NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
NOTE 1 – BASIS OF PRESENTATION
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of ArthroCare Corporation (“ArthroCare”) and its subsidiaries (collectively with ArthroCare, the “Company”) have been prepared in accordance with the instructions to Form 10-Q and do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with United States generally accepted accounting principles (“GAAP”). The condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto together with management’s discussion and analysis of financial condition and results of operations contained in the Company’s 2013 Annual Report on Form 10-K filed with the Securities and Exchange Commission (the "SEC") on February 13, 2014 (“2013 Form 10-K”). In the opinion of management, the accompanying condensed consolidated financial statements reflect all adjustments of a normal recurring nature considered necessary to fairly state the financial position of the Company at
March 31, 2014
and
December 31, 2013
, the results of its operations and its cash flows for the three month periods ended
March 31, 2014
and
2013
. The results of operations for the periods presented are not necessarily indicative of results that may be expected for the year ending
December 31, 2014
.
Use of Estimates
The unaudited condensed consolidated financial statements have been prepared in conformity with GAAP, using management’s best estimates and judgments where appropriate. These estimates and judgments affect the reported amounts of assets and liabilities and disclosure of the contingent assets and liabilities at the date of the financial statements. The estimates and judgments will also affect the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ materially from these estimates and judgments.
Significant Accounting Policies
There have been no significant changes to the Company’s significant accounting policies from those disclosed in its
2013
Form 10-K.
New Accounting Pronouncements
Accounting Standards Update ("ASU") 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” was issued in July 2013 and addresses when an unrecognized tax benefit shall be recorded as a reduction to a deferred tax asset or presented as a gross liability. ASU 2013-11 was adopted by the Company beginning in 2014 which resulted in a decrease to non-current deferred tax assets of $1.1 million and an offsetting decrease to other non-current liabilities of $1.1 million.
NOTE 2 – MERGER
On February 3, 2014, the Company announced the entry into an Agreement and Plan of Merger, dated February 2, 2014 (the "Merger Agreement") with Smith & Nephew, Inc. ("Parent"), Rosebud Acquisition Corporation, a wholly owned subsidiary of Parent ("Merger Subsidiary") and Smith & Nephew plc ("Parent Holdco"), pursuant to which the Company agreed to be acquired by Parent and become a wholly-owned subsidiary of Parent (the "Merger"). At the effective time of the Merger, each issued and outstanding share of common stock of the Company (other than common shares held by the Company or its subsidiaries, Parent or its subsidiaries, Merger Subsidiary or a stockholder who properly demands appraisal of such common shares under Delaware Law) will be converted into a right to receive
$48.25
per share in cash.
At the effective time of the Merger, each equity award with respect to shares of common stock of the Company that is outstanding immediately prior to the Merger will be canceled in consideration of a cash payment to the holder of the award (subject to reduction for withholding taxes). In the case of a stock option or stock appreciation award, the holder will receive an amount equal to
$48.25
less the applicable exercise price per share, multiplied by the number of shares covered by the award. In the case of a restricted stock award, the holder will receive an amount equal to
$48.25
multiplied by the number of shares covered by the award. In the case of a performance award, the holder will receive an amount equal to
$48.25
multiplied by the number of shares covered by the award that are earned based on performance through the last business day of the completed
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
fiscal quarter that immediately precedes the effective time of the Merger (but in no event less than
one-third
of the target number of shares covered by the award). Each of the Company and Parent made customary representations, warranties and covenants in the Merger Agreement, including, among others, covenants by the Company to conduct its business in the ordinary course during the interim period between the execution of the Merger Agreement and the consummation of the Merger.
The completion of the Merger is subject to customary conditions, including approval by the Company’s stockholders, the absence of any material adverse effect on the Company’s business and receiving antitrust approvals (including under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the "HSR Act") and the competition laws of Germany and the United Kingdom). On March 13, 2014, the Federal Trade Commission granted early termination of the waiting period under the HSR Act in connection with the Company’s proposed Merger. On March 28, 2014, the German Federal Cartel Office also granted unconditional clearance. The proposed Merger remains subject to certain other closing conditions, including approval by ArthroCare stockholders and approval by the United Kingdom Competition and Markets Authority. A vote of the Company's stockholders is scheduled for May 8, 2014.
The Company has also agreed, subject to certain exceptions, not to enter into discussions concerning, or provide confidential information in connection with, any alternative transaction. In addition, each of the parties have agreed to use their reasonable best efforts to cause the Merger to be consummated. Prior to adoption of the Merger Agreement by the Company’s stockholders, the Board of Directors (the "Board") may in certain circumstances change its recommendation that the Company’s stockholders adopt the Merger Agreement, subject to complying with certain notice and other specified conditions set forth in the Merger Agreement, including giving Parent the opportunity to propose changes to the Merger Agreement.
