0001142596-13-000010.txt : 20131030 0001142596-13-000010.hdr.sgml : 20131030 20131029191428 ACCESSION NUMBER: 0001142596-13-000010 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 20130930 FILED AS OF DATE: 20131030 DATE AS OF CHANGE: 20131029 FILER: COMPANY DATA: COMPANY CONFORMED NAME: NUVASIVE INC CENTRAL INDEX KEY: 0001142596 STANDARD INDUSTRIAL CLASSIFICATION: SURGICAL & MEDICAL INSTRUMENTS & APPARATUS [3841] IRS NUMBER: 330768598 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-50744 FILM NUMBER: 131177471 BUSINESS ADDRESS: STREET 1: 7475 LUSK BLVD. CITY: SAN DIEGO STATE: CA ZIP: 92121 BUSINESS PHONE: (858) 909-1800 MAIL ADDRESS: STREET 1: 7475 LUSK BLVD. CITY: SAN DIEGO STATE: CA ZIP: 92121 10-Q 1 nuva-9x30x2013x10xq.htm 10-Q NUVA-9-30-2013-10-Q
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q

(Mark One)
 
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2013
OR
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                 to
Commission file number: 000-50744


NUVASIVE, INC.
(Exact name of registrant as specified in its charter)
Delaware
  
33-0768598
(State or other jurisdiction of
incorporation or organization)
  
(I.R.S. Employer
Identification No.)
 
 
7475 Lusk Boulevard,
San Diego, CA 92121
(Address of principal executive offices)
Registrant’s telephone number, including area code:
(858) 909-1800

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 than the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  þ    NO  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 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  þ    NO  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer  þ
 
Accelerated filer  ¨
 
Non-accelerated filer  ¨
 
Smaller reporting company  ¨
 
 
 
 
(Do not check if a smaller reporting company)
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  ¨    NO  þ

As of October 21, 2013, there were 44,618,891 shares of the registrant’s common stock issued and outstanding.




NuVasive, Inc.
Quarterly Report on Form 10-Q
September 30, 2013
 

1


PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
NUVASIVE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par values)
 
 
September 30,
 
December 31,
 
2013
 
2012
 
(Unaudited)
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
100,616

 
$
123,299

Short-term marketable securities
109,214

 
138,405

Accounts receivable, net
96,208

 
88,958

Inventory
140,709

 
126,335

Deferred tax assets, current
31,136

 
28,236

Prepaid expenses and other current assets
10,100

 
8,516

Total current assets
487,983

 
513,749

Property and equipment, net
130,796

 
125,123

Long-term marketable securities
92,999

 
84,412

Intangible assets, net
93,037

 
101,362

Goodwill
154,913

 
154,106

Deferred tax assets
39,719

 
40,575

Restricted cash and investments
119,168

 
118,995

Other assets
21,624

 
25,463

Total assets
$
1,140,239

 
$
1,163,785

LIABILITIES AND EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable and accrued liabilities
$
81,820

 
$
62,048

Accrued payroll and related expenses
26,117

 
27,916

Senior Convertible Notes, current

 
74,311

Total current liabilities
107,937

 
164,275

Senior Convertible Notes
342,552

 
332,404

Deferred tax liabilities
3,143

 
3,129

Litigation liability
93,700

 
101,200

Other long-term liabilities
14,789

 
15,199

Commitments and contingencies

 

Noncontrolling interests

 
10,003

Stockholders’ equity:
 
 
 
Preferred stock, $0.001 par value; 5,000 shares authorized, none outstanding

 

Common stock, $0.001 par value; 120,000 shares authorized at September 30, 2013 and December 31, 2012, 44,596 and 43,686 issued and outstanding at September 30, 2013 and December 31, 2012, respectively
45

 
44

Additional paid-in capital
746,518

 
714,865

Accumulated other comprehensive (loss) income
(1,476
)
 
786

Accumulated deficit
(176,227
)
 
(178,120
)
Total NuVasive, Inc. stockholders’ equity
568,860

 
537,575

Noncontrolling interests
9,258

 

Total equity
578,118

 
537,575

Total liabilities and equity
$
1,140,239

 
$
1,163,785

See accompanying notes to unaudited condensed consolidated financial statements.

2


NUVASIVE, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Revenue
$
169,156

 
$
148,391

 
$
494,358

 
$
454,501

Cost of goods sold (excluding amortization of purchased technology)
43,291

 
37,746

 
131,131

 
111,213

Gross profit
125,865

 
110,645

 
363,227

 
343,288

Operating expenses:
 
 
 
 
 
 
 
Sales, marketing and administrative
102,085

 
87,410

 
306,243

 
274,703

Research and development
7,248

 
7,575

 
24,654

 
26,898

Amortization of intangible assets
4,974

 
3,081

 
14,263

 
8,830

Total operating expenses
114,307

 
98,066

 
345,160

 
310,431

Interest and other expense, net:
 
 
 
 
 
 
 
Interest income
157

 
249

 
560

 
661

Interest expense
(6,712
)
 
(6,885
)
 
(20,396
)
 
(20,682
)
Other income, net
3,137

 
260

 
2,937

 
146

Total interest and other expense, net
(3,418
)
 
(6,376
)
 
(16,899
)
 
(19,875
)
Income before income taxes
8,140

 
6,203

 
1,168

 
12,982

Income tax expense
860

 
4,064

 
20

 
7,764

Consolidated net income
$
7,280

 
$
2,139

 
$
1,148

 
$
5,218

Net loss attributable to noncontrolling interests
$
(231
)
 
$
(215
)
 
$
(745
)
 
$
(672
)
Net income attributable to NuVasive, Inc.
$
7,511

 
$
2,354

 
$
1,893

 
$
5,890

 
 
 
 
 
 
 
 
Net income per share attributable to NuVasive, Inc.:
 
 
 
 
 
 
 
Basic
$
0.17

 
$
0.05

 
$
0.04

 
$
0.14

Diluted
$
0.16

 
$
0.05

 
$
0.04

 
$
0.13

Weighted average shares outstanding:
 
 
 
 
 
 
 
Basic
44,572

 
43,488

 
44,339

 
43,227

Diluted
47,220

 
44,735

 
46,387

 
44,151

 

See accompanying notes to unaudited condensed consolidated financial statements.

3


NUVASIVE, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Consolidated net income
$
7,280

 
$
2,139

 
$
1,148

 
$
5,218

Other comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized gain (loss) on marketable securities, net of tax
283

 
102

 
13

 
(43
)
Translation adjustments, net of tax
1,654

 
1,029

 
(2,275
)
 
732

Other comprehensive income (loss)
1,937

 
1,131


(2,262
)
 
689

Total consolidated comprehensive income (loss)
9,217

 
3,270

 
(1,114
)
 
5,907

Plus: Net loss attributable to noncontrolling interests
231

 
215

 
745

 
672

Comprehensive income (loss) attributable to NuVasive, Inc.
$
9,448

 
$
3,485

 
$
(369
)
 
$
6,579





































See accompanying notes to unaudited condensed consolidated financial statements.


4


NUVASIVE, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) 
 
Nine Months Ended September 30,
 
2013
 
2012
Operating activities:
 
 
 
Consolidated net income
$
1,148

 
$
5,218

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
46,289

 
38,237

Amortization of debt discount
10,148

 
9,435

Amortization of debt issuance costs
1,265

 
1,386

Stock-based compensation
24,002

 
20,400

Allowance for doubtful accounts and sales return reserves
665

 
816

Allowance for excess and obsolete inventory, net of write-offs
1,984

 
2,000

Other non-cash adjustments
3,881

 
5,002

Changes in operating assets and liabilities, net of effects from acquisitions:
 
 
 
Accounts receivable
(8,253
)
 
8,421

Inventory
(16,749
)
 
(14,222
)
Prepaid expenses and other current assets
(2,838
)
 
13,582

Accounts payable and accrued liabilities
10,415

 
9,480

Accrued payroll and related expenses
(1,824
)
 
(269
)
Net cash provided by operating activities
70,133

 
99,486

Investing activities:
 
 
 
Cash paid for business and asset acquisitions
(8,019
)
 
(9,838
)
Purchases of property and equipment
(38,018
)
 
(35,706
)
Purchases of marketable securities
(164,338
)
 
(192,759
)
Sales of marketable securities
183,756

 
193,035

Purchases of restricted investments

 
(113,331
)
Net cash used in investing activities
(26,619
)
 
(158,599
)
Financing activities:
 
 
 
Principal payment of 2013 Senior Convertible Notes
(74,311
)
 

Tax benefits related to stock-based compensation awards
5,247

 

Proceeds from the issuance of common stock
3,492

 
3,183

Other assets
(72
)
 
132

Net cash (used in) provided by financing activities
(65,644
)
 
3,315

Effect of exchange rate changes on cash
(553
)
 
37

Decrease in cash and cash equivalents
(22,683
)
 
(55,761
)
Cash and cash equivalents at beginning of period
123,299

 
163,492

Cash and cash equivalents at end of period
$
100,616

 
$
107,731

Supplemental disclosure of non-cash transactions:
 
 
 
Issuance of common stock in connection with asset acquisitions
$

 
$
7,560



See accompanying notes to unaudited condensed consolidated financial statements.

