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 3, 2022, 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 a few selected 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 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 37 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 188 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 29 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. For example, on April 1, 2022, the Company acquired MD Orthopaedics, Inc., a developer and manufacturer of a portfolio of orthopedic clubfoot products. The consideration paid by the Company included (a) $8.2 million in cash, and (b) 173,241 shares of its common stock, $0.00025 par value per share, representing approximately $9.7 million (based on the April 1, 2022 closing share price of $56.03). Environmental, Social and Governance ("ESG") Activities OrthoPediatrics was founded on the cause of impacting the lives of children with orthopedic conditions. Since inception we have impacted the lives of over 243,000 children. We believe we should continue to expand our social efforts while minimizing our impact to the environment and ensuring corporate governance. In 2021, we created an internal ESG team, which reports directly to our Board’s Governance and Nominating Committee, to identify ESG topics for disclosure by assessing both the impact on our business and the importance to our stakeholders. We encourage you to review our ESG page under the "About" section of our corporate website for more detailed information regarding our ESG efforts and current initiatives. On our website, among other information, are the following highlights: • OrthoPediatrics cares about our environmental impact while working in a highly regulated industry and we are certified according to ISO 13485. • The Company and its associates regularly participate in philanthropic causes important to our local communities. We also partner with charitable organizations that provide pediatric orthopedic care around the world. In 2020 we were named as "Corporate Partner of the Year" by the World Pediatric Project - with whom we work to provide access to medical care for children in developing countries. • We are committed to fostering an environment that is respectful, compassionate, and inclusive of everyone in our community. • The Board of Directors understands the value of diversity and will increase the diversity of the Board over the next 18 months. The Governance and Nominating Committee engaged a global recruiting firm to assist in adding two diverse Board candidates. We believe effectively managing our priorities, as well as increasing our transparency related to ESG programs, will help create long-term value for our stakeholders. We expect to increase our disclosures and communicate our ESG efforts in future SEC filings. Nothing on our website shall be deemed part of or incorporated by reference into this Quarterly Report on Form 10-Q. Impact of COVID-19 on our Business 30 As a result of the COVID-19 pandemic (“COVID-19” or the “pandemic”), we have experienced significant business disruption. For example, in order to meet the demand for COVID-19-related hospitalizations, various governments, governmental agencies and hospital administrators required certain hospitals to postpone some elective procedures. As a majority of our products are utilized in elective surgeries or procedures, the deferrals of such surgeries and procedures have had, and may continue to have, a significant negative impact on our business and results of operations. 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 3, 2022 and in other reports filed with the SEC that discuss the risks and factors that may affect our business. 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, including our short-term investments, 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. 31 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. Other Trends and Uncertainties From time to time we acquire, make investments in or license other technologies, products and business that may enhance our capabilities, complement our current products or expand the breadth of our markets or customer base. As a result of these transactions, we may record certain intangible assets, including goodwill and trademarks, which are subject to annual impairment testing. Impairment is based on our current assessment of the expected future cash flows based on recent results and other specific market factors. Although we have not recorded any impairment charges to date, the most recently prepared assessment indicates our passing rate has narrowed for certain intangible assets. We believe that the expected future cash flows represent management’s best estimate; however, if actual results differ materially from these estimates, we could record an impairment charge which could be material to our consolidated financial statements and have an adverse impact on our results of operations. 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 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 Months Ended March 31, 2022 and 2021 The following table sets forth our results of operations for the three months ended March 31, 2022 and 2021: Three Months Ended March 31, 2022 2021 Increase (Decrease) % Net revenue $ 23,417 $ 21,462 $ 1,955 9 % Cost of revenue 4,851 5,137 (286) (6) % Sales and marketing expenses 9,758 8,949 809 9 % General and administrative expenses 13,167 12,041 1,126 9 % Research and development expenses 2,027 1,308 719 55 % Other (income) expenses 3,031 4,718 (1,687) (36) % Provision for income taxes (benefit) (317) (312) (5) (2) % Net loss $ (9,100) $ (10,379) $ (1,279) (12) % 32 Net Revenue The following tables set forth our net revenue by geography and product category for the three months ended March 31, 2022 and 2021: Three Months Ended March 31, Product sales by geographic location: 2022 2021 U.S. $ 18,188 $ 16,839 International 5,229 4,623 Total $ 23,417 $ 21,462 Three Months Ended March 31, Product sales by category: 2022 2021 Trauma and deformity $ 16,516 $ 14,552 Scoliosis 5,983 5,951 Sports medicine/other 918 959 Total $ 23,417 $ 21,462 Net revenue increased $2.0 million, or 9%, from $21.5 million for the three months ended March 31, 2021 to $23.4 million for the three months ended March 31, 2022. The increase during the three months ended March 31, 2022 was driven primarily by non-elective trauma sales. Additionally, we continue to see the benefit of converting Germany, Austria, and Switzerland to a direct agency sales model. Trauma and deformity sales increased $2.0 million, or 13%, during the three months ended March 31, 2022, primarily driven by strong trauma and deformity growth across numerous product lines, specifically our PNP Femur, Cannulated Screws and Orthex systems. Scoliosis sales increased $32 thousand, or 1%, during the three months ended March 31, 2022, primarily driven by increased sales of our RESPONSE 4.5/5.0 and sales of the FireFly surgical