruments to manage earnings and cash flow exposure to changes in interest rates of the Term Loan A component of the Senior Credit Facility. At September 30, 2017 and December 31, 2016, the notional amounts related to the Company’s interest rate swaps were $400.0 million and $150.0 million , respectively.

15

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

Contractual repayments of the Term Loan A will begin March 31, 2018 and are due as follows:
Year Ended December 31,
 
Principal Repayment
 
 
(In thousands)
2017
 

2018
 
25,000

2019
 
25,000

2020
 
37,500

2021
 
412,500

 
 
$
500,000

The outstanding balance of revolving credit component of the Senior Credit Facility is due on December 7, 2021.
2016 Convertible Senior Notes
On December 15, 2016, the Company extinguished its 1.625% Convertible Senior Notes due in 2016 (the "2016 Convertible Notes") by paying the principal amount of $227.1 million and issued 2.9 million shares of common stock with a fair value of $122.0 million related to excess conversion value. No gain or loss on extinguishment was recognized as a result of the conversion. The Company also received 2.9 million shares of common stock from the exercise of call options with hedge participants with a fair value of $123.1 million at the date of the exercise. The shares of common stock received from the exercise of the call options were held as treasury stock as of December 31, 2016 at a weighted average price of $41.78 for a total of $123.1 million .
The 2016 Convertible Notes were issued on June 15, 2011 with the aggregate principal of $230.0 million and a maturity date of December 15, 2016. The 2016 Convertible Notes bore interest at a rate of 1.625%  per annum payable semi-annually in arrears on December 15 and June 15 of each year. The 2016 Convertible Notes were senior, unsecured obligations and were convertible into cash and, if applicable, shares of its common stock based on a conversion rate defined within the note agreement.
In connection with the issuance of the 2016 Convertible 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 was approximately $28.72 per share, subject to customary anti-dilution adjustments. The initial strike price of the warrant transaction was approximately $35.03 per share, subject to customary anti-dilution adjustments. The strike price of the call transactions and warrant transactions has been adjusted similar to the 2016 Convertible Notes as a result of the spin-off of the Company's spine business in July 2015 to $26.42 per share and $32.22 per share, respectively. The warrants expired on a series of expiration dates from March 2017 to August 2017. For the three and nine months ended September 30, 2017 , the hedge participants exercised 2,089,802 and 8,707,202 warrants, respectively and, as a result, the Company issued 946,323 and 2,839,743 shares of common stock for the three and nine months ended September 30, 2017 , respectively. The Company has no warrants outstanding as of September 30, 2017 .
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, 2016
 
Nine Months Ended September 30, 2016
 
(In thousands)
2016 Notes:
 
 
 
 
Amortization of the discount on the liability component (1)
 
$
2,132

 
$
6,300

Cash interest related to the contractual interest coupon (2)
 
892

 
2,671

Total
 
$
3,024

 
$
8,971

(1) The amortization of the discount on the liability component of the 2016 Notes is presented net of capitalized interest of $0.1 million and $0.2 million for the three and nine months ended September 30, 2016 , respectively.
(2) The cash interest related to the contractual interest coupon on the 2016 Notes is presented net of a minimal amount and $0.1 million of capitalized interest for the three and nine months ended September 30, 2016 , respectively.




16

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

6. DERIVATIVE INSTRUMENTS
Interest Rate Hedging
The Company’s interest rate risk relates to U.S. dollar denominated variable interest rate borrowings. The Company uses interest rate swap derivative instruments to manage earnings and cash flow exposure resulting from changes in interest rates. These interest rate swaps apply a fixed interest rate on a portion of our expected LIBOR-indexed floating-rate borrowings. The Company held the following interest rate swaps as of September 30, 2017 (amounts in thousands):
Hedged Item
 
Current Notional Amount
 
Designation Date
 
Effective Date
 
Termination Date
 
Fixed Interest Rate
 
Floating Rate
 
Estimated Fair Value
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Assets (Liabilities)
Term Loan A
 
$
50,000

 
June 22, 2016
 
December 31, 2016
 
June 30, 2019
 
1.062
%
 
3-month BBA LIBOR
 
$
540

Term Loan A
 
50,000

 
June 22, 2016
 
December 31, 2016
 
June 30, 2019
 
1.062
%
 
3-month BBA LIBOR
 
525

Term Loan A
 
50,000

 
July 12, 2016
 
December 31, 2016
 
June 30, 2019
 
0.825
%
 
1-month USD LIBOR
 
654

Term Loan A
 
50,000

 
February 6, 2017
 
June 30, 2017
 
June 30, 2020
 
1.834
%
 
3-month USD LIBOR
 
(68
)
Term Loan A
 
100,000

 
February 6, 2017
 
June 30, 2017
 
June 30, 2020
 
1.652
%
 
1-month USD LIBOR
 
120

Term Loan A
 
100,000

 
March 27, 2017
 
December 31, 2017
 
June 30, 2021
 
1.971
%
 
1-month USD LIBOR
 
(476
)
Total interested rate derivatives designated as cash flow hedge
 
$
400,000

 
 
 
 
 
 
 
 
 
 
 
$
1,295

The Company designated these derivative instruments as cash flow hedges. The Company records the effective portion of the 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 affected earnings, at which point the effective portion of any gain or loss is 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.
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 is subject to collateral or other security arrangements, and none contain provisions that depend upon the Company’s credit ratings from any credit rating agency.