5


NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1.    Description of Business and Basis of Presentation
Description of Business.    NuVasive, Inc. (the Company or NuVasive) was incorporated in Delaware on July 21, 1997, and began commercializing its products in 2001. The Company is focused on developing minimally disruptive surgical products and procedurally integrated solutions for the spine. NuVasive's principal product offering includes a minimally disruptive surgical platform called Maximum Access Surgery, or MAS®, as well as an offering of biologics, cervical and motion preservation products. The MAS platform combines three categories of solutions that collectively minimize soft tissue disruption during spine fusion surgery, provide maximum visualization and are designed to enable reproducible outcomes for the surgeon. The platform includes a proprietary software-driven nerve detection and avoidance systems, NVM5 and NVJJB, and Intra-Operative Monitoring (IOM) support; MaXcess®, a unique and integrated split-blade retractor system; and a wide variety of specialized implants. When the three elements of MAS are used together, they may significantly reduce surgery time and return patients to activities of daily living much faster than conventional approaches. The individual components of NuVasive's MAS platform, and many of the Company's products, can also be used in open or traditional spine surgery and may independently offer patient benefits to various surgical approaches dealing with a wide variety of pathologies. The Company continues to focus significant research and development efforts to expand its MAS product platform and advance the applications of its unique technology into procedurally integrated surgical solutions. The Company dedicates significant resources toward training spine surgeons on its unique technology and products.
The Company’s primary business model is to loan its MAS systems to surgeons and hospitals who purchase disposables and implants for use in individual procedures. In addition, for larger customers, the Company’s proprietary nerve monitoring systems, MaXcess and surgical instrument sets are placed with hospitals for an extended period at no up-front cost to them. The Company also offers a range of bone allograft in patented saline packaging, disposables and spine implants, which include its branded CoRoent® products and fixation devices such as rods, plates and screws. Implants and disposables are shipped from the Company’s inventories. The Company sells an immaterial quantity of MAS instrument sets, MaXcess and nerve monitoring systems to hospitals.
Basis of Presentation and Principles of Consolidation.    The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Pursuant to these rules and regulations, the Company has condensed or omitted certain information and footnote disclosures it normally includes in its annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States (GAAP). In the opinion of management, the condensed consolidated financial statements include all adjustments necessary, which are of a normal and recurring nature, for the fair presentation of the Company's financial position and of the results of operations and cash flows for the periods presented.
The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Additionally, the unaudited condensed consolidated financial statements for all periods presented include the accounts of a variable interest entity, Progentix Orthobiology, B.V. (Progentix), which is consolidated pursuant to existing guidance issued by the Financial Accounting Standards Board (FASB).
As a result of the 2011 acquisition of Impulse Monitoring Inc. (Impulse Monitoring), the Company maintains a contractual relationship with several physician practices (PCs) whereby the PCs provide the physician oversight service associated with the IOM services. Pursuant to such contractual arrangements, the Company provides management services to the PCs. As of September 30, 2013 and December 31, 2012, the associated PCs are American Neuromonitoring Associates, P.C.; Pacific Neuromonitoring Associates, Inc.; Keystone Neuromonitoring Associates, P.C.; North Pacific Neuromonitoring Associates, P.C.; and Midwest Neuromonitoring Associates, Inc. Under the management services agreements, the Company provides all non-medical services to the PCs in return for a management fee that is settled on a monthly basis. The management services include management reporting, billing and collections of all charges for medical services provided and all administrative support to the PCs. Pursuant to existing guidance issued by the FASB, these represent variable interest entities for which the Company is the primary beneficiary, and the accompanying consolidated financial statements include the accounts of the PCs from the date of acquisition.
All significant intercompany balances and transactions have been eliminated in consolidation.
 
These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2012 included in NuVasive's Annual Report on Form 10-K filed with the SEC. Operating results for the three and nine months ended September 30, 2013 are not necessarily indicative of the results that may be expected for any other interim period or for the full year. The balance sheet at December 31, 2012 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by GAAP for complete financial statements.

6

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Reclassifications.    Certain reclassifications have been made to the prior period condensed consolidated financial statements and notes to conform to the current year presentation.
2.    Recently Adopted Accounting Standards
Effective January 1, 2013, the Company adopted the FASB's requirements for presentation of reclassifications out of accumulated other comprehensive income (AOCI). The guidance requires companies to report, in one place, information about reclassifications out of AOCI and to present reclassifications by component when reporting changes in AOCI balances. The adoption of this authoritative guidance did not have an impact on the Company's financial position or results of operations.
3.    Investment in Progentix Orthobiology, B.V.
In 2009, the Company completed the purchase of forty percent (40%) of the capital stock of Progentix, a company organized under the laws of the Netherlands, from existing shareholders (the Progentix Shareholders) pursuant to a Preferred Stock Purchase Agreement for $10 million in cash (the Initial Investment). Concurrent with the Initial Investment, NuVasive and Progentix also entered into a Senior Secured Facility Agreement, whereby Progentix may borrow up to $5.0 million from NuVasive to fund ongoing clinical and regulatory efforts (the Loan). At September 30, 2013, the Company had advanced Progentix the full $5.0 million in accordance with the Loan Agreement. The Loan accrues interest at a rate of six percent (6%) per year. Other than its obligations under the Loan Agreement, NuVasive is not obligated to provide additional funding, nor has any additional funding been provided, to Progentix.
Also concurrent with the Preferred Stock Purchase Agreement, NuVasive, Progentix and the Progentix Shareholders entered into an Option Purchase Agreement, as amended (the Option Agreement), whereby NuVasive was obligated (the Put Option), upon the achievement of an annual sales run rate on Progentix products in excess of a specified amount between June 14, 2011 and June 13, 2013 (the Option Period), to purchase the remaining sixty percent (60%) of capital stock of Progentix from its shareholders (the Remaining Shares) for an amount up to $35.0 million, subject to certain reductions, payable in a combination of cash and NuVasive common stock, at NuVasive’s sole discretion. In accordance with the Option Agreement, NuVasive had the right to purchase the Remaining Shares (the Call Option) during the Option Period for an amount up to $35.0 million, subject to certain reductions, payable in a combination of cash and NuVasive common stock, at NuVasive’s sole discretion. The Option Agreement expired unexercised on June 13, 2013. NuVasive and Progentix also entered into a Distribution Agreement during 2009, as amended, whereby Progentix appointed NuVasive as its exclusive distributor for certain Progentix products. The Distribution Agreement will be in effect for a term of ten years unless terminated earlier in accordance with its terms.
 
In accordance with authoritative guidance, the Company has determined that Progentix is a variable interest entity as it does not have the ability to finance its activities without additional subordinated financial support and its equity investors will not absorb their proportionate share of expected losses and will be limited in the receipt of the potential residual returns of Progentix. Additionally, pursuant to this guidance, NuVasive is considered its primary beneficiary as NuVasive has both (1) the power to direct the economically significant activities of Progentix and (2) the obligation to absorb losses of, or the right to receive benefits from, Progentix. Accordingly, the financial position and results of operations of Progentix have been included in the Company’s consolidated financial statements from the date of the Initial Investment. The liabilities recognized as a result of consolidating Progentix do not represent additional claims on the Company’s general assets. The creditors of Progentix have claims only on the assets of Progentix, which are not material, and the assets of Progentix are not available to NuVasive.
Pursuant to authoritative guidance, the equity interests in Progentix not owned by the Company, which includes shares of both common and preferred stock, are reported as noncontrolling interests on the consolidated balance sheet of the Company. The preferred stock represents 18% of the noncontrolling equity interests and provides for a cumulative 8% dividend, if and when declared by Progentix’s Board of Directors. As the rights of the preferred stock are substantially the same as those of the common stock, the preferred stock is classified as noncontrolling interest and shares in the allocation of the losses incurred by Progentix. Losses incurred by Progentix are charged to the Company and to the noncontrolling interest holders based on their ownership percentage. The Remaining Shares and the Option Agreement that was entered into between NuVasive, Progentix and the Progentix Shareholders were not considered to be freestanding financial instruments during the Option Period as defined by authoritative guidance. Therefore, during the Option Period, the Remaining Shares and the Option Agreement were accounted for as a combined unit on the condensed consolidated financial statements as a redeemable noncontrolling interest that was initially recorded at fair value and classified as mezzanine equity. Upon the expiration of the Option Agreement on June 13, 2013, the noncontrolling interest was no longer redeemable and therefore, pursuant to the authoritative guidance, the noncontrolling interest was reclassified out of mezzanine equity to its own component of total equity within the Company's condensed consolidated balance sheet.

7

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Total assets and liabilities of Progentix included in the accompanying condensed consolidated balance sheet are as follows (in thousands):
 
 
September 30, 2013
 
December 31, 2012
Total current assets
$
523

 
$
657

Identifiable intangible assets, net
14,520

 
14,871

Goodwill
12,654

 
12,654

Other long-term assets
9

 
15

Accounts payable & accrued expenses
364

 
230

Deferred tax liabilities, net
2,890

 
2,890

Noncontrolling interests
9,258

 
10,003

 The following is a reconciliation of equity (net assets) attributable to the noncontrolling interests (in thousands):
 
Nine Months Ended
September 30,
 
2013
 
2012
Noncontrolling interests at beginning of period
$
10,003

 
$
10,705

Less: Net loss attributable to the noncontrolling interests
745

 
672

Noncontrolling interests at end of period
$
9,258

 
$
10,033


4.    Balance Sheet Reserves
The balances of the reserves for accounts receivable and inventory are as follows (in thousands):
 
September 30, 2013
 
December 31, 2012
Reserves for accounts receivable and sales returns
$
3,362

 
$
2,780

Reserves for excess and obsolete inventory
$
18,722

 
$
16,856

The Company's inventory consists primarily of purchased finished goods, which includes specialized implants and disposables, and is stated at the lower of cost or market determined by a weighted average cost method. The Company reviews the components of its inventory on a periodic basis for excess, obsolete or impaired inventory, and records a reserve for the identified items.
5.    Marketable Securities and Fair Value Measurements
Marketable securities consist of certificates of deposit, corporate notes, commercial paper, U.S. government treasury securities and securities of government-sponsored entities. The Company classifies all securities as available-for-sale, as the sale of such securities may be required prior to maturity to implement management strategies. These securities are carried at fair value, with the unrealized gains and losses reported as a component of other comprehensive income in equity until realized. A decline in the market value of any marketable security below cost that is determined to be other-than-temporary will result in a revaluation of its carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established. No such impairment charges were recorded for any period presented.
Realized gains and losses from the sale of marketable securities, if any, are determined on a specific identification basis. Realized gains and losses and declines in value judged to be other-than-temporary, if any, on available-for-sale securities are included in other income or expense on the consolidated statements of operations. Realized gains and losses during the periods presented were immaterial. Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to yield using the straight-line method and are included in interest income on the condensed consolidated statements of operations. Interest and dividends on securities classified as available-for-sale are included in interest income on the condensed consolidated statements of operations.

