10-Q 1 exac2017063010q.htm 10-Q Document

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_________________________________ 
FORM 10-Q
 _________________________________
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
 
For the quarterly period ended June 30, 2017
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from              to             
Commission File Number 0-28240
 _________________________________
EXACTECH, INC.
(Exact name of registrant as specified in its charter)
_________________________________
FLORIDA
59-2603930
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)
2320 NW 66TH COURT
GAINESVILLE, FL 32653
(Address of principal executive offices)
(352) 377-1140
(Registrant’s telephone number, including area code)
_________________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x   No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes x   No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer
o
 
Accelerated Filer
x
Smaller reporting company
o
Non-Accelerated Filer
o
(Do not check if a smaller reporting company)
 
Emerging growth company
o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o   No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
 
Outstanding at August 4, 2017
Common Stock, $.01 par value
 
14,348,090



EXACTECH, INC.
INDEX
 
 
Page
Number
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 




Item 1. Financial Statements
EXACTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
 
(unaudited)
 
(audited)
 
June 30,
 
December 31,
 
2017
 
2016
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
8,917

 
$
13,052

Accounts receivable, net of allowances of $1,707 and $1,473
57,733

 
53,051

Prepaid expenses and other assets, net
3,606

 
3,075

Income taxes receivable
1,848

 
2,140

Inventories – current
67,358

 
65,264

Assets held for sale
2,695

 
6,477

Total current assets
142,157

 
143,059

PROPERTY AND EQUIPMENT:
 
 
 
Land
4,530

 
4,474

Machinery and equipment
43,033

 
42,034

Surgical instruments
144,018

 
132,134

Furniture and fixtures
4,713

 
4,700

Facilities
21,690

 
21,726

Projects in process
6,818

 
2,473

Total property and equipment
224,802

 
207,541

Accumulated depreciation
(108,160
)
 
(100,234
)
Net property and equipment
116,642

 
107,307

OTHER ASSETS:
 
 
 
Deferred financing and other non-current assets, net
4,326

 
968

Equity investment
1,952

 
2,047

Deferred tax assets

 
887

Non-current inventories
11,823

 
15,723

Product licenses and designs, net
8,933

 
9,102

Patents and trademarks, net
717

 
821

Customer relationships, net
467

 
476

Goodwill
14,758

 
13,819

Total other assets
42,976

 
43,843

TOTAL ASSETS
$
301,775

 
$
294,209

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
16,602

 
$
17,566

Income taxes payable
1,772

 
780

Accrued expenses and other liabilities
13,017

 
11,832

Liabilities held for sale
325

 

Other current liabilities
2,884

 
2,927

Total current liabilities
34,600

 
33,105

LONG-TERM LIABILITIES:
 
 
 
Deferred tax liabilities
3,243

 
1,773

Line of credit
14,000

 
20,000

Other long-term liabilities
3,152

 
5,089

Total long-term liabilities
20,395

 
26,862

Total liabilities
54,995

 
59,967

SHAREHOLDERS’ EQUITY:
 
 
 
Common stock
145

 
144

Additional paid-in capital
90,228

 
87,319

Treasury stock
(3,042
)
 
(3,042
)
Accumulated other comprehensive loss
(8,398
)
 
(8,611
)
Retained earnings
167,847

 
158,432

Total shareholders’ equity
246,780

 
234,242

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
301,775

 
$
294,209

See notes to condensed consolidated financial statements

2


EXACTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(Unaudited)
 
Three Month Periods Ended June 30,
 
Six Month Periods Ended June 30,
 
2017
 
2016
 
2017
 
2016
NET SALES
$
67,327

 
$
66,124

 
$
136,809

 
$
131,422

COST OF GOODS SOLD
21,054

 
20,268

 
41,695

 
40,636

Gross profit
46,273

 
45,856

 
95,114

 
90,786

OPERATING EXPENSES:
 
 
 
 
 
 
 
Sales and marketing
23,569

 
23,835

 
48,622

 
47,154

General and administrative
5,621

 
5,640

 
12,157

 
11,554

Research and development
5,380

 
5,329

 
11,604

 
10,399

Depreciation and amortization
4,732

 
4,410

 
9,391

 
8,734

Total operating expenses
39,302

 
39,214

 
81,774

 
77,841

INCOME FROM OPERATIONS
6,971

 
6,642

 
13,340

 
12,945

OTHER INCOME (EXPENSE):
 
 
 
 
 
 
 
Interest income
52

 
2

 
55

 
6

Other income
185

 
32

 
328

 
72

Interest expense
(238
)
 
(268
)
 
(464
)
 
(530
)
Foreign currency gain, net
168

 
98

 
730

 
592

Total other income (expense)
167

 
(136
)
 
649

 
140

INCOME BEFORE INCOME TAXES AND EQUITY IN LOSS OF INVESTEE
7,138

 
6,506

 
13,989

 
13,085

PROVISION FOR INCOME TAXES
2,255

 
2,120

 
4,479

 
4,297

 
 
 
 
 
 
 
 
INCOME BEFORE EQUITY IN LOSS OF INVESTEE
4,883

 
4,386

 
9,510

 
8,788

 
 
 
 
 
 
 
 
EQUITY IN LOSS OF INVESTEE, NET OF TAX
(52
)
 

 
(95
)
 

NET INCOME
$
4,831

 
$
4,386

 
$
9,415

 
$
8,788

BASIC EARNINGS PER SHARE
$
0.34

 
$
0.31

 
$
0.66

 
$
0.62

DILUTED EARNINGS PER SHARE
$
0.33

 
$
0.31

 
$
0.65

 
$
0.62

See notes to condensed consolidated financial statements




3


EXACTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
(Unaudited)
 
Three Month Periods Ended June 30,
 
Six Month Periods Ended June 30,
 
2017
 
2016
 
2017
 
2016
Net Income
$
4,831

 
$
4,386

 
$
9,415

 
$
8,788

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Change in currency translation
442

 
(1,024
)
 
213

 
1,548

Other comprehensive income (loss), net of tax
442

 
(1,024
)
 
213

 
1,548

Comprehensive income
$
5,273

 
$
3,362

 
$
9,628

 
$
10,336

See notes to condensed consolidated financial statements

4


EXACTECH, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
Six Month Periods Ended June 30,
 
2017
 
2016
OPERATING ACTIVITIES:
 
 
 
Net income
$
9,415

 
$
8,788

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
 
 
Provision for allowance for doubtful accounts and sales returns
234

 
228

Inventory allowance
2,310

 
1,748

Depreciation and amortization
9,964

 
9,367

Restricted common stock issued for services
193

 
193

Compensation cost of stock awards
922

 
988

Loss on disposal of equipment
474

 
678

Foreign currency option loss (gain)

 
221

Foreign currency exchange gain
(1,269
)
 
(926
)
Equity in net loss of equity investee
95

 

Deferred income taxes
2,358

 
(958
)
Changes in assets and liabilities, net of business combination effect, which provided (used) cash:
 
 
 
Accounts receivable
(2,363
)
 
(1,986
)
Prepaids and other assets
(1,859
)
 
(1,549
)
Inventories
421

 
(6,708
)
Accounts payable
(1,734
)
 
1,501

Income taxes receivable/payable
1,293

 
537

Accrued expense & other liabilities
(2,349
)
 