17

INTEGRA LIFESCIENCES HOLDINGS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (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, 2017 and December 31, 2016 :
 
 
 
Fair Value as of
Location on Balance Sheet (1) :
 
September 30, 2017
 
December 31, 2016
 
 
(In thousands)
Derivatives designated as hedges — Assets:
 
 
 
 
Interest rate swap — Prepaid expenses and other current assets (2)
 
$
825

 
$
242

Interest rate swap — Other assets  (2)
 
$
1,654

 
1,629

 
 
$
2,479

 
$
1,871

Derivatives designated as hedges — Liabilities:
 
 
 
 
Interest rate swap — Accrued expenses and other current liabilities (2)
 
$
1,184

 
$

 
(1)  
The Company classifies derivative assets and liabilities as non-current based on the cash flows expected to be incurred within the following 12 months.
(2)  
At September 30, 2017 and December 31, 2016 , the notional amounts related to the Company’s interest rate swaps were $400.0 million and $150.0 million , respectively. There is no expected reduction in this notional amount in the next twelve months.

18

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

The following presents the effect of derivative instruments designated as cash flow hedges on the accompanying condensed consolidated statement of operations during the three and nine months ended September 30, 2017 and 2016 :
 
 
Balance in AOCI
Beginning of
Quarter
 
Amount of
Gain
Recognized in
AOCI-
Effective Portion
 
Amount of 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, 2017
 
 
 
 
 
 
 
 
 
Interest rate swap
$
935

 
$
297

 
$
(63
)
 
$
1,295

 
Interest (expense)
 
$
935

 
$
297

 
$
(63
)
 
$
1,295

 
 
Three Months Ended September 30, 2016
 
 
 
 
 
 
 
 
 
Interest rate swap
$
(602
)
 
$
618

 
$

 
$
16

 
Interest (expense)
 
$
(602
)
 
$
618

 
$

 
$
16

 
 
 
 
 
 
 
 
 
 
 
 
 
Balance in AOCI
Beginning of
Year
 
Amount of
(Loss) Gain
Recognized in
AOCI-
Effective Portion
 
Amount of 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, 2017
 
 
 
 
 
 
 
 
 
Interest rate swap
$
1,871

 
$
(618
)
 
$
(42
)
 
$
1,295

 
Interest (expense)
 
$
1,871

 
$
(618
)
 
$
(42
)
 
$
1,295

 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2016
 
 
 
 
 
 
 
 
 
Interest rate swap
$

 
$
16

 

 
$
16

 
Interest (expense)
 
$

 
$
16

 
$

 
$
16

 
 

The Company recognized no gains or losses resulting from ineffectiveness of cash flow hedges during the three and nine months ended September 30, 2017 and 2016 . The Company expects a minimal amount of pre-tax income recorded in AOCI related to interest rate hedges to be reclassified to earnings in the next twelve months.


7. STOCK-BASED COMPENSATION
As of September 30, 2017 , the Company had stock options, restricted stock awards, performance stock units, contract stock awards and restricted stock unit awards outstanding under two plans, 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 three to four years from the date of grant for officers and employees, and within a year from date of grant for directors and generally expire eight years from the grant date for employees, and from eight 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, 2017 , there were approximately $4.6 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 three years . There were 186,853 stock options granted during the nine months ended September 30, 2017 .

19

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


Awards of Restricted Stock and Performance Stock

Performance stock and restricted 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 awards on a straight-line basis over the requisite service period. As of September 30, 2017 , there were approximately $23.0 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 347,590 restricted stock awards and 133,333 performance shares during the nine months ended September 30, 2017 .
The Company has no formal policy related to the repurchase of shares for the purpose of satisfying stock-based compensation obligations.
The Company also maintains an Employee Stock Purchase Plan (the “ESPP”), which provides eligible employees with the opportunity to acquire shares of common stock at periodic intervals by means of accumulated payroll deductions. The ESPP is a non-compensatory plan based on its terms.

8. TREASURY STOCK

On October 25, 2016, the Board of Directors terminated its October 2014 authorization for the repurchase of its outstanding common stock and authorized management to repurchase up to $150.0 million of its outstanding common stock through December 2018. Shares may be repurchased either in the open market or in privately negotiated transactions. As of September 30, 2017 , there remained $150.0 million available for repurchase under this authorization.

As part of the conversion of the 2016 Convertible Notes, the Company received 2.9 million shares of common stock from the exercise of call options with hedge participants. The shares of common stock received from the exercise of the call options are held as treasury stock, and there were 2.9 million shares of treasury stock outstanding as of September 30, 2017 and December 31, 2016 , with a cost of $121.8 million and $123.1 million , respectively, at a weighted average of $41.77 and $41.78 per share, respectively.

There were no cash treasury stock repurchases during the nine months ended September 30, 2017 or 2016 .