8

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The composition of marketable securities is as follows (in thousands, except years):
 
Contractual
Maturity
(in Years)
 
Amortized Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
September 30, 2013:
 
 
 
 
 
 
 
 
 
Classified as current assets
 
 
 
 
 
 
 
 
 
Certificates of deposit
Less than 1
 
$
1,099

 
$

 
$

 
$
1,099

Corporate notes
Less than 1
 
58,787

 
23

 
(18
)
 
58,792

Commercial paper
Less than 1
 
14,992

 

 

 
14,992

U.S. government treasury securities
Less than 1
 
14,616

 
8

 

 
14,624

Securities of government-sponsored entities
Less than 1
 
19,697

 
10

 

 
19,707

Short-term marketable securities
 
 
109,191

 
41

 
(18
)
 
109,214

Classified as non-current assets
 
 
 
 
 
 
 
 
 
Certificates of deposit
1 to 2
 
575

 

 

 
575

Corporate notes
1 to 2
 
26,332

 
15

 
(18
)
 
26,329

U.S. government treasury securities
1 to 2
 
1,500

 
1

 

 
1,501

Securities of government-sponsored entities
1 to 2
 
64,557

 
42

 
(5
)
 
64,594

Long-term marketable securities
 
 
92,964

 
58

 
(23
)
 
92,999

Classified as restricted investments
 
 
 
 
 
 
 
 
 
U.S. government treasury securities
Less than 2
 
47,407

 
22

 
(2
)
 
47,427

Securities of government-sponsored entities
Less than 2
 
39,149

 
9

 
(2
)
 
39,156

Restricted investments
 
 
86,556

 
31

 
(4
)
 
86,583

Total marketable securities at September 30, 2013
 
 
$
288,711

 
$
130

 
$
(45
)
 
$
288,796

 
 
 
 
 
 
 
 
 
 
December 31, 2012:
 
 
 
 
 
 
 
 
 
Classified as current assets
 
 
 
 
 
 
 
 
 
Certificates of deposit
Less than 1
 
$
998

 
$

 
$

 
$
998

Corporate notes
Less than 1
 
19,169

 
3

 
(1
)
 
19,171

Commercial paper
Less than 1
 
9,995

 
2

 

 
9,997

U.S. government treasury securities
Less than 1
 
17,055

 
6

 

 
17,061

Securities of government-sponsored entities
Less than 1
 
91,151

 
27

 

 
91,178

Short-term marketable securities
 
 
138,368

 
38

 
(1
)
 
138,405

Classified as non-current assets
 
 
 
 
 
 
 
 
 
Corporate notes
1 to 2
 
23,293

 

 
(17
)
 
23,276

U.S. government treasury securities
1 to 2
 
7,619

 
4

 

 
7,623

Securities of government-sponsored entities
1 to 2
 
53,493

 
22

 
(2
)
 
53,513

Long-term marketable securities
 
 
84,405

 
26

 
(19
)
 
84,412

Classified as restricted investments
 
 
 
 
 
 
 
 
 
U.S. government treasury securities
Less than 2
 
31,784

 
5

 
(1
)
 
31,788

Securities of government-sponsored entities
Less than 2
 
53,618

 
18

 
(1
)
 
53,635

Restricted investments
 
 
85,402

 
23

 
(2
)
 
85,423

Total marketable securities at December 31, 2012
 
 
$
308,175

 
$
87

 
$
(22
)
 
$
308,240


9

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

As of September 30, 2013, the Company had no investments that were in a significant unrealized loss position. The Company reviews its investments to identify and evaluate investments that have an indication of possible other-than-temporary impairment. Factors considered in determining whether a loss is other-than-temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. The Company maintains an investment portfolio of various holdings, types and maturities. The Company does not hold derivative financial investments. The Company places its cash investments in instruments that meet high credit quality standards, as specified in its investment policy guidelines. These guidelines also limit the amount of credit exposure to any one issue, issuer or type of instrument.
The Company measures certain assets and liabilities in accordance with authoritative guidance which requires fair value measurements be classified and disclosed in one of the following three categories:
Level 1: Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities.
Level 2: Observable prices that are based on inputs not quoted on active markets, but corroborated by market data.
Level 3: Unobservable inputs are used when little or no market data is available.
Assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurements. The Company reviews the fair value hierarchy classification on a quarterly basis. Changes in the ability to observe valuation inputs may result in a reclassification of levels for certain assets or liabilities within the fair value hierarchy. The Company did not have any transfers of assets and liabilities between Level 1 and Level 2 of the fair value measurement hierarchy during the three and nine months ended September 30, 2013 and 2012. The Company had no transfers from Level 3 of the fair value measurement hierarchy during the three and nine months ended September 30, 2013 and the three months ended September 30, 2012. The Company had one transfer from Level 3 of the fair value measurement hierarchy during the nine months ended September 30, 2012, as a result of the settlement of a milestone.

10

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The fair values of the Company’s assets and liabilities, which are measured at fair value on a recurring basis, were determined using the following inputs (in thousands):
 
Total
 
Quoted Price in
Active Market
(Level 1)
 
Significant Other
Observable Inputs
(Level 2)
 
Significant
Unobservable
Inputs (Level 3)
September 30, 2013:
 
 
 
 
 
 
 
Cash Equivalents, Marketable Securities and Restricted Investments:
 
 
 
 
 
 
 
Money market funds
$
59,107

 
$
59,107

 
$

 
$

Certificates of deposit
1,674

 
1,674

 

 

Corporate notes
85,121

 

 
85,121

 

Commercial paper
14,992

 

 
14,992

 

U.S. government treasury securities
63,552

 
63,552

 

 

Securities of government-sponsored entities
123,457

 

 
123,457

 

Total cash equivalents, marketable securities and restricted investments
$
347,903

 
$
124,333

 
$
223,570

 
$

 
 
 
 
 
 
 
 
Contingent Consideration:
 
 
 
 
 
 
 
Acquisition-related liabilities, current
$
(573
)
 
$

 
$

 
$
(573
)
Acquisition-related liabilities, non-current
$
(576
)
 
$

 
$

 
$
(576
)
Total contingent consideration
$
(1,149
)
 
$

 
$

 
$
(1,149
)
 
 
 
 
 
 
 
 
December 31, 2012:
 
 
 
 
 
 
 
Cash Equivalents, Marketable Securities and Restricted Investments:
 
 
 
 
 
 
 
Money market funds
$
89,101

 
$
89,101

 
$

 
$

Certificates of deposit
998

 
998

 

 

Corporate notes
42,447

 

 
42,447

 

Commercial paper
9,997

 

 
9,997

 

U.S. government treasury securities
56,472

 
56,472

 

 

Securities of government-sponsored entities
198,326

 

 
198,326

 

Total cash equivalents, marketable securities and restricted investments
$
397,341

 
$
146,571

 
$
250,770

 
$

 
 
 
 
 
 
 
 
Contingent Consideration:
 
 
 
 
 
 
 
Acquisition-related liabilities, non-current
$
(1,074
)
 
$

 
$

 
$
(1,074
)
The carrying amounts of financial instruments such as cash equivalents, accounts receivable, prepaid expenses, other current assets, accounts payable, accrued expenses, and other current liabilities approximate the related fair values due to the short-term maturities of these instruments. The estimated fair value of the Company's capital lease obligations approximated their carrying values as of September 30, 2013 and December 31, 2012. The fair and carrying value of the Company’s Senior Convertible Notes is discussed in Note 7.
Contingent Consideration Liability
In connection with the acquisition of Cervitech, Inc. (Cervitech) in May 2009, the Company was required to pay an additional amount not to exceed $33.0 million in the event that the PCM Cervical Disc System (PCM) received FDA approval. The fair value of the contingent consideration was determined using a probability-weighted discounted cash flow model, the significant inputs of which were not observable in the market. The key assumptions in applying this approach were the interest rate, the timing of expected approval and the probability assigned to the milestone being achieved. During the fourth quarter of 2012, the PCM was

11

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

approved by the FDA. Accordingly, the contingent consideration liability was accreted to $33.0 million. Changes in fair value were recorded in the statement of operations as sales, marketing and administrative expenses.
In connection with an immaterial acquisition in 2012, the Company is required to pay an amount not to exceed €2.0 million in the event two specified revenue-based milestones are met. The fair value of the contingent consideration was determined using a discounted cash flow model, the significant inputs of which are not observable in the market. The key assumptions in applying this approach are the revenue projections, the interest rate and the probabilities assigned to the milestones being achieved. Based on these assumptions, the estimated fair value of the contingent consideration totaled $1.1 million at September 30, 2013 and is included in accrued liabilities in the September 30, 2013 condensed consolidated balance sheet. Changes in fair value are recorded in the statements of operations as sales, marketing and administrative expenses.
In addition, during the nine months ended September 30, 2012, approximately $0.5 million related to contingent consideration recorded in connection with an immaterial acquisition which occurred in 2010 was settled and no longer considered contingent consideration.
The following table sets forth the changes in the estimated fair value of the Company’s liabilities measured on a recurring basis using significant unobservable inputs (Level 3) (in thousands):
 
Nine Months Ended September 30,
 
2013
 
2012
Fair value measurement at beginning of period
$
1,074

 
$
32,221

Contingent consideration liability recorded upon acquisition

 
1,019

Change in fair value measurement included in operating expenses
75

 
708

Contingent consideration settled

 
(530
)
Fair value measurement at end of period
$
1,149

 
$
33,418

6.    Goodwill and Intangible Assets
Goodwill and intangible assets consisted of the following (in thousands, except years):
 
Weighted-
Average
Amortization
Period
(in years)
 
Gross
Amount
 
Accumulated
Amortization
 
Intangible
Assets, net
September 30, 2013:
 
 
 
 
 
 
 
Intangible Assets Subject to Amortization:
 
 
 
 
 
 
 
Purchased technology:
 
 
 
 
 
 
 
Developed technology
10
 
$
56,328

 
$
(19,668
)
 
$
36,660

Manufacturing know-how and trade secrets
12
 
21,979

 
(9,412
)
 
12,567

Trade name and trademarks
11
 
9,500

 
(3,071
)
 
6,429

Customer relationships
8
 
43,865

 
(17,124
)
 
26,741

 
10
 
$
131,672

 
$
(49,275
)
 
$
82,397

Intangible Assets Not Subject to Amortization:
 
 
 
 
 
 
 
In-process research and development
 
 
 
 
 
 
10,640

Goodwill
 
 
 
 
 
 
154,913

Total goodwill and intangible assets, net
 
 
 
 
 
 
$
247,950

 

12

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Weighted-
Average
Amortization
Period
(in years)
 
Gross
Amount
 
Accumulated
Amortization
 
Intangible
Assets, net
December 31, 2012:
 
 
 
 
 
 
 
Intangible Assets Subject to Amortization:
 
 
 
 
 
 
 
Purchased technology:
 
 
 
 
 
 
 