741

Net cash provided by operating activities
18,105

 
12,863

INVESTING ACTIVITIES:
 
 
 
Purchases of property and equipment
(18,286
)
 
(17,498
)
Purchase of business, net of cash acquired

 
(833
)
Proceeds from sale of spine assets
4,000

 

Proceeds from sale of property and equipment

 
118

Investment in note receivable
(1,500
)
 

Net cash used in investing activities
(15,786
)
 
(18,213
)
FINANCING ACTIVITIES:
 
 
 
Net repayments on line of credit
(6,000
)
 
4,000

Payments of contingency consideration
(2,589
)
 
(669
)
Payments on capital leases
(7
)
 
(25
)
Repurchase of common stock

 
(3,042
)
Proceeds from issuance of common stock
1,795

 
2,433

Net cash used in financing activities
(6,801
)
 
2,697

Effect of foreign currency translation on cash and cash equivalents
460

 
(8
)
Cash and cash equivalents held for sale
(113
)
 

NET DECREASE IN CASH AND CASH EQUIVALENTS
(4,135
)
 
(2,661
)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
13,052

 
12,713

CASH AND CASH EQUIVALENTS, END OF PERIOD
$
8,917

 
$
10,052

 
 
 
 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid during the period for:
 
 
 
Interest
$
313

 
$
286

Income taxes
1,189

 
5,642

Non-cash investing and financing activities:
 
 
 
Capitalized lease additions

 
29

Purchase of equipment payable
541

 
289

Business combination, contingent consideration payable
2,014

 
2,147

See notes to condensed consolidated financial statements

5


EXACTECH, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTH PERIODS ENDED JUNE 30, 2017 AND 2016
(Unaudited)
1.
BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of Exactech, Inc. and its subsidiaries (the “Company”, “Exactech”, "we", "us" or "our"), which are for interim periods, have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission relating to interim financial statements. These unaudited condensed consolidated financial statements do not include all disclosures provided in the Company's audited annual financial statements. The condensed financial statements should be read in conjunction with the audited financial statements and notes contained in Exactech's Annual Report on Form 10-K for the year ended December 31, 2016, as filed with the Securities and Exchange Commission.
In the opinion of management, all adjustments considered necessary for a fair presentation have been included, consisting of normal recurring adjustments. Our subsidiaries, Exactech Asia, Exactech UK, Exactech Japan, Exactech France, Exactech Deutschland, Exactech Ibérica, Exactech International Operations, Blue Ortho, Exactech Australia and Exactech U.S., are consolidated for financial reporting purposes, and all intercompany balances and transactions have been eliminated. Results of operations for the three and six month periods ended June 30, 2017 are not necessarily indicative of the results to be expected for the full year.
Certain amounts reported for prior periods have been reclassified to be consistent with the current period presentation.
2.
NEW ACCOUNTING PRONOUNCEMENTS AND STANDARDS
In May 2017, the Financial Accounting Standards Board (“FASB”) issued amended guidance related to accounting for changes in terms or conditions of share-based payment awards. The amended guidance is effective for interim and annual periods beginning after December 15, 2017, with early adoption permitted. We do not expect the adoption of this guidance to have a material impact on our financial statements.
In January 2017, the FASB issued amended guidance to simplify the accounting for goodwill impairment. The guidance removes step two of the goodwill impairment test, which requires a hypothetical purchase price allocation. A goodwill impairment will now be recognized for the amount by which the carrying value of a reporting unit exceeds its fair value, not to exceed the carrying amount of goodwill. The amended guidance is effective for interim and annual periods beginning after December 15, 2019, with early adoption permitted for periods beginning after December 15, 2016. We are currently assessing the impact on our financial statements of adopting this guidance.
In January 2017, the FASB issued amended guidance on the accounting for business combinations to clarify the definition of a business and to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. Under the guidance, if substantially all of the fair value of gross assets acquired is concentrated in a single asset (or group of similar assets), the assets acquired would not represent a business. In addition, in order to be considered a business, an acquisition would have to include at a minimum an input and a substantive process that together significantly contribute to the ability to create an output. The amended guidance also narrows the definition of outputs by more closely aligning it with how outputs are described in FASB guidance for revenue recognition. This guidance is effective for interim and annual periods beginning after December 15, 2017, and early adoption is permitted. We do not expect the adoption of this guidance to have a material impact on our financial statements.
In November 2016, the FASB issued new guidance, which requires entities to show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flow. The new standard is required to be applied retrospectively. The guidance is effective for interim and annual periods beginning after December 15, 2017, and early adoption is permitted. We do not expect the adoption of this guidance to have a material impact on our financial statements.
In October 2016, the FASB issued new guidance which allows recognition of the income tax consequences upon intra-entity transfers of assets other than inventory when the transfer occurs. The guidance should be applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. The new guidance is effective for annual and interim periods beginning after December 15, 2017, and early adoption is permitted. We are currently assessing the impact of adopting this guidance on our financial statements.

6


In August 2016, the FASB issued new guidance to clarify how certain transactions are presented and classified in the statement of cash flows. The guidance is aimed at reducing the existing diversity in practice. The guidance will be effective for annual and interim periods beginning after December 15, 2017, with early adoption permitted. We are currently assessing the impact of adopting this guidance on our financial statements.
In February 2016, the FASB issued updated guidance on leases. The new standard requires all lessees to recognize a lease liability and a right-of-use asset, measured at the present value of the future minimum lease payments, at the lease commencement date. Lessor accounting remains largely unchanged under the new guidance. A modified retrospective approach should be applied for leases existing at the beginning of the earliest comparative period presented in the financial statements. The guidance is effective for annual and interim periods beginning after December 15, 2018, and early adoption is permitted. We are currently assessing the impact of adopting this guidance on our financial statements.
In September 2015, the FASB issued guidance on business combination provisional adjustments during the measurement period. The new standard requires that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The guidance is effective for annual and interim periods beginning on or after December 15, 2017, and early application is permitted. We are currently assessing the impact of adopting this guidance on our financial statements; however, we do not expect the adoption of this guidance to have a material impact on our financial position or results of operations.
In May 2014, the FASB issued new revenue recognition guidance that supersedes the existing revenue recognition guidance and most industry-specific guidance applicable to revenue recognition. The new guidance is based on the principle that revenue is recognized upon the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance will also result in enhanced disclosures about revenue, provide guidance for transactions that were not previously addressed comprehensively, and clarify guidance for multiple-element arrangements. The guidance is effective for the first fiscal quarter of 2018, and early application is permitted for periods beginning on or after January 1, 2017. Companies have the option to apply the new guidance under a retrospective approach to each prior reporting period presented, or a modified retrospective approach with the cumulative effect of initially applying the new guidance recognized at the date of initial application within the Consolidated Statement of Changes in Stockholders' Equity. We plan to adopt the new guidance effective January 1, 2018. At this time we have not identified any material impact on our financial position or results of operations that would result in the year of adoption. However, we are still assessing the impact of adopting this guidance and expect to complete this assessment during the second half of 2017. We plan to adopt the new guidance under the retrospective approach.
3.
FAIR VALUE MEASURES
Our financial instruments include cash and cash equivalents, trade receivables, debt, and cash flow hedges. The carrying amounts of cash and cash equivalents, and trade receivables approximate fair value due to their short maturities. The carrying amount of debt approximates fair value due to the variable rate associated with the debt. The fair value of cash flow hedges are based on dealer quotes.
The table below provides information on our assets and liabilities that are measured at fair value on a recurring basis:
 