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,
 
2017
 
2016
 
2017
 
2016
Reported tax rate
2.3
%
 
19.4
%
 
(27.6
)%
 
15.7
%

The Company’s effective income tax rates for the three months ended September 30, 2017 and 2016 were 2.3% and 19.4% , respectively. For the three months ended September 30, 2017 , the primary drivers of the lower tax rate are lower income before income taxes compared to the same period in 2016 , the jurisdictional mix of income before tax in U.S.-based operations relative to foreign operations, offset by a decrease of $0.4 million in excess tax benefits from stock-based compensation compared to the same period in 2016. The change in jurisdictional mix of income primarily results from significant acquisition and integration costs incurred in the U.S. in 2017. The tax rate for the three months ended September 30, 2016 included a benefit of $0.2 million related to the release of uncertain tax positions .

The Company's effective income tax rates for the nine months ended September 30, 2017 and 2016 were (27.6)% and 15.7% , respectively. For the nine months ended September 30, 2017 , the primary drivers of the lower tax rate are lower income before income taxes compared to the same period in 2016 , the jurisdictional mix of income before tax in U.S.-based operations relative to foreign operations, and an increase of $3.7 million in excess tax benefits from stock-based compensation for the nine months ended September 30, 2017 . The change in jurisdictional mix of income results primarily from significant acquisition and integration costs incurred in the U.S. in 2017.





20

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

10. NET INCOME PER SHARE
Basic and diluted net income per share was as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(In thousands, except per share amounts)
Basic net income per share:
 
 
 
 
 
 
 
Net income
$
3,159

 
$
20,144

 
$
20,388

 
$
46,316

Weighted average common shares outstanding
78,186

 
74,534

 
76,387

 
74,286

Basic net income per common share
$
0.04

 
$
0.27

 
$
0.27

 
$
0.62

 
 
 
 
 
 
 
 
Diluted net income per share:
 
 
 
 
 
 
 
Net income
$
3,159

 
$
20,144

 
$
20,388

 
$
46,316

 
 
 
 
 
 
 
 
Weighted average common shares outstanding — Basic
78,186

 
74,534

 
76,387

 
74,286

Effect of dilutive securities:
 
 
 
 
 
 
 
2016 Convertible notes

 
3,176

 

 
2,256

Warrants
158

 
2,012

 
1,295

 
974

Stock options and restricted stock
1,111

 
1,310

 
1,291

 
1,288

Weighted average common shares for diluted earnings per share
79,455

 
81,032

 
78,973

 
78,804

 
 
 
 
 
 
 
 
Diluted net income per common share
$
0.04

 
$
0.25

 
$
0.26

 
$
0.59


Shares of common stock of approximately 0.3 million and 0.4 million at September 30, 2017 and 2016 , respectively, that are issuable through the exercise of dilutive securities were not included in the computation of diluted net income per share because their effect would have been antidilutive.

For the three and nine months ended September 30, 2017 and 2016 the potential excess conversion value on warrants was included in the Company's dilutive share calculation because the average stock price for the three and nine months ended September 30, 2017 and 2016 exceeded the conversion price.

For the three and nine months ended September 30, 2016 the potential excess conversion value on the 2016 Notes were included in the Company's dilutive share calculation because the average stock price for the three and nine months ended September 30, 2016 exceeded the conversion price.

Restricted and performance units that entitle the holders to approximately 0.5 million shares of common stock are included in the basic and diluted weighted average shares outstanding calculation because no further consideration is due related to the issuance of the underlying common shares.


21

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

11. COMPREHENSIVE INCOME
Comprehensive income was as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(In thousands)
Net income
$
3,159

 
$
20,144

 
$
20,388

 
$
46,316

Foreign currency translation adjustment
10,175

 
2,914

 
33,724

 
7,589

Change in unrealized gain (loss) on derivatives, net of tax
207

 
354

 
(331
)
 
9

Pension liability adjustment, net of tax
(7
)
 
(2
)
 
(22
)
 
(6
)
Comprehensive income, net
$
13,534

 
$
23,410

 
$
53,759

 
$
53,908


Changes in Accumulated Other Comprehensive Income by component between December 31, 2016 and September 30, 2017 are presented in the table below, net of tax:
 
 
Cash Flow Hedges
 
Defined Benefit Pension Items
 
Foreign Currency Items
 
Short-term Investment
 
Total
 
 
(In thousands)
Beginning balance
 
$
1,071

 
$
(36
)
 
$
(58,189
)
 

 
$
(57,154
)
Other comprehensive (loss) income
 
(290
)
 
(22
)
 
33,724

 
(3,019
)
 
30,393

Amounts reclassified from accumulated other comprehensive income
 
(41
)
 

 

 
3,019

 
2,978

Net current-period other comprehensive (loss) income
 
(331
)
 
(22
)
 
33,724

 

 
33,371

Ending balance
 
$
740

 
$
(58
)
 
$
(24,465
)
 
$

 
$
(23,783
)

For the nine months ended September 30, 2017 , the Company reclassified a minimal amount and $ 3 million from AOCI to interest expense and other expenses, respectively.

12. SEGMENT AND GEOGRAPHIC INFORMATION

The Company internally manages two global reportable segments and reports the results of its businesses to its chief operating decision maker. The two reportable segments and their activities are described below.