The Merger Agreement may be terminated under certain circumstances by the Company, prior to the adoption of the Merger Agreement by the Company’s stockholders, including in the event that the Company receives an unsolicited alternative acquisition proposal that the Company concludes, after following certain procedures, is a Superior Proposal (as defined in the Merger Agreement). If the Company receives a Superior Proposal, Parent must be given the opportunity to match the Superior Proposal. In addition, Parent may terminate the Merger Agreement under certain circumstances, including if the Board changes its recommendation that stockholders adopt the Merger Agreement, if after a request from Parent the Board fails to reaffirm its recommendation of the Merger following an alternative acquisition proposal or if there is a material breach of the Company’s obligations relating to non-solicitation of an alternative acquisition proposal or the procedures to be followed following receipt of an unsolicited alternative acquisition proposal. If the Merger Agreement is terminated under certain circumstances, the Company may be required to pay Parent a termination fee equal to
$54.9 million
.
NOTE 3 – COMPUTATION OF EARNINGS PER SHARE
On February 11, 2014 the Company's Series A 3% Redeemable Convertible Preferred Stock (the "Series A Preferred Stock") was converted to
5,805,921
shares of the Company's common stock in accordance with the terms of its automatic conversion feature. Net income available to common stockholders for the first quarter of 2014 includes the accrued dividend and accretion charges on the Series A Preferred Stock through the date of conversion. Upon conversion, the remaining unamortized beneficial conversion feature related to the Series A Preferred Stock was recognized as an accrued dividend and accretion charge which further reduced net income available to common stockholders by $2.3 million in the first quarter of 2014. The following is a reconciliation of net income applicable to common stockholders and the number of shares used in the calculation of basic and diluted earnings per share applicable to common stockholders (in thousands, except per-share data):
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three months ended
March 31,
|
|
|
|
2014
|
|
2013
|
|
|
|
|
|
|
|
Net income allocated to common stockholders, net of $278 and $1,753 attributable to Series A Preferred Stock for the three months ended March 31, 2014 and 2013, respectively.
|
|
$
|
3,349
|
|
|
$
|
8,513
|
|
|
|
|
|
|
|
|
Basic:
|
|
|
|
|
|
|
|
Weighted-average common shares outstanding
|
|
31,837
|
|
|
28,055
|
|
|
Earnings per share allocated to common stockholders
|
|
$
|
0.11
|
|
|
$
|
0.30
|
|
|
|
|
|
|
|
|
Diluted:
|
|
|
|
|
|
|
|
Weighted-average shares outstanding used in basic calculation
|
|
31,837
|
|
|
28,055
|
|
|
Dilutive effect of options
|
|
400
|
|
|
308
|
|
|
Dilutive effect of unvested restricted stock
|
|
417
|
|
|
422
|
|
|
Weighted-average common stock and common stock equivalents
|
|
32,654
|
|
|
28,785
|
|
|
Earnings per share allocated to common stockholders
|
|
$
|
0.10
|
|
|
$
|
0.30
|
|
|
|
|
|
|
|
|
Stock issuable upon conversion of the Series A Preferred Stock
|
|
—
|
|
|
5,806
|
|
|
Stock awards excluded from calculation as their effect would be anti-dilutive
|
|
27
|
|
|
834
|
|
Awards approved under the Company’s Long Term Incentive Program are excluded from diluted shares as the market conditions and performance conditions of the awards have not been met.