 
 
 
 
 
 
 
 
(In Thousands)
Total Fair Value at June 30, 2017
 
Quoted Prices in Active Markets
(Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
June 30, 2017
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
Contingent consideration
$
5,898

 
$

 
$

 
$
5,898

 
Total:
$
5,898

 
$

 
$

 
$
5,898

 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
Contingent consideration
$
7,912

 
$

 
$

 
$
7,912

 
Total:
$
7,912

 
$

 
$

 
$
7,912

 
 
 
 
 
 
 
 
 

7


The fair value of our contingent consideration liability for the Blue Ortho and Exactech Australia acquisitions is management's estimate based on the present value of estimated payment scenarios. See Note 12, Business Acquisition and Divestiture, for further discussion on the contingent consideration.
The inputs and assumptions we use in our outstanding fair value measures are not observable in the market; however, they are assumptions we believe would be made by a market participant. We evaluate our estimates on a quarterly basis, as we obtain additional data impacting the assumptions, and recognize any changes in the unaudited condensed consolidated statements of income.
4.
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill – The following table provides the changes to the carrying value of goodwill for the six month period ended June 30, 2017:
 
 
 
 
 
 
 
 
 
 
(in thousands)
Extremities
 
Knee
 
Hip
 
Other
 
Total
Balance as of December 31, 2016
$
5,154

 
$
6,449

 
$
1,301

 
$
915

 
$
13,819

Foreign currency translation effects
424

 
342

 
101

 
72

 
939

Balance as of June 30, 2017
$
5,578

 
$
6,791

 
$
1,402

 
$
987

 
$
14,758

 
 
 
 
 
 
 
 
 
 
We test goodwill for impairment annually as of the 1st of October. Our impairment analysis as of October 1, 2016 resulted in a full impairment of our biologics and spine goodwill, which we recognized in the fourth quarter of 2016. No other impairment to goodwill was indicated.
Other Intangible Assets – The following table summarizes the carrying values of our other intangible assets at June 30, 2017 and December 31, 2016:
 
 
 
 
 
 
 
 
(in thousands)
Carrying Value
 
Accumulated Amortization
 
Net Carrying Value
 
Weighted Avg Amortization Period (In Years)
Balance at June 30, 2017
 
 
 
 
 
 
 
Product licenses and designs
$
15,393

 
$
6,460

 
$
8,933

 
11.2
Patents and trademarks
4,184

 
3,467

 
717

 
12.9
Customer relationships
1,552

 
1,085

 
467

 
6.9
 
 
 
 
 
 
 
 
Balance at December 31, 2016
 
 
 
 
 
 
 
Product licenses and designs
$
14,842

 
$
5,740

 
$
9,102

 
11.5
Patents and trademarks
4,182

 
3,361

 
821

 
14.0
Customer relationships
1,438

 
962

 
476

 
6.9
 
 
 
 
 
 
 
 

8


5.
HEDGING ACTIVITIES AND FOREIGN CURRENCY TRANSLATION
Foreign Currency Transactions
The following table provides information on the components of our foreign currency activities recognized in the unaudited condensed consolidated statements of income:
 
 
 
 
 
 
 
 
(in thousands)
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2017
 
2016
 
2017
 
2016
Foreign currency transactions gain
$
737

 
$
200

 
$
1,269

 
$
926

Foreign currency option loss
(569
)
 
(102
)
 
(539
)
 
(334
)
Foreign currency gain, net
$
168

 
$
98

 
$
730

 
$
592

 
 
 
 
 
 
 
 
Foreign Currency Transactions Gains and losses resulting from our transactions and our subsidiaries’ transactions that are made in currencies different from our and their own are included in income as they occur and as other income (expense) in the condensed consolidated statements of income.
Foreign Currency Options During the first six months of 2017, we entered into foreign currency forward contracts as economic hedges against exchange rate fluctuations of the U.S. Dollar (USD) against the Euro (EUR) and the Australian Dollar (AUD). During the six months ended June 30, 2017, we recognized losses of $0.5 million, related to these instruments. The recognized losses are recorded in other income (expense) in the unaudited condensed consolidated statements of income related to the fair value of these currency options based upon dealers' quotes.
During 2016, we entered into foreign currency forward contracts as economic hedges against the exchange rate fluctuations of the USD against the EUR, the British Pound (GBP) and the Japanese Yen (JPY). During the six months ended June 30, 2016, we recognized losses of $0.3 million related to these instruments. The recognized losses were recorded in other income (expense) in the unaudited condensed consolidated statements of income related to the fair value of these currency options based upon dealers' quotes.
Foreign Currency Translation
We are exposed to market risk related to changes in foreign currency exchange rates. The functional currency of substantially all of our international subsidiaries is their local currency. Transactions are translated into USD, and translation gains and losses are recognized in “Other comprehensive income (loss)”. Fluctuations in exchange rates affect our financial position and results of operations. The majority of our foreign currency exposure is to the EUR, GBP, JPY, and AUD. During the six months ended June 30, 2017, translation gains were $0.2 million, which were primarily due to the strengthening of the EUR and AUD against the USD during the six months ended June 30, 2017. During the six months ended June 30, 2016, translation gains were $1.5 million, which were primarily due to the strengthening of the JPY and the AUD, and offset partially by the weakening of the GBP, in each case against the USD. While we may experience translation gains and losses during the balance of the year ending December 31, 2017, these gains and losses are not expected to have a material adverse effect on our financial position, results of operations, or cash flows.
6.
INVENTORIES
Inventories are valued at the lower of cost or net realizable value using a FIFO inventory method. Inventory is comprised of implants and instruments held for sale, including implants consigned or loaned to customers and agents. The consigned or loaned inventory remains our inventory until we are notified of the implantation. Our independent agents have contractual responsibility for any discrepancies in our consigned or loaned inventory, which can result in the agent’s loss of compensation if the inventory is lost. We are required to maintain substantial levels of inventory because it is necessary to maintain all sizes of each component to fill customer orders. The size of the component to be used for a specific patient is typically not known with certainty until the time of surgery, and certain sizes are typically used less frequently than the “standard” sizes. Due to this uncertainty, a minimum of one of each size of each component in the system to be used must be available to each sales representative at the time of surgery, including unusual sizes that will be sold less frequently than “standard” sizes. Although we may conclude that it is more likely than not that all quantities on hand of certain sizes will eventually not be sold, we do not consider such items “excess inventory,” as our business model requires that we maintain such quantities in order to sell the “standard” sizes.