The Specialty Surgical Solutions segment includes (i) the Neurosurgery business, which sells a full line of products for neurosurgery and neuro critical care such as tissue ablation equipment, dural repair products, cerebral spinal fluid management devices, intracranial monitoring equipment, and cranial stabilization equipment and (ii) the precision tools and instruments business, which sells more than 60,000 instrument patterns and surgical and lighting products to hospitals, surgery centers, and dental, podiatry, and veterinary offices.
The Orthopedics and Tissue Technologies segment includes such offerings as skin repair, advanced wound care, amniotic tissue, bone and joint fixation implants in the upper and lower extremities, bone grafts and nerve and tendon repair.

The Corporate and other category includes (i) various legal, finance, information systems, executive, and human resource functions, (ii) brand management, and (iii) share-based compensation costs.

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, 2017 and 2016 are as follows:

22

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

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(In thousands)
Segment Net Sales
 
 
 
 
 
 
 
Specialty Surgical Solutions
$
164,760

 
$
159,409

 
$
480,907

 
$
468,767

Orthopedics and Tissue Technologies
114,074

 
90,923

 
338,727

 
267,644

Total revenues
$
278,834

 
$
250,332

 
$
819,634

 
$
736,411

Segment Profit
 
 
 
 
 
 
 
Specialty Surgical Solutions
$
68,289

 
$
67,148

 
$
198,242

 
$
188,126

Orthopedics and Tissue Technologies
30,411

 
27,727

 
88,500

 
74,027

Segment profit
98,700

 
94,875

 
286,742

 
262,153

Amortization
(5,456
)
 
(3,467)

 
(14,976)

 
(10,410)

Corporate and other
(82,602
)
 
(61,313
)
 
(234,180)

 
(177,173
)
Operating income
$
10,642

 
$
30,095

 
$
37,586

 
$
74,570


The Company does not allocate any assets to the reportable segments. No asset information is reported to the chief operating decision maker and disclosed in the financial information for each segment.

The Company attributes revenues to geographic areas based on the location of the customer. Total revenue by major geographic area consisted of the following:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(In thousands)
United States
$
213,685

 
$
194,346

 
$
634,047

 
$
567,103

Europe
32,609

 
28,553

 
93,924

 
89,623

Rest of World
32,540

 
27,433

 
91,663

 
79,685

Total Revenues
$
278,834

 
$
250,332

 
$
819,634

 
$
736,411


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 it sells. 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.
TEI, acquired by Integra on July 17, 2015, manufactures a bovine-derived surgical mesh product for Boston Scientific Corporation ("BSC") and has been named as a defendant in lawsuits under a broad range of products liability theories, many of which have not been served on TEI. As of September 30, 2017 , only ten active cases remained against TEI. Pursuant to an indemnification agreement with BSC (i) BSC is managing the litigation; and (ii) TEI has in place a product liability insurance policy, of which it must exhaust $3.0 million before BSC’s indemnity begins to cover relevant claims (and of which only a small portion has been utilized to date and against which the insurer has reserved the entire $3.0 million ). Because the thrust of products liability litigation focuses on synthetic surgical mesh products, counsel is filing motions to dismiss on behalf of TEI in many cases. In addition, Integra has certain protections in the merger agreements with TEI which would indemnify it for approximately $30.0 million for the first fifteen months after closing and between $20.0 and $30.0 million for the remainder of the three -year period after closing for losses relating to a variety of matters, including half of certain products liability claims (including those related to the product it manufactures for BSC) not covered by insurance. As of October 26, 2017 , no indemnification payments were received nor owed in relation to the lawsuits.

23

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

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 associated with loss contingencies as incurred with outside counsel as a selling, general and administrative expense in the consolidated statements of operations.
Contingent Consideration
The Company determined the fair value of contingent consideration during the nine -month period ended September 30, 2017 and 2016 to reflect the change in estimate, additions, payments, transfers and the time value of money during the period.
A reconciliation of the opening balances to the closing balances of these Level 3 measurements for the nine months ended September 30, 2017 and 2016 is as follows (in thousands):
Nine Months Ended September 30, 2017
 
Contingent Considerations Liabilities Related to Acquisition of Derma Sciences ( See Note 2 )
 
Contingent Consideration Liability Related to Acquisition of Confluent Surgical, Inc.
 
Location in Financial Statements
 
 
Short-term
 
Long-term
 
Short-term
 
Long-term
 
 
Balance as of January 1, 2017
 
$

 
$

 
$

 
$
22,036

 

Additions from acquisition of Derma Sciences
 
33,707

 
3,467

 

 

 
 
Transfers from long-term to current portion
 
2,193

 
(2,193
)
 
21,312

 
(21,312
)
 
 
Payments
 
(31,346
)
 

 

 

 
 
(Gain) loss from change in fair value of contingent consideration liabilities
 
(2,421
)
 
82

 

 
148

 
Selling, general and administrative
Balance as of September 30, 2017
 
$
2,133

 
$
1,356

 
$
21,312

 
$
872

 

Nine Months Ended September 30, 2016
 
Contingent Consideration Liability Related to Acquisition of Confluent Surgical, Inc.
 
Location in Financial Statements
 
 
Long-term
 
 
Balance as of January 1, 2016
 
$
21,831

 
 
Loss from change in fair value of contingent consideration liabilities
 
74

 
Selling, general and administrative
Balance as of September 30, 2016
 
$
21,905

 
 
On January 15, 2014, the Company acquired all outstanding shares of Confluent Surgical, Inc., ("Confluent Surgical"). The purchase price includes contingent consideration. 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 fair values of contingent consideration related to the acquisition of Confluent Surgical were estimated using a discounted cash flow model using discount rate of 2.2% .