Developed technology
10
 
$
55,178

 
$
(14,966
)
 
$
40,212

Manufacturing know-how and trade secrets
12
 
21,712

 
(7,996
)
 
13,716

Trade name and trademarks
11
 
9,500

 
(2,333
)
 
7,167

Customer relationships
9
 
39,330

 
(9,703
)
 
29,627

 
10
 
$
125,720

 
$
(34,998
)
 
$
90,722

Intangible Assets Not Subject to Amortization:
 
 
 
 
 
 
 
In-process research and development
 
 
 
 
 
 
10,640

Goodwill
 
 
 
 
 
 
154,106

Total goodwill and intangible assets, net
 
 
 
 
 
 
$
255,468

Total expense related to the amortization of intangible assets was $5.0 million and $3.1 million for the three months ended September 30, 2013 and 2012, respectively, and $14.3 million and $8.8 million for the nine months ended September 30, 2013 and 2012, respectively. In-process research and development will be amortized beginning on the regulatory approval date of the respective acquired products and will be amortized over the estimated useful life determined at that time.
Total future amortization expense related to intangible assets subject to amortization at September 30, 2013 is set forth in the table below (in thousands):
Remaining 2013
$
4,971

2014
13,603

2015
12,515

2016
12,040

2017
9,688

2018
9,171

Thereafter through 2026
20,409

Total future amortization expense
$
82,397

7.    Senior Convertible Notes
The carrying values of the Company’s Senior Convertible Notes are as follows (in thousands):
 
September 30, 2013
 
December 31, 2012
2.75% Senior Convertible Notes due 2017:
 
 
 
Principal amount
$
402,500

 
$
402,500

Unamortized debt discount
(59,948
)
 
(70,096
)
 
342,552

 
332,404

2.25% Senior Convertible Notes due 2013

 
74,311

Total Senior Convertible Notes
$
342,552

 
$
406,715

2.75% Senior Convertible Notes due 2017
In June 2011, the Company issued $402.5 million principal amount of the 2017 Notes, which includes the issuance of $52.5 million principal amount for the exercise of the initial purchasers’ option to purchase additional notes. The net proceeds from the offering, after deducting initial purchasers’ discounts and costs directly related to the offering, were approximately $359.2 million. The 2017 Notes have a stated interest rate of 2.75% and mature on July 1, 2017. Prior to September 28, 2011, the date on which

13

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

stockholder approval to increase the number of the Company’s authorized shares of common stock from 70 million to 120 million was obtained, the 2017 Notes were settleable only in cash. Subsequent to the receipt of this approval, the 2017 Notes may be settled in cash, stock, or a combination thereof, solely at the Company’s election. It is the Company’s current intent and policy to settle all conversions through combination settlement, which involves repayment of an amount of cash equal to the principal amount and any excess of the conversion value over the principal amount in shares of common stock. The initial conversion rate of the 2017 Notes is 23.7344 shares per $1,000 principal amount, subject to adjustment (which represents an initial conversion price of approximately $42.13 per share).
Interest on the 2017 Notes began accruing in June 2011 and is payable semi-annually each January 1st and July 1st, beginning January 1, 2012. The fair value, based on a quoted market price, or Level 1, of the outstanding 2017 Notes at September 30, 2013 and December 31, 2012 was approximately $392.8 million and $361.3 million, respectively.
Prior to January 1, 2017, holders may convert their 2017 Notes only under the following conditions: a) During any calendar quarter beginning October 1, 2011, if the reported sale price of the Company’s common stock for at least 20 days of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than 130% of the conversion price on each applicable trading day; b) During the five business day period in which the trading price of the 2017 Notes falls below 98% of the product of (i) the last reported sale price of the Company’s common stock and (ii) the conversion rate on that date; and c) Upon the occurrence of specified corporate events, as defined in the 2017 Notes. From January 1, 2017 and until the close of business on the second scheduled trading day immediately preceding July 1, 2017, holders may convert their 2017 Notes at any time, regardless of the foregoing circumstances. The Company may not redeem the 2017 Notes prior to maturity. As of September 30, 2013, the “if-converted” value of the 2017 Notes did not exceed its principal amount and none of the conditions allowing holders of the 2017 Notes to convert had been met.
Other than restrictions relating to certain fundamental changes and consolidations, mergers or asset sales and customary anti-dilution adjustments, the 2017 Notes do not contain any financial covenants and do not restrict the Company from paying dividends or issuing or repurchasing any of its other securities.
In accordance with authoritative guidance, the cash conversion feature of the 2017 Notes (the 2017 Notes Embedded Conversion Derivative) required bifurcation from the 2017 Notes and was initially accounted for as a derivative liability. The fair value of the 2017 Notes Embedded Conversion Derivative at the time of issuance of the 2017 Notes was $88.9 million, and was recorded as the original debt discount for purposes of accounting for the debt component of the 2017 Notes. On September 28, 2011, upon obtaining stockholder approval of the additional authorized shares of the Company’s common stock, in accordance with authoritative literature, the derivative liability was marked to fair value and reclassified to equity. The original debt discount is being recognized as interest expense using an effective interest rate of 8.0% over the term of the 2017 Notes. At September 30, 2013 and December 31, 2012, the net carrying value of the equity component is $49.3 million.
The interest expense recognized on the 2017 Notes during the three months ended September 30, 2013 includes $2.8 million and $3.4 million for the contractual coupon interest and the accretion of the debt discount, respectively. The interest expense recognized on the 2017 Notes during the nine months ended September 30, 2013 includes $8.3 million and $10.1 million for the contractual coupon interest and the accretion of the debt discount, respectively. During the three months ended September 30, 2012, interest expense recognized on the 2017 Notes includes $2.8 million and $3.2 million for the contractual coupon interest and the accretion of the debt discount, respectively. The interest expense recognized on the 2017 Notes during the nine months ended September 30, 2012 includes $8.3 million and $9.4 million for the contractual coupon interest and the accretion of the debt discount, respectively.
In connection with the offering of the 2017 Notes, the Company entered into a convertible note hedge transaction (the 2017 Hedge) with the initial purchasers and/or their affiliates (the 2017 Counterparties) entitling the Company to purchase up to 9,553,096 shares of the Company’s common stock at an initial stock price of $42.13 per share, each of which is subject to adjustment. Prior to obtaining the stockholder approval to increase the number of the Company’s authorized common shares discussed above, the 2017 Hedge was settleable only in cash and was accounted for as a derivative asset. The cost of the 2017 Hedge was $80.1 million. On September 28, 2011, upon obtaining stockholder approval of the additional authorized shares of the Company’s common stock, in accordance with authoritative literature, the derivative asset was marked to fair value and reclassified to stockholders’ equity. The 2017 Hedge expires on July 1, 2017. The 2017 Hedge is expected to reduce the potential equity dilution upon conversion of the 2017 Notes if the daily volume-weighted average price per share of the Company’s common stock exceeds the strike price of the 2017 Hedge. 
In addition, the Company sold warrants to the 2017 Counterparties to acquire up to 477,654 shares of the Company’s Series A Participating Preferred Stock (the 2017 Warrants), at an initial strike price of $988.51 per share, subject to adjustment. Each share of Series A Participating Preferred Stock is initially convertible into 20 shares of the Company’s common stock. The 2017

14

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Warrants expire on various dates from September 2017 through January 2018 and may be settled in cash or net shares. The Company received $47.9 million in cash proceeds from the sale of the 2017 Warrants, which has been recorded as an increase in additional paid-in-capital. The 2017 Warrants could have a dilutive effect on the Company’s earnings per share to the extent that the price of the Company’s common stock during a given measurement period (the quarter or year-to-date period) exceeds the strike price of the 2017 Warrants.
2.25% Senior Convertible Notes due 2013
In March 2008, the Company issued $230.0 million principal amount of 2.25% unsecured Senior Convertible Notes (the 2013 Notes). The net proceeds from the offering, after deducting the initial purchasers’ discounts and costs directly related to the offering, were approximately $208.4 million. During the year ended December 31, 2011, the Company repurchased, in privately negotiated transactions, approximately $155.7 million in principal of its 2013 Notes. The remaining balance of the 2013 Notes matured on March 15, 2013 and accordingly, during the three months ended March 31, 2013, the Company repaid the total outstanding principal amount of $74.3 million in cash.
In connection with the offering of the 2013 Notes, the Company sold to the initial purchasers and/or their affiliates warrants to acquire up to 5.1 million shares of the Company's common stock (the 2013 Warrants), at an initial strike price of $49.13 per share, subject to adjustment. The 2013 Warrants could have a dilutive effect on the Company's earnings per share to the extent that the price of the Company's common stock during a given measurement period (the quarter or year to date period) exceeds the strike price of the 2013 Warrants. The 2013 Warrants began expiring in June 2013 and at September 30, 2013, warrants to acquire up to 0.4 million shares of the Company's common stock remained outstanding. All remaining outstanding warrants expired on or before October 8, 2013.
8.   Net Income Per Share
The Company computes basic net income per share using the weighted-average number of common shares outstanding during the period. Diluted net income per share assumes the conversion, exercise or issuance of all potential common stock equivalents, unless the effect of inclusion would be anti-dilutive. For purposes of this calculation, common stock equivalents include the Company’s stock options, unvested restricted stock units, including those with performance and market conditions, warrants, and the shares to be issued upon the conversion of the Senior Convertible Notes. No shares related to the assumed exercise of outstanding warrants or the conversion of the Senior Convertible Notes were included in the diluted net income per share calculation for the three and nine months ended September 30, 2013 and 2012 because the inclusion of such shares would have had an anti-dilutive effect.

