ITEM 1. Business
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 about Natus Medical Incorporated (“Natus,” “we,” “us,” or “our Company”). These statements include, among other things, statements concerning our expectations, beliefs, plans, intentions, future operations, financial condition and prospects, and business strategies. The words “may,” “will,” “continue,” “estimate,” “project,” “intend,” “believe,” “expect,” “anticipate,” and other similar expressions generally identify forward-looking statements. Forward-looking statements in this Item 1 include, but are not limited to, statements regarding the effectiveness and advantages of our products, factors relating to demand for and economic advantages of our products, our plan to develop and acquire additional technologies, products or businesses, and our marketing, technology enhancement, and product development strategies.
Forward-looking statements are not guarantees of future performance and are subject to substantial risks and uncertainties that could cause the actual results to differ materially from those that we predicted in the forward-looking statements. Investors should carefully review the information contained under the caption “Risk Factors” contained in Item 1A
ITEM 1A. Risk Factors
We have completed a number of acquisitions and expect to complete additional acquisitions in the future. There are numerous risks associated with acquisitions and we may not achieve the expected benefit of any of our acquisitions
Our acquisitions of products, technology assets, or businesses may have a negative impact on our business if we fail to achieve the anticipated financial, strategic, and other benefits of acquisitions or investments, and our operating results may suffer because of this.
We acquired intellectual property assets and technology patents from Pemstar Pacific Consultants during 2002; we acquired the assets of Neometrics Inc. and affiliated entities during 2003; and we acquired Fischer-Zoth in 2004. We completed the acquisitions of Bio-logic, Deltamed and Olympic Medical, and of certain assets from Nascor in 2006. In November 2007 we completed the acquisition of Xltek.
We expect to continue to pursue opportunities to acquire other businesses in future periods. The acquisitions that we have completed may not result in improved operating results for us, or in our achieving a financial condition superior to that which we would have achieved had we not completed them. Our results of operations may be adversely impacted by costs associated with our acquisitions, including one-time charges associated with restructurings or in-process research and development assets. Our acquisitions could fail to produce the benefits that we anticipate, or could have other adverse effects that we currently do not foresee. In addition, some of the assumptions that we have relied upon, such as achievement of operating synergies, may not be realized. In this event, one or more of the acquisitions could result in reduced earnings of Natus as compared to the earnings that would have been achieved by Natus if the acquisition had not occurred.
If we fail to successfully manage the combined operations of Natus and the businesses we have acquired, we may not realize the potential benefits of the acquisition. Our corporate headquarters are located in San Carlos,
California. Bio-logic’s primary offices are located in Illinois, Olympic Medical’s operations are in Washington, Xltek’s operations are located in Ontario, Canada, Neometrics’ operations are located in New York, Deltamed’s operations are in France, and Fischer-Zoth’s operations are in Germany. The geographical distance between our various facilities may further adversely affect our ability to manage these operations. If we fail to manage these disparate operations effectively, our results of operations could be harmed, employee morale could decline, key employees could leave, and customers could cancel existing orders or choose not to place new ones. In addition, we may not achieve the synergies or other benefits of the acquisition that we anticipate. We may encounter the following additional difficulties, costs, and delays involved in integrating and managing these operations, and the operations of companies we may acquire:
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Failure of customers to continue using the products and services of the combined company;
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Failure to successfully develop the acquired technology into the desired products or enhancements;
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Assumption of unknown liabilities;
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Failure to understand and compete effectively in markets and with products or technologies with which we have limited previous experience;
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Impairment charges incurred to write down the carrying amount of intangible assets, including goodwill, generated as a result of the acquisition;
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Decreased liquidity, restrictive bank covenants, and incremental financing costs associated with debt we may incur to complete future acquisitions; and
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Diversion of the attention of management from other ongoing business concerns.
Indicative of the types of risks associated with our acquisitions, on October 15, 2007 we received a warning letter from the United States Food and Drug Administration (the “FDA”) related to the operations of our Olympic Medical manufacturing facility in Seattle, Washington. The letter focused on process deficiencies that were identified during an FDA inspection in April 2007. In November 2007 we instituted a voluntary suspension of operations at the Olympic Medical facility in order to better enable us to continue to address the findings identified by the FDA in its warning letter. We responded to the FDA’s warning letter in late November. We have not had further communication from the FDA since we responded to their warning letter. However, we do not know what the ultimate outcome of the FDA’s action will be or that our business will not be adversely affected by these or similar actions. A more comprehensive discussion of the risks associated with FDA oversight of our business and our regulatory environment is contained in this Item 1A, Risk Factors.
In November 2007 we completed the acquisition of Xltek for cash and used substantially all of our available cash and entered into a credit facility to fund the acquisition
We used virtually all of our existing cash resources to complete the acquisition of Xltek, and also incurred indebtedness under a new bank facility for a portion of the purchase price. This usage of cash had an adverse impact on our liquidity and forces us to place more reliance on cash flow from operations for our liquidity. If our cash flow from operations is not sufficient for our needs, our business could be adversely affected. If we are required to seek additional external financing to support our need for cash, we may not have access to financing on terms that are acceptable to us, or at all. Alternatively, we may feel compelled to access additional financing on terms that are dilutive to existing holders of our common stock or that include covenants that restrict our business, or both.
The senior secured borrowing facility that we established to obtain a portion of the funds needed to complete the acquisition of Xltek contains various covenants that directly or indirectly restrict our ability to engage in activities that we may otherwise believe to be in the best interest of the Company. The loan is secured by the assets of the Company, and this security interest may also negatively impact our flexibility to engage in financing or other activities in future periods.
Our growth in recent years has depended substantially on the completion of acquisitions and we may not be able to complete acquisitions of this nature or of a relative size in the future to support a similar level of growth
The acquisitions that we have completed have been the primary source of our growth in revenue over the last four years. We expend considerable effort in seeking to identify attractive acquisition candidates and, upon doing so, to convince the potential target to consider a sale to us and, ultimately, to negotiate mutually agreeable acquisition terms. If we are not successful in these efforts in the future, our growth rate will not increase at a rate corresponding to that which we have achieved in recent years. Further, as we grow larger it will be necessary to complete the acquisition of larger companies and product lines to support a growth similar to that which we have achieved in the past. The market for attractive acquisitions is competitive and others with greater financial resources than we have may be better positioned than we are to acquire desirable targets. Further, we may not be able to negotiate acquisition terms with target companies that will allow us to achieve positive financial returns from the transaction.
Following our acquisitions we have implemented integration and restructuring activities that could be disruptive to our operations, and we could fail to achieve the synergies and cost savings the activities are designed to produce
Following our acquisition of Xltek we initiated an integration plan that resulted in a reduction in force and realignment of our domestic sales force. In addition, in February 2008, we adopted an integration and restructuring plan that is designed to eliminate redundant costs resulting from our acquisitions and to improve efficiencies in operations. This plan will be implemented over the first three quarters of 2008.
The realignment of our domestic sales organization could be disruptive to our sales efforts while this new structure is implemented, and once implemented may not be effective. In addition, our integration and restructuring activities may not result in the acquisition synergies or cost savings these activities are designed to produce and could, among other things, impair new products development and our support of existing products.
Future changes in technology or market conditions could result in adjustments to our recorded asset balance for intangible assets, including goodwill, resulting in additional charges that could significantly impact our operating results
At December 31, 2007, we had significant intangible assets, including goodwill and other acquired intangible assets. The determination of related estimated useful lives and whether these assets are impaired involves significant judgments. Our ability to accurately predict future cash flows related to these intangible assets might be hindered by events over which we have no control. Due to the highly competitive nature of the medical device industry, new technologies could impair the value of our intangible assets if they create market conditions that adversely affect the competitiveness of our products. Any future determination that these assets are carried at greater than their fair value could result in substantial impairment charges, which could significantly impact our operating results.
Our acquisitions have included in-process research and development assets (“IPR&D assets”) for which we hope to generate future cash flows; our results of operations could be adversely affected if we are unable to bring these assets to market
Through our acquisitions of other businesses, we have acquired IPR&D assets from which we hope to generate future cash flows. There is inherent risk in bringing these IPR&D assets to market and we may be unable to realize the full value we have assigned to them. We may be unable to complete the development of these IPR&D assets within a timely manner, or we may encounter technological difficulties that prevent us from completing their development. If we are unable to derive future revenue from our IPR&D assets, our results of operations could be adversely impacted.
We may not be able to preserve the value of our intellectual property because we may not be able to protect access to it or we may lose our intellectual property rights due to expiration of our licenses or patents
If we fail to protect our intellectual property rights or if our intellectual property rights do not adequately cover the technology we employ, other medical device companies could sell products with features similar to ours, and this could reduce demand for our products. We protect our intellectual property through a combination of patent, copyright, trade secret and trademark laws. Despite our efforts to protect our proprietary rights, others may attempt to copy or otherwise improperly obtain and use our products or technology. Policing unauthorized use of our technology is difficult and expensive, and we cannot be certain that the steps we have taken will prevent misappropriation. Our means of protecting our proprietary rights may be inadequate. Enforcing our intellectual property rights could be costly and time consuming and may divert our management’s attention and resources. Failing to enforce our intellectual property rights could also result in the loss of those rights.
If health care providers are not adequately reimbursed for procedures conducted with our devices or supplies, or if reimbursement policies change adversely, we may not be successful marketing and selling products or technologies
Clinicians, hospitals, and government agencies are unlikely to purchase our products if clinicians are not adequately reimbursed for the procedures conducted with our devices or supplies. Unless a sufficient amount of conclusive, peer-reviewed clinical data about our products has been published, third-party payors, including insurance companies and government agencies, may refuse to provide reimbursement. Furthermore, even if reimbursement is provided, it may not be adequate to fully compensate the clinicians or hospitals. Some third-party payors may impose restrictions on the procedures for which they will provide reimbursement. If health care providers cannot obtain sufficient reimbursement from third-party payors for our products or the screenings conducted with our products, we may not achieve significant market acceptance of our products. Acceptance of our products in international markets will depend upon the availability of adequate reimbursement or funding within prevailing health care payment systems. Reimbursement, funding, and health care payment systems vary significantly by country. We may not obtain approvals for reimbursement in a timely manner or at all.
Adverse changes in reimbursement policies in general could harm our business. We are unable to predict changes in the reimbursement methods used by third-party health care payors, particularly those in countries and regions outside the U.S. For example, some payors are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. In a managed care system the cost of our products may not be incorporated into the overall payment for patient care or there may not be adequate reimbursement for our products separate from reimbursement for other procedures.