9


As a result of the need to maintain substantial levels of all sizes and components of inventory, we are subject to the risk of inventory obsolescence. In the event that a substantial portion of our inventory becomes obsolete, it would have a material adverse effect on the Company. For items that we identify as obsolete, we record a charge to reduce their carrying value to net realizable value. We also maintain an allowance for lost or damaged inventory to allow for the cost of items that are lost or damaged. We experienced charges related to the lost or damaged and obsolete inventory allowances of $0.9 million and $0.7 million, during the three months ended June 30, 2017 and 2016, respectively; and $1.3 million and $0.7 million, during the six months ended June 30, 2017 and 2016, respectively.
An allowance charge for slow moving inventories is recorded based upon an analysis of slow moving inventory items within a product group level. The slow moving inventory allowance is analyzed and calculated based on comparing the current quantity of inventory to historical sales and provides an allowance for any slow moving inventory on a systematic basis, which recognizes the cost of anticipated future obsolescence over the average fifteen year expected life of product groups. We believe this method is appropriate as it recognizes the lack of utility of these items (as a charge to cost of goods sold) over the related product group revenue life cycle. The key inputs to our slow moving allowance are trailing twelve months usage and the expected product life. As the slow moving allowance is an estimate of future obsolescence, changes in sales patterns from historical trends and future product release schedules, could impact the slow moving allowance balance, and result in higher or lower charges to the periodic cost of goods sold. As of June 30, 2017, we have inventory items with a cost basis of approximately $17.3 million that we determined to be slow moving inventory and for which we have provided an allowance of approximately $12.5 million. We experienced charges related to the slow moving inventory allowances of $0.5 million and $0.8 million, during the three months ended June 30, 2017 and 2016, respectively; and $1.0 million and $1.6 million, during the six months ended June 30, 2017 and 2016, respectively.
We also test our inventory levels for the amount of inventory that we expect to sell within one year. Due to the scope of products required to support surgeries and the fact that we stock new subsidiaries, add consignment locations, and launch new products, the level of inventory often exceeds the forecasted level of cost of goods sold for the next twelve months. We classify our estimate of such inventory as non-current.
The following table summarizes our classifications of inventory as of June 30, 2017 and December 31, 2016:
 
 
 
 
(in thousands)
June 30,
2017
 
December 31,
2016
Raw materials
$
21,143

 
$
23,183

Work in process
1,876

 
1,634

Finished goods on hand
15,944

 
7,913

Finished goods on loan/consignment
40,218

 
48,257

Inventory total
79,181

 
80,987

Non-current inventories
11,823

 
15,723

Inventories, current
$
67,358

 
$
65,264

 
 
 
 
7.
INCOME TAX
At June 30, 2017, net operating loss carry forwards of our foreign and domestic subsidiaries totaled $26.6 million, some of which begin to expire in 2020. For accounting purposes, the estimated tax effect of this net operating loss carry forward results in a deferred tax asset. The deferred tax asset associated with these losses was $8.3 million with a valuation allowance of $6.4 million charged against this deferred tax asset assuming these losses will not be fully realized. At December 31, 2016, these net operating loss carry forwards totaled $32.6 million, and the deferred tax asset was $9.5 million with a valuation allowance of $7.3 million charged against this deferred tax asset assuming these losses will not be fully realized. The change in the operating loss carry forward and the valuation allowance was a result of our divestiture in Exactech Taiwan and the elimination of their deferred tax asset.
Our income tax returns are subject to examination in numerous state, federal and foreign jurisdictions due to the multiple income tax jurisdictions in which we operate. We are not currently aware of any open examinations by the various government jurisdictions. As of June 30, 2017, we had no liability recorded as an uncertain tax benefit.

10


8.
DEBT
Debt consisted of the following at June 30, 2017 and December 31, 2016:
 
 
 
 
(in thousands)
June 30,
2017
 
December 31,
2016
Business line of credit payable on a revolving basis, plus interest based on adjustable rate as determined by one month LIBOR based on our ratio of funded debt to EBITDA, 2.50% as of June 30, 2017.
14,000

 
20,000

Total debt
$
14,000

 
$
20,000

 
 
 
 
The following is a schedule of future debt maturities as of June 30, 2017, for the years ending December 31 (in thousands):
 
 
2017
$

2018

2019

2020
14,000

2021

Thereafter

 
$
14,000

 
 
9.
COMMITMENTS AND CONTINGENCIES
Litigation
There are various claims, lawsuits, and disputes with third parties and pending actions involving various allegations against us incident to the operation of our business, principally product liability cases. While we believe that the various claims are without merit, we are unable to predict the ultimate outcome of such litigation. We therefore maintain insurance, subject to self-insured retention limits, for all such claims, and establish accruals for product liability and other claims based upon our experience with similar past claims, advice of counsel and the best information reasonably available. At June 30, 2017 and December 31, 2016, we had $75,000 and $25,000 accrued, respectively, for product liability claims. These product liability claims are subject to various uncertainties, and it is possible that they may be resolved unfavorably to us. While it is not possible to predict with certainty the outcome of the various cases, it is the opinion of management that, upon ultimate resolution, the cases will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.
Our insurance policies covering product liability claims must be renewed annually. Although we have been able to obtain insurance coverage for product liability claims at a cost and on other terms and conditions that have been acceptable to us, we may not be able to procure acceptable policies in the future.
Commitments
In June 2017 we loaned our independent distributor in South Korea $1.5 million and entered into a long-term note receivable. The loan is intended to assist this distributor with its business development and operating cash flows. The fair value of the notes receivable are management's estimate based on the present value of estimated collectability scenarios.
At June 30, 2017, we had outstanding commitments for the purchase of inventory, raw materials and supplies of $17.6 million and outstanding commitments for the purchase of capital equipment of $3.4 million.
10.
SEGMENT INFORMATION
We evaluate our operating segments by our major product lines: extremity, knee, hip, and other products. The “other products” segment includes miscellaneous sales categories, such as bone cement, instrument rental fees, shipping charges, and other implant product lines. As a result of our divestiture of our spine assets, we have also aggregated our remaining biologics and spine products into the "other" segment. To conform to current period presentation we have reclassified prior period biologics and spine results to the "other" segment, and prior period instrument sales and

11


segment profit (loss) from the "other" segment to their individual product lines. Evaluation of the performance of operating segments is based on their respective incomes from operations before taxes, interest income and expense, and nonrecurring items. Intersegment sales and transfers are not significant. The accounting policies of the reportable segments are the same as those described in Note 2 of the notes to our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2016.
Total assets not identified with a specific segment are listed as “corporate” and include cash and cash equivalents, accounts receivable, income taxes receivable, deposits and prepaid expenses, deferred tax assets, land, facilities, office furniture and computer equipment, notes receivable, and other investments. Depreciation and amortization on corporate assets is allocated to the product segments for purposes of evaluating the income (loss) from operations, and capitalized surgical instruments are allocated to the appropriate product line supported by those assets.
Summarized information concerning our reportable segments is shown in the following table (in thousands):
 
 
 
 
 
 
 
Three Months Ended June 30,
Extremity
Knee
Hip
Other
Corporate
Total
2017
 
 
 
 
 
 
Net sales
$
29,456

$
19,612

$
11,517

$
6,742

$

$
67,327

Segment profit (loss)
4,293

1,089

1,045

544

167

7,138

Total assets, net
52,884

73,809

42,576

16,928

115,578

301,775

Capital expenditures
3,015

1,142

2,667

156

526

7,506

Depreciation and Amortization
935

1,767

725

184

1,397

5,008

2016
 
 
 
 
 