15

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Numerator:
 
 
 
 
 
 
 
Net income attributable to NuVasive, Inc.
$
7,511

 
$
2,354

 
$
1,893

 
$
5,890

Denominator for basic and diluted net income per share:
 
 
 
 
 
 
 
Weighted average common shares outstanding for basic
44,572

 
43,488

 
44,339

 
43,227

Dilutive potential common stock outstanding:
 
 
 
 
 
 
 
Stock options and Employee Stock Purchase Plan (ESPP)
473

 
317

 
304

 
215

Restricted stock units
2,175

 
930

 
1,744

 
709

Weighted average common shares outstanding for diluted
47,220

 
44,735

 
46,387

 
44,151

Basic net income per share attributable to NuVasive, Inc.
$
0.17

 
$
0.05

 
$
0.04

 
$
0.14

Diluted net income per share attributable to NuVasive, Inc.
$
0.16

 
$
0.05

 
$
0.04

 
$
0.13

The following weighted outstanding common stock equivalents were not included in the calculation of net income per diluted share because their effects were anti-dilutive (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Stock options, ESPP shares and unvested restricted stock units
4,957

 
5,921

 
5,759

 
6,047

Warrants
11,998

 
14,694

 
13,768

 
14,694

Senior Convertible Notes
9,553

 
11,214

 
10,003

 
11,214

Total
26,508

 
31,829

 
29,530

 
31,955

9.   Stock-Based Compensation
The Company estimates the fair value of stock options and shares issued to employees under the ESPP using a Black-Scholes option-pricing model on the date of grant. The fair value of restricted stock units is based on the stock price on the date of grant. The fair value of equity instruments that are expected to vest are recognized and amortized on an accelerated basis over the requisite service period.
The weighted average assumptions used to estimate the fair value of stock purchase rights under the ESPP are as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
ESPP
 
 
 
 
 
 
 
Volatility
57
%
 
55
%
 
57
%
 
55
%
Expected term (years)
1.7

 
1.6

 
1.6

 
1.5

Risk free interest rate
0.2
%
 
0.2
%
 
0.2
%
 
0.2
%
Expected dividend yield
%
 
%
 
%
 
%
The Company did not grant any stock options during the three or nine months ended September 30, 2013 or 2012.
The Company issued 24,000 and 29,000 shares of common stock upon the exercise of stock options during the three and nine months ended September 30, 2013, respectively, and issued 48,000 shares of common stock upon the exercise of stock options during the year ended December 31, 2012. The Company issued 70,000 and 510,000 shares of common stock upon the vesting

16

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

of RSUs during the three and nine months ended September 30, 2013, respectively, and issued 339,000 shares of common stock upon the vesting of RSUs during the year ended December 31, 2012.
In 2012, the Compensation Committee of the Board of Directors (the Compensation Committee) granted performance-based restricted stock units (PRSUs) to certain senior Company executives that were earned based on the achievement of pre-defined Company-specific performance criteria for the year ended December 31, 2012. The fair value of the PRSUs was based on the closing price of the Company's common stock on the date of grant. One-third of the PRSUs vested on March 1, 2013 and the remaining two-thirds vest equally on March 1, 2014 and March 1, 2015. The Company issued 117,000 shares of common stock upon the vesting of PRSUs during the three months ended March 31, 2013.
During the first quarter of 2013, the Compensation Committee granted restricted stock units to certain senior Company executives that are earned based on the achievement of pre-defined market conditions (total stockholder return) for the year ended December 31, 2013 (TSR PRSUs). The fair value of the TSR PRSUs was estimated on the date of grant using a Monte Carlo valuation model. The key assumptions in applying this model are an expected volatility of 49% and a risk free interest rate of 0.13%. The TSR PRSUs vest in two equal installments on February 1, 2014 and February 1, 2015.
The compensation cost that has been included in the statement of operations for all stock-based compensation arrangements was as follows (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Sales, marketing and administrative expense
$
7,965

 
$
4,844

 
$
22,667

 
$
18,723

Research and development expense
448

 
567

 
1,239

 
1,624

Cost of goods sold
41

 
23

 
96

 
53

Total stock-based compensation expense
$
8,454

 
$
5,434

 
$
24,002

 
$
20,400

10.    Income Taxes
The Company recorded income tax expense of $0.9 million and $4.1 million for the three months ended September 30, 2013 and 2012, respectively, and an income tax expense of $20 thousand and $7.8 million for the nine months ended September 30, 2013 and 2012, respectively. The effective income tax rate for the nine months ended September 30, 2013 was 2%, and reflected a discrete tax benefit of $0.9 million, or 77% of pre-tax income, related to the 2012 federal research and development (R&D) credit which was retrospectively reinstated in the nine months ended September 30, 2013. The Company updates its annual effective income tax rate each quarter and if the estimated effective income tax rate changes, a cumulative adjustment is made.
There were no material changes to the Company's unrecognized tax benefits and interest accrued related to unrecognized tax benefits during the nine months ended September 30, 2013.
11.    Business Segment, Product and Geographic Information
The Company’s business operates in one segment based upon the Company’s organizational structure, the way in which the operations are managed and evaluated and the lack of availability of separate financial results.
The Company’s Spine Surgery Product line offerings, which include thoracolumbar product offerings, cervical offerings, and a set of motion preservation products still under development, are primarily used to enable access to the spine and to perform restorative and fusion procedures in a minimally disruptive fashion. The Company’s Biologic product line offerings includes allograft (donated human tissue), FormaGraft®, a collagen synthetic product, Osteocel Plus®, an allograft cellular matrix containing viable mesenchymal stem cells, or MSCs, and AttraX®, a synthetic bone graft material, all used to aid the spinal fusion process. The Company’s Monitoring Service offering includes IOM services. Revenue by product line offerings was as follows (in thousands):

17

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013

2012

2013
 
2012
Spine Surgery Products
$
131,137


$
112,590


$
382,485

 
$
343,962

Biologics
28,743


26,158


83,754

 
81,256

Monitoring Service
9,276


9,643


28,119

 
29,283

Total Revenue
$
169,156


$
148,391


$
494,358

 
$
454,501

Revenue and property and equipment, net, by geographic area were as follows (in thousands):
 
Revenue
 
Property and Equipment, Net
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
As of September 30,
 
As of December 31,
 
2013
 
2012
 
2013
 
2012
 
2013
 
2012
United States
$
152,377

 
$
136,885

 
$
450,024

 
$
422,754

 
$
112,976

 
$
112,701

International (excludes Puerto Rico)
16,779

 
11,506

 
44,334

 
31,747

 
17,820

 
12,422

Total
$
169,156

 
$
148,391

 
$
494,358

 
$
454,501

 
$
130,796

 
$
125,123

12.    Legal Proceedings
Medtronic Sofamor Danek USA, Inc. Litigation
In August 2008, Warsaw Orthopedic, Inc., Medtronic Sofamor Danek USA, Inc. and other Medtronic related entities (collectively, Medtronic) filed suit against NuVasive in the U.S. District Court for the Southern District of California (the Medtronic Litigation), alleging that certain of NuVasive’s products infringe, or contribute to the infringement of, twelve U.S. patents assigned or licensed to Medtronic. Three of the patents were later withdrawn by Medtronic, leaving nine patents. NuVasive brought counterclaims against Medtronic alleging infringement of certain of NuVasive’s patents. The case has been administratively broken into serial phases. The first phase of the case included three Medtronic patents and one NuVasive patent and on September 20, 2011, a jury from the U.S. District Court delivered an unfavorable verdict against NuVasive with respect to the three Medtronic patents and a favorable verdict with respect to the one NuVasive patent. The jury awarded monetary damages of approximately $101.2 million to Medtronic, which includes lost profits and back royalties (the 2011 verdict). Medtronic’s subsequent motion for a permanent injunction was denied by the District Court on January 26, 2012. The District Court entered judgment on March 2, 2012. Both parties appealed the verdict. Medtronic subsequently filed a motion to dismiss its own appeal and NuVasive's cross-appeal with the Federal Circuit Court of Appeals. On August 2, 2012, the Federal Circuit issued a ruling stating that ongoing royalties must be determined by the District Court prior to the appeal going forward. On June 11, 2013, the District Court ruled on the ongoing royalty rates (the June 2013 ruling). On August 20, 2013, NuVasive and Medtronic filed their respective notices of appeal, and the appeal is now proceeding before the U.S. Court of Appeals for the Federal Circuit. In addition, on March 19, 2012, the District Court issued an order granting prejudgment interest. The Company entered into an escrow arrangement in 2012 and transferred $113.3 million of cash into a restricted escrow account to secure the amount of judgment, plus prejudgment interest, during pendency of the appeal. These funds are included in restricted cash and investments on the Company's September 30, 2013 condensed consolidated balance sheet.
In accordance with the authoritative guidance on the evaluation of loss contingencies, during the year ended December 31, 2011, the Company recorded an accrual of $101.2 million for the 2011 verdict. In addition, on sales subsequent to the 2011 verdict and through March 31, 2013, the Company accrued royalties at the royalty rates stated in the 2011 verdict. Upon receiving the District Court ruling in June 2013, the Company began accruing ongoing royalties on sales at the royalty rates stated in the June 2013 ruling, and recorded a charge of approximately $7.9 million to account for the difference between using the royalty rates stated in the 2011 verdict and those in the June 2013 ruling on sales through March 31, 2013. As a result of the June 2013 ruling, the Company will be required to escrow funds to secure accrued royalties, estimated at $21 million to date, and ongoing royalties. The Company is also accruing post-judgment interest. With respect to the prejudgment interest award, the Company, based on its own assessment, as well as that of outside counsel, believes a reversal of the prejudgment interest award on appeal is probable, and therefore, in accordance with authoritative guidance on the evaluation of loss contingencies, the Company has not recorded an accrual for this amount, which is estimated to approximate $13 million. Additional damages, including interest may still be awarded, and at September 30, 2013, the Company cannot estimate a range of additional potential loss. 