NOTE 4 –
INVENTORIES
The following summarizes the Company’s inventories (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March 31,
2014
|
|
December 31,
2013
|
|
|
|
|
|
|
|
Raw materials
|
|
$
|
11,798
|
|
|
$
|
12,815
|
|
|
Work-in-process
|
|
15,830
|
|
|
12,281
|
|
|
Finished goods
|
|
25,619
|
|
|
26,265
|
|
|
|
|
53,247
|
|
|
51,361
|
|
|
Inventory valuation reserves
|
|
(4,540
|
)
|
|
(5,073
|
)
|
|
Inventories, net
|
|
$
|
48,707
|
|
|
$
|
46,288
|
|
NOTE 5 – INTANGIBLE ASSETS
Estimated future amortization expense as disclosed in Note 7 of the 2013 Form 10-K (and included below) has been revised as follows (in thousands):
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
|
|
|
|
|
|
|
|
2014 (remaining)
|
$
|
1,499
|
|
|
2015
|
$
|
1,733
|
|
|
2016
|
$
|
949
|
|
|
2017
|
$
|
927
|
|
|
2018
|
$
|
867
|
|
|
Thereafter
|
8,091
|
|
|
|
$
|
14,066
|
|
NOTE 6 – ACCRUED LIABILITIES
The following summarizes the Company’s accrued liabilities (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March 31,
2014
|
|
December 31,
2013
|
|
|
|
|
|
|
|
Compensation
|
|
$
|
12,696
|
|
|
$
|
19,367
|
|
|
Insurance dispute and settlement reserve
|
|
—
|
|
|
30,000
|
|
|
Legal expenses
|
|
7,813
|
|
|
2,226
|
|
|
Other
|
|
13,372
|
|
|
13,355
|
|
|
|
|
$
|
33,881
|
|
|
$
|
64,948
|
|
NOTE 7 – COMMITMENTS
Operating Leases
The Company leases certain facilities and equipment under operating leases. The Company recognizes rent expense on a straight-line basis over the lease term. Rent expense was
$1.6 million
for the three months ended
March 31, 2014
, compared to
$1.8 million
for the same period in
2013
. There were
no
material changes from the Company’s lease obligations presented in its
2013
Form 10-K.
Indemnification Agreements
The Company advances legal fees as required pursuant to indemnification agreements that were entered into with certain former executives and employees while they were employed with the Company. During the three months ended
March 31, 2014
the Company advanced
$3.1 million
and has expensed
$5.2 million
under these indemnity agreements. The Company expects to continue to advance payments pursuant to certain of these agreements in future periods; however, management is unable to estimate the amount or timing of future payments under such agreements.
NOTE 8 – LITIGATION AND CONTINGENCIES
In addition to the matters specifically described below, the Company is involved in other legal and regulatory proceedings that arise in the ordinary course of business that do not have a material impact on the Company’s business. Litigation claims and proceedings of all types are subject to many factors that generally cannot be predicted accurately.
The Company records reserves for claims and lawsuits when they are probable and reasonably estimable. Except as otherwise specifically noted, the Company currently cannot determine the ultimate resolution of the matters described below. For matters where the likelihood or extent of a loss is not probable or cannot be reasonably estimated, the Company has not recognized in its condensed consolidated financial statements the potential liability that may result from these matters. Further, for such matters where a loss is believed to be reasonably possible, but not probable,
no
accrual has been made and an estimate of the reasonably possible loss cannot be made at this time. If one or more of these matters is determined against the Company, it could have a material adverse effect on the Company’s earnings, liquidity and financial condition.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
The Company continues to gather additional facts and information related to insurance billing and healthcare compliance issues and marketing and promotional practices in connection with these legal and administrative proceedings with the assistance of legal counsel.
Department of Justice Investigation
On December 31, 2013, the Company entered into a Deferred Prosecution Agreement (“DPA”) with the Department of Justice (the "DOJ"). The DPA resolves the ongoing investigation by the DOJ regarding allegations of securities and related fraud committed under a previous management team.
In conjunction with the DPA, the DOJ concurrently filed a criminal information concerning a single-count of conspiracy to commit wire and securities fraud. The DPA is for a
24
month period and, subject to its successful completion, the DOJ agrees that the DPA will expire and that the DOJ will seek dismissal of the criminal information. Pursuant to the DPA, ArthroCare paid a
$30 million
fine during the first quarter of 2014 to the DOJ and agreed to maintain a compliance program meeting certain criteria specified in the DPA. ArthroCare also must report annually on the status of the Compliance Program to the DOJ.
False Claims Act Investigation
In the first quarter of 2012, the Company received a Civil Investigative Demand ("CID") from the DOJ, requesting information related to the marketing of its radio-frequency ablation devices, which could implicate the False Claims Act, 31 U.S.C. § 3729. On January 17, 2014, a representative of the DOJ confirmed to the Company that the CID related to a qui tam case, in which the DOJ elected not to intervene, had been dismissed by the United States District Court in the Eastern District of New York. The case, United States of America ex rel. Michael Scherl v. ArthroCare Corporation et al., 2:11-cv-00668-LDW-AKT (E.D.N.Y. Feb 10, 2011), had previously been filed under seal and alleged violations of the False Claims Act. Based on the confirmation from the DOJ, the Company believes that the CID matter is closed.