 
Net sales
$
24,847

$
19,593

$
12,490

$
9,194

$

$
66,124

Segment profit (loss)
3,867

1,216

1,429

130

(136
)
6,506

Total assets, net
42,381

74,295

40,822

34,190

104,101

295,789

Capital expenditures
1,361

2,888

1,516

692

2,038

8,495

Depreciation and Amortization
727

1,772

694

430

1,084

4,707

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Six Months Ended June 30,
Extremity
Knee
Hip
Other
Corporate
Total
2017
 
 
 
 
 
 
Net sales
$
59,421

$
39,653

$
23,645

$
14,090

$

$
136,809

Segment profit (loss)
8,566

2,300

2,136

338

649

13,989

Total assets, net
52,884

73,809

42,576

16,928

115,578

301,775

Capital expenditures
5,263

2,294

3,657

3,548

4,065

18,827

Depreciation and Amortization
1,802

3,450

1,436

443

2,833

9,964

2016
 
 
 
 
 
 
Net sales
$
49,667

$
39,405

$
23,925

$
18,425

$

$
131,422

Segment profit (loss)
7,804

2,433

2,452

256

140

13,085

Total assets, net
42,381

74,295

40,822

34,190

104,101

295,789

Capital expenditures
2,613

4,096

2,518

5,095

3,494

17,816

Depreciation and Amortization
1,439

3,760

1,363

864

1,941

9,367

 
 
 
 
 
 
 
Geographic distribution of our long-lived assets and inventory is shown in the following table (in thousands):
 
 
 
 
 
 
 
 
As of:
June 30, 2017
 
December 31, 2016
 
Domestic
 
International
 
Domestic
 
International
Long lived assets, gross
$
177,843

 
$
68,088

 
$
167,326

 
$
63,805

Accumulated depreciation and amortization
(91,468
)
 
(27,704
)
 
(89,445
)
 
(23,980
)
Long lived assets, net
86,375

 
40,384

 
77,881

 
39,825

 
 
 
 
 
 
 
 
Inventory
$
45,939

 
$
33,242

 
$
47,538

 
$
33,449

 
 
 
 
 
 
 
 

12


Geographic distribution of our sales is summarized in the following table (in thousands):
 
 
 
 
 
 
Three Months Ended June 30,
2017
 
2016
 
% Inc/Decr
Domestic sales
$
45,682

 
$
44,612

 
2.4
International sales
21,645

 
21,512

 
0.6
Total sales
$
67,327

 
$
66,124

 
1.8
 
 
 
 
 
 
Six Months Ended June 30,
2017
 
2016
 
% Inc/Decr
Domestic sales
$
93,355

 
$
89,185

 
4.7
International sales
43,454

 
42,237

 
2.9
Total sales
$
136,809

 
$
131,422

 
4.1
 
 
 
 
 
 
11.
SHAREHOLDERS’ EQUITY
The following is a reconciliation of the numerators and denominators of the basic and diluted EPS computations for net income and net income available to common shareholders:
 
 
 
 
 
 
 
 
 
Income (Numerator)
Shares (Denominator)
Per Share
 
Income (Numerator)
Shares (Denominator)
Per Share
 
Three Months Ended
 
Three Months Ended
(in thousands, except per share amounts)
June 30, 2017
 
June 30, 2016
Net income
$
4,831

 
 
 
$
4,386

 
 
Basic EPS:
 
 
 
 
 
 
 
Net income available to common shareholders
$
4,831

14,321

$
0.34

 
$
4,386

14,112

$
0.31

Effect of dilutive securities:
 
 
 
 
 
 
 
Stock options
 
253

 
 
 
186

 
Diluted EPS:
 
 
 
 
 
 
 
Net income available to common shareholders plus assumed conversions
$
4,831

14,574

$
0.33

 
$
4,386

14,298

$
0.31

 
 
 
 
 
 
 
 
 
Six Months Ended
 
Six Months Ended
(in thousands, except per share amounts)
June 30, 2017
 
June 30, 2016
Net income
$
9,415

 
 
 
$
8,788

 
 
Basic EPS:
 
 
 
 
 
 
 
Net income available to common shareholders
$
9,415

14,297

$
0.66

 
$
8,788

14,084

$
0.62

Effect of dilutive securities:
 
 
 
 
 
 
 
Stock options
 
216

 
 
 
159

 
Diluted EPS:
 
 
 
 
 
 
 
Net income available to common shareholders plus assumed conversions
$
9,415

14,513

$
0.65

 
$
8,788

14,243

$
0.62

 
 
 
 
 
 
 
 
For the three months ended June 30, 2017, weighted average options to purchase 119,962 shares of common stock were outstanding but were not included in the computation of diluted EPS because the options were antidilutive under the treasury stock method. For the three months ended June 30, 2016, weighted average options to purchase 185,724 shares of common stock were not included in the computation of diluted EPS because the options were antidilutive under the treasury stock method.
For the six months ended June 30, 2017, weighted average options to purchase 78,305 shares of common stock were outstanding but were not included in the computation of diluted EPS because the options were antidilutive under the treasury stock method. For the six months ended June 30, 2016, weighted average options to purchase 182,625

13


shares of common stock were not included in the computation of diluted EPS because the options were antidilutive under the treasury stock method.
Changes in Shareholders’ Equity:
The following is a summary of the changes in shareholders’ equity for the six months ended June 30, 2017: 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Common Stock
 
Additional Paid-In Capital
 
Retained Earnings
 
Common Stock Held in Treasury
 
Accumulated Other Comprehensive Income (Loss)
 
Total
(in thousands)
Shares
 
Amount
 
Balance December 31, 2016
14,413

 
$
144

 
$
87,319

 
$
158,432

 
$
(3,042
)
 
$
(8,611
)
 
$
234,242

Net income

 

 

 
9,415

 

 

 
9,415

Other comprehensive income, net of tax

 

 

 

 

 
213

 
213

Exercise of stock options
70

 
1

 
1,323

 

 

 

 
1,324

Issuance of restricted common stock for services
7

 

 
193

 

 

 

 
193

Issuance of common stock under Employee Stock Purchase Plan
21

 

 
471

 

 

 

 
471

Compensation cost of stock options

 

 
922

 

 

 

 
922

Balance June 30, 2017
14,511

 
$
145

 
$
90,228

 
$
167,847

 
$
(3,042
)
 
$
(8,398
)
 
