ORTHOPEDIATRICS CORP 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the condensed consolidated financial statements and related notes thereto contained elsewhere in this quarterly report, as well as the information under "Note Regarding Forward-Looking Statements." The description of our business included in this quarterly report is summary in nature and only includes material developments that have occurred since the latest full description. The full description of the history and general development of our business is included in "Item 1. Description of Business" section of the Company's Annual Report on Form 10-K filed with the SEC on March 11, 2021, which section is incorporated herein by reference. Overview We are the only global medical device company focused exclusively on providing a comprehensive trauma and deformity correction, scoliosis and sports medicine product offering to the pediatric orthopedic market in order to improve the lives of children with orthopedic conditions. We design, develop and commercialize innovative orthopedic implants and instruments to meet the specialized needs of pediatric surgeons and their patients, who we believe have been largely neglected by the orthopedic industry. We currently serve three of the largest categories in this market. We estimate that the portion of this market that we currently serve represents a $3.3 billion opportunity globally, including over $1.5 billion in the United States. We sell implants and instruments to our customers for use by pediatric orthopedic surgeons to treat orthopedic conditions in children. We provide our implants in sets that consist of a range of implant sizes and include the instruments necessary to perform the surgical procedure. In the United States and multiple international markets, our customers typically expect us to have full sets of implants and instruments on site at each hospital but do not purchase the implants until they are used in surgery. Accordingly, we must make an up-front investment in inventory of consigned implants and instruments before we can generate revenue from a particular hospital and we maintain substantial levels of 32 inventory at any given time. In the international markets where we sell to stocking distributors, we transfer control of our products to the distributor when title passes upon shipment. We currently market 36 surgical systems that serve three of the largest categories within the pediatric orthopedic market: (i) trauma and deformity, (ii) scoliosis and (iii) sports medicine/other. We rely on a broad network of third parties to manufacture the components of our products, which we then inspect and package. We believe our innovative products promote improved surgical accuracy, increase consistency of outcomes and enhance surgeon confidence in achieving high standards of care. In the future, we expect to expand our product offering within these categories, as well as to address additional categories of the pediatric orthopedic market. The majority of our revenue has been generated in the United States, where we sell our products through a network of 40 independent sales agencies employing more than 182 sales representatives specifically focused on pediatrics. These independent sales agents are trained by us, distribute our products and are compensated through sales-based commissions and performance bonuses. We do not sell our products through or participate in physician-owned distributorships, or PODs. We market and sell our products internationally in 45 countries, through independent stocking distributors and sales agencies. Our independent distributors manage the billing relationship with each hospital in their respective territories and are responsible for servicing the product needs of their surgeon customers. In 2017, we began to supplement our international stocking distributors with sales agencies using direct sales programs in the United Kingdom, Ireland, Australia and New Zealand where we sell directly to the hospitals. We began selling direct to Canada in September 2018, Belgium and the Netherlands in January 2019, Italy in March 2020 and Germany, Switzerland and Austria in January 2021. Additionally, in March 2019, we established an operating company in the Netherlands in order to enhance our operations in Europe. In these markets, we work through sales agencies that are paid a commission, similar to our U.S. sales model. We expect these arrangements to generate an increase in revenue and gross margin. We believe there are significant opportunities for us to strengthen our position in U.S. and international markets by increasing investments in consigned implant and instrument sets, strengthening our global sales and distribution infrastructure and expanding our product offering. Impact of COVID-19 on our Business The global COVID-19 pandemic (“COVID-19” or the “pandemic”), together with the preventative and precautionary measures taken by governments, governmental agencies, communities, businesses and hospital administrators, has impacted, and may continue to impact significant aspects of our business, including demand for our products, supply chain and distribution systems, our operations generally, and the timing for bringing new products to market. We also expect medical procedure rates to continue to vary by type and country, and could be impacted by regional COVID-19 case volumes, hospital and clinical occupancy and staffing levels, the