The Company assesses these assumptions on an ongoing basis as additional information affecting the assumptions is obtained. The contingent consideration balance was included in accrued expenses and other current liabilities and other liabilities at September 30, 2017 and in other liabilities at September 30, 2016 .

Supply Agreement Liability and Above Market Supply Agreement Liability
On January 15, 2014, the Company entered into a transitional supply agreement with Covidien Group S.a.r.l ("Covidien"). This agreement contains financial incentives to 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 in each of the following three years.
The Company determined the fair value of its supply agreement liability and above market supply agreement liability with Covidien during the nine -month period ended September 30, 2017 and 2016 to reflect the payments, change in estimate and the time value of money during the period.

24

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

A reconciliation of the opening balances to the closing balances of these Level 3 measurements is as follows (in thousands):
Nine Months Ended September 30, 2017
 
Supply Agreement Liability - Short-term
 
Above Market Supply Agreement Liability - Short-term
 
Above Market Supply Agreement Liability - Long-term
 
Location in Financial Statements
Balance as of January 1, 2017
 
$
166

 
$

 
$
2,648

 

Payments
 
(166
)
 

 
(415
)
 
 
Transfer from long-term to current portion
 

 
3,216

 
(3,216
)
 
 
Loss from increase in fair value
 

 
(352
)
 
1,040

 
Selling, general and administrative
Balance as of September 30, 2017
 
$

 
$
2,864

 
$
57

 

Nine Months Ended September 30, 2016
 
Supply Agreement Liability - Short-term
 
Supply Agreement Liability - Long-term
 
Above Market Supply Agreement Liability - Long-term
 
Location in Financial Statements
Balance as of January 1, 2016
 
$
1,991

 
$
161

 
$
931

 
 
Payments
 
(1,500
)
 
 
 

 
 
Transfer from long-term to current portion
 
161

 
(161
)
 

 
 
Loss from increase in fair value
 
13

 

 
1,009

 
Selling, general and administrative
Other
 

 

 
681

 
Goodwill
Balance as of September 30, 2016
 
$
665

 
$

 
$
2,621

 
 
The fair values of supply agreement liability and above market supply agreement liability were estimated using a discounted cash flow model using a discount rate of 12.0% . The Company assesses these assumptions on an ongoing basis as additional information impacting the assumptions is obtained. The supply agreement liability - short-term and above market supply agreement liability - short-term were included in accrued expenses and other current liabilities and the supply agreement - long-term and above market supply agreement liability - long-term were included in other liabilities at September 30, 2017 and December 31, 2016 .

There are no transfers between level 1, 2 or 3 during the nine months ended September 30, 2017 and 2016 . If the Company's estimate regarding the fair value of its contingent consideration liabilities, supply agreement liability and above market supply agreement liability are inaccurate, a future adjustment to these estimated fair values may be required which could change significantly.

BioD

On April 7, 2017, the Company's indirect wholly-owned subsidiary, BioD filed an action in the Superior Court of New Jersey, Chancery Division, Middlesex County seeking a declaration that the resignation of Russell Olsen, the former CEO of BioD, was “for Good Reason” (as defined in Olsen’s employment agreement); a finding that Olsen breached the implied covenant of good faith and fair dealing, committed legal fraud, equitable fraud and negligent misrepresentation; and an award of damages for such actions, including a return of severance fees paid to Olsen. BioD was acquired in August 2016 by Derma Sciences, which Integra subsequently acquired in February 2017. After receiving a job offer from Integra that Olsen believed materially diminished his title and authority, on February 24, 2017 Olsen indicated his intention to terminate his position with BioD for Good Reason, as otherwise permitted by his employment agreement with BioD. Shortly thereafter, Cynthia Weatherly (as representative of the former equity owners of BioD) claimed in a letter to Derma Sciences that Olsen’s resignation was a “termination Without Cause” (as also defined in Olsen’s employment agreement), which would arguably trigger an acceleration of the earn out under a merger agreement between Derma Sciences, BioD and other parties (the "BioD Merger Agreement"), which was entered into in July 2016, and require as a result of the acceleration the payment of $26.5 million by BioD. As previously disclosed and described in Note 2 - Business Acquisition , to the Company's consolidated financial statements for the three and nine months ended September 30, 2017, Integra assumed this contingent liability in connection with its acquisition of Derma Sciences. The action for a declaratory judgment was filed to clarify that Olsen’s termination was for Good Reason and not Without Cause. If the employment agreement was terminated for Good Reason, then the Company believes that the earn out provision under the BioD Merger Agreement should not be accelerated and the likelihood of loss is remote.