18

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

With respect to the favorable verdict delivered regarding the one NuVasive patent, the jury awarded the Company monetary damages of approximately $0.7 million for reasonable royalty damages. In accordance with the authoritative guidance on the evaluation of gain contingencies, this amount has not been recorded at September 30, 2013. Additionally, the June 2013 ruling determined the ongoing royalty rate to be paid to the Company by Medtronic for its post-verdict sales of the one NuVasive patent. Consistent with the treatment afforded the $0.7 million damage award; no amount has been recorded for royalty revenue as of September 30, 2013.
The second phase of the case pending in the Southern District of California involved one Medtronic cervical plate patent. On April 25, 2013, NuVasive and Medtronic entered into a settlement agreement fully resolving the second phase of the case. The settlement also removes from the case the cervical plate patent that was part of the first phase. As part of the settlement, NuVasive received a broad license to practice (i) the Medtronic patent that was the sole subject of the second phase of the litigation, (ii) the Medtronic patent that was part of the first phase of the litigation, and (iii) each of the Medtronic patent families that collectively represent the vast majority of Medtronic's patent rights related to cervical plate technology. In exchange for these license rights, NuVasive made a one-time payment to Medtronic of $7.5 million, which amount will be fully offset against any damage award ultimately determined to be owed by NuVasive in connection with a final resolution of the first phase of the litigation. In addition, Medtronic will receive a royalty on certain cervical plate products sold by NuVasive, including the Helix® and Gradient® lines of products. As a result of this settlement, all current patent disputes between the parties related to cervical plate technology have been resolved.
On August 17, 2012, Medtronic filed additional patent claims in the U.S. District Court for the Northern District of Indiana alleging that various NuVasive spinal implants (including its CoRoent® XL family of spinal implants) and NuVasive's Osteocel® Plus bone graft product infringe two additional Medtronic Patents not asserted in the Southern District of California. On August 28, 2012, Medtronic amended its complaint alleging that NuVasive's XLIF procedure and use of MaXcess IV retractor during the XLIF procedure infringe methodology claims of another Medtronic patent. The Company denies infringing any valid claims of these additional patents and on September 4, 2012, the Company filed a motion to transfer the case to the Southern District of California. The Indiana District Court granted the Company's motion and transferred the case to the Southern District of California.
On March 7, 2013, NuVasive amended its counterclaims to allege infringement by Medtronic of eight NuVasive patents not asserted in the first or second phases of the litigation. On March 22, 2013, NuVasive moved to stay the litigation of two of Medtronic's patents pending the U.S. Patent Office proceedings with respect to these patents. The Court granted the Company's motion with respect to one of the patents, and denied without prejudice to renew the motion with respect to the second patent. On September 23, 2013, the U.S. Patent Office granted inter partes review of the second patent. The Court granted the Company's motion with respect to one of the patents, and denied without prejudice to renew the motion with respect to the second patent. On June 27, 2013, NuVasive filed an inter partes review petition with the U.S. Patent Office challenging a third patent that issued to Medtronic on May 21, 2013. On July 25, 2013, the Court granted Medtronic leave to amend the complaint to add a charge of infringement of the third patent. On September 23, 2013, the U.S. Patent Office granted inter partes review of the second patent. Based on the U.S. Patent Office's grant of inter partes review, the Company intends to renew its motion to stay the second patent. On July 25, 2013, the Court granted Medtronic leave to amend the complaint to add a charge of infringement of U.S. Patent No. 8,444,696. A claim construction hearing is scheduled for November 7, 2013 and a pre-trial conference for June 20, 2014. No trial date is set. At September 30, 2013, the probable outcome of this litigation cannot be determined, nor can the Company estimate a range of potential loss. In accordance with the authoritative guidance on the evaluation of loss contingencies, the Company has not recorded an accrual related to this litigation.
Trademark Infringement Litigation
In September 2009, Neurovision Medical Products, Inc. (NMP) filed suit against NuVasive in the U.S. District Court for the Central District of California (Case No. 2:9-cv-6988-R-JEM) alleging trademark infringement and unfair competition. NMP sought cancellation of NuVasive’s “NeuroVision” trademark registrations, injunctive relief and damages based on NMP’s common law use of the “Neurovision” mark. On November 23, 2009, the Company denied the allegations in NMP’s complaint. The matter was tried in October 2010 and an unfavorable jury verdict was delivered against the Company relating to its use of the NeuroVision trade name. The verdict awarded damages to NMP of $60.0 million. The Company appealed the judgment and on September 10, 2012, the Court of Appeals reversed and vacated the District Court judgment and ordered the case back to the District Court for a new trial before a different judge. On October 5, 2012, the case was reassigned to a new District Court judge and re-trial of the matter is currently scheduled to begin in the District Court in January 2014. During pendency of the appeal, the Company was required to escrow funds totaling $62.5 million to secure the amount of the judgment, plus interest, attorneys’ fees and costs. As a result of the reversal of the judgment, the full $62.5 million was released from escrow and returned to the Company. At September 30, 2013, the probable outcome of this litigation cannot be determined, nor can the Company estimate a range of

19

NUVASIVE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

potential loss. In accordance with the authoritative guidance on the evaluation of loss contingencies, the Company has not recorded an accrual related to this litigation.
Securities Litigation
On August 28, 2013, a purported securities class action lawsuit was filed by Danny Popov in the United States District Court for the Southern District of California naming NuVasive and certain of its current and former executive officers for allegedly making false and materially misleading statements regarding the Company's business and financial results, specifically relating to the purported improper submission of false claims to Medicare and Medicaid. The complaint asserts a putative class period stemming from October 22, 2008 to July 30, 2013. The complaint alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder and seeks unspecified monetary relief, interest, and attorneys’ fees. The Company intends to vigorously defend against this action. At September 30, 2013, the probable outcome of this litigation cannot be determined, nor can the Company estimate a range of potential loss. In accordance with authoritative guidance on the evaluation of loss contingencies, the Company has not recorded an accrual related to this litigation.
Contingencies
The Company is party to certain claims and legal actions arising in the normal course of business. The Company does not expect any such claims and legal actions to have a material adverse effect on its business, results of operations or financial condition.
13.    Regulatory Matter
During the three months ended June 30, 2013, the Company received a federal administrative subpoena from the Office of the Inspector General of the U.S. Department of Health and Human Services (OIG) in connection with an investigation into possible false or otherwise improper claims submitted to Medicare and Medicaid. The subpoena seeks discovery of documents for the period January 2007 through April 2013. The Company is working with the OIG to understand the scope of the subpoena and its request for documents, but does not expect to have greater clarity regarding the request for several months. The Company intends to fully cooperate with the OIG's request. At September 30 2013, the Company is unable to determine the potential financial impact, if any, that will result from this investigation.
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements May Prove Inaccurate
You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the unaudited condensed consolidated financial statements and the notes to those statements included in this report. This discussion and analysis may contain forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, such as those set forth under heading “Risk Factors,” and elsewhere in this report, and similar discussions in our other Securities and Exchange Commission filings, including our Annual Report on Form 10-K for the year ended December 31, 2012. We do not intend to update these forward looking statements to reflect future events or circumstances.
Overview
We are a medical device company focused on developing minimally disruptive surgical products and procedurally integrated solutions for the spine. Our currently-marketed product portfolio is focused on applications for spine fusion surgery, including biologics, a combined market estimated to approximate $8.2 billion globally in 2013. Our principal product offering includes a minimally disruptive surgical platform called Maximum Access Surgery, or MAS®. The MAS platform combines three categories of solutions that collectively minimize soft tissue disruption during spine fusion surgery, provide maximum visualization and are designed to enable reproducible outcomes for the surgeon. The platform includes a proprietary software-driven nerve detection and avoidance systems, NVM5 and NVJJB, and Intra-Operative Monitoring (IOM) support; MaXcess®, a unique and integrated split-blade retractor system; and a wide variety of specialized implants. When the three elements of MAS are used together, they may significantly reduce surgery time and return patients to activities of daily living much faster than conventional approaches. The individual components of our MAS platform, and many of our products, can also be used in open or traditional spine surgery and may independently offer patient benefits to various surgical approaches dealing with a wide variety of pathologies. Our spine surgery product line offerings, which include products for the thoracolumbar and the cervical spine, are primarily used to enable access to the spine and to perform restorative and fusion procedures in a minimally disruptive fashion. Our biologic product line offerings include allograft (donated human tissue), FormaGraft®, a collagen synthetic product, Osteocel Plus®, an allograft cellular

20


matrix containing viable mesenchymal stem cells, or MSCs, and AttraX®, a synthetic bone graft material, which is still in the process of U.S. regulatory clearance, all used to aid the spinal fusion process. Our subsidiary, Impulse Monitoring, Inc. (Impulse Monitoring) provides IOM services for insight into the nervous system during spine and other surgeries. We continue to focus significant research and development efforts to expand our MAS product platform and advance the applications of our unique technology into procedurally integrated surgical solutions. We dedicate significant resources toward training spine surgeons on our unique technology and products. We continue to train surgeons who are new to our MAS product platform as well as surgeons previously trained on our MAS product platform who are attending advanced training courses.
Our MAS platform, with the unique advantages provided by our nerve monitoring systems, enables an innovative lateral procedure known as eXtreme Lateral Interbody Fusion, or XLIF®, in which surgeons access the spine for a fusion procedure from the side of the patient’s body, rather than from the front or back. Our MaXcess instruments provide access to the spine in a manner that affords direct visualization and our nerve monitoring systems assist surgeons in avoiding critical nerves.
At various times in the past, certain insurance providers have adopted policies of not providing reimbursement for the XLIF procedure or some of its components. We have worked with our surgeon customers and the North American Spine Society (NASS) who, in turn, have worked with these insurance providers to supply the information, explanation and clinical data they require to categorize the XLIF procedure as a procedure entitled to reimbursement under their policies. At present, the majority of insurance companies provide reimbursement for XLIF procedures. However, certain carriers, large and small, may have policies significantly limiting coverage of XLIF, Instrumented Lumbar Interlaminar Fusion (ILIF), Osteocel Plus, the PCM® Cervical Disc System, Cervical interbody implants, or other procedures or products we sell. We cannot offer definitive time frames or final outcomes regarding reversal of the coverage-limiting policies, as the process is dictated by the third-party insurance providers. To date, we have not experienced significant lack of payment for our procedures based on these policies.
In addition, there is a downward pressure on reimbursement for IOM services such as those provided by our subsidiary Impulse Monitoring. Significant coding changes for IOM services took effect in 2013. New Current Procedural Terminology (CPT) codes were introduced that have led to reduced reimbursement by private payers for the professional remote oversight component of the service. Medicare patients will be subject to additional coding changes imposed by CMS which may restrict access to care and limit Impulse Monitoring's ability to cover, bill and collect for cases performed. Private payers may also elect to adopt these coding changes.
In recent years, we have significantly expanded our product offerings relating to procedures in the cervical spine as well as in the area of nerve monitoring. Our cervical product offerings now provide a full set of solutions for cervical fusion surgery, including both allograft tissue and CoRoent® implants, as well as cervical plating and posterior fixation products. In the fourth quarter of 2012, we received U.S. Food and Drug Administration (FDA) approval of the PCM Cervical Disc System, a motion preserving total disc replacement device, which further strengthens our cervical product offerings and enables us to continue our trend of increasing our market share. Our nerve monitoring offerings include both the NVM5 and NVJJB products based on our proprietary software-driven nerve monitoring systems and our IOM services business, Impulse Monitoring.
To date, the majority of our revenues are derived from the sale of disposables and implants and we expect this trend to continue for the foreseeable future. We loan our proprietary software-driven nerve monitoring systems and surgical instrument sets at no cost to surgeons and hospitals that purchase disposables and implants for use in individual procedures. In addition, we place our proprietary software-driven nerve monitoring systems, MaXcess® and other MAS or cervical surgical instrument sets with hospitals for an extended period at no up-front cost to them. Our implants and disposables are currently sold and shipped from our primary distribution and warehousing operations facility located in Memphis, Tennessee. We generally recognize revenue for disposables or implants used upon receiving acknowledgment of a purchase order from the hospital indicating product use or implantation. In addition, we sell an immaterial number of MAS instrument sets, MaXcess devices, and our proprietary software-driven nerve monitoring systems. To date, we have derived less than 5% of our total revenues from these sales.
We expect monitoring service revenue from IOM services to be slightly down in the current year. Monitoring service revenue consists of hospital based revenues and net patient service revenues and is recorded in the period the service is provided. Hospital based revenues are recorded based upon contracted billing rates. Net patient services are billed to various payers, including Medicare, commercial insurance companies, other directly billed managed healthcare plans, employers, and individuals. We report revenues based on the amount expected to be collected.
The majority of our operations are located in the United States and the majority of our sales have been generated in the United States. We sell our products in the United States through a sales force comprised of exclusive independent sales agencies and directly-employed sales shareowners; both selling only NuVasive products. Our sales force provides a delivery and consultative service to our surgeon and hospital customers and is compensated based on sales and product placements in their territories. Sales force commissions are reflected in our statement of operations in the sales, marketing and administrative expense line. We expect to continue to expand our distribution channels. We are continuing our expansion of international sales efforts with the focus on