If we fail in our efforts to educate clinicians, government agency personnel, and third-party payors on the effectiveness of our products, we will not achieve future sales growth
It is critical to the success of our sales efforts that we educate a sufficient number of clinicians, hospital administrators, and government agencies about our products and the costs and benefits of their use. The commercial success of our products depends upon clinician, government agency and other third-party payor confidence in the economic and clinical benefits of our products as well as their comfort with the efficacy, reliability, sensitivity and specificity of our products. We believe that clinicians will not use our products unless they determine, based on published peer-reviewed journal articles and experience, that our products provide an accurate and cost-effective alternative to other means of testing or treatment. Our customers may choose to use competitive products, which may be less expensive or may provide faster results than our devices. Clinicians are traditionally slow to adopt new products, testing practices and clinical treatments, partly because of perceived liability risks and the uncertainty of third-party reimbursement. If clinicians, government agencies and hospital administrators do not adopt our products, we may not maintain profitability. Factors that may adversely affect the medical community’s acceptance of our products include:
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Publication of clinical study results that demonstrate a lack of efficacy or cost-effectiveness of our products;
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Changing governmental and physician group guidelines;
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Actual or perceived performance, quality, price, and total cost of ownership deficiencies of our products relative to other competitive products;
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Our ability to maintain and enhance our existing relationships and to form new relationships with leading physicians, physician organizations, hospitals, state laboratory personnel, and third-party payors;
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Changes in state and third-party payor reimbursement policies for our products; and
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Repeal of laws requiring universal newborn hearing screening and metabolic screening.
Increased sales through group purchasing organizations and sales to high volume purchasers may reduce our average selling prices, which would reduce our revenue and gross profits
We have entered, and expect in the future to enter into agreements with customers who purchase high volumes of our products. Our agreements with these customers may contain discounts from our normal selling prices and other special pricing considerations, which could cause our revenue and profits to decline. In addition, we have entered into agreements to sell our products to members of GPOs, which negotiate volume purchase prices for medical devices and supplies for member hospitals, group practices and other clinics. While we make sales directly to GPO members, the GPO members receive volume discounts from our normal selling price and may receive other special pricing considerations from us. Sales to members of all GPOs accounted for approximately 35%, 31% and 28% of our total revenue during 2007, 2006 and 2005, respectively, and sales to members of one GPO, Novation LLC, accounted for approximately 9%, 12% and 15% of our total revenue in 2007, 2006 and 2005, respectively. Other of our existing customers may be members of GPOs with which we do not have agreements. Our sales efforts through GPOs may conflict with our direct sales efforts to our existing customers. If we enter into agreements with new GPOs and some of our existing customers begin purchasing our products through those GPOs, our revenue and profits could decline.
Demand for some of our products depends on the capital spending policies of our customers, and changes in these policies could harm our business
A majority of customers for our products are hospitals, physician offices, and clinics. Many factors, including public policy spending provisions, available resources, and economic cycles have a significant effect on the capital spending policies of these entities and therefore the amount that they can spend on our equipment products. If budget resources limit the capital spending of our customers, they will be unlikely to either purchase any new equipment from us or upgrade to any of our newer equipment products. These factors can have a significant adverse effect on the demand for our products.
Our markets are very competitive and in the United States we sell certain of our products in a mature market
We face competition from other companies in all of our product lines. Our competitors range from small, privately-held companies to multinational corporations and their product offerings vary in scope and breadth. We do not believe that any single competitor is dominant in any of our product lines.
The markets for certain of our products in the U.S., including the newborn hearing screening and EEG monitoring markets, are mature and we are unlikely to see significant growth for such products in the U.S. In the U.S. we derive a significant portion of our revenue from the sale of disposable supplies that are used with our hearing screening devices. Because these disposable supply products can generate high margins, we expect that our products, particularly our hearing screening disposable supply products, could face increasing competition, including competitors offering lower prices, which could have an adverse affect on our revenue and margins.
We believe that our primary competitive strengths relate to the functionality and reliability of our products, our recognized brands, and our developed sales channels. Our competitors may have certain competitive
advantages, which include the ability to devote greater resources to the development, promotion, and sale of their products. Consequently, we may need to increase our efforts, and related expenses for research and development, marketing, and selling to maintain or improve our position.
We expect recurring sales to our existing customers to generate a majority of our revenue in the future, and if our existing customers do not continue to purchase products from us, our revenue may decline.
Our operating results may decline if we do not succeed in developing, acquiring and marketing additional products or improving our existing products
We intend to develop additional products and technologies, including enhancements of existing products, for the screening, detection, treatment, monitoring and tracking of common medical ailments. Developing new products, and improving our existing products, to meet the needs of current and future customers requires significant investments in research and development. If we fail to successfully sell new products, update our existing products, or timely react to changes in technology, our operating results may decline as our existing products reach the end of their commercial life cycles.
Our plan to expand our international operations will result in increased costs and is subject to numerous risks; if our efforts are not successful, this could harm our business
We have expanded our international operations through acquisitions and plan to expand our international sales and marketing efforts to increase sales of our products in foreign countries. We may not realize corresponding growth in revenue from growth in international unit sales, due to the lower average selling prices we receive on sales outside of the U.S. Even if we are able to successfully expand our international selling efforts, we cannot be certain that we will be able to create or increase demand for our products outside of the U.S. Our international operations are subject to other risks, which include:
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Impact of possible recessions in economies outside the U.S.;
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Political and economic instability, including instability related to war and terrorist attacks in the U.S. and abroad;
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Contractual provisions governed by foreign law, such as local law rights to sales commissions by terminated distributors;
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Decreased health care spending by foreign governments that would reduce international demand for our products;
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A strengthening of the U.S. dollar relative to foreign currencies that could make our products less competitive because most of our international sales are denominated in the U.S. dollar;
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Greater difficulty in accounts receivable collection and longer collection periods;
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Difficulties of staffing and managing foreign operations;
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Reduced protection for intellectual property rights in some countries and potentially conflicting intellectual property rights of third parties under the laws of various foreign jurisdictions;
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Difficulty in obtaining and maintaining foreign regulatory approval; and
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Attitudes by clinicians, and cost reimbursement policies, towards use of disposable supplies that are potentially unfavorable to our business.
If guidelines mandating universal newborn hearing screening do not continue to develop in foreign countries and governments do not mandate testing of all newborns as we anticipate, or if those guidelines have a long phase-in period, our revenue may be adversely impacted
We estimate that approximately 95% of the children born in the U.S. are currently being tested for hearing impairment prior to discharge from the hospital. To date, there has been only limited adoption of newborn
hearing screening prior to hospital discharge by foreign governments, and the phase-in period generally spans several years. The widespread adoption of guidelines depends, in part, on our ability to educate foreign government agencies, neonatologists, pediatricians, third-party payors, and hospital administrators about the benefits of universal newborn hearing screening as well as the use of our products to perform the screening and monitoring. Our revenue from our newborn hearing screening product lines may not grow if foreign governments do not require universal newborn hearing screening prior to hospital discharge, if physicians or hospitals are slow to comply with those guidelines, or if governments provide for a lengthy phase-in period for compliance.
Because we rely on distributors or sub-distributors to sell our products in most of our markets outside of the U.S., our revenue could decline if our existing distributors reduce the volume of purchases from us, or if our relationship with any of these distributors is terminated
We currently rely on our distributors or sub-distributors for a majority of our sales outside the U.S. Our reliance on international distributors has increased because of our decisions in 2004 and 2005 to close our Japanese and U.K. sales subsidiaries and sell through distributors in those countries, and because of our acquisition of Fischer-Zoth, which sells its products through distributors in Europe and Asia. We may also sell Deltamed products through distributors in countries outside of France and Germany. Some distributors also assist us with regulatory approvals and education of clinicians and government agencies. We intend to continue our efforts to increase our sales in Europe, Japan, and other developed countries. If we fail to sell our products through our international distributors, we would experience a decline in revenues unless we begin to sell our products directly in those markets. We cannot be certain that we will be able to attract new international distributors to market our products effectively or provide timely and cost-effective customer support and service. Even if we are successful in selling our products through new distributors, the rate of growth of our revenue could be harmed if our existing distributors do not continue to sell a large dollar volume of our products. None of our existing distributors are obligated to continue selling our products.
We may be subject to foreign laws governing our relationships with our international distributors. These laws may require us to make payments to our distributors if we terminate our relationship for any reason, including for cause. Some countries require termination payments under local law or legislation that may supersede our contractual relationship with the distributor. Any required payments would adversely affect our operating results.
Our operating results may suffer because of our exposure to foreign currency exchange rate fluctuations and may require us to engage in foreign currency hedging
Substantially all of our sales contracts with our U.S. based customers provide for payment in U.S. dollars. In addition, sales to most of our international distributors provide for payment in U.S. dollars. However, substantially all of the revenue and expenses of our foreign subsidiaries are denominated in the applicable foreign currency. To date we have not undertaken any significant foreign currency transactions to hedge these currency risks and, as a result, our future revenue and expenses may be subject to volatility due to exchange rate fluctuations that could result in foreign exchange gains and losses associated with foreign currency transactions and the translation of assets and liabilities denominated in foreign currencies.
If we lose our relationship with any supplier of key product components or our relationship with a supplier deteriorates or key components are not available in sufficient quantities, our manufacturing could be delayed and our business could suffer
We contract with third parties for the supply of some of the components used in our products and the production of our disposable products. Some of our suppliers are not obligated to continue to supply us. We have relatively few sources of supply for some of the components used in our products and in some cases we rely entirely on sole-source suppliers. In addition, the lead-time involved in the manufacturing of some of these components can be lengthy and unpredictable. For example, during 2005, we relied on a single supplier of cables used in our ALGO hearing screening devices to help us complete a field replacement program of those cables. If our suppliers become unwilling or unable to supply us with components meeting our requirements, it might be
difficult to establish additional or replacement suppliers in a timely manner, or at all. This would cause our product sales to be disrupted and our revenue and operating results to suffer.
Replacement or alternative sources might not be readily obtainable due to regulatory requirements and other factors applicable to our manufacturing operations. Incorporation of components from a new supplier into our products may require a new or supplemental filing with applicable regulatory authorities and clearance or approval of the filing before we could resume product sales. This process may take a substantial period of time, and we may not be able to obtain the necessary regulatory clearance or approval. This could create supply disruptions that would harm our product sales and operating results.
We depend upon key employees in a competitive market for skilled personnel, and, without additional employees, we cannot grow or maintain profitability
Our products and technologies are complex, and we depend substantially on the continued service of our senior management team. The loss of any of our key employees could adversely affect our business and slow our product development process. Our future success also will depend, in part, on the continued service of our key management personnel, software engineers, and other research and development employees and our ability to identify, hire, and retain additional personnel, including customer service, marketing, and sales staff. Hiring research and development, engineering, sales, marketing and customer service personnel in our industry is very competitive due to the limited number of people available with the necessary technical skills and understanding of our product technologies. We may be unable to attract and retain personnel necessary for the development of our business.