25

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


14. SUBSEQUENT EVENTS
Johnson & Johnson's Codman Neurosurgery Business
On October 2, 2017, upon the terms and subject to the conditions set forth in the Purchase Agreement, the Codman Acquisition was completed. Under the terms of the Purchase Agreement, the Company paid an aggregate purchase price of $1.014 billion , subject to adjustments set forth in the Purchase Agreement relating to the book value of inventory transferred to the Company at the closing of the Codman Acquisition, the book value of certain inventory retained by DePuy Synthes will be transferred to the Company in the future along with certain prepaid taxes.
To facilitate the completion of the Codman Acquisition, the Company drew $700.0 million from the Term Loan A-1 compnent of the Senior Credit Facility and used cash available as of September 30, 2017 .
The Codman Acquisition will be accounted for using the acquisition method of business combination under ASC 805, Business Combinations. The initial accounting for the business combination is incomplete due to the timing of the acquisition, therefore, the Company is unable to disclose certain information required by ASC 805. The Company will provide preliminary purchase price allocation information in the Company's Annual Report on Form 10-K for year ending December 31, 2017
Divestiture to Natus
On October 6, 2017, upon the terms and subject to the conditions set forth in the Divestiture Agreement (see Note 1 - Basis of Presentation ), the Divestiture was completed and Natus paid an aggregate purchase price of $46.4 million . The assets sold to Natus pursuant to the Divestiture Agreement are related to the Company’s intracranial pressure monitoring and U.S. fixed pressure valve shunt systems businesses along with certain assets related to the Codman U.S. dural graft implant, external ventricular drainage catheter and cerebrospinal fluid collection systems businesses that the Company purchased from DePuy Synthes on October 2, 2017.
A portion of the proceeds from the Divestiture of $36.4 million were used to settle a portion of the revolving credit component of the Senior Credit Facility.
Cross-Currency Rate Swap
On October 2, 2017, the Company entered into cross currency swap agreements to convert a notional amount of $300.0 million equivalent to 291.2 million of Swiss Franc ("CHF") denominated intercompany loans into U.S. dollars. The CHF denominated intercompany loans were the result of the purchase of intellectual property by a subsidiary in Switzerland as part of the Codman Acquisition. The objective of these cross-currency swaps is to reduce volatility of earnings and cash flows associated with changes in the foreign currency exchange rate. Under the terms of these contracts, which have been designated as cash flow hedges, the Company will make interest payments in Swiss Francs and receive interest in U.S. dollars. Upon the maturity of these contracts, the Company will pay the principal amount of the loans in Swiss Francs and receive U.S. dollars from the counterparties.
The following table summarizes the cross-currency swaps entered on October 2, 2017:
 
 
Effective Date
 
Termination Date
 
Fixed Rate
 
Aggregate Notional Amount
 
 
 
 
 
 
 
 
(amounts in thousands)
Pay CHF
 
October 2, 2017
 
October 2, 2020
 
1.75%
 
CHF
97,065

Receive U.S.$
 
 
4.38%
 
$
100,000

 
 
 
 
 
 
 
 
 
 
Pay CHF
 
October 2, 2017
 
October 2, 2021
 
1.85%
 
CHF
48,532

Receive U.S.$
 
 
4.46%
 
$
50,000

 
 
 
 
 
 
 
 
 
 
Pay CHF
 
October 2, 2017
 
October 2, 2022
 
1.95%
 
CHF
145,598

Receive U.S.$
 
 
4.52%
 
$
150,000



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, 2016 included in our Annual Report on Form 10-K.
We have made statements in this report which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). These forward-looking statements are subject to a number of risks, uncertainties and assumptions about the Company. Our actual results could differ

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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, 2016 , Quarterly Report on Form 10-Q for the quarterly periods ended March 31, 2017 and June 30, 2017, and 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,” “might,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should,” “would” and similar expressions in this report.

GENERAL
Integra is a worldwide leader in medical technology focused on limiting uncertainty for surgeons so that they can concentrate on providing the best patient care. Integra provides customers with clinically relevant, innovative and cost-effective products that improve the quality of life for patients. We focus on cranial procedures, small bone and joint reconstruction, the repair and reconstruction of soft tissue, and instruments for surgery.
We manufacture and sell our products in two reportable business segments — Specialty Surgical Solutions and Orthopedics and Tissue Technologies. Our Specialty Surgical Solutions products offer specialty surgical implants and instrumentation for a broad range of specialties. This product category includes products and solutions for dural repair, precision tools and instruments, tissue ablation, and neuro critical care including market-leading product portfolios used in neurosurgery operating suites and critical care units. Our Orthopedics and Tissue Technologies products offer a unique combination of differentiated regenerative technology products for soft tissue repair and tissue regeneration products, alongside small bone fixation and joint replacement hardware products for both upper extremities and lower extremities. This product category also includes private-label sales of a broad set of our regenerative medicine technologies.
We manufacture many of our products in plants located in the United States, Puerto Rico, France, Germany, Ireland, Canada, China and Mexico. We also source most of our handheld surgical instruments and specialty metal and pyrocarbon implants, and dural sealant products through specialized third-party vendors.
We have several sales channels in the United States. Specialty Surgical Solutions products are sold through a combination of directly employed sales representatives, distributors and wholesalers, depending on the customer call point. Orthopedics and Tissue Technologies products are sold through directly employed sales representatives and specialty distributors focused on their respective surgical specialties. We sell in the international markets through a combination of direct sales organizations and distributors.
We also market certain products through strategic partners in the United States.
Our objective is to become a multi-billion dollar diversified global medical technology company that 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 so they can concentrate on providing the best care for their patients and by becoming a company recognized as a leader by our customers worldwide in specialty surgical applications, regenerative technologies and extremities orthopedics. Our strategy is built around three pillars - execute, optimize, and accelerate growth. These three pillars support our strategic initiatives to deliver on our commitments through improved planning and communication, optimizing our infrastructure, and growing by introducing new products to the market through internal development, geographic expansion, and strategic acquisitions.
We aim to achieve growth in our revenues while maintaining strong financial results. While we pay attention to any meaningful trend in our financial results, we pay particular attention to measurements that are indicative of long-term profitable growth. These measurements include (1) revenue growth (including organic growth and acquisitions), (2) gross margins on total revenues, (3) operating margins (which we aim to expand as we leverage our existing infrastructure), (4) earnings before interest, taxes, depreciation, and amortization, (5) earnings per diluted share of common stock, and (6) operating cash flows.
We believe that we are particularly effective in the following aspects of our business:
Regenerative Technology Platform . We have developed numerous product lines through our proprietary collagen and polyethylene glycol technologies that are sold through all of our sales channels.