21


European, Asian and Latin American markets. Our international sales force is comprised of directly-employed sales shareowners as well as exclusive distributors and independent sales agents.
During the second quarter of 2013, we received a federal administrative subpoena from the Office of the Inspector General of the U.S. Department of Health and Human Services (OIG) in connection with an investigation into possible false or otherwise improper claims submitted to Medicare and Medicaid. The subpoena seeks discovery of documents for the period January 2007 through April 2013. We are working with the OIG to understand the scope of the subpoena and its request for documents, but do not expect to have greater clarity regarding the request for several months. We intend to fully cooperate with the OIG's request and will provide periodic updates as information becomes available. Responding to the subpoena will require management's attention and will result in significant legal expense. Any adverse findings related to this investigation could result in significant financial penalties against the Company.
Results of Operations
Revenue 
 
September 30,
 
 
 
2013
 
2012
 
$ Change
 
% Change
 
(Dollars in thousands)
Three months ended:
 
 
 
 
 
 
 
Spine Surgery Products
$
131,137

 
$
112,590

 
 
 
 
Biologics
28,743

 
26,158

 
 
 
 
Monitoring Service
9,276

 
9,643

 
 
 
 
Total revenue
$
169,156

 
$
148,391

 
$
20,765

 
14
%
Nine months ended:
 
 
 
 
 
 
 
Spine Surgery Products
$
382,485

 
$
343,962

 
 
 
 
Biologics
83,754

 
81,256

 
 
 
 
Monitoring Service
28,119

 
29,283

 
 
 
 
Total revenue
$
494,358

 
$
454,501

 
$
39,857

 
9
%
Our Spine Surgery Product line offerings, which include products for the thoracolumbar spine, the cervical spine, and a set of motion preservation product offerings, are primarily used to enable access to the spine and to perform restorative and fusion procedures in a minimally disruptive fashion. Our Biologics product line offerings include allograft (donated human tissue), FormaGraft, a collagen synthetic product, Osteocel Plus, an allograft cellular matrix containing viable mesenchymal stem cells, or MSCs, and AttraX, a synthetic bone graft material, all used to aid the spinal fusion process. Our Monitoring Service line offering includes hospital-based revenues and net patient service revenues related to IOM services performed.
The continued adoption of minimally invasive procedures for spine has led to the expansion of our innovative procedures. In addition, increased market acceptance in our international markets contributed to the increase in revenues noted for the periods presented. We expect continued adoption of our innovative minimally invasive procedures and deeper penetration into existing accounts and our newer international markets as our sales force executes on the strategy of selling the full mix of our products. However, recent changes in market dynamics, the public and private insurance markets and ongoing policy and legislative changes in the United States have created less predictability in the lumbar portion of the spine market and have substantially reduced the overall spine market’s procedural growth rate. Accordingly, we believe that our growth in revenue in 2013 will come primarily from market share gains related to the market shift toward less invasive spinal surgery, both domestically and internationally.
Our total revenues increased $20.8 million and $39.9 million in the three and nine months ended September 30, 2013, respectively, representing total revenue growth of 14% and 9% for the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012.
Revenue from our Spine Surgery Products increased $18.5 million and $38.5 million, or 16% and 11%, in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012. This increase resulted from increases in volume of approximately 18% and 13% in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012, offset by small unfavorable changes in price of approximately 1% in both the three and nine months ended September 30, 2013, compared to the same periods in 2012. In addition, foreign currency had an unfavorable impact on revenues of approximately 1% in the three and nine months ended September 30, 2013 compared to the same periods in 2012.
Revenue from Biologics increased $2.6 million and $2.5 million, or 10% and 3%, in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012. This increase resulted from increases in volume of

22


approximately 11% and 4% in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012, offset by small unfavorable changes in price of approximately 1% in both the three and nine months ended September 30, 2013, compared to the same periods in 2012.
Revenue from Monitoring Services decreased $0.4 million and $1.2 million, or 4% in both the three and nine months ended September 30, 2013, compared to the same periods in 2012. This decrease resulted primarily from unfavorable changes in reimbursement rates offset by increases in case volume in the three and nine months ended September 30, 2013 compared to the same periods in 2012.
Cost of Goods Sold, excluding amortization of purchased technology
 
September 30,
 
 
 
2013
 
2012
 
$ Change
 
% Change
 
(Dollars in thousands)
Three months ended
$
43,291

 
$
37,746

 
$
5,545

 
15
%
% of total revenue
26
%
 
25
%
 
 
 
 
Nine months ended
$
131,131

 
$
111,213

 
$
19,918

 
18
%
% of total revenue
27
%
 
24
%
 
 
 
 
Cost of goods sold consists primarily of purchased materials, labor and overhead associated with product manufacturing, purchased goods, inventory-related costs and royalty expense, as well as the cost of providing IOM services, which includes personnel and physician oversight costs.
Cost of goods sold as a percentage of revenue increased in the three months ended September 30, 2013 compared to the same period in 2012. The increase is primarily a result of the medical device excise tax effective January 1, 2013 of approximately 1% of total revenues. As a percentage of revenue, cost of goods sold increased in the nine months ended September 30, 2013 compared to the same periods in 2012. The increase was a result of both the medical device excise tax effective January 1, 2013 of approximately 1% and the June 2013 ruling related to the Medtronic litigation that determined the ongoing royalty rates and resulted in the Company recording a charge of approximately $7.9 million during the three months ended June 30, 2013 to account for the difference in using the royalty rates stated in the September 2011 verdict and those in the June 2013 ruling on sales through March 31, 2013 (see Note 12 of Notes to Unaudited Condensed Consolidated Financial Statements).
We expect cost of goods sold, as a percentage of revenue, to approximate 26% for the remainder of 2013.
Operating Expenses
Sales, Marketing and Administrative
 
 
September 30,
 
 
 
2013
 
2012
 
$ Change
 
% Change
 
(Dollars in thousands)
Three months ended
$
102,085

 
$
87,410

 
$
14,675

 
17
%
% of total revenue
60
%
 
59
%
 
 
 
 
Nine months ended
$
306,243

 
$
274,703

 
$
31,540

 
11
%
% of total revenue
62
%
 
60
%
 
 
 
 
Sales, marketing and administrative expenses consist primarily of compensation, commission and training costs for shareowners engaged in sales, marketing and customer support functions; distributor commissions; depreciation expense for surgical instrument sets; shipping costs; surgeon training costs; shareowner (employee) related expenses for our administrative functions; and third-party professional service fees.
As a percentage of revenue, sales, marketing and administrative expenses increased in the three and nine months ended September 30, 2013 compared to the same periods in 2012, primarily as a result of our continued expansion of our international operations.
Costs that tend to vary based on revenue, which include commissions, depreciation expense for loaned surgical instrument sets, worldwide sales force headcount, distribution and customer support headcount, and shipping, increased $6.8 million and

23


$14.8 million in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012. This increase is primarily a result of our revenue growth during the three and nine months ended September 30, 2013 compared to the same periods in 2012, as well as increases in freight expenses and continued investment in our international markets.
We continue to make significant investments in our Japanese operations. This investment, along with depreciation expense associated with certain system software investments, increased $1.9 million and $5.6 million in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012.
Legal expenses increased $1.5 million and $5.3 million in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012. Legal expenses incurred in connection with the Medtronic litigation and the OIG subpoena received in the second quarter of 2013, increased $1.5 million and $4.2 million in the three and nine months ended September 30, 2013, respectively. In addition, legal expenses incurred in connection with other matters increased by $1.2 million and $2.3 million for the three and nine months ended September 30, 2013, respectively. These increases are offset by the reimbursement of $1.2 million related to legal expenses in connection with the settlement of several lawsuits related to a competitor during the three months ended September 30, 2013.
Stock-based compensation increased $3.1 million and $3.9 million in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012. This increase is primarily attributed to a reversal of approximately $0.9 million in compensation expense previously recorded for performance-based awards in the three months ended September 30, 2012, as well as the increase in the weighted average grant date fair value of 2013 grants compared to 2012 grants.
Compensation and other shareowner related expenses for our marketing and administrative support functions increased $2.1 million and $3.3 million in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012. This increase is primarily the result of an increase in headcount as well as computer-related expenses.
For the remainder of 2013 and on a long-term basis, we expect total sales, marketing and administrative costs, as a percentage of revenue, to decrease moderately.
Research and Development
 
September 30,
 
 
 
2013
 
2012
 
$ Change
 
% Change
 
(Dollars in thousands)
Three months ended
$
7,248

 
$
7,575

 
$
(327
)
 
(4
)%
% of total revenue
4
%
 
5
%
 
 
 
 
Nine months ended
$
24,654

 
$
26,898

 
$
(2,244
)
 
(8
)%
% of total revenue
5
%
 
6
%
 
 
 
 
Research and development expense consists primarily of product research and development, clinical trial and study costs, regulatory and clinical functions, and compensation and other shareowner related expenses.
In the last several years, we have introduced numerous new products and product enhancements that have significantly expanded our MAS platform, enhanced the applications of the XLIF procedure, expanded our offering of cervical products, and continued to invest to further enable our entry into the growing motion preservation market. We have also acquired complementary and strategic assets and technology, particularly in the area of biologics. We are developing total disc replacement devices for spine applications, which are currently in different phases of development, clinical trials and related studies. We anticipate continuing to incur costs associated with patient follow-up and advancing the products through the regulatory process related to these clinical trials and studies through at least the end of 2013.
Research and development facilities expenses and compensation and other shareowner related expenses, including performance-based and stock-based compensation, decreased $0.4 million and $3.2 million in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012, and relates to compensation-related savings.
Expenses incurred related to the acquisition of research and development intangible assets charged to expense in accordance with the authoritative accounting guidance remained materially consistent in the three months ended September 30, 2013 compared to the same period in 2012. In the nine months ended September 30, 2013, these expenses increased $2.1 million compared to the same period in 2012.