Our ability to market and sell products depends upon receipt of domestic and foreign regulatory approval of our products and manufacturing operations. Our failure to obtain or maintain regulatory approvals and compliance could negatively affect our business
Our products and manufacturing operations are subject to extensive regulation in the United States by the FDA and by similar regulatory agencies in many other countries in which we do business. Unless an exemption applies, each medical device that we propose to market in the U.S. must first receive one of the following types of FDA premarket review authorizations:
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Clearance via Section 510(k) of the Food, Drug, and Cosmetics Act of 1938, as amended; or
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Premarket approval via Section 515 of the Food, Drug, and Cosmetics Act if the FDA has determined that the medical device in question poses a greater risk of injury.
The FDA’s Section 510(k) clearance process usually takes from three to 12 months, but can take longer. The process of obtaining premarket approval via Section 515 is much more costly, lengthy and uncertain. Premarket approval generally takes from one to three years, but can take even longer. The FDA may not grant either Section 510(k) clearance or premarket approval for any product we propose to market. The FDA may impose the more burdensome premarket approval requirement on modifications to our existing products or future products, which in either case could be costly and cause us to divert our attention and resources from the development of new products or the enhancement of existing products.
Domestic regulation of our products and manufacturing operations, other than that which is administered by the FDA, includes the Environmental Protection Act, the Occupational Safety and Health Act, and state and local counterparts to these Acts.
Our business would be harmed if the FDA determines that we have failed to comply with applicable regulations or we do not pass an inspection
We are subject to market surveillance by the FDA concerning compliance with pertinent regulatory requirements. If the FDA finds that we have failed to comply with these requirements, the Agency can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions such as:
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Fines, injunctions and civil penalties;
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Recall or seizure of our products;
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Issuance of public notices or warnings;
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Imposition of operating restrictions, partial suspension, or total shutdown of production;
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Refusal of our requests for Section 510(k) clearance or premarket approval of new products;
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Withdrawal of Section 510(k) clearance or premarket approvals already granted; or
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Criminal prosecution.
Our facilities are subject to inspection by the FDA. Upon completing these inspections, the FDA may take a variety of actions, including issuing observations on Form FDA-483 or issuing a warning letter. The issuance of a warning letter by the FDA could result in regulatory action being initiated by the FDA without further notice, and these actions could include seizure, injunction, and/or civil money penalties. In the past, we have cooperated fully with the FDA in their inspections and have responded to their observations on Form 483 in the ordinary course of business, and to the warning letter received in October 2007. To date, these inspections and observations have not resulted in a significant adverse impact on the operations of the Company; however, they could have a significant adverse impact in the future.
We have received clearance from the FDA to market a new product that will potentially expose us to greater products liability exposure and FDA regulation
In December 2006 we received clearance from the FDA to market the Olympic Cool-Cap, a product designed to lower the cerebral temperature of newborns born with a particular medical condition. This product is a Class III minimally invasive medical device, and as such we may be subject to an increased product liability risk relative to our other Class I and Class II non-invasive products. In addition, this type of product is subject to greater FDA oversight than our other products and there is greater risk that sales of the product could be interrupted due to the premarket approval processes of the FDA and other regulatory bodies.
Our business may suffer if we are required to revise our labeling or promotional materials, or the FDA takes an enforcement action against us for off-label uses
We are prohibited by the FDA from promoting or advertising our medical device products for uses not within the scope of our clearances or approvals, or from making unsupported promotional claims about the benefits of our products. If the FDA determines that our claims are outside the scope of our clearances, or are unsupported, it could require us to revise our promotional claims or take enforcement action against us. If we were subject to such an action by the FDA, our sales could be delayed, our revenue could decline, and our reputation among clinicians could be harmed.
If we, or our suppliers, fail to comply with applicable regulations, sales of our products could be delayed and our revenue could be harmed
Every manufacturer of a finished medical device, including Natus and some of our contract manufacturers and suppliers, is required to demonstrate and maintain compliance with the FDA’s quality system regulation and comparable regulations of states and other countries. The FDA enforces the quality system regulation through periodic inspections. For example in October 2007 we received a warning letter from the FDA that focused on process deficiencies at our Olympic facility in Seattle, Washington. As a result, we initiated a voluntary plant shutdown of the Olympic facility for the month of November 2007. After reviewing processes at the facility, we responded to the FDA’s warning letter in late November 2007. To date, the FDA has not further communicated with us concerning this matter, but they could decide that we undertook insufficient remedial actions, which could have an adverse impact on the operations of the Company.
If we or our contract manufacturers fail to take adequate corrective action in a timely fashion in response to a quality system regulation inspection, the FDA could shut down our or our contract manufacturers’ manufacturing operations or require us, among other things, to recall our products, either of which would harm our business.
Our operating results would suffer if we were subject to a protracted infringement claim
The medical technology industry has, in the past, been characterized by a substantial amount of litigation and related administrative proceedings regarding patents and intellectual property rights. We expect that medical screening and diagnostic products may become increasingly subject to third-party infringement claims as the number of competitors in our industry segment grows and the functionality of products in different industry segments overlap. Third parties such as individuals, educational institutions or other medical device companies may claim that we infringe their intellectual property rights. Any claims, with or without merit, could have any of the following negative consequences:
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Result in costly litigation and damage awards;
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Divert our management’s attention and resources;
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Cause product shipment delays or suspensions; or
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Require us to seek to enter into royalty or licensing agreements.
A successful claim of infringement against us could result in a substantial damage award and materially harm our financial condition. Our failure or inability to license the infringed or similar technology, or design and build non-infringing products, could prevent us from selling our products and adversely affect our business and financial results.
We license intellectual property rights from third parties and would be adversely affected if our licensors do not appropriately defend their proprietary rights or if we breach any of the agreements under which we license commercialization rights to products or technology from others
We license rights from third parties for products and technology that are important to our business. If our licensors are unsuccessful in asserting and defending their proprietary rights, including patent rights and trade secrets, we may lose the competitive advantages we have through selling products that we license from third parties. Additionally, if it is found that our licensors infringe on the proprietary rights of others, we may be prohibited from marketing our existing products that incorporate those proprietary rights. Under our licenses, we are subject to commercialization and development, sublicensing, royalty, insurance and other obligations. If we fail to comply with any of these requirements, or otherwise breach a license agreement, the licensor may have the right to terminate the license in whole or to terminate the exclusive nature of the license.
Product liability suits against us could result in expensive and time consuming litigation, payment of substantial damages, and an increase in our insurance rates
The sale and use of our products could lead to the filing of a product liability claim by someone claiming to have been injured using one of our products or claiming that one of our products failed to perform properly. A product liability claim could result in substantial damages and be costly and time consuming to defend, either of which could materially harm our business reputation or financial condition. Our product liability insurance may not protect our assets from the financial impact of defending a product liability claim. Any product liability claim brought against us, with or without merit, could increase our product liability insurance rates or prevent us from securing any coverage in the future.
We have experienced seasonality in the sale of our products
We experience seasonality in our revenue. For example, our sales typically decline from our fourth fiscal quarter to our first fiscal quarter, due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers, many of which are government agencies. We may also experience declining sales in the third fiscal quarter due to summer holiday and vacation schedules. We anticipate that we will continue to experience these seasonal fluctuations, which may lead to fluctuations in our quarterly operating results. We
believe that you should not rely on our results of operations for interim periods as an indication of our expected results in any future period.
ITEM 1B.
ITEM 1B. Unresolved Staff Comments.
Not applicable.
ITEM 2.
ITEM 2. Properties
The corporate headquarters of the Company are located in San Carlos, California, in facilities covering 39,200 square feet pursuant to a lease that expires in June 2010.
The Company also utilizes the following properties:
Company-owned Facilities:
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44,900 square feet in Oakville, Ontario, Canada, in a facility owned by the Company that is utilized substantially for the operations of Xltek.
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26,000 square feet in Mundelein, Illinois, in a facility owned by the Company that is utilized substantially for the operations of Bio-logic;
Leased Facilities:
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65,000 square feet in Seattle, Washington, of which 12,000 square feet are currently sub-let, pursuant to a lease that expires in December 2011, that is utilized substantially for the operations of Olympic Medical;
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3,800 square feet in Munich, and 6,700 square feet in Usingen, both in Germany, pursuant to leases that expire in 2007 and 2008 that are utilized substantially for the operations of Fischer-Zoth;
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2,900 square feet in Hauppauge, New York, pursuant to a lease that expires in October 2012, that is utilized substantially for the operations of Neometrics;
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2,700 square feet in Paris, and 7,500 square feet in Bordeaux, both in France, pursuant to leases that expire in November 2009 and March 2009, respectively, that are utilized substantially for the operations of Deltamed; and
ITEM 3.
ITEM 3. Legal Proceedings
On January 29, 2008, David Carey, a former employee of Olympic Medical, which we acquired in October 2006, filed a wrongful termination suit against Natus Medical, Olympic, and two persons who were officers of Olympic at the time of Mr. Carey’s termination in March 2007. This action was filed in Federal District Court in Seattle, Washington and alleges that Mr. Carey’s termination by Olympic was illegal retaliation under federal law and Washington state public policy and further asserts a claim that Mr. Carey was misclassified as an exempt employee from the overtime requirements of Washington law. The complaint does not include a demand for a specific dollar amount of damages. We believe that we, Olympic, and the individual defendants behaved properly in connection with Mr. Carey’s termination and that we have meritorious defenses to the claims asserted, and we intend to vigorously defend this action.
We may from time to time become a party to various other legal proceedings or claims that arise in the ordinary course of business. Our management has reviewed these matters and believes that the resolution of them will not have a significant adverse effect on our financial condition.
ITEM 4.
ITEM 4. Submission of Matters to a Vote of Security Holders
No stockholder votes took place during the fourth quarter of the year ended December 31, 2007.
PART II
ITEM 5.
ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock has been traded on the Nasdaq Global Market under the symbol “BABY” since our initial public offering in July 2001. The following table sets forth, for the periods indicated, the high and low closing sales price per share of our common stock, as reported on the Nasdaq Global Market.
As of March 7, 2008, there were 21,768,855 shares of our common stock issued and outstanding and held by approximately 57 stockholders of record. We estimate that there are approximately 4,500 beneficial owners of our common stock.
Dividends
We have never declared or paid cash dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Based on the terms of our Amended and Restated Credit Agreement with Wells Fargo Bank, National Association, we are prevented from paying dividends without the prior approval of the bank.
Securities Authorized for Issuance Under Equity Compensation Plans
Additional information required by this item regarding equity compensation plans is incorporated by reference to the information set forth in Item 12 of this report on Form 10-K.
Stock Performance Graph
The following information of Part II Item 5 is being furnished and shall not be deemed to be “soliciting material” or to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of that Section, nor will it be deemed incorporated by reference into any filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent that we specifically incorporate such information by reference thereto.
The following graph shows a comparison, from January 1, 2003 through December 31, 2007, of cumulative total return for our common stock, the Nasdaq Composite Index and the Standard & Poor’s 500 Health Care Equipment Index. Such returns are based on historical results and are not intended to suggest future performance. Data for the Nasdaq Composite Index and the Standard & Poor’s 500 Health Care Equipment Index assumes reinvestment of dividends.