willingness of patients to schedule elective procedures, travel and quarantine restrictions, vaccine immunization rates, and new COVID-19 variants. While COVID-19 case volumes appear to be decreasing in the U.S. and certain other countries as a result of higher vaccination rates, the global COVID-19 outlook remains uncertain as vaccination rates have slowed and the spread of new variants has accelerated. While the impact of COVID-19 has had, and may continue to have, an adverse effect on our business, results of operations, financial condition and cash flows, the nature and extent of such impact is unknown, as we cannot predict with confidence the ultimate duration or further severity of the pandemic. We encourage the readers of this document to read our risk factors in their entirety contained in Item 1A “Risk Factors” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (the "SEC") on March 11, 2021 and in other reports filed with the SEC that discuss the risks and factors that may affect our business. 33 Despite the impact COVID-19 has had on our business, we continue to invest in research and development, invest in our people, and take steps to position ourselves for long-term success. Health and Safety From the earliest signs of the outbreak, we have taken proactive, aggressive action to protect the health and safety of our employees, customers, partners and suppliers. We enacted rigorous safety measures in all applicable locations, including implementing social distancing protocols, requiring working from home for those employees that do not need to be physically present on the warehouse floor, suspending travel, extensively and frequently disinfecting our workspaces and providing masks to those employees who must be physically present. We will continue to utilize some or all of these measures until we determine that the COVID-19 pandemic is adequately contained for purposes of our business. We may also take further actions as government authorities require or recommend or as we determine to be in the best interests of our employees, customers, partners and suppliers. Supply We have not yet experienced any significant impacts or interruptions to our supply chain as a result of the COVID-19 pandemic. To mitigate the risk of any potential supply interruptions from the COVID-19 pandemic, we chose to increase certain inventory levels during the quarter. We may decide to take similar actions going forward. Additionally, restrictions or disruptions of transportation, such as reduced availability of air transport, port closures and increased border controls or closures, may result in higher costs and delays. Demand The outbreak has significantly increased economic and demand uncertainty. We anticipate that the current outbreak or continued spread of COVID-19, and the actions taken by governmental authorities and other third parties to contain the virus, may cause a global economic slowdown, and it is possible that it could cause a global recession. In the event of a recession, demand for our products would decline and our business would be adversely effected. We have experienced a reduction in revenue as a result of global delays in elective surgeries. Liquidity Although there is uncertainty related to the anticipated impact of the recent COVID-19 outbreak on our future results, we believe our business model, our current cash reserves and the recent steps we have taken to strengthen our balance sheet, including our June 2020 and December 2019 equity offerings, leave us well-positioned to manage our business through this crisis as it continues to unfold. We believe our existing balances of cash and our currently anticipated operating cash flows will be sufficient to meet our cash needs arising in the ordinary course of business for the next twelve months. We continue to monitor the rapidly evolving situation and guidance from international and domestic authorities, including federal, state and local public health authorities and may take additional actions based on their recommendations. In these circumstances, there may be developments outside our control requiring us to adjust our operating plan. As such, given the dynamic nature of this situation, we cannot reasonably estimate the impacts of COVID-19 on our financial condition, results of operations or cash flows in the future. Emerging Growth Company and Smaller Reporting Company Status We will qualify as an “emerging growth company” as defined in the Jumpstart Our Business Startups Act (the “JOBS Act”) until December 31, 2022. For as long as a company is deemed to be an emerging growth company, it may take advantage of specified reduced reporting and other regulatory requirements 34 that are generally unavailable to other public companies. We also qualify as a "smaller reporting company," as such term is defined in Rule 12b-2 under the Exchange Act. To the extent that we continue to qualify as a smaller reporting company, after we cease to qualify as an emerging growth company, certain of the exemptions available to us as an emerging growth company may continue to be available to us as a smaller reporting company. The JOBS Act also provides that an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards and, therefore, we are subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. Summary of Statements of Operations for the Three and Six Months Ended June 30, 2021 and 2020 The following table sets forth our results of operations