$
246,780

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Treasury Stock:
In December 2015, our Board of Directors authorized the repurchase of up to 1.0 million shares of our common stock over a two year period. As of June 30, 2017, we have reacquired 163,529 shares of our common stock at an average price of $18.60 per share, or an aggregate of $3.0 million.
Stock-based Compensation Awards:
We sponsor an Executive Incentive Compensation Plan, which provides for the award of stock-based compensation, including options, stock appreciation rights, restricted stock and other stock-based incentive compensation awards to key employees, directors and independent agents and consultants. We implemented a comprehensive, consolidated incentive compensation plan upon shareholder approval at our Annual Meeting of Shareholders on May 7, 2009, referred to as the 2009 Plan, which was amended and restated at our 2014 Annual Meeting of Shareholders, held on May 8, 2014, to increase the maximum number of shares issuable under the 2009 Plan by 500,000. The maximum number of common shares issuable under the 2009 Plan is 1,500,000 plus (a) the number of shares with respect to awards previously granted under our preexisting plans that terminate without being exercised, expire, are forfeited or canceled, plus (b) the number of shares that remain available for future issuance under our preexisting plans plus (c) the number of shares that are surrendered in payment of any awards or any tax withholding with respect thereto. Common stock issued upon exercise of stock options is settled with authorized but unissued shares available. Under the 2009 Plan, the exercise price of option awards equals the market price of our common stock on the date of grant, and each award has a maximum term of ten years. As of June 30, 2017, there were 225,595 total shares remaining issuable under the 2009 Plan.
The aggregate compensation cost charged against income with respect to awards issued under the 2009 Plan and the 2009 Employee Stock Purchase Plan, referred to as the 2009 ESPP, was $0.9 million and $1.0 million for the six months ended June 30, 2017 and 2016, respectively. Income tax benefit on exercises of non-qualified stock options was $0.2 million and $0.3 million for the six months ended June 30, 2017 and 2016, respectively. As of June 30, 2017, total unrecognized compensation cost related to unvested awards was $2.4 million and is expected to be recognized over a weighted-average period of 2.07 years.

14


Stock Options:
A summary of the status of stock option activity under our stock-based compensation plans as of June 30, 2017 and changes during the year to date is presented below:
 
 
 
 
 
 
 
 
 
2017
 
Options    
 
Weighted Avg Exercise Price
 
Weighted Avg Remaining Contractual Term
 
Aggregate Intrinsic Value (In thousands)
Outstanding - January 1
902,775

 
$
19.43

 
 
 
 
Granted
185,500

 
30.50

 
 
 
 
Exercised
(69,979
)
 
18.91

 
 
 
$
529

Forfeited or Expired
(3,381
)
 
24.67

 
 
 
 
Outstanding - June 30
1,014,915

 
$
21.47

 
3.80
 
$
8,581

Exercisable - June 30
590,242

 
$
18.60

 
2.70
 
$
6,612

 
 
 
 
 
 
 
 
Outstanding options, consisting of five-year to ten-year incentive and non-qualified stock options, vest and become exercisable ratably over a three to five year period from the date of grant. The outstanding options expire from five to ten years from the date of grant or upon termination of employment with Exactech, and are contingent upon continued employment during the applicable option term. Certain non-qualified stock options are granted to non-employee sales agents and consultants, and they typically vest ratably over a period of three to four years from the date of grant and expire in five years or less from the date of grant, or upon termination of the agent's or consultant’s contract with Exactech. Stock options for the purchase of shares of $185,500 and $18,500 common stock were granted during the six months ended June 30, 2017and 2016, respectively.
Restricted Stock Awards:
Under the 2009 Plan, we may grant restricted stock awards to eligible employees, directors, and independent agents and consultants. Restrictions on transferability, risk of forfeiture and other restrictions are determined by the Compensation Committee of the Board of Directors, or the Committee, at the time of the award. During February 2017, the Committee approved equity compensation to the outside members of the Board of Directors for their service on the Board of Directors. The annual compensation for each director consists of the grant of stock awards with an aggregate market value of $77,500, payable in four equal quarterly grants of common stock based on the market prices of our common stock on the respective dates of grant. The summary information of the restricted stock grants for the first six months of 2017 is presented below: 
 
 
 
Grant date
February 28, 2017

May 31, 2017

Aggregate shares of restricted stock granted
3,985

3,195

Grant date fair value
$
97,000

$
97,000

Weighted average fair value per share
$
24.30

$
30.30

 
 
 
During February 2016, the Committee approved equity compensation to the outside members of the Board of Directors for their service on the Board of Directors. The annual compensation for each director consisted of the grant of stock awards with an aggregate market value of $77,500, payable in four equal quarterly grants of common stock based on the market prices of our common stock on the respective dates of grant. The summary information of the restricted stock grants for the first six months of 2016 is presented below:
 
 
 
Grant date
February 29, 2016

May 31, 2016

Aggregate shares of restricted stock granted
5,190

3,925

Grant date fair value
$
97,000

$
97,000

Weighted average fair value per share
$
18.65

$
24.68

 
 
 
 
All of the restricted stock awards in 2017 and 2016 were fully vested at each of the grant dates. The restricted stock awards require no service period and thus contain no risk of, or provision for, forfeiture.

15


Employee Stock Purchase Plan:
On February 18, 2009, our board of directors adopted the 2009 ESPP, and our shareholders approved the 2009 ESPP at our Annual Meeting of Shareholders on May 7, 2009. Under the 2009 ESPP, employees are able to purchase shares of our common stock at a fifteen percent (15%) discount via payroll deduction, up to a maximum number of shares issuable under the 2009 ESPP of 450,000. There are four offering periods during an annual period. As of June 30, 2017, 116,645 shares remained available for purchase under this 2009 ESPP. The fair value of the employees' purchase rights is estimated using the Black-Scholes model. Purchase information and fair value assumptions are presented in the following table:
 
 
 
 
Six Months Ended June 30,
2017
 
2016
Shares purchased
20,982
 
23,179
Dividend yield
 
Expected life
1 year
 
1 year
Expected volatility
34%
 
32%
Risk free interest rates
1.0%
 
0.7%
Weighted average per share fair value
$5.80
 
$4.08
 
 
 
 
12.
BUSINESS ACQUISITION AND DIVESTITURE
Exactech Australia
On February 1, 2016, we completed the acquisition of all of the outstanding capital stock of Exactech Australia Pty Ltd, an Australia-based company. Exactech Australia was our independent importer and distribution partner in Australia from 2013 through our acquisition of Exactech Australia in 2016. The acquisition was accomplished to further the partnership between us and the team at Exactech Australia and to further service customers in the Asia Pacific area.
The aggregate purchase price for Exactech Australia will range from $3.1 million AUD to $7.6 million AUD, of which $1.6 million AUD, or $1.1 million USD at a 0.7034 AUD:USD exchange rate at closing, was paid to the Exactech Australia shareholders in cash at the closing of the acquisition, and the remainder will be paid to such shareholders contingent on the achievement of certain future milestones. The first contingent consideration payment of $1.2 million USD was paid in February 2017, and we expect the final payment to be made during the first quarter of 2018. Consideration also included $2.0 million USD in forgiven accounts receivable that were owed to us as of February 1, 2016. The estimated fair value of the contingent consideration was determined using the following assumptions: discount rate of 3.7%, probability levels of milestone range of outcomes, and expected timing of achievement of contingent consideration earn-out amounts. We financed the acquisition from our operating cash flows.
We acquired tangible assets of $2.7 million, assumed liabilities of $0.4 million, intangible assets, comprising customer relationships of $0.5 million, and goodwill of $2.8 million. Upon completion of the acquisition, we effectively concluded a pre-existing distribution agreement for the distribution of our products, which was stated at fair value; therefore, we recognized no impact to the statement of income. The accounting for our acquisition of Exactech Australia was finalized as of December 31, 2016. The goodwill was determined as the excess of the consideration over the fair value of the net assets acquired, and was due to the synergies we obtained in the extended service in Australia. Goodwill was allocated to the knee, extremity and hip segments based on expected sales for the segments. Pro-forma revenue and earnings for the business combination have not been presented because the effects, both individually and in the aggregate, were not material to our results of operations.
Blue Ortho
On January 15, 2015, we completed the acquisition of all of the outstanding capital stock of Blue Ortho SAS, a France-based company. Blue Ortho is the computer-assisted surgical technology development and manufacturing firm that partnered with the Company to develop the ExactechGPS® Guided Personalized Surgery system. The aggregate purchase price for Blue Ortho is a maximum of €10.0 million, of which €2.0 million, or $2.3 million at a 1.16 EUR:USD exchange rate at closing, was paid to the Blue Ortho shareholders in cash at the closing of the acquisition, and payment of the remainder is contingent on the achievement of certain milestones. We expect the contingent consideration to be paid over the next five to ten years. We acquired tangible assets of $1.5 million, assumed liabilities of $2.9 million, intangible assets, comprising product licenses and designs, of $7.5 million, and goodwill of $6.5 million.