ITEM 6.
ITEM 6. Selected Financial Data
The following tables set forth certain selected consolidated financial data as of December 31, 2007, 2006, 2005, 2004 and 2003 and for each of the years in the five-year period ended December 31, 2007, and is derived from the consolidated financial statements of Natus Medical Incorporated and its subsidiaries. The consolidated financial statements as of December 31, 2007 and 2006 and for each of the years in the three-year period ended December 31, 2007 are included elsewhere in this report. The selected consolidated balance sheet data as of December 31, 2005, 2004 and 2003 and the consolidated statements of operations data for the years ended December 31, 2004 and 2003 are derived from our consolidated financial statements, which are not included in this report. The selected consolidated financial data set forth below is qualified in its entirety by, and should be read in conjunction with, the Consolidated Financial Statements and Notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report.
a Results of operations of Neometrics, Fischer-Zoth, Bio-logic, Deltamed, Olympic and Xltek are included from their acquisition dates of July 2003, September 2004, January 2006, September 2006, October 2006, and November 2007, respectively.
b Acquired in-process research and development charges in 2007 are associated with our acquisition of Xltek, in 2006 with our acquisitions of Bio-logic and Olympic, and in 2004 with our acquisition of Fischer-Zoth.
ITEM 7.
ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the Company’s financial statements and the accompanying footnotes. MD&A includes the following sections:
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Our Business. A general description of our business.
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Year 2007 Overview. A summary of key information concerning the financial results for 2007 and changes from 2006.
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Application of Critical Accounting Policies. A discussion of the accounting policies that are most important to the portrayal of our financial condition and results of operations and that require critical judgments and estimates.
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Results of Operations. An analysis of our results of operations for the three years presented in the financial statements.
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Liquidity and Capital Resources. An analysis of capital resources, sources and uses of cash, investing and financing activities, and contractual obligations.
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Quantitative and Qualitative Disclosures about Market Risk. A summary of currency exchange issues and interest rate hedging.
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Off-Balance Sheet Arrangements. An analysis of off-balance sheet arrangements.
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Recent Accounting Pronouncements. A recap of recently issued accounting pronouncements that may have an impact on our results of operations, financial position or cash flows.
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Cautionary Information Regarding Forward-Looking Statements. Cautionary information about forward-looking statements.
Business
Natus provides healthcare products used for the screening, detection, treatment, monitoring and tracking of common medical ailments such as hearing impairment, neurological dysfunction, epilepsy, sleep disorders, and certain newborn conditions. We develop, manufacture, and market advanced neurodiagnostic and newborn care products to healthcare professionals. Our product offerings include computerized neurodiagnostic systems for audiology, neurology, polysomnography, and neonatology, as well as newborn care products such as hearing screening systems, phototherapy devices for the treatment of newborn jaundice, head-cooling products for the treatment of brain injury in newborns, and software systems for managing and tracking disorders and diseases for public health laboratories.
Our principal product families and product lines consist of:
Hearing
Newborn Hearing Screening. ALGO, ABaer, AuDX, and Echo-Screen
Diagnostic Hearing Assessment. Navigator, AuDX Pro, Scout, and Cochlea-Scan
Monitoring Systems for Neurology
Diagnostic EEG Monitoring. Ceegraph VISION, Kortex, Coherence, and CFM 6000
Diagnostic Sleep Analysis. Sleepscan VISION, Sleepworks, and Coherence
Diagnostic EMG. NeuroMAX and XCalibur
Intra-operative Monitoring. Protektor
Newborn Care
Cool-Cap, NeoBLUE, Bili-Lites, Smart Scales, Neometrics MSDS,
Other
HINT, Pasteurmatic washer and pasteurizer, Bio-Clean Sterile Dryer, and VAC-PAC.
Our revenue is generated almost exclusively from sales of devices and systems, which are generally non-recurring, and related supplies and services, which are generally recurring.
We sell our products in the United States primarily through a direct sales organization and also sell certain products through distributors and under private-label agreements. We sell our products outside the U.S. primarily through a distributor sales channel, which consists of distributors selling Natus products into more than 80 countries; however, we sell some of our products in France and Germany through a direct sales organization. We previously had direct sales organizations in Japan and the United Kingdom (“U.K.”). In 2004 we ceased selling through a direct sales force in Japan and began to sell through a distributor, and in February 2006 we ceased selling through a direct sales force in the U.K. and began to sell through a distributor.
We intend to continue expansion of our international operations because we believe international markets represent a significant growth opportunity. International sales made to distributors are characterized by lower gross profits due to the discount from our list prices that the distributors receive. International sales contributed to 33% of our revenue during 2007, compared to 29% of our revenue during 2006. The increase in international sales as a percent of total sales in 2007 compared to 2006 was attributable to our acquisition of Olympic and strong sales from Fischer-Zoth. We anticipate that international revenue will increase as a percent of revenue in the future.
We estimate that approximately 95% of the children born in the U.S. are currently being tested for hearing impairment prior to discharge from the hospital. As such, the U.S. market is mature and competitive. We derive a significant portion of our revenue from the sale of disposable supplies that are used with our screening devices. Because these products can generate high margins, we may face increasing competition. We believe that our primary competitive advantage relates to the functionality and reliability of our products and that other suppliers may compete against us by offering lower prices.
Our net income or loss can be markedly impacted by our decisions regarding the level of resources applied to our business. Management and our board of directors make these decisions on the basis of sales forecasts, expected customer orders, economic conditions, and other factors. These costs are primarily personnel and facilities costs that are relatively fixed in the short term and directly impact net income.
Year 2007 Overview
In the first quarter of 2007, we began marketing the Olympic Cool-Cap, a Class III medical device. The Cool-Cap system, which is the only FDA-approved device for the treatment of hypoxic ischemic encephalopathy (“HIE”) in term newborns, provides selective head cooling to prevent or reduce the severity of neurologic injury associated with HIE.
In June 2007 we put a hold on domestic shipments of Cool-Cap units in order to update some of the components used in its manufacture and submitted a PMA supplement to the FDA in October 2007 seeking approval of the component updates. The FDA approved the PMA supplement on February 5, 2008; however, we were unable to ship any Cool-Cap units in the U.S. during the second half of 2007. Our inability to ship Cool-Cap units in the U.S. also affected our sales of the Olympic Cerebral Function Monitor, as the Cool-Cap and CFM are sold into level three NICU’s together as a system.
In October 2007 we received a warning letter from the FDA that focused on process deficiencies at our Olympic facility in Seattle, Washington. As a result, we initiated a voluntary plant shutdown for the month of November 2007. After reviewing processes at the facility, we responded to the FDA’s warning letter in late November 2007. To date, the FDA has had no further communication with us concerning this matter.
On November 29, 2007 we acquired Excel-Tech Ltd. (“Xltek”) for $64 million. Xltek, based in Oakville, Ontario, Canada and which was publicly traded on the Toronto exchange, develops and markets computer-based electrodiagnostic systems and disposable supplies used by medical practitioners to aid in the detection, diagnosis, and monitoring of neurologic and sleep disorders. Xltek reported revenue of approximately $26.7 million during its fiscal year ended January 31, 2007.
Shortly after the acquisition of Xltek we initiated integration and restructuring activities at their facility that resulted in an immediate reduction of 15 employees, with further cost synergies expected later in the second half of 2008.
Application of Critical Accounting Policies
We prepare our financial statements in accordance with accounting principles generally accepted in the United Sates of America (“GAAP”). In so doing, we must often make estimates and use assumptions that can be subjective and, consequently, our actual results could differ from those estimates. For any given individual estimate or assumption we make, there may also be other estimates or assumptions that are reasonable.
We believe that the following critical accounting policies require the use of significant estimates, assumptions, and judgments. The use of different estimates, assumptions, and judgments could have a material affect on the reported amounts of assets, liabilities, revenue, expenses, and related disclosures as of the date of the financial statements and during the reporting period.
Revenue recognition
We recognize revenue, net of discounts, from sales of medical devices and supplies, including sales to distributors, when a purchase order has been received, when title transfers, when the selling price is fixed or determinable, and when collection of the resulting receivable is reasonably assured. Revenue from sales of certain EEG and PSG systems is recognized in accordance with FASB Statement of Position No. 97-2, Software Revenue Recognition, wherein revenue is recognized when there is persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collection is reasonably assured. When contractual arrangements contain multiple elements, revenue is allocated to each element based on its relative fair value determined using prices charged when elements are sold separately. Terms of sale for most domestic sales are FOB origin, reflecting that title and risk of loss are assumed by the purchaser at the shipping point, however, terms of sale for some neurology and sleep-diagnostic systems are FOB destination, reflecting that title and risk of loss are assumed by the purchaser upon delivery. Terms of sales to international distributors are EXW, reflecting that goods are shipped “ex works,” in which title and risk of loss are assumed by the distributor at the shipping point.
Revenue from extended service and maintenance agreements, for both medical devices and data management systems, is recognized ratably over the service period. Advance payments from customers are recorded as deferred revenue and recognized as revenue as otherwise described above. We generally do not provide rights of return on products. We accept trade-ins of our own and competitive medical devices. Trade-ins are recorded as a reduction of the replacement medical device sale. Provisions are made for initial standard warranty obligations of one year, and post-sale training and customer support at the time the related revenue is recognized. Negotiated pricing and discounts for sales subject to GPO contract terms are recognized as a reduction of the selling price of our products.
Allowance for doubtful accounts
We must exercise judgment when assessing the sufficiency of our allowance for estimated uncollectible accounts receivable. Our estimates are based on our historical collection experience within the markets in which we operate, assessment of our average accounts receivable aging days, and any other specific information of which we may be aware, such as bankruptcy filings or liquidity problems of our customers. Based on the results of our analyses, activity associated with our provision for doubtful accounts has historically been within our expectations. Any future determination that our allowance for estimated uncollectible accounts receivable is not properly stated could result in a change in our operating expenses and results of operations.
Inventory is carried at the lower of cost or market value
As a medical device manufacturer, we may be exposed to a number of factors that could result in portions of our inventory becoming either obsolete or being held in quantities that exceed anticipated usage. These factors include, but are not limited to: technological changes in our markets, competitive pressures in products and prices, and our own introduction of new product lines.
We regularly evaluate our ability to realize the value of our inventory based on a combination of factors, including historical usage rates, forecasted sales, product life cycles, and market acceptance of new products. When we identify inventory that is obsolete or in excess of anticipated usage we write it down to realizable salvage value. The estimates we use in projecting future product demand may prove to be incorrect. Any future determination that our inventory is overvalued could result in increases to our cost of sales and decreases to our operating margins and results of operations.
Carrying value of intangible assets
We amortize intangible assets with finite lives over their useful lives; any future changes that would limit their useful lives or any determination that these assets are carried at amounts greater than their estimated fair value could result in additional charges. We carry goodwill and any other intangible assets with indefinite lives at original cost but do not amortize them. Any future determination that these assets are carried at amounts greater than their estimated fair value could result in additional charges, which could significantly impact our operating results.