Legal Proceedings Related to the Merger
Shortly following the announcement of the Merger (see further discussion in Note 2 above),
eight
putative class action and/or derivative lawsuits were filed in the Court of Chancery of the State of Delaware (the “Court”) by alleged stockholders of ArthroCare against various combinations of the Company, the individual directors of the Company, Smith & Nephew, Merger Sub, Parent HoldCo, One Equity Partners LLC, One Equity Partners, ("OEP" and together with One Equity Partners LLC, the “OEP Entities”), J.P. Morgan Securities LLC (“J.P. Morgan Securities”), and JPMorgan Chase & Co. (together with its subsidiaries, “JPM”). By orders entered on February 25, March 14, and March 19, 2014, the Court consolidated these actions under the caption
In re ArthroCare Corporation Stockholder Litigation
, Consol. C.A. No. 9313-VCL (the “Consolidated Action”), and appointed co-lead plaintiffs and co-lead counsel.
On March 18, 2014, co-lead plaintiffs filed a Verified Consolidated Class Action and Derivative Complaint (the “Complaint”) in the Consolidated Action. The Complaint generally alleges, among other things, that the directors of the Company breached their fiduciary duties to the Company’s stockholders and that Smith & Nephew, Merger Sub, Parent HoldCo, the OEP Entities, J.P. Morgan Securities, and JPMorgan Chase & Co. aided and abetted these fiduciary breaches. In support of these claims, the lawsuits generally allege, among other things, that the Merger consideration undervalues the Company, that the sales process leading up to the Merger was flawed and influenced by conflicts of interest, that JPM, J.P. Morgan Securities, and the OEP Entities facilitated the sale of the Company to Smith & Nephew in order to facilitate OEP’s exit from its investment in the Company, assist OEP and JPM in the spin-off of OEP out of JPM, and obtain for JPM and its affiliates fees for roles as financial adviser to Smith & Nephew in the Merger and in the transaction financing for the Merger, and that the Merger Agreement contains deal-protection provisions that unduly favor Smith & Nephew and deter potential superior proposals.
The Complaint also alleges that the Merger violates 8
Del C.
§ 203 (“Section 203”). In support of this claim, the Complaint alleges that Smith & Nephew became an owner of
15%
or more of the Company’s voting securities and an interested stockholder in the Company (as those terms are defined in Section 203) by engaging J.P. Morgan Securities and a JPM subsidiary as its financial adviser and loan underwriter, respectively, in connection with the Merger. In light of this allegation, the Complaint further alleges that because the Merger is not subject to approval of holders of
66 2 / 3 %
of the Company’s outstanding shares (other than those shares deemed to be owned by Smith & Nephew), the Merger violates Section 203.
The Complaint also alleges that the Merger violates, and that the Company failed to enforce, certain standstill
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
provisions of the August 14, 2009 Securities Purchase Agreement, which was entered into with the Company at the time that the OEP Entities invested in the Company. The Complaint further alleges that the preliminary proxy statement filed by the Company on March 6, 2014 omits certain material information concerning, among other things, the process leading up to the Merger, the financial interests of, and roles in the Merger by, JPM and the OEP Entities, the inputs and analysis in Piper Jaffray & Co.’s fairness opinion analysis, and the role of Goldman Sachs & Co. The Consolidated Action seeks, among other things, a declaratory judgment, to enjoin the Merger, unspecified money damages, costs and attorneys’ and experts’ fees.
On March 21, 2014, the Court scheduled a hearing for April 28-29, 2014 to hear co-lead plaintiffs’ motion to preliminarily enjoin the Merger and hear, on an expedited basis, the parties’ arguments on whether Section 203 applies to the Merger.
On April 9, 2014, following expedited discovery, the parties to the Consolidated Action reached an agreement in principle providing for the settlement of all of the claims in the Consolidated Action on the terms and conditions set forth in a memorandum of understanding (the “MOU”). Pursuant to the MOU, Smith & Nephew agreed to pay or cause to be paid on behalf of itself and all other defendants twelve million U.S. dollars (US
$12,000,000
) (the “Settlement Payment”) into an interest-bearing account established by co-lead counsel (the “Common Fund”). Co-lead counsel for plaintiffs and the class will retain an administrator (the “Administrator”) to oversee the administration and distribution of the Common Fund and the Settlement Payment. The Administrator’s costs and any other costs of administering the Settlement Payment (other than the reasonable costs of notice to class members) will be deducted from the Common Fund prior to distribution of the Settlement Payment. Following final Court approval of the settlement, the Administrator will distribute the Settlement Payment on a pro rata basis to all holders of record of shares of ArthroCare common stock as of the date the Merger closes, except no such payment shall be made to any defendant in the Consolidated Action or its respective affiliates for their own account(s), pursuant to further terms and conditions set forth in the MOU. In addition, pursuant to the MOU, defendants acknowledged that the pendency and prosecution of the Consolidated Action were causal factors underlying ArthroCare’s decision to include certain supplemental disclosures in the definitive proxy statement filed by ArthroCare with the SEC on April 3, 2014. Plaintiffs and plaintiffs’ counsel intend to petition the Court for an award of attorneys’ fees and expenses, to which defendants reserve all rights. The parties to the Consolidated Action have agreed that any such award will not be deducted from the Common Fund.