16


Contingent Consideration
The following table summarizes the contingent consideration balance and activity for the six months ended June 30, 2017, and the year ended December 31, 2016 (in thousands):
 
 
 
 
 

 
Exactech Australia
Blue Ortho
Total
Contingent liability balance, December 31, 2015

6,222

6,222

Initial fair value of contingent consideration
2,435


2,435

Period change in valuation
(125
)
187

62

Payments

(669
)
(669
)
Foreign currency translation effects
63

(201
)
(138
)
Contingent liability balance, December 31, 2016
2,373

5,539

7,912

Period change in valuation
(38
)
70

32

Payments
(1,206
)
(1,383
)
(2,589
)
Foreign currency translation effects
163

380

543

Contingent liability balance, June 30, 2017
1,292

4,606

5,898

Current liability
1,292

1,592

2,884

Non-current liability

3,014

3,014

 
 
 
 

Due to our expected timing of earn-out payments, a portion of the contingent consideration is classified in other current liabilities on our consolidated balance sheets. The remainder is classified as other non-current liabilities. The change in the period change in valuation contingent consideration during the six months ended June 30, 2017 was interest expense of $0.1 million and partially offset by a gain from a change in the expectations of contingent payment of $0.1 million. The change in the contingent consideration during the year ended December 31, 2016 included interest expense of $0.3 million and a gain from a change in the expectations of contingent payment of $0.2 million. Both adjustments were recognized in other income (expense) in the consolidated statements of income.
Divestiture of Exactech Taiwan
In June 2017, we completed an agreement to issue common stock of Exactech Taiwan to Biogend Therapeutics Co., LTD ("Biogend") and a former employee of Exactech, effectively divesting 82% of our ownership in Exactech Taiwan in exchange for a cash investment, by Biogend, in Exactech Taiwan of $6.5 million. As a result, we disposed of $0.2 million in assets and $0.1 million in liabilities and recognized a $0.1 million equity investment, representing our fair value estimate of our retained 18% ownership in Exactech Taiwan. Additionally, we recognized $0.2 million as the fair value of a long-term note receivable owed to us by Exactech Taiwan. The fair value of our retained investment and note receivable were determined based on management's estimate of the present value of probability scenarios of return on investment and collectability of the note receivable.
Divestiture of Spine Business
During the first quarter of 2017, we obtained a long-term earn-out receivable for $3.0 million as partial payment to us for the sale of our spine business. The fair value of the receivable is management's estimate based on the present value of estimated milestone payments, and adjusted for collectability assumptions.
13.
SUBSEQUENT EVENT
In July 2017, we executed an agreement with Double Medical Technology, Inc., to sell 100% of our investment in Exactech Medical Shanghai for cash proceeds of $1.6 million at the closing targeted during the second half of 2017. As of June 30, 2017, Exactech Medical Shanghai had assets of $2.3 million, consisting primarily of inventory and surgical instrumentation, and liabilities of $1.4 million, which included a current accounts payable balance of $1.1 million owed to us that we expect to fully collect at closing. At closing, we expect to enter into a distribution agreement with Double Medical Technology, Inc., pursuant to which they will agree to distribute our product in China after our sale of Exactech Medical Shanghai.


17


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and related notes appearing elsewhere in this report.
Overview of the Company
We develop, manufacture, market and sell orthopaedic implant devices, related surgical instrumentation, supplies and biologic materials to hospitals and physicians in the United States and internationally. Our revenues are principally derived from sales of extremity, knee, and hip joint replacement systems. We believe that our research and development projects will enable us to continue to introduce both extensions to our existing product families, as well as new reconstructive product lines intended to address challenging clinical issues. Revenue from sales of other products, including Cemex® bone cement and the InterSpace™ pre-formed, antibiotic cement hip, knee and shoulder spacers are expected to continue to contribute to our anticipated future revenue growth. In January 2017, we divested our spine products business.
Our operating expenses consist of sales and marketing expenses, general and administrative expenses, research and development expenses, and depreciation expenses. The largest component of operating expenses, sales and marketing expenses, primarily consists of payments made to independent sales representatives for their services to hospitals and surgical facilities on our behalf. These expenses tend to be variable in nature and related to sales growth.
Research and development expenses primarily consist of expenditures on projects concerning knee, extremities and hip implant product lines and biologic materials and services. In marketing our products, we use a combination of traditional targeted media advertising together with our primary marketing focus, direct customer contact and service to orthopaedic surgeons. Because surgeons are the primary decision makers when it comes to the choice of products and services that best meet the needs of their patients, we focus our marketing strategy on meeting the needs of the orthopaedic surgeon community. In addition to surgeon’s preference, hospitals and buying groups, as the economic customers, actively participate with physicians in the choice of implants and services.
Overview of the Three and Six Months Ended June 30, 2017
During the quarter ended June 30, 2017, sales increased 2% to $67.3 million from $66.1 million in the quarter ended June 30, 2016, as a result of both domestic and international sales growth, which increased 2% and 1%, respectively. Worldwide gross margins decreased modestly to 68.7% for the second quarter of 2017 from 69.3% during the second quarter of 2016. Operating expenses were flat when compared to the quarter ended June 30, 2016, and, as a percentage of sales, decreased to 58% during the second quarter of 2017 compared to 59% during the second quarter of 2016. Increases in research and development expenses in our core segments were offset by the removal of operating expenses from the divested spine business, as compared to the second quarter of 2016. Net income for the quarter ended June 30, 2017 increased 10%, and diluted earnings per share was $0.33 as compared to $0.31 in the same quarter last year, which was primarily a result of our increase in sales.
During the six months ended June 30, 2017, sales increased 4% to $136.8 million from $131.4 million in the six months ended June 30, 2016, as a result of worldwide sales growth, which increased 5% domestically and 3% internationally. Gross margins increased slightly to 69.5% in the first half of 2017 from 69.1% in the first half of 2016. Operating expenses increased 5% when compared to the six months ended June 30, 2016, and as a percentage of sales, increased to 60% during the first half of 2017 compared to 59% during the first half of 2016. The increase in operating expenses was primarily due to increases in research and development expenses associated with continued product development projects. Net income for the six months ended June 30, 2017 increased 7%, and diluted earnings per share was $0.65 as compared to $0.62 in the same six months last year.
During the six months ended June 30, 2017, we acquired $18.8 million in property and equipment, including new production equipment, surgical instrumentation, and spending for facility expansion. Net cash flow from operations was $18.1 million for the six months ended June 30, 2017, as compared to net cash flow from operations of $12.9 million during the six months ended June 30, 2016. The increase was primarily due to general working capital needs during the first six months of 2017, as compared to the first six months of 2016.