We test our definite-lived intangible assets for impairment whenever changes in circumstances indicate the carrying value of these assets may be impaired. Impairment indicators include, but are not limited to, net book value as compared to market capitalization, significant negative industry and economic trends, and significant underperformance relative to historical and projected future operating results. Impairment is considered to have occurred when the estimated undiscounted future cash flows related to the asset are less than its carrying value. Estimates of future cash flows involve consideration of many factors including the marketability of new products, product acceptance and lifecycle, competition, appropriate discount rates, and operating margins.
We test our goodwill and indefinite-lived intangible assets for impairment at least annually as of October 1st; this assessment is also performed whenever there is a change in circumstances that indicates the carrying value of these assets may be impaired. The determination of whether any potential impairment of goodwill exists is based upon a comparison of the estimated fair value of a reporting unit to the basis of the underlying net assets of such reporting unit. To determine the estimated fair value of our reporting units, we utilize subjective valuations based upon discounted cash flow analysis. The discounted cash flow analysis is dependent upon a number of factors including estimates of forecasted revenue and costs, and appropriate discount rates, as use of a higher rate will result in a lower estimate of fair value. In performing the discounted cash flow analysis, we use discount rates consistent with the risk-adjusted discount rates utilized in our valuation analyses pursuant to Statement of Financial Accounting Standards No. (“SFAS”) 141, Business Combinations. Use of discount rates that were 150% of the rates we utilized would have had no impact on the conclusions we reached in our impairment analysis.
Liability for product warranties
Our medical device products are covered by standard one-year product warranty plans. A liability has been established for the expected cost of servicing our medical device products during these service periods. We base the liability in part upon our historical experience; however, estimates of the costs to honor our warranties are often difficult to determine due to uncertainty surrounding the extent to which new products will require servicing and the costs that will be incurred to service those products. Until we have historical experience of the cost to honor warranties on new products, we base additions to the reserve on a combination of factors including the standard cost of the product, experience with similar products, and other judgments, such as the degree to which the product incorporates new technology. The estimates we use in projecting future product warranty costs may prove to be incorrect. Any future determination that our product warranty reserves are understated could result in increases to our cost of sales and reductions in our operating profits and results of operations.
Share-based compensation
On January 1, 2006, we adopted SFAS 123R, Share-Based Compensation, using the modified prospective approach. With the adoption of SFAS 123R, the Company now records the fair value of share-based compensation awards as expenses in the consolidated statement of operations. In order to determine the fair value of stock options on the date of grant, the Company applies the Black-Scholes option-pricing model. Inherent in this model are assumptions related to expected dividend yield, risk-free interest rate, expected stock-price volatility, expected term, and forfeiture rate. While the risk-free interest rate and dividend yield are less subjective assumptions, typically based on factual data derived from public sources, expected stock-price volatility, expected life, and forfeiture rate assumptions require a greater level of judgment which makes them critical accounting estimates. If we used different assumptions, we would have recorded different amounts of share-based compensation.
Results of Operations
The following table sets forth, for the periods indicated, selected consolidated statement of operations data as a percentage of total revenue. Our historical operating results are not necessarily indicative of the results for any future period.
Acquisitions
We completed four significant acquisitions during 2007 and 2006, and the timing of these acquisitions had an impact on the comparison of our results of operations for the years ended December 31, 2007, 2006 and 2005.
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Xltek. This acquisition was completed on November 29, 2007. Xltek reported revenue of approximately $26.7 million during its last completed fiscal year prior to the acquisition.
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Olympic Medical. This acquisition was completed on October 16, 2006. Olympic reported revenue of approximately $15.0 million during its last completed fiscal year prior to the acquisition.
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Deltamed. This acquisition was completed on September 6, 2006. Deltamed reported revenue of approximately $5.4 million during its last completed fiscal year prior to the acquisition.
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Bio-logic. This acquisition was completed on January 5, 2006. Bio-logic reported revenue of approximately $31.6 million during its last completed fiscal year prior to the acquisition.
Comparison of 2007 and 2006
Operating Results
We analyze our revenue from two perspectives. Because our acquisitions have been significant, we measure the contribution to consolidated revenue of the businesses we acquire. We also analyze our revenue as coming from two sources: sales of devices and systems, and sales of related supplies and services. We report freight revenue separate from these two sources.
Our revenue increased 32%, or $28.5 million, to $118.4 million in 2007, from $89.9 million in 2006. Xltek contributed to $2.2 million of our revenue in 2007. Olympic and Deltamed contributed to $20.5 million of the increase.
Revenue from devices and systems was $73.2 million in 2007, representing an increase of 42% or $21.6 million, from $51.6 million reported in 2006. Olympic and Deltamed contributed to $17.1 million of this increase. Revenue from supplies and services was $43.5 million in 2007, representing an increase of 18% or $6.6 million, from $36.9 million in 2006. Olympic and Deltamed contributed to $3.4 million of this increase.
Revenue from devices and systems was 62% of total revenue in 2007, compared to 57% in 2006, and revenue from supplies and services was 37% of total revenue in 2007 compared to 41% of revenue in 2006. The changes in the percentages from 2006 to 2007 resulted primarily from the contribution of a full year of operations from Olympic, whose mix of sales includes more devices than our existing product lines. Freight revenue of $1.6 million in 2007 represented 1% of total revenue, while freight revenue of $1.4 million in 2006 represented 2% of total revenue.
No customer accounted for more than 10% of our revenue in either 2007 or 2006. Revenue from domestic sales increased 23% to $78.9 million in 2007, from $64.0 million in 2006. Revenue from international sales increased 52% to $39.5 million in 2007, compared to $25.9 million in 2006. Revenue from domestic sales was 67% of total revenue in 2007, compared to 71% in 2006, and revenue from international sales was 33% of total revenue in 2007 compared to 29% of revenue in 2006. The changes in the percentages from 2006 to 2007 resulted primarily from the contribution of our German subsidiary, Fisher-Zoth, and a full year of operations from Olympic.
Our cost of revenue increased $9.4 million, or 28%, to $43.1 million in 2007, from $33.7 million in 2006. The increase was primarily due to our increased sales, and also includes $175,000 of share-based compensation expense in 2007 compared to $116,000 in 2006. Gross profit increased $19.0 million, or 34%, to $75.3 million in 2007 from $56.3 million in 2006, primarily due to our increased sales. Gross profit as a percentage of revenue was 64% in 2007 compared to 63% in 2006.
Total operating costs increased $6.0 million, or 11%, to $59.4 million in 2007, from $53.4 million in 2006. The operations of Olympic and Deltamed contributed to $4.1 million of the increase in operating costs, and Xltek contributed to $1.4 million of the increase. In addition, operating expense in 2007 included a charge for in-process research and development of $300,000, compared to charges of $9.8 million in 2006. We also recorded $1.9 million of employee share-based compensation expense in 2007 compared to $1.3 million in 2006. Our operating costs other than the charges for in-process research and development declined as a percentage of revenue in 2007 relative to 2006.
In February 2008, we adopted an integration and restructuring plan that is designed to eliminate redundant costs resulting from prior acquisitions and to improve efficiencies in operations. Under the plan, we will centralize the research and development activities supporting each of our three main product families, eliminate redundancies in North American field sales and service personnel resulting from the acquisition of Xltek, and eliminate certain production resources. We expect these actions to be essentially cost neutral in 2008, as savings during the year will be largely offset by severance costs.
Our marketing and selling expenses increased $6.3 million, or 29%, to $28.2 million in 2007 from $21.9 million in 2006. Olympic and Deltamed contributed to $3.2 million of the increase, while the marketing and selling expenses of Xltek were $645,000. We recorded $509,000 of employee share-based compensation expense in marketing and selling expenses in 2007 compared to $483,000 in 2006.
Our research and development expenses increased $5.0 million, or 47%, to $15.6 million in 2007 from $10.6 million in 2006. Olympic and Deltamed contributed to $3.1 million of the increase, while the research and development expenses of Xltek were $199,000. We recorded $108,000 of employee share-based compensation expense in research and development expenses in 2007, compared to $111,000 in 2006.
Our general and administrative expenses increased $4.2 million, or 38%, to $15.2 million in 2007 from $11.0 million in 2006. General and administrative expenses of Xltek were $238,000 and Olympic and Deltamed represented $1.8 million of the increase. In addition, outside consulting costs increased by $1.1 million, primarily due to incremental legal, auditing, tax consulting, and other outside services associated with the increase in the size of the Company resulting from our acquisitions. In addition we recorded $1.3 million of employee share-based compensation expense in general and administrative expenses in 2007 compared to $695,000 for 2006.
Other income, net consists of investment income, interest expense, net currency exchange gains and losses, and other miscellaneous income and expense. We reported net other income of $101,000 in 2007, compared to $225,000 in 2006. The net decrease in other income, net is due to an increase in foreign currency exchange losses. Unrealized exchange gains and losses from our consolidated foreign subsidiaries are not included in net income, but are reported as a component of other comprehensive income. In connection with the acquisition of Xltek, in mid October 2007 the Company entered into a forward contract for the purchase of CAD $50 million. This contract was executed on November 27, 2007, and resulted in a currency hedging loss of approximately $480,000. During the two days between the execution of the contract and the funding of the acquisition, the Company incurred an additional currency loss of $250,000. The Company did not enter into any other significant hedging activities in 2007 or 2006.
We recorded income tax expense of $6.2 million in 2007, compared to $4.1 million recorded in 2006. Our effective tax rate for 2007 was 38.9% compared to 44.9% in 2006. Our effective tax rate decreased in 2007 because of research and development tax credits, tax deductions for domestic manufacturing, and tax deductions associated with disqualifying dispositions of stock purchased by our employees under our stock awards and stock purchase plans. At December 31, 2007, we had federal net operating loss carryforwards of approximately $4.2 million and federal research credit carryforwards of $110,000 available to offset future taxable income. Income tax expense related to our international operations is based on the statutory rates in those jurisdictions.
Comparison of 2006 and 2005
Operating Results
Our revenue increased 109%, or $46.9 million, to $89.9 million in 2006, from $43.0 million in 2005. Bio-logic contributed to $38.2 million of our 2006 revenue, which amount represents an 18% increase over Bio-logic’s stand-alone revenue of $32.3 million for the twelve months ended December 31, 2005. Deltamed and Olympic contributed to $6.1 million of our revenue in 2006.
Revenue from devices and systems was $51.6 million in 2006, representing an increase of 166% or $32.1 million, from $19.4 million reported in 2005. Revenue from supplies and services was $36.9 million in 2006, representing an increase of 59% or $13.8 million, from $23.2 million in 2005.