guides. Sports medicine / other decreased $41 thousand, or 4%, during the three months ended March 31, 2022, primarily driven by a decline in sales from our Telos operations. Nearly all the change in each category was due to an increase or decrease in the unit volume sold and not a result of price changes. Cost of Revenue and Gross Margin Cost of revenue decreased $0.3 million, or 6%, from $5.1 million for the three months ended March 31, 2021 to $4.9 million for the three months ended March 31, 2022. The decrease is due primarily to an increased gross margin rate, offset by an increase in volumes sold. Gross margin was 76% for the three months ended March 31, 2021 and 79% for the three months ended March 31, 2022. The change in gross margin is primarily driven by sales through the converted international agencies, favorable purchase price variances, and fewer scoliosis set sales to our international stocking distributors. Sales and Marketing Expenses Sales and marketing expenses increased $0.8 million, or 9%, to $9.8 million for the three months ended March 31, 2022 from $8.9 million for the three months ended March 31, 2021. The change in the three month period ended March 31, 2022 was due primarily to increased sales commission expenses, driven by increased unit volumes sold. 33 General and Administrative Expenses General and administrative expenses increased $1.1 million, or 9%, from $12.0 million for the three months ended March 31, 2021 to $13.2 million for the three months ended March 31, 2022. The increase for the three month period ended March 31, 2022 was due primarily to the addition of personnel and resources to support the continued expansion of our business and an increase in legal and other professional service expense. Depreciation and amortization expenses increased $0.4 million, or 17%, from $2.5 million for the three months ended March 31, 2021 to $3.0 million for the three months ended March 31, 2022. The increase for the three month period ended March 31, 2022 was primarily due to an increase in depreciation from higher set deployments and the amortization of intangible assets, including licenses which had not yet been put into the market in the first quarter 2021. Research and Development Expenses Research and development expenses increased $0.7 million, or 55%, from $1.3 million for the three months ended March 31, 2021 to $2.0 million for the three months ended March 31, 2022. The increase for the three month period ended March 31, 2022 was primarily due to incremental product development and the addition of personnel to support the future growth of the business. Total Other Expenses Other expenses were $3.0 million and $4.7 million for the three months ended March 31, 2022 and 2021, respectively, a decrease of $1.7 million or 36%. The decrease in other expense for the three months ended March 31, 2022 was primarily due to the fair value adjustment of contingent consideration, which was driven by the valuation inputs that were lower in comparison to the same period last year. The aggregate of accreted interest expense and fair value adjustments for the three months ended March 31, 2022 and 2021 were $3.0 million and $4.8 million, respectively. Liquidity and Capital Resources We have incurred operating losses since inception which resulted in negative cash flows for continuing operations from operating activities of $4.2 million and $1.9 million for the three months ended March 31, 2022 and 2021, respectively. As of March 31, 2022, we had an accumulated deficit of $187.1 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 March 31, 2022, we had cash and cash equivalents, restricted cash and short term investments of $46.4 million. 34 Cash Flows The following table sets forth our cash flows from operating, investing and financing activities for the periods indicated: Three Months Ended March 31, 2022 2021 Net cash used in operating activities $ (4,197) $ (1,915) Net cash provided by (used in) investing activities 14,303 (5,607) Net cash provided by (used in) financing activities (33) 30 Effect of exchange rate changes on cash 241 155 Net increase (decrease) in cash $ 10,314 $ (7,337) Cash Used in Operating Activities Net cash used in operating activities from continuing operations was $4.2 million and $1.9 million for the three months ended March 31, 2022 and 2021, 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 periods. Net cash used for working capital was $2.3 million for the three months ended March 31, 2022 compared to a source of $0.1 million for the three months ended March 31, 2021. During the three months ended March 31, 2022, the primary driver of working capital cash usage was the increase in inventory of $6.8 million and the offset related to trade payables of $5.3 million to support future sales growth. We also saw an increase in the use of cash from the accrued expenses of $0.7 million which was offset by a decrease in prepaid expenses. Cash Provided by (Used in) Investing Activities Net cash provided by investing activities for the three months ended March 31, 2022 was $14.3 million compared to a use of cash of $5.6 million for the three months ended March 31, 2021. Net cash provided by investing activities for the three months ended March 31, 2022 consisted primarily of the sale of short-term marketable securities offset by purchases of instrument sets of $4.2 million. Cash Provided By (Used in) Financing Activities Net cash used in and provided by financing activities for the three months ended March 31, 2022 and 2021, respectively, was not material to the results of our operations. Indebtedness Loan Agreement Effective December 31, 2021, the Company entered into a Third Amendment (the "Third Amendment") to its Fourth Amended and Restated Loan and Security Agreement with Squadron Capital LLC, or Squadron (as so amended, the “Loan Agreement”). The Loan Agreement provides a $25.0 million revolving credit facility, with interest only payments, at an annual interest rate equal to the greater of (a) six month SOFR plus 8.69% and (b) 10.0%. The Company pays 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. Prior to the Third Amendment, the interest rate on the facility had been equal to the greater of (a) three month LIBOR plus 8.61%, and (b) 10.0%. While the Loan Agreement previously provided for certain term loans, there are no longer any outstanding term loan obligations. 35 Borrowings under the revolving credit facility are 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. Borrowings under the 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 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 Loan Agreement. The 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 $1.0 million and $1.0 million at March 31, 2022 and December 31, 2021, 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 36 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 As a "smaller reporting company," we are not required to provide the information required by this item.