24


Expenses incurred in connection with clinical trials, various studies, and ongoing development projects, including outside professional services, increased $0.2 million in the three months ended September 30, 2013 compared to the same period in 2012. In the nine months ended September 30, 2013 compared to the same period in 2012, these expenses decreased approximately $0.3 million due to reduced costs as a result of the completion of enrollment in a clinical trial and ongoing study related activities.
For the remainder of 2013, as a percentage of revenue, we expect total research and development costs to remain relatively consistent with current levels in support of our ongoing development and 510k product approval efforts.
Amortization of Intangible Assets
 
September 30,
 
 
 
2013
 
2012
 
$ Change
 
% Change
 
(Dollars in thousands)
Three months ended
$
4,974

 
$
3,081

 
$
1,893

 
61
%
% of total revenue
3
%
 
2
%
 
 
 
 
Nine months ended
$
14,263

 
$
8,830

 
$
5,433

 
62
%
% of total revenue
3
%
 
2
%
 
 
 
 
Amortization of intangible assets relates to the amortization of finite-lived intangible assets acquired. Amortization expense increased $1.9 million and $5.4 million in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012, primarily due to the acquisition of intangible assets acquired subsequent to September 30, 2012, and additional expense resulting from the approval of the PCM Cervical Disc System that occurred during the fourth quarter of 2012.
We expect expenses recorded in connection with the amortization of intangible assets to continue to increase in absolute dollars for the foreseeable future as amortization of acquired in-process research and development commences once acquired research and development projects reach technological feasibility.
Interest and Other Expense, Net
 
September 30,
 
 
 
2013
 
2012
 
$ Change
 
% Change
 
(Dollars in thousands)
Three months ended:
 
 
 
 
 
 
 
Interest income
$
157

 
$
249

 
 
 
 
Interest expense
(6,712
)
 
(6,885
)
 
 
 
 
Other income, net
3,137

 
260

 
 
 
 
Total interest and other expense, net
$
(3,418
)
 
$
(6,376
)
 
$
2,958

 
(46
)%
% of total revenue
(2
)%
 
(4
)%
 
 
 
 
Nine months ended:
 
 
 
 
 
 
 
Interest income
$
560

 
$
661

 
 
 
 
Interest expense
(20,396
)
 
(20,682
)
 
 
 
 
Other income, net
2,937

 
146

 
 
 
 
Total interest and other expense, net
$
(16,899
)
 
$
(19,875
)
 
$
2,976

 
(15
)%
% of total revenue
(3
)%
 
(4
)%
 
 
 
 
Interest and other expense, net, consists principally of interest expense incurred on our Senior Convertible Notes, offset by income earned on marketable securities and other income (expense) items. Interest and other expense, net decreased $3.0 million in both the three and nine months ended September 30, 2013, compared to the same periods in 2012. Both decreases are primarily due to the recognition of other income of approximately $2.8 million in connection with the settlement of several lawsuits related to a competitor during the three months ended September 30, 2013.
Interest and other expense, net, as a percentage of revenues, is expected to moderately decrease for the remainder of the year as a result of the maturity of the 2013 Senior Convertible Notes on March 15, 2013.

25


Income Tax Expense
 
September 30,
 
 
 
2013
 
2012
 
$ Change
 
% Change
 
(Dollars in thousands)
Three months ended
$
860

 
$
4,064

 
$
(3,204
)
 
(79
)%
Effective income tax rate
11
%
 
66
%
 
 
 
 
Nine months ended
$
20

 
$
7,764

 
$
(7,744
)
 
(100
)%
Effective income tax rate
2
%
 
60
%
 
 
 
 
We recorded income tax expense of $0.9 million and $4.1 million for the three months ended September 30, 2013 and 2012, respectively, and income tax expense of $20 thousand and $7.8 million for the nine months ended September 30, 2013 and 2012, respectively. The effective income tax rate for the nine months ended September 30, 2013 was 2% compared to 60% for the nine months ended September 30, 2012. The income tax provision for the nine months ended September 30, 2013 reflects a discrete tax benefit of $0.9 million, or 77% of pre-tax income, related to the 2012 federal research and development (R&D) credit which was retrospectively reinstated in the nine months ended September 30, 2013. No federal R&D credit benefit was recorded in the income tax provision for the nine months ended September 30, 2012. We update our annual effective income tax rate each quarter and if the estimated effective income tax rate changes, a cumulative adjustment is made.
Stock-Based Compensation
 
September 30,
 
 
 
2013
 
2012
 
$ Change
 
% Change
 
(Dollars in thousands)
Three months ended:
 
 
 
 
 
 
 
Stock-Based Compensation
 
 
 
 
 
 
 
Sales, Marketing & Administrative
$
7,965

 
$
4,844

 
 
 
 
Research & Development
448

 
567

 
 
 
 
Cost of Goods Sold
41

 
23

 
 
 
 
Total Stock-Based Compensation
$
8,454

 
$
5,434

 
$
3,020

 
56
%
% of total revenue
5
%
 
4
%
 
 
 
 
Nine months ended:
 
 
 
 
 
 
 
Stock-Based Compensation
 
 
 
 
 
 
 
Sales, Marketing & Administrative
$
22,667

 
$
18,723

 
 
 
 
Research & Development
1,239

 
1,624

 
 
 
 
Cost of Goods Sold
96

 
53

 
 
 
 
Total Stock-Based Compensation
$
24,002

 
$
20,400

 
$
3,602

 
18
%
% of total revenue
5
%
 
4
%
 
 
 
 
Stock-based compensation related to stock awards is recognized and amortized on an accelerated basis in accordance with authoritative guidance. Stock-based compensation increased $3.0 million and $3.6 million in the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012. These increases are primarily attributed to a reversal of approximately $0.9 million in compensation expense previously recorded for performance-based awards in the three months ended September 30, 2012, as well as the increase in the weighted average grant date fair value of 2013 grants compared to 2012 grants, slightly offset by the timing of annual grants in the current year as compared to the prior year.

26


Liquidity, Cash Flows and Capital Resources
Liquidity and Capital Resources
Our principal sources of liquidity are our existing cash, cash equivalents and marketable securities, cash generated from operations and proceeds from our convertible debt financing issued in June 2011.
In June 2011, we issued $402.5 million principal amount of the 2.75% Convertible Senior Notes due 2017 (the 2017 Notes). The net proceeds from the offering, after deducting initial purchasers’ discounts and costs directly related to the offering, were approximately $359.2 million. We pay 2.75% interest per annum on the principal amount of the 2017 Notes. The 2017 Notes mature on July 1, 2017 and may be settled in cash, stock, or a combination thereof, solely at our election. Interest on the 2017 Notes began accruing in June 2011 and is payable semi-annually on January 1 and July 1 of each year.
In connection with the Medtronic litigation, a jury from the U.S. District Court, Southern District of California delivered an unfavorable verdict to us and awarded monetary damages of approximately $101.2 million to Medtronic. In May 2012, in accordance with an escrow arrangement, we transferred $113.3 million of cash into a restricted escrow account to secure the amount of the judgment, plus prejudgment interest, during pendency of our appeal of the judgment. These funds are included in restricted cash and investments in our September 30, 2013 consolidated balance sheet. Further, as a result of the June 2013 District Court ruling on the ongoing royalty rates, we will be required to escrow funds to secure accrued royalties, estimated at $21 million to date, and ongoing royalties.
Cash, cash equivalents and marketable securities was $302.8 million and $346.1 million at September 30, 2013 and December 31, 2012, respectively, the decrease primarily relates to the payment of the 2013 Senior Convertible Notes on March 15, 2013 offset by cash generated from operations during the nine months ended September 30, 2013. We believe that our existing cash, cash equivalents and short-term marketable securities will be sufficient to meet our anticipated cash needs for the next 12 months. Our future capital requirements will depend on many factors including our rate of revenue growth, the timing and extent of spending to support development efforts, the expansion of sales, marketing and administrative activities, the timing of introductions of new products and enhancements to existing products, the continuing market acceptance of our products, the expenditures associated with possible future acquisitions or other business combination transactions, and the outcome of current and future litigation. At September 30, 2013, we have cash and investments totaling $119.2 million in restricted accounts which are not available to us to meet any ongoing capital requirements if and when needed. This could negatively impact our liquidity and our ability to invest in and run our business on an ongoing basis.
We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors, including fluctuations in our operating results and working capital requirements. We have historically invested our cash primarily in U.S. treasuries and government agencies, corporate debt, and money market funds. Certain of these investments are subject to general credit, liquidity and other market risks. The general condition of the financial markets and the economy has exacerbated those risks and may affect the value of our current investments and restrict our ability to access the capital markets or even our own funds.
Cash Flows
The following table summarizes, for the periods indicated, selected items in our consolidated statements of cash flows (in thousands):
 
Nine Months Ended September 30,
 
 
 
2013
 
2012
 
$ Change
Cash provided by operating activities
$
70,133

 
$
99,486

 
$
(29,353
)
Cash used in investing activities
(26,619
)
 
(158,599
)
 
131,980

Cash (used in) provided by financing activities
(65,644
)
 
3,315

 
(68,959
)
Effect of exchange rate changes on cash
(553
)