Revenue from devices and systems was 57% of total revenue in 2006, compared to 45% in 2005, and revenue from supplies and services was 41% of total revenue in 2006 compared to 54% of revenue in 2005. The changes in the percentages from 2005 to 2006 resulted primarily from the contribution of Bio-logic. Freight revenue of $1.4 million in 2006 represented 2% of total revenue, while freight revenue of $488,000 in 2005 represented 1% of total revenue.
No customer accounted for more than 10% of our revenue in either 2006 or 2005. Revenue from domestic sales increased 133% to $64.0 million in 2006, from $27.5 million in 2005. Revenue from international sales increased 67% to $25.9 million in 2006, compared to $15.6 million in 2005. Revenue from domestic sales was 71% of total revenue in 2006, compared to 64% in 2005, and revenue from international sales was 29% of total revenue in 2006 compared to 36% of revenue in 2005. The changes in the percentages from 2006 to 2005 resulted primarily from the contribution of Bio-logic and Deltamed.
Our cost of revenue increased $17.6 million, or 109%, to $33.7 million in 2006, from $16.1 million in 2005. The increase was primarily due to our increased sales, and also includes $116,000 of share based compensation expense in 2006 for which there was no corresponding charge in 2005. Gross profit increased $29.3 million, or 109%, to $56.3 million in 2006 from $27.0 million in 2005, primarily due to our increased sales. Gross profit as a percentage of revenue was 62.6% in both 2006 and 2005. Sales of Olympic products reduced consolidated gross profit by 0.4% in 2006.
Total operating costs increased $31.8 million, or 148%, to $53.4 million in 2006, from $21.5 million in 2005. The operations of Bio-logic, Deltamed, and Olympic contributed to $19.4 million of the increase, while charges for in-process research and development contributed an additional $9.8 million; we had no such costs in 2005. Our operating costs other than the charges for in-process research and development declined as a percentage of revenue in 2006 relative to 2005. We also recorded $1.3 million of employee share-based compensation expense in 2006 for which there was no cost in 2005.
Our marketing and selling expenses increased $10.5 million, or 92.6%, to $21.9 million in 2006 from $11.4 million in 2005. The marketing and selling expenses of Bio-logic, Deltamed, and Olympic were $10.7 million in 2006. We recorded $483,000 of employee share-based compensation expense in marketing and selling expenses in 2006 for which there was no cost in 2005.
Our research and development expenses increased $6.3 million, or 146%, to $10.6 million in 2006 from $4.3 million in 2005. The research and development expenses of Bio-logic, Deltamed, and Olympic were $6.2 million. We recorded $111,000 of employee share-based compensation expense in research and development expenses in 2006 for which there was no cost in 2005.
Our general and administrative expenses increased $5.2 million, or 90%, to $11.0 million in 2006 from $5.8 million in 2005. General and administrative expenses of Bio-logic, Deltamed, and Olympic were $2.6 million. Our general and administrative costs other than those associated with our acquisitions increased by $2.6 million.
Outside consulting costs increased by $1.1 million, primarily due to incremental legal, auditing, and tax consulting fees associated with the increase in the size of the Company resulting from our acquisitions. In addition we recorded $695,000 of employee share-based compensation expense in general and administrative expenses in 2006 for which there was no cost in 2005.
During 2006, we recorded charges for acquired in-process research development of $5.9 million associated with our acquisition of Bio-Logic in January 2006 and $3.9 million associated with our acquisition of Olympic in October 2006. We had no such costs in 2005.
Other income (expense) net consists of investment income and net capital gains and losses from our investment portfolio, interest expense, net currency exchange gains and losses, and other miscellaneous income and expenses. We reported a net other income of $225,000 in 2006, compared to $1.2 million in 2005. The reduction in net other income resulted primarily from the decrease in our investment portfolio and an increase in interest expense related to a bank obligation outstanding during ten months of 2006, both of which were related to our acquisition of Bio-logic in January 2006. Our net foreign currency gains and losses were not material in 2006 or 2005. Unrealized translation gains and losses from our consolidated foreign subsidiaries are not included in net income, but are reported as a component of other comprehensive income.
We recorded income tax expense of $4.1 million in 2006, compared to $509,000 recorded in 2005. The charge for acquired in-process research and development associated with the acquisition of Bio-logic does not represent a deductible expense for purposes of calculating our effective tax rate. Our effective tax rate for 2006 without giving effect to non-deductible in-process research and development was 44.9%. Our effective tax rate in 2005 was 7.6%. Our effective tax rate increased in 2006 because we released the valuation allowance against our deferred tax assets through purchase accounting associated with the acquisition of Bio-logic.
Liquidity and Capital Resources
Comparison of 2007 and 2006
Liquidity represents our ability to generate sufficient cash flows from operating activities, and to obtain financing, to meet our obligations and commitments
As of December 31, 2007, we had cash and cash equivalents of $11.9 million, stockholders’ equity of $115.7 million, and working capital of $19.2 million, compared with cash and cash equivalents of $15.4 million, stockholders’ equity of $101.0 million, and working capital of $30.8 million as of December 31, 2006. The reduction in our cash and cash equivalents is primarily related to our acquisition of Xltek.
On November 29, 2007, we acquired Xltek for $64 million in cash, of which $35 million was funded by the credit facility described below, $14 million was provided by Xltek cash, and $15 million was provided by our existing cash.
On November 28, 2007, we entered into an Amended and Restated Credit Agreement (the “Credit Agreement”) with Wells Fargo Bank, National Association (“Wells Fargo”). The Credit Agreement restates and supercedes the credit agreement that we entered into with Wells Fargo on November 8, 2006. We paid to Wells Fargo a commitment fee of $350,000 for the credit facilities provided under the Credit Agreement. The credit facility consists of a $25 million Term Loan to be used for working capital and general corporate purposes, and to finance a portion of our acquisition of Xltek, and a Revolving Line of Credit in the amount of $13.0 million to be used for working capital and general corporate purposes, and to finance a portion of our acquisition of Xltek. On November 28, 2007, we borrowed $10 million under the Revolving Line of Credit, and at December 31, 2007 we had $3.0 million available for additional borrowing. The credit facility contains covenants, including covenants relating to liquidity and other financial measurements, and provides for events of default, including failure to pay any interest when due, failure to perform or observe covenants, bankruptcy or insolvency events
and the occurrence of a material adverse effect. At December 31, 2007, we were in compliance with all covenants of the revolving credit facility and there was an outstanding balance of $25 million under the Term Loan and $10 million under the Revolving Line of Credit. The Company has granted Wells Fargo a security interest in all of the assets of the Company.
As a result of our acquisition of Xltek, our cash reserves and working capital have been significantly reduced. However, we believe that our current cash and cash equivalents, and any cash generated from operations will be sufficient to fund our ongoing operations for the foreseeable future. We intend to continue to acquire additional technologies, products or businesses, and these acquisitions could be significant. These actions would likely affect our future capital requirements and the adequacy of our available funds. We may be required to raise additional funds through public or private financings, strategic relationships, or other arrangements. Any additional equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants and increase our cost of capital.
Net cash provided by operations increased by $7.7 million for the year ended December 31, 2007 to $10.9 million, compared to $3.2 million for the same period in 2006. The sum of our net income and certain non-cash expense items, such as reserves, depreciation and amortization, and share based compensation was approximately $17 million in 2007, compared to $13.7 million in 2006. The overall impact of changes in certain operating assets and liabilities on total operating cash flows resulted in a cash outflow of $6.1 million in the 2007 fiscal year compared to an outflow of $10.5 million in the 2006 fiscal year.
We used cash for investing purposes of $52.7 million for the year ended December 31, 2007, compared to $59.5 million in the same period in 2006. We used $2.1 million and $2.4 million of cash to acquire property and equipment, during the year ended December 31, 2007 and 2006, respectively. During the year ended December 31, 2007, we used $50 million of cash to acquire businesses compared to $71.8 million used during the year ended December 31, 2006. In 2006 we generated $12.2 million of cash through the sale of short-term investments and $2.5 million from the sale of land. We had no similar sources of cash during the year ended December 31, 2007.
Cash provided by financing activities was $37.6 million in the year ended December 31, 2007, compared to $32.0 million in 2006. Sources of cash from financing activities in 2007 were primarily from borrowings under our credit agreement of $35.0 million, exercises of stock options pursuant to our stock awards plans, and purchases of our stock by employees pursuant to our Employee Stock Purchase Plan in the amount of $2.0 million, compared with proceeds from the issuance of common stock of $29.2 million, borrowing net of repayments under our credit agreement of $10.0 million, exercises of stock options pursuant to our stock awards plans and purchases of our stock by employees pursuant to our Employee Stock Purchase Plan in the amount of $1.7 million in 2006. During 2007 we also realized an excess tax benefit of $598,000 on the exercise of employee stock options compared with an excess tax benefit of $1.1 million in 2006 that was recorded in both years as an increase to stockholders’ equity.
Comparison of 2006 and 2005
As of December 31, 2006, we had cash, cash equivalents, and short-term investments of $15.4 million, stockholders’ equity of $101.0 million, and working capital of $30.8 million, compared with cash, cash equivalents, and short-term investments of $52.2 million, stockholders’ equity of $69.0 million, and working capital of $57.5 million as of December 31, 2005. The reduction in our cash, cash equivalents and short-term investments is primarily related to our acquisitions of Bio-logic, Deltamed, and Olympic.
In January 2006 we acquired Bio-logic for $69.3 million cash, in September 2006 we acquired Deltamed for $4.1 million cash, and in October 2006, we acquired Olympic for $16.6 million cash, plus the immediate satisfaction of approximately $2.7 million of obligations associated with the acquisition.
In August 2006, we issued 2,645,000 shares of our common stock in a registered offering. The offering was priced at $11.66 per share, which was the closing price of our stock on the day prior to the offering. We raised $29.3 million, net of underwriting fees and other costs of the offering.
On November 8, 2006 we entered into a $15.0 million revolving credit facility and transferred the outstanding balance of an existing term credit facility to the revolving facility. We repaid the outstanding balance of the revolving credit facility later in November 2006.
Net cash provided by operations was $3.2 million in 2006 compared to net cash provided by operations of $7.9 million in 2005. Cash provided by operation in 2006 was largely attributable to our net loss for the year offset by substantial non-cash charges for in-process research and development, and depreciation and amortization. Additionally, during the 2006 period, we assumed accrued liabilities of $2.5 million and $2.7 million, respectively, associated with the Bio-logic and Olympic acquisitions that were paid off shortly after the acquisitions were consummated. The reduction of these accrued liabilities reduced cash provided by operations by $5.2 million in 2006. Increases in accounts receivable, inventories, and accounts payable of $11.9 million, $8.3 million, and $6.3 million, respectively, were largely the result of our acquisitions.
Other than $71.8 million of the Company’s cash used to acquire Bio-logic, Deltamed, the Nascor assets, and Olympic, offset by sales of short-term investments, cash used in investing activities in 2006 was $2.4 million, primarily to acquire equipment, offset by proceeds from the sale of land of $2.5 million and a reduction in deposits and other assets. In 2005, we used $480,000 for earnout payments associated with our previous acquisitions and $931,000 for purchases of equipment.