18


The following table includes the net sales and percentage of net sales, as well as a comparison of net sales change to net sales change calculated on a constant currency basis, for each of our product lines, which are also our reportable segments, for the three and six month periods ended June 30, 2017 and June 30, 2016. We completed the divestiture of our spine products business in January 2017, and we aggregated our remaining biologics and spine products into the "other" segment. To conform to current period presentation we have reclassified prior period biologics and spine results to the "other" segment, and prior period instrument sales and segment profit (loss) from the "other" segment to their individual product lines.
Sales by Product Line
($ in 000’s)
 
Three Months Ended
 
Inc (decr)
 
June 30, 2017
 
June 30, 2016
 
2017 - 2016
 
Constant Currency
Extremity
29,456

 
43.8
%
 
24,847

 
37.6
%
 
18.5
 %
 
19.1
 %
Knee
19,612

 
29.1
%
 
19,593

 
29.6
%
 
0.1

 
0.9

Hip
11,517

 
17.1
%
 
12,490

 
18.9
%
 
(7.8
)
 
(7.2
)
Other
6,742

 
10.0
%
 
9,194

 
13.9
%
 
(26.7
)
 
(25.7
)
Total
$
67,327

 
100.0
%
 
$
66,124

 
100.0
%
 
1.8
 %
 
2.5
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
Six Months Ended
 
Inc (decr)
 
June 30, 2017
 
June 30, 2016
 
2017 - 2016
 
Constant Currency
Extremity
59,421

 
43.4
%
 
49,667

 
37.8
%
 
19.6
 %
 
20.0
 %
Knee
39,653

 
29.0
%
 
39,405

 
30.0
%
 
0.6
 %
 
1.4
 %
Hip
23,645

 
17.3
%
 
23,925

 
18.2
%
 
(1.2
)%
 
(0.1
)%
Other
14,090

 
10.3
%
 
18,425

 
14.0
%
 
(23.5
)%
 
(22.6
)%
Total
$
136,809

 
100.0
%
 
$
131,422

 
100.0
%
 
4.1
 %
 
4.8
 %
 
 
 
 
 
 
 
 
 
 
 
 
The following table includes the net sales, percentage of net sales, net sales change, and net sales change calculated on a constant currency basis, for our geographic distribution for the three and six month periods ended June 30, 2017 and June 30, 2016:
Sales by Geographic Distribution
($ in 000’s)
 
Three Months Ended
 
Inc (decr)
 
June 30, 2017
 
June 30, 2016
 
2017- 2016
 
Constant Currency
Domestic Sales
$
45,682

 
67.9
%
 
$
44,612

 
67.5
%
 
2.4
%
 
2.4
%
International Sales
21,645

 
32.1
%
 
21,512

 
32.5
%
 
0.6
%
 
2.8
%
Total
$
67,327

 
100.0
%
 
$
66,124

 
100.0
%
 
1.8
%
 
2.5
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Six Months Ended
 
Inc (decr)
 
June 30, 2017
 
June 30, 2016
 
2017- 2016
 
Constant Currency
Domestic Sales
$
93,355

 
68.2
%
 
$
89,185

 
67.9
%
 
4.7
%
 
4.7
%
International Sales
43,454

 
31.8
%
 
42,237

 
32.1
%
 
2.9
%
 
5.1
%
Total
$
136,809

 
100.0
%
 
$
131,422

 
100.0
%
 
4.1
%
 
4.8
%
 
 
 
 
 
 
 
 
 
 
 
 

19


The following table includes items from the unaudited condensed consolidated statements of income for the three and six months ended June 30, 2017 as compared to the three and six months ended June 30, 2016, the dollar and percentage change from period to period and the percentage relationship to net sales (dollars in thousands):
Comparative Statement of Income Data
 
Three Months Ended June 30,
 
2017 – 2016 Inc (decr)
 
% of Sales
 
2017
 
2016
 
$
 
%
 
2017
 
2016
Net sales
$
67,327

 
$
66,124

 
1,203

 
1.8

 
100.0
 %
 
100.0
 %
Cost of goods sold
21,054

 
20,268

 
786

 
3.9

 
31.3

 
30.7

Gross profit
46,273

 
45,856

 
417

 
0.9

 
68.7

 
69.3

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
23,569

 
23,835

 
(266
)
 
(1.1
)
 
35.0

 
36.0

General and administrative
5,621

 
5,640

 
(19
)
 
(0.3
)
 
8.4

 
8.5

Research and development
5,380

 
5,329

 
51

 
1.0

 
8.0

 
8.1

Depreciation and amortization
4,732

 
4,410

 
322

 
7.3

 
7.0

 
6.7

Total operating expenses
39,302

 
39,214

 
88

 
0.2

 
58.4

 
59.3

Income from operations
6,971

 
6,642

 
329

 
5.0

 
10.4

 
10.0

Other income (expense), net
167

 
(136
)
 
303

 
222.8

 
0.2

 
(0.2
)
Income before income tax and equity in loss of investee
7,138

 
6,506

 
632

 
9.7

 
10.6

 
9.8

Provision for income taxes
2,255

 
2,120

 
135

 
6.4

 
3.3

 
3.2

Income before equity in loss of investee
4,883

 
4,386

 
497

 
11.3

 
7.3

 
6.6

Equity in loss of investee
(52
)
 

 
(52
)
 
 
 
(0.1
)
 

Net income
$
4,831

 
$
4,386

 
445

 
10.1

 
7.2

 
6.6

 
 
 
 
 
 
 
 
 
 
 
 
 
Six Months Ended June 30,
 
2017 – 2016 Inc (decr)
 
% of Sales
 
2017
 
2016
 
$
 
%
 
2017
 
2016
Net sales
$
136,809

 
$
131,422

 
5,387

 
4.1

 
100.0
 %
 
100.0
 %
Cost of goods sold
41,695

 
40,636

 
1,059

 
2.6

 
30.5

 
30.9

Gross profit
95,114

 
90,786

 
4,328

 
4.8

 
69.5

 
69.1

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
48,622

 
47,154

 
1,468

 
3.1

 
35.5

 
35.9

General and administrative
12,157

 
11,554

 
603

 
5.2

 
8.9

 
8.8

Research and development
11,604

 
10,399

 
1,205

 
11.6

 
8.5

 
7.9

Depreciation and amortization
9,391

 
8,734

 
657

 
7.5

 
6.9

 
6.6

Total operating expenses
81,774

 
77,841

 
3,933

 
5.1

 
59.8

 
59.2

Income from operations
13,340

 
12,945

 
395

 
3.1

 
9.7

 
9.9

Other income (expense), net
649

 
140

 
509

 
(363.6
)
 
0.5

 
0.1

Income before income tax and equity in loss of investee
13,989

 
13,085

 
904

 
6.9

 
10.2

 
10.0

Provision for income taxes
4,479

 
4,297

 
182

 
4.2

 
3.2

 
3.3

Income before equity in loss of investee
9,510

 
8,788