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Diversification and Platform Synergies . The selling platforms of Specialty Surgical Solutions and Orthopedics and Tissue Technologies each contribute a different strength to our core business. Specialty Surgical Solutions provides us with a strong presence in the hospital, with market-leading products and comprehensive solutions for surgical specialties, such as neurosurgery, as well as a strong capacity to generate cash flows. Orthopedics and Tissue Technologies enables us to grow our top line by continuing to introduce new, differentiated products in fast-growing markets, such as small joint replacement and advanced wound care, as well as to increase gross margins. We have unique synergies between these platforms, such as our regenerative technology, instrument sourcing capabilities, and enterprise contract management.
Specialized Sales Footprint . Our medical technology investment and manufacturing strategy provide us with a specialized set of customer call-points and synergies. We have market-leading products across our portfolio providing both scale and depth in solutions for a broad set of clinical needs across many departments in healthcare systems. We also have clinical expertise across all our channels in the United States, and an opportunity to expand and leverage this expertise in markets worldwide. In response to our customers’ needs for clinical and technical solutions across multiple departments and clinical areas, we have developed and deployed our enterprise selling team to bring unique clinical solutions for the most difficult healthcare issues in our key accounts across multiple clinical sites and multi-hospital integrated delivery networks.
Ability to Change and Adapt . Our corporate culture is what enables us to adapt and evolve. We have demonstrated that we can quickly and profitably integrate new products and businesses. This core strength has made it possible for us to grow over the years, and is key to our ability to grow into a multi-billion-dollar company.
Acquisitions
Derma Sciences
On February 24, 2017, the Company executed the Agreement and Plan of Merger (the "Merger Agreement") under which the Company acquired all the outstanding shares of Derma Sciences, Inc., a Delaware corporation ("Derma Sciences") for an aggregate purchase price of approximately $210.8 million including payment of certain of Derma Sciences' closing expenses and settlement of stock-based compensation plans of $4.8 million and $4.3 million, respectively. The purchase price consisted of a cash payment to the former shareholders of Derma Sciences of approximately $201.7 million upon the closing of the transaction.
Derma Sciences is a tissue regeneration company focused on advanced wound and burn care that offers products to help manage chronic and hard-to-heal wounds, especially those resulting from diabetes and poor vascular functioning.
TGX Medical
On April 4, 2017, the Company entered into a Membership Interest Purchase Agreement (the "Purchase Agreement"), by and among the Company, MCF I LP THX Medical System LLC Holdings, Inc., Terragraphix, Inc. and TGX Medical Systems, LLC (collectively, "TGX Medical"). Pursuant to the Purchase Agreement, the Company purchased all issued and outstanding membership interests in TGX Medical for $5.4 million , including a $0.1 million adjustment made in the third quarter of 2017 related to additional closing costs incurred by TGX Medical.
TGX Medical designs, develops and markets software solutions that track surgical instruments from the operating room, sterilization, to storage, which helps ensure that the instruments have been properly cleaned, assembled and maintained. TGX Medical’s customers are located in the U.S. and Canada.
Johnson & Johnson's Codman Neurosurgery Business
On May 11, 2017, the Company entered into an asset purchase agreement (the “Purchase Agreement”) with DePuy Synthes, Inc., a Delaware corporation (“DePuy Synthes”), a wholly-owned subsidiary of Johnson & Johnson, pursuant to which the Company agreed to acquire certain assets, and assume certain liabilities, of Johnson & Johnson’s Codman neurosurgery business (the “Codman Acquisition”). The assets and liabilities subject to the Codman Acquisition relate to the research, development, manufacturing, marketing, distribution and sale of certain products used in connection with neurosurgery procedures.
On October 2, 2017, upon the terms and subject to the conditions set forth in the Purchase Agreement, the Codman Acquisition was completed. Under the terms of the Purchase Agreement, the Company paid an aggregate purchase price of $1.014 billion , subject to adjustments set forth in the Purchase Agreement relating to the book value of inventory transferred to us at the closing of the Codman Acquisition, the book value of certain inventory retained by DePuy Synthes that will be transferred to the Company in the future along with certain prepaid taxes.
To facilitate the completion of the Codman Acquisition, the Company drew $700.0 million from the Term Loan A-1 component of the Senior Credit Facility and cash available as of September 30, 2017 .