for the three and six months ended June 30, 2021 and 2020: Three Months Ended June 30, Six Months Ended June 30, 2021 2020 Increase (Decrease) % 2021 2020 Increase (Decrease) % Net revenue $ 26,695 $ 13,593 $ 13,102 96 % $ 48,157 $ 29,949 $ 18,208 61 % Cost of revenue 6,252 3,532 2,720 77 % 11,389 7,675 3,714 48 % Sales and marketing expenses 10,876 5,620 5,256 94 % 19,825 13,184 6,641 50 % General and administrative expenses 11,088 10,577 511 5 % 23,129 18,458 4,671 25 % Research and development expenses 1,325 881 444 50 % 2,633 2,146 487 23 % Other expenses 1,196 2,430 (1,234) (51) % 5,914 2,878 3,036 105 % Provision for income taxes (benefit) (286) — (286) 100 % (598) — (598) 100 % Net loss $ (3,756) $ (9,447) $ (5,691) (60) % $ (14,135) $ (14,392) $ (257) (2) % Net Revenue The following tables set forth our net revenue by geography and product category for the three and six months ended June 30, 2021 and 2020: Three Months Ended June 30, Six Months Ended June 30, Product sales by geographic location: 2021 2020 2021 2020 U.S. $ 21,737 $ 12,146 $ 38,576 $ 25,530 International 4,958 1,447 9,581 4,419 Total $ 26,695 $ 13,593 $ 48,157 $ 29,949 Three Months Ended June 30, Six Months Ended June 30, Product sales by category: 2021 2020 2021 2020 Trauma and deformity $ 17,933 $ 9,220 $ 32,485 $ 21,430 Scoliosis 7,657 3,836 13,608 7,547 Sports medicine/other 1,105 537 2,064 972 Total $ 26,695 $ 13,593 $ 48,157 $ 29,949 Net revenue increased $13.1 million, or 96%, from $13.6 million for the three months ended June 30, 2020 to $26.7 million for the three months ended June 30, 2021 and increased $18.2 million, or 61%, from $29.9 million for the six months ended June 30, 2020 to $48.2 million for the six months ended June 30, 2021. The increase during the three and six months ended June 30, 2021 reflects the continued 35 return to normalization in both the U.S. and international markets which, during the three months ended June 30, 2020, experienced the most significant impacts from the COVID-19 pandemic. Additionally, we continue to see the benefit of converting Germany, Austria, and Switzerland to a direct agency sales model. Trauma and deformity sales increased $8.7 million, or 95%, during the three months ended June 30, 2021, and increased $11.1 million, or 52%, during the six months ended June 30, 2021, in each case, primarily driven by strong trauma and deformity growth across numerous product lines, specifically our PNP Femur, Cannulated Screws and Orthex systems. Scoliosis sales increased $3.8 million, or 100%, during the three months ended June 30, 2021, and increased $6.1 million, or 80%, during the six months ended June 30, 2021, in each case , primarily driven by increased sales of our RESPONSE 5.5/6.0 system and FIREFLY ® Pedicle Screw Navigation Guides, and additional sales contributed from the ApiFix acquisition. Sports medicine / other increased $0.6 million, or 106%, during the three months ended June 30, 2021, and increased $1.1 million, or 112%, during the six months ended June 30, 2021, in each case, primarily driven by the additional sales contributed from Telos. Nearly all the change in each category was due to an increase in the unit volume sold and not a result of price changes. Cost of Revenue and Gross Margin Cost of revenue increased $2.7 million, or 77%, from $3.5 million for the three months ended June 30, 2020 to $6.3 million for the three months ended June 30, 2021. Cost of revenue increased $3.7 million, or 48%, from $7.7 million for the six months ended June 30, 2020 to $11.4 million for the six months ended June 30, 2021. The increases were due primarily to increased sales volume in both the U.S. and international markets. Gross margin was 74% for the three months ended June 30, 2020 and 77% for the three months ended June 30, 2021. Gross margin was 74% for the six months ended June 30, 2020 and 76% for the six months ended June 30, 2021. Sales and Marketing Expenses Sales and marketing expenses increased $5.3 million, or 94%, to $10.9 million for the three months ended June 30, 2021 from $5.6 million for the three months ended June 30, 2020. Sales and marketing expenses increased $6.6 million, or 50%, to $19.8 million for the six months ended June 30, 2021 from $13.2 million for the six months ended June 30, 2020. The changes in the three and six month periods ended June 30, 2021 were due primarily to increased sales commission expenses, driven by increased unit volumes sold. General and Administrative Expenses General and administrative expenses increased $0.5 million, or 5%, from $10.6 million for the three months ended June 30, 2020 to $11.1 million for the three months ended June 30, 2021. General and administrative expenses increased $4.7 million, or 25%, from $18.5 million for the six months ended June 30, 2020 to $23.1 million for the six months ended June 30, 2021. The increases for the three and six month periods ended June 30, 2021 were due primarily to the additional expenses associated with the ApiFix and Telos acquisitions, the addition of personnel and resources to support the continued expansion of our business and an increase in legal and other professional service expense associated with litigation. Depreciation and amortization expenses increased $0.7 million, or 34%, from $1.9 million for the three months ended June 30, 2020 to $2.6 million for the three months ended June 30, 2021. Depreciation and amortization expenses increased $1.8 