The MOU further provides that, among other things, (a) the parties will enter into a definitive stipulation of settlement (the “Stipulation”) and will submit the Stipulation to the Court for review and approval; (b) the Stipulation will provide for dismissal of the Consolidated Action on the merits; (c) the Stipulation will include a general release of defendants of claims relating to the Merger; and (d) the proposed settlement is conditioned on, among other things, consummation of the Merger, completion of confirmatory discovery, class certification, and final approval by the Court after notice to ArthroCare’s stockholders.
NOTE 9 – CONTRACT TERMINATION AND OTHER FEES
The Company completed the consolidation of its Sunnyvale, California activities to Austin, Texas in the fourth quarter of 2011. In the second quarter of 2012, the Company entered into a sublease for its former Austin, Texas location which decreased the amount accrued for contract termination by
$1.1 million
. During the fourth quarter of 2013, as a result of the termination of a contract with one of the subtenants in our former Austin, Texas location, an additional
$0.7 million
expense was accrued for contract termination.
The following table summarizes the accrued and paid contract termination and other fees during the three month period ended
March 31, 2014
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance at
December 31, 2013
|
|
Cost Incurred
|
|
Payments
|
|
Balance at
March 31, 2014
|
|
Contract termination and other fees
|
|
$
|
1,443
|
|
|
$
|
—
|
|
|
$
|
270
|
|
|
$
|
1,173
|
|
|
|
|
$
|
1,443
|
|
|
$
|
—
|
|
|
$
|
270
|
|
|
$
|
1,173
|
|
NOTE 10 – SEGMENT INFORMATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Our business consists of
one
operating and reportable segment for the development, manufacturing and marketing of disposable devices and implants for select surgical procedures. The development, manufacturing and other supporting functions, such as regulatory affairs and distribution, are common across our Company. We organize and manage our sales and marketing functions according to geography and the surgical specialty that typically employs our products. Most of the Company’s products are used in Sports Medicine or ENT procedures.
Product sales by product area for the periods shown were as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three months ended
March 31, 2014
|
|
Three months ended
March 31, 2013
|
|
|
|
Americas
|
|
International
|
|
Total Product Sales
|
|
Americas
|
|
International
|
|
Total Product Sales
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Sports Medicine
|
|
$
|
40,179
|
|
|
$
|
23,618
|
|
|
$
|
63,797
|
|
|
$
|
38,862
|
|
|
$
|
20,754
|
|
|
$
|
59,616
|
|
|
ENT
|
|
18,785
|
|
|
5,558
|
|
|
24,343
|
|
|
19,748
|
|
|
5,868
|
|
|
25,616
|
|
|
Other
|
|
315
|
|
|
1,523
|
|
|
1,838
|
|
|
503
|
|
|
1,743
|
|
|
2,246
|
|
|
Total product sales
|
|
$
|
59,279
|
|
|
$
|
30,699
|
|
|
$
|
89,978
|
|
|
$
|
59,113
|
|
|
$
|
28,365
|
|
|
$
|
87,478
|
|
Internationally, the Company markets and supports its products primarily through its subsidiaries and various distributors. Product sales attributed to geographic areas are based on the country or regional area where the Company’s customer is domiciled. Product sales by geography for the periods shown were as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three months ended
March 31,
|
|
|
|
2014
|
|
2013
|
|
|
|
|
|
|
|
United States
|
|
$
|
56,773
|
|
|
$
|
56,908
|
|
|
Non-United States (1)
|
|
33,205
|
|
|
30,570
|
|
|
Total product sales
|
|
$
|
89,978
|
|
|
$
|
87,478
|
|
___________________________________________
(1) No additional locations are individually significant.
Long-lived assets, net by geography, at the balance sheet dates shown were as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March 31,
2014
|
|
December 31,
2013
|
|
|
|
|
|
|
|
United States
|
|
$
|
171,716
|
|
|
$
|
172,360
|
|
|
Non-United States (1)
|
|
62,454
|
|
|
63,560
|
|
|
Total long-lived assets
|
|
$
|
234,170
|
|
|
$
|
235,920
|
|
___________________________________________
(1) No additional locations are individually significant.