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Divestitures
On September 8, 2017, the Company and certain of its subsidiaries entered into an asset purchase agreement (the “Divestiture Agreement”) with Natus Medical Incorporated (“Natus”), pursuant to which the Company agreed to divest its Camino Intracranial Pressure monitoring and the U.S. rights to the fixed pressure shunts businesses together with certain of the neurosurgery assets that will be acquired as part of the Codman Acquisition (the “Divestiture”). The Divestiture Agreement was entered in connection with the review of the Codman Acquisition by the Federal Trade Commission and the antitrust authority of Spain. The Divestiture was conditioned upon completion of the Codman Acquisition.
On October 6, 2017, upon the terms and subject to the conditions set forth in the Divestiture Agreement (see Note 1 - Basis of Presentation ), the Divestiture was completed and Natus paid an aggregate purchase price of $46.4 million. The assets sold to Natus pursuant to the Divestiture Agreement are related to the Company’s intracranial pressure monitoring and the U.S. rights to the fixed pressure valve shunt systems businesses along with certain assets related to the Codman U.S. rights to the dural graft implant, external ventricular drainage catheter and cerebrospinal fluid collection systems businesses that the Company purchased from DePuy Synthes on October 2, 2017.

Clinical and Product Development Activities

After finalizing our multi-center clinical trial evaluating the safety and effectiveness of the INTEGRA Dermal Regeneration Template for the treatment of diabetic foot ulcers ("DFU") in 2015, we filed the resulting data with the FDA and received PMA approval on January 7, 2016. The Company started commercializing the resulting DFU product, Omnigraft, late in 2016. Additionally, we finalized patient follow-up in a post-approval study for our DuraSeal Exact Spine Sealant System, and submitted the study results to the FDA in October 2016. The study showed the continued safety and effectiveness of this approved medical device, and we expect that this study will satisfy the post-approval commitment related to this product. We continue to invest in additional clinical studies to support market access and promotion of existing products, and to pursue new product indications, such as breast reconstruction. The Company continues to invest in product development such as long-term research programs to evaluate products as well as next generation nerve product.

FDA Untitled Letter

On June 22, 2015, the FDA issued an Untitled Letter (the "Untitled Letter") alleging that BioD LLC's ("BioD") morselized amniotic membrane based products do not meet the criteria for regulation as human cellular tissue-based products (“HCT/Ps”) solely under Section 361 of the Public Health Service Act and that, as a result, BioD would need a biologics license to lawfully market those morselized products (BioD is a wholly owned subsidiary of Derma Sciences). Since the issuance of the Untitled Letter, BioD and now the Company had and plan to continue discussions with the FDA to communicate its disagreement with the FDA’s assertion that certain products are more than minimally manipulated. To date, the FDA has not changed its position that certain of the acquired morselized products are not eligible for marketing solely under Section 361 of the Public Health Service Act. The Company continues to market these products.

On December 22, 2014, the FDA issued for comment “Draft Guidance for Industry and FDA Staff: Minimal Manipulation of Human Cells, Tissues, and Cellular and Tissue-Based Products.” On October 28, 2015, the FDA issued for comment, "Draft Guidance for Industry and FDA Staff: Homologous Use of Human Cells, Tissues, and Cellular and Tissue-Based Products." The FDA held a public hearing on September 12 and 13, 2016 to obtain input on the Homologous Use draft guidance and the Minimal Manipulation draft guidance, as well as other recently issued guidance documents on HCT/Ps.

If the FDA does allow us to continue to market its morselized products without a 510(k) or biologics license either prior to or after finalization of the draft guidance documents, it may impose conditions on marketing, such as labeling restrictions and compliance with current Good Manufacturing Practices. Compliance with these conditions would require significant additional time and cost investments from us. It also is possible that the FDA will not allow us to market any form of a morselized product without a biologics license even prior to finalization of the draft guidance documents and could require us to recall our morselized products. We continue to market these products. The Company continues to monitor the FDA's position on these products. Any potential action of the FDA could have a financial impact on the sales of BioD’s morselized amniotic tissue-based products. Revenues from BioD morselized amniotic membrane based products for the three and nine months ended September 30, 2017 were less than 1.0% of consolidated revenues.


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RESULTS OF OPERATIONS
Executive Summary
Net income for the three months ended September 30, 2017 was $3.2 million , or $0.04 per diluted share, as compared to $20.1 million or $0.25 per diluted share for the three months ended September 30, 2016 .
Net income for the nine months ended September 30, 2017 was $20.4 million , or $0.26 per diluted share, as compared to $46.3 million or $0.59 per diluted share for the nine months ended September 30, 2016 .
Net income for the nine months ended September 30, 2017 decreased from the same period last year, primarily resulting from higher acquisition-related expenses of $51.9 million , and offset by growth in both of our Orthopedics and Tissue Technologies and Specialty Surgical Solutions segments. The results also reflect strong growth in our regenerative technology franchise.
Income before taxes includes the following special charges:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(In thousands)
Global ERP implementation charges
$

 
$
3,366

 
$
3,261

 
$
12,386

Structural optimization charges
1,944

 
1,993

 
5,336

 
5,540

Certain employee severance charges

 
153

 
125

 
1,420

Discontinued product lines charges

 

 
1,025

 

Acquisition-related charges
24,904

 
4,935