million, or 54%, from $3.3 million for the six months ended June 30, 2020 to $5.1 million for the six months ended June 30, 2021. The increases for the three and six month periods ended June 30, 2021 were primarily due to the amortization of intangible assets acquired through the Vilex, Telos and ApiFix acquisitions and the purchase of the Band-Lok intellectual property. Research and Development Expenses 36 Research and development expenses increased $0.4 million, or 50%, from $0.9 million for the three months ended June 30, 2021 to $1.3 million for the three months ended June 30, 2021. Research and development expenses increased $0.5 million, or 23%, from $2.1 million for the six months ended June 30, 2020 to $2.6 million for the six months ended June 30, 2021. The increases for the three and six month periods ended June 30, 2021 were primarily due to incremental product development including the addition of personnel and the growth of our business. Total Other Expenses Other expenses were $1.2 million and $2.4 million for the three months ended June 30, 2021 and 2020, respectively, and $5.9 million and $2.9 million for the six months ended June 30, 2021 and 2020, respectively. The decrease in other expense for the three months ended June 30, 2021 was primarily due to the decrease in interest expense after repaying all outstanding debt with Squadron. The increase in other expense for the six months ended June 30, 2021 is primarily due to the accretion of interest expense attributable to the acquisition installment payable and the fair value adjustments of contingent consideration related to the ApiFix acquisition. The aggregate of accreted interest expense and fair value adjustments for the three and six months ended June 30, 2021 were $1.6 million and $6.4 million, respectively, and for both the three and six months ended June 30, 2020, was $1.8 million. Liquidity and Capital Resources We have incurred operating losses since inception which resulted in negative cash flows for continuing operations from operating activities of $10.9 million and $14.7 million for the six months ended June 30, 2021 and 2020, respectively. As of June 30, 2021, we had an accumulated deficit of $175.9 million. We anticipate that our losses will continue in the near term as we continue to expand our product portfolio and invest in additional consigned implant and instrument sets to support our expansion into existing and new markets. Since inception, we have funded our operations primarily with proceeds from the sales of our common and preferred stock, convertible securities and debt, as well as through sales of our products. At June 30, 2021, we had cash and cash equivalents, restricted cash and short term investments of $67.2 million. Cash Flows The following table sets forth our cash flows from operating, investing and financing activities for the periods indicated: Six Months Ended June 30, 2021 2020 Net cash used in operating activities $ (10,891) $ (14,707) Net cash used in investing activities (7,332) (9,349) Net cash provided by (used in) financing activities (2) 66,427 Effect of exchange rate changes on cash 29 17 Net (decrease) increase in cash $ (18,196) $ 42,388 Cash Used in Operating Activities Net cash used in operating activities from continuing operations was $10.9 million and $14.7 million for the six months ended June 30, 2021 and 2020, respectively. The primary use of this cash was to fund our operations related to the development and commercialization of our products in each of these years. Net cash used for working capital was $10.4 million and $8.8 million for the six months ended June 30, 2021 and 2020, respectively. During the six months ended June 30, 2021, the primary driver of working capital cash usage was the increase in accounts receivable of $1.8 million due to increased sales during the 37 period, the increase in inventory of $3.3 million to support future sales growth, and legal settlements of $6.3 million. This cash usage was offset primarily by other accrued expenses which was a source of cash of $1.1 million. Cash Used in Investing Activities Net cash used in investing activities was $7.3 million and $9.3 million for the six months ended June 30, 2021 and 2020, respectively. Net cash used in investing activities for the six months ended June 30, 2021 consisted of the purchase of a license agreement as a result of the Dr. Barry legal settlement and purchases of instrument sets of $4.5 million. Net cash used in investing activities for the six months ended June 30, 2020 consisted of $1.7 million for the acquisition of Telos, net of cash received, the acquisition of ApiFix for $1.7 million, net of cash received, the acquisition of the Band-Lok intellectual propoerty of $0.8 million and $5.2 million for purchases of instrument sets. Cash Provided By Financing Activities Net cash used in financing activities for the six months ended June 30, 2021 was immaterial to the results of our operations. Net cash provided by financing activities for the six months ended June 30, 2020 was $66.4 million, consisting primarily of the proceeds from the issuance of common stock of $70.2 million and $1.3 million from the exercise of stock options and offset by the payment of $5.0 million of the revolving credit facility with Squadron. Indebtedness Loan Agreement On December 31, 2017, we entered into a Fourth Amended and Restated Loan and Security Agreement, or the Loan Agreement, with Squadron