Cash provided by financing activities was $32.0 million in the year ended December 31, 2006, compared to $10.2 million in 2005. During 2006 we raised $29.3 million in a registered common stock offering, and during 2005 we raised $7.1 million in a private placement of our stock. Other sources of cash from financing activities were primarily from exercises of stock options pursuant to our stock awards plans and purchases of our stock by employees pursuant to our Employee Stock Purchase Plan in the amount of $1.7 million and $3.0 in the years ended December 31, 2006 and 2005, respectively. During 2006 we also realized an excess tax benefit of $1.1 million on the exercise of employee stock options that was recorded as an increase to stockholders’ equity.
Future Liquidity
Our future liquidity and capital requirements will depend on numerous factors, including the:
•
Amount and timing of revenue;
•
Extent to which our existing and new products gain market acceptance;
•
Extent to which we make acquisitions;
•
Cost and timing of product development efforts and the success of these development efforts;
•
Cost and timing of marketing and selling activities; and
•
Availability of borrowings under line of credit arrangements and the availability of other means of financing.
Contractual Obligations
In the normal course of business, we enter into obligations and commitments that require future contractual payments. The commitments result primarily from firm, noncancellable purchase orders placed with contract vendors that manufacture some of the components used in our medical devices and related disposable supply products, as well as commitments for leased office, manufacturing, and warehouse facilities. On November 28, 2007 we entered into a $13.0 million revolving credit facility and $25.0 million term loan. The outstanding
principal due under the credit facility at December 31, 2007 was $35.0 million. On November 29, 2007 we acquired Xltek and assumed $2 million of term debt.
The following table summarizes our contractual obligations and commercial commitments as of December 31, 2007 (in thousands):
Purchase obligations are defined as agreements to purchase goods or services that are enforceable and legally binding. Included in the purchase obligations category above are obligations related to purchase orders for inventory purchases under our standard terms and conditions and under negotiated agreements with vendors. We expect to receive consideration (products or services) for these purchase obligations. The purchase obligation amounts do not represent all anticipated purchases in the future, but represent only those items for which we are contractually obligated. The table above does not include obligations under employment agreements for services rendered in the ordinary course of business.
We are not able to reasonably estimate the timing of any potential payments for uncertain tax positions under FASB Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement 109. As a result, the preceding table excludes any potential future payments related to our FIN 48 liability for uncertain tax positions. See Note 14 of our consolidated financial statements for further discussion on income taxes.
Quantitative and Qualitative Disclosures about Market Risk
We develop products in the U.S, Canada, and Europe and sell those products primarily in the U.S., Europe, and Asia. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Most of our sales in Europe and Asia are denominated in U.S. dollars and Euros and with the acquisition of Xltek in November 2007, a small portion of our sales are now denominated in Canadian dollars. As our sales in currencies other than the U.S. dollar increase, our exposure to foreign currency fluctuations may increase.
In addition, changes in exchange rates also may affect the end-user prices of our products compared to those of our foreign competitors, who may be selling their products based on local currency pricing. These factors may make our products less competitive in some countries.
If the U.S. dollar uniformly increased or decreased in strength by 10% relative to the currencies in which our sales were denominated, our net income would have correspondingly increased or decreased by an immaterial amount for the year ended December 31, 2007. Our interest income is sensitive to changes in the general level of interest rates in the U.S., particularly since the majority of our investments are in short-term instruments and cash equivalents. However, as substantially all of our short-term investments carry a fixed rate of interest, a hypothetical decrease of 10% in market interest rates would not result in a material decrease in interest income earned on investments held at December 31, 2007 through the date of maturity on those investments.
The fair value of our short-term investments and cash equivalents is also sensitive to changes in the general level of interest rates in the U.S., and the fair value of our portfolio will fall if market interest rates increase.
However, since we generally have the ability to hold these investments to maturity, these declines in fair value may never be realized. If market interest rates were to increase by 10% from levels at December 31, 2007, the fair value of our portfolio would decline by an immaterial amount. At December 31, 2007 we did not hold any short-term investments or cash equivalents with maturities greater than 90 days.
All of the potential changes noted above are based on sensitivity analyses performed on our financial position as of December 31, 2007. Actual results may differ as our analysis of the effects of changes in interest rates does not account for, among other things, sales of securities prior to maturity and repurchase of replacement securities, the change in mix or quality of the investments in the portfolio, and changes in the relationship between short-term and long-term interest rates.
Off-Balance Sheet Arrangements
Under our bylaws, we have agreed to indemnify our officers and directors for certain events or occurrences arising as a result of the officer or director’s serving in such capacity. We have a directors and officers liability insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid resulting from the indemnification of our officers and directors. In addition, we enter into indemnification agreements with other parties in the ordinary course of business. In some cases we have obtained liability insurance providing coverage that limits our exposure for these other indemnified matters. We have not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements. We believe the estimated fair value of these indemnification agreements is minimal and have not recorded a liability for these agreements as of December 31, 2007. We had no other off-balance sheet arrangements during any of fiscal 2007, 2006 or 2005 that had, or are reasonably likely to have, a material effect on our consolidated financial condition, results of operations, or liquidity.
Recent Accounting Pronouncements
See Note 1-Organization and Significant Accounting Policies to the Consolidated Financial Statements contained herein for a full description of recent accounting pronouncements including the respective expected dates of adoption and effects on results of our operations and financial condition.
Cautionary Information Regarding Forward Looking Statements
This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 about Natus Medical Incorporated (“Natus,” “we,” “us,” or “our Company”). These statements include, among other things, statements concerning our expectations, beliefs, plans, intentions, future operations, financial condition and prospects, and business strategies. The words “may,” “will,” “continue,” “estimate,” “project,” “intend,” “believe,” “expect,” “anticipate,” and other similar expressions generally identify forward-looking statements. Forward-looking statements in this Item 7 include, but are not limited to, statements regarding the following: our expectations regarding the sufficiency of our cash to meet cash flow requirements, the cost of share-based compensation expense under SFAS 123R, our intention to acquire additional technologies, products or businesses, and the expected cost savings from restructuring activities adopted in February 2008.
Forward-looking statements are not guarantees of future performance and are subject to substantial risks and uncertainties that could cause the actual results to differ materially from those that we predicted in the forward-looking statements. Investors should carefully review the information contained under the caption “Risk Factors” contained in Item 1A for a description of risks and uncertainties that could cause actual results to differ from those that we predicted. All forward-looking statements are based on information available to us on the date hereof, and we assume no obligation to update forward-looking statements.
ITEM 7A.
ITEM 7A.
Quantitative and Qualitative Disclosures About Market Risk
The information required by this Item is set forth in the section entitled Management’s Discussion and Analysis of Financial Condition and Results of Operations-Quantitative and Qualitative Disclosures About Market Risk, and is incorporated by reference in this section.
ITEM 8.
ITEM 8.
Financial Statements and Supplementary Data
The Consolidated Financial Statements and Supplementary Data required by this Item are set forth where indicated in Item 15 of this report.
Selected Quarterly Financial Data (Unaudited)
The following table presents our operating results for each of the eight quarters in the period ending December 31, 2007. The information for each of these quarters is unaudited and has been prepared on the same basis as our audited financial statements appearing elsewhere in this report. In the opinion of our management, all necessary adjustments, consisting only of normal recurring adjustments, have been included to present fairly the unaudited quarterly results when read in conjunction with our audited consolidated financial statements and the related notes appearing elsewhere in this report. These operating results are not necessarily indicative of the results of any future period.
We acquired Excel-Tech Ltd. in November 2007, Olympic Medical Corp. in October 2006, Deltamed SA in September 2006 and Bio-logic Systems Corp. in January 2006. Results of operations of each of the acquired entities are included in the above table from the date of acquisition forward.
ITEM 9A.
ITEM 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Under the rules of the Securities and Exchange Commission, “disclosure controls and procedures” are controls and other procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in our reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.
Our management, with the participation of our chief executive officer and our chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2007. Our chief executive officer and chief financial officer determined that as of December 31, 2007 our disclosure controls and procedures were effective for the purpose set forth above.
Internal Control Over Financial Reporting
(a) Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15-(f) promulgated under the Securities Exchange Act of 1934. Under the supervision and with the participation of our management, including our principal executive officer and our principal financial officer, we assessed the effectiveness of our internal control over financial reporting as of December 31, 2007. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in the Internal Control-Integrated Framework. Our management has concluded that, as of December 31, 2007, our internal control over financial reporting is effective based on these criteria. We acquired Xltek in November 2007, and as permitted by SEC guidance, we excluded from our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2007, the internal control over financial reporting of this entity. Total assets related to Xltek of $62.8 million, including goodwill and intangibles, and revenue for the period from the date of acquisition of Xltek to December 31, 2007 of $2.2 million were included in our consolidated financial statements as of and for the year ended December 31, 2007. Our assessment of internal control over financial reporting excluded an evaluation of the internal control over financial reporting of this entity as of December 31, 2007.
Our independent registered public accounting firm, Deloitte & Touche LLP. has audited the consolidated financial statements of Natus Medical Incorporated for the three years ended December 31, 2007 and have issued an attestation report on the effectiveness of our internal controls over financial reporting , which is included herein.
(b) Attestation Report of the Independent Registered Public Accounting Firm
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Natus Medical Incorporated
San Carlos, California
We have audited the internal control over financial reporting of Natus Medical Incorporated and its subsidiaries (the “Company”) as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. As described in Management’s Report on Internal Control Over Financial Reporting, management excluded from its assessment the internal control over financial reporting of Excel-Tech Ltd., which was acquired on November 29, 2007 whose financial statements constitute 55% and 33% of net and total assets respectively, 2% of revenues, and 3% of net income of the consolidated financial statement amounts as of and for the year ended December 31, 2007. Accordingly, our audit did not include the internal control over financial reporting at Excel-Tech. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and the financial statement schedule listed in the Index at Item 15(a)(2), as of and for the year ended December 31, 2007 of the Company and our report dated March 14, 2007 expressed an unqualified opinion on those financial statements and the financial statement schedule.
DELOITTE & TOUCHE LLP
San Francisco, California
March 14, 2007
(c) Changes in Internal Control over Financial Reporting
There was no change in internal control over financial reporting that occurred during the fourth quarter of 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART III
This Part incorporates certain information from our definitive Proxy Statement for our 2008 Annual Meeting of Stockholders that is to be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year covered by this Report on Form 10-K.
ITEM 10.
ITEM 10. Directors, Executive Officers, and Corporate Governance
The information required by this Item concerning our directors is incorporated by reference to our Proxy Statement including but not necessarily limited to the section entitled Election of Directors. Certain information required by this item concerning executive officers is set forth in Part I of this Report in Business-Executive Officers. The information required by this item concerning compliance with Section 16(a) of the Exchange Act of 1934, as amended (the “Exchange Act”), is incorporated by reference to the Proxy Statement including but not necessarily limited to the section entitled Section 16(a) Beneficial Ownership Reporting Compliance.