Capital LLC, or Squadron, the Company's largest investor. Under the terms of the Loan Agreement, which has been amended by a First Amendment dated as of June 4, 2019 and a Second Amendment dated as of August 4, 2020 (as so amended, the “Second Amended Loan Agreement”), Squadron is providing the Company a revolving credit facility in the amount of $25.0 million. Borrowings under the revolving credit facility are to be made under a First Amended and Restated Revolving Note, dated August 4, 2020 (the “Amended Revolving Note”), payable, jointly and severally, by the Company and each of its subsidiaries party thereto. The Amended Revolving Note will mature at the earlier of: (i) the date on which any person or persons acquire (x) capital stock of the Company possessing the voting power to elect a majority of the Company’s Board of Directors (whether by merger, consolidation, reorganization, combination, sale or transfer), or (y) all or substantially all of the Company’s assets, determined on a consolidated basis; and (ii) January 1, 2024. The Second Amended Loan Agreement provides for interest only payments, which are payable monthly, with an interest rate equal to the greater of (a) three month LIBOR plus 8.61%, and (b) 10.00%. On January 4, 2020, the Company repaid Squadron $5.0 million outstanding under the revolving credit facility in effect at that time and, on July 15, 2020, the Company repaid the $20.0 million Term Note A outstanding under the Loan Agreement, together with all unpaid interest and other related amounts payable. The Company does not currently have any borrowings outstanding under the Second Amended Loan Agreement. The Company has agreed to pay Squadron an unused commitment fee in an amount equal to the per annum rate of 0.50% (computed on the basis of a year of 360 days and the actual number of days elapsed) times the daily unused portion of the revolving credit commitment. The unused commitment fee is payable quarterly in arrears. 38 Borrowings under the Second Amended Loan Agreement are secured by substantially all of the Company's assets and are unconditionally guaranteed by each of its subsidiaries with the exception of Vilex. There are no traditional financial covenants associated with the Second Amended Loan Agreement. However, there are negative covenants that prohibit us from, among other things, transferring any of our material assets, merging with or acquiring another entity, entering into a transaction that would result in a change of control, incurring additional indebtedness, creating any lien on our property, making investments in third parties and redeeming stock or paying dividends, in each case subject to certain exceptions as further detailed in the Second Amended Loan Agreement. The Second Amended Loan Agreement includes events of default, the occurrence and continuation of any of which provides Squadron with the right to exercise remedies against us and the collateral securing the loans, including cash. These events of default include, among other things, the failure to pay amounts due under the credit facilities, insolvency, the occurrence of a material adverse event, which includes a material adverse change in our business, operations or properties (financial or otherwise) or a material impairment of the prospect of repayment of any portion of the obligations, the occurrence of any default under certain other indebtedness and a final judgment against us in an amount greater than $250 thousand. The occurrence of a material adverse change could result in the acceleration of payment of the debt. Mortgage Note In August 2013, pursuant to the purchase of our office and warehouse space, we entered into a mortgage note payable to Tawani Enterprises Inc., the owner of which is a member of Squadron’s management committee. Pursuant to the terms of the mortgage note, we pay Tawani Enterprises Inc. monthly principal and interest installments of $15,543, with interest compounded at 5% until maturity in August 2028, at which time a final payment of remaining principal and interest will become due. The mortgage is secured by the related real estate and building. The mortgage balance was $1.1 million and $1.2 million at June 30, 2021 and December 31, 2020, respectively. Pediatric Orthopedic Business Seasonality Our revenue is typically higher in the summer months and holiday periods, driven by higher sales of our trauma and deformity and scoliosis products, which is influenced by the higher incidence of pediatric surgeries during these periods due to recovery time provided by breaks in the school year. Additionally, our scoliosis patients tend to have additional health challenges that make scheduling their procedures variable in nature. Critical Accounting Policies and Significant Judgments and Estimates This management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue and expenses during the reporting periods. We monitor and analyze these items for changes in facts and circumstances, and material changes in these estimates could occur in the future. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Changes in estimates are reflected in reported results for the period in which they become known. Actual results may differ materially from these estimates under different assumptions or conditions. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 39 As a "smaller reporting company," we are not required to provide the information required by this item.