Audit Committee and Audit Committee Financial Expert
The members of the Audit Committee of our Board of Directors are Ken Ludlum, Robert A. Gunst, and Mark D. Michael. Our Board of Directors has determined that Ken Ludlum is an audit committee financial expert as defined in Item 407(d) of Regulation S-K. All of the members of our audit committee are considered “independent” as the term is used in Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act.
Code of Conduct and Ethics
We have a code of conduct and ethics that applies to all of our employees, including our principal executive officer, principal financial officer, and principal accounting officer or controller. This code of conduct and ethics is posted on our internet website. The internet address for our website is www.natus.com, and the code of conduct and ethics may be found in the “Governance” section of our “Investor” webpage.
We intend to satisfy the disclosure requirement under Item 10 of Form 8-K regarding certain amendments to, or waivers from, provisions of this code of conduct and ethics by posting such information on our website, at the address and location specified above, or as otherwise required by The Nasdaq Stock Market.
The information required by this Item concerning our corporate governance is incorporated by reference to our Proxy Statement including but not necessarily limited to the section entitled Corporate Governance.
ITEM 11.
ITEM 11. Executive Compensation
The information required by this Item is incorporated by reference to our 2008 Proxy Statement including but not necessarily limited to the section entitled Executive Compensation.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Equity Compensation Plan Information
The following table provides information as of December 31, 2007 about our common stock that may be issued upon the exercise of options, warrants, and rights under all of our existing equity compensation plans, including the 1991 Stock Option Plan, 2000 Stock Awards Plan, 2000 Supplemental Stock Option Plan, 2000 Director Option Plan, and 2000 Employee Stock Purchase Plan, each as amended.
Of the shares of common stock to be issued upon exercise of outstanding options, warrants, and rights, 18,009 shares related to outstanding options under our 1991 Stock Option Plan, 2,494,658 shares related to outstanding options under our 2000 Stock Awards Plan, 150,000 shares related to outstanding options under our 2000 Supplemental Stock Option Plan, and 230,000 shares related to outstanding options under our 2000 Director Option Plan.
Of the shares of common stock remaining available for future issuance under equity compensation plans, 4,996,564 shares remained available for future issuance under our 2000 Stock Awards Plan, 586,142 shares remained available for future issuance under our 2000 Director Option Plan, and 4,401,613 shares remained available for future issuance under our 2000 Employee Stock Purchase Plan. The 1991 Stock Option Plan and 2000 Supplemental Stock Option Plan were terminated as to new grants in July 2001. The number of shares reserved for issuance pursuant to our 2000 Stock Awards Plan is subject to an automatic increase on the first day of our fiscal year in an amount equal to the lesser of (a) 1,500,000 shares of common stock; (b) 7% of our outstanding shares of common stock on the last day of the prior fiscal year; or (c) an amount determined by our board of directors. The number of shares reserved for issuance pursuant to our 2000 Director Option Plan is subject to an automatic increase on the first day of our fiscal year in an amount equal to the lesser of (a) 100,000 shares of common stock; (b) one-half of one percent of our outstanding shares of common stock on the last day of the prior fiscal year; or (c) an amount determined by our board of directors. The number of shares reserved for issuance pursuant to our 2000 Employee Stock Purchase Plan is subject to an automatic increase on the first day of our fiscal year in an amount equal to the lesser of (a) 650,000 shares of common stock; (b) 4% of our outstanding shares of common stock on the last day of the prior fiscal year; or (c) an amount determined by our board of directors. We are unable to ascertain with specificity the number of securities to be issued upon exercise of outstanding rights under, or the weighted average exercise price of outstanding rights under, the 2000 Employee Stock Purchase Plan.
Additional information required by this Item concerning ownership of our securities by certain beneficial owners and management is incorporated by reference to our 2008 Proxy Statement including but not necessarily limited to the section entitled Beneficial Ownership of Common Stock. Information concerning securities authorized for issuance under equity compensation plans is incorporated by reference to our 2008 Proxy Statement including but not necessarily limited to the section entitled Equity Compensation Plan Information.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this Item is incorporated by reference to the 2008 Proxy Statement including but not necessarily limited to the section entitled Corporate Governance Principles and Board Matters-Certain Relationships and Policies on Related Party Transactions
ITEM 14.
ITEM 14. Principal Accountant Fees and Services
The information required by this Item is incorporated by reference to the 2008 Proxy Statement including but not necessarily limited to the section entitled Audit Fees.
PART IV
ITEM 15.
ITEM 15. Exhibits and Financial Statement Schedules
(a)(1) Financial Statements
The following consolidated financial statements are filed as part of this Report:
Page
Report of Independent Registered Public Accounting Firms
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedule
SCHEDULE II: VALUATION AND QUALIFYING ACCOUNTS
For the years ended December 31, 2007, 2006 and 2005
(in thousands)
(a) Reversal of allowance for doubtful accounts
(a)(3) Exhibits
(b) Exhibits
See Item 15(a)(3) above.
(c) Financial Statement Schedules
See Item 15(a)(2) above.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned thereunto duly authorized.
NATUS MEDICAL INCORPORATED
By
/s/ James B. Hawkins
James B. Hawkins
President and Chief Executive Officer
By
/s/ Steven J. Murphy
Steven J. Murphy
Vice President Finance and Chief Financial Officer
Dated: March 14, 2008
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints James B. Hawkins and Steven J. Murphy and each of them acting individually, as his or her attorney-in-fact, each with full power of substitution, for him or her in any and all capacities, to sign any and all amendments to this Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed by the following persons on behalf of the registrant and in the capacity and dates indicated:
NATUS MEDICAL INCORPORATED
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Natus Medical Incorporated
San Carlos, California
We have audited the accompanying consolidated balance sheets of Natus Medical Incorporated and its subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Natus Medical Incorporated and its subsidiaries at December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
As discussed in Notes 1 and 14 to consolidated financial statements, the Company adopted Financial Accounting Standard Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes, as of January 1, 2007 and also as discussed in Notes 1 and 11, the Company adopted Statement of Financial Accounting Standards No. 123R, Share-Based Payment, as of January 1, 2006.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2008 expressed an unqualified opinion on the Company’s internal control over financial reporting.
DELOITTE & TOUCHE LLP
San Francisco, California
March 14,
NATUS MEDICAL INCORPORATED
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
NATUS MEDICAL INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
NATUS MEDICAL INCORPORATED
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME (LOSS)
(In thousands, except share and per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
NATUS MEDICAL INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2007, 2006 and 2005
1-ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Organization
Natus Medical Incorporated (the “Company”) was incorporated in California in May 1987 and reincorporated in Delaware in August 2000. Natus is a provider of healthcare products used for the screening, detection, treatment, monitoring and tracking of common medical ailments such as hearing impairment, neurological dysfunction, epilepsy, sleep disorders, and newborn care. The Company develops, manufactures, and markets advanced neurodiagnostic and newborn care products to healthcare professionals in over 80 countries. The Company’s product offerings include computerized neurodiagnostic systems for audiology, neurology, polysomnography, and neonatology, as well as newborn care products such as hearing screening systems, phototherapy devices for the treatment of newborn jaundice, head-cooling products for the treatment of brain injury in newborns, and software systems for managing and tracking disorders and diseases for public health laboratories. The Company’s headquarters are in San Carlos, California.
In July 2003 the Company acquired the assets of Neometrics, Inc., (“Neometrics”) located in Hauppauge, New York. In September 2004 the Company acquired Fischer-Zoth Diagnosesysteme GmbH and related entities (“Fischer-Zoth”) located near Munich, Germany. In January 2006, the Company acquired Bio-logic Systems Corp. (“Bio-logic”) located near Chicago, Illinois. In September 2006, the Company acquired Deltamed S.A. and related entities (“Deltamed”) located in Paris and Bordeaux, France. In October 2006, the Company acquired Olympic Medical Corp. (“Olympic”) located in Seattle, Washington. In November 2007, the Company acquired Excel-Tech Ltd. (“Xltek”) located near Toronto, Ontario, Canada.
In July 2000, the Company established a wholly-owned subsidiary in Japan; this subsidiary was substantially liquidated during 2004. In December 2000, the Company established a wholly-owned subsidiary in the U.K. In February 2006, the Company ceased selling through a direct sales force in the U.K. and began to sell through a distributor. The Company is currently evaluating whether or not it will maintain its U.K. subsidiary as a legal entity.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities in the consolidated financial statements. Such estimates include allowances for potentially uncollectible accounts receivable, valuation of inventory, intangible assets, goodwill, sales and use tax obligations, share-based compensation, deferred income taxes, and reserves for warranty obligations, and the provision for income taxes. Actual results could differ from those estimates.
Revenue Recognition
Revenue, net of discounts, is recognized from sales of medical devices and supplies, including sales to distributors, when a purchase order has been received, when title transfers, when the selling price is fixed or determinable, and when collection of the resulting receivable is reasonably assured. Revenue from sales of
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
certain EEG and PSG systems is recognized in accordance with FASB Statement of Position 97-2, Software Revenue Recognition, wherein revenue is recognized when there is persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collection is reasonably assured. When contractual arrangements contain multiple elements, revenue is allocated to each element based on its relative fair value determined using prices charged when elements are sold separately. Terms of sale for most domestic sales are FOB origin, reflecting that title and risk of loss are assumed by the purchaser at the shipping point; however, terms of sale for some neurology, sleep-diagnostic, and head-cooling systems are FOB destination, reflecting that title and risk of loss are assumed by the purchaser upon delivery. Terms of sales to international distributors are EXW, reflecting that goods are shipped “ex works,” in which title and risk of loss are assumed by the distributor at the shipping point.
Revenue from extended service and maintenance agreements, for both medical devices and data management systems, is recognized ratably over the service period. Advance payments from customers are recorded as deferred revenue and recognized as revenue as otherwise described above. The Company generally does not provide rights of return on products. The Company accepts trade-ins of its own and competitive medical devices. Trade-ins are recorded as a reduction of the replacement medical device sale. Provisions are made for initial standard warranty obligations that are generally one year in length.
More than 90% of the hospitals in the U.S. are members of Group Purchasing Organizations (“GPO”s), which negotiate volume purchase prices for member hospitals, group practices, and other clinics. The Company’s agreements with GPOs typically contain preferential terms for the GPO and its members, including provisions for some, if not all, of the following:
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Negotiated pricing for all group members;
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Volume discounts and other preferential terms on their member’s direct purchases from us;
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Promotion of Natus’ products by the GPO to its members;
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Payment of marketing fees by Natus to the GPO, usually based on purchasing experience of group members; and
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Non-recourse cancellation provisions.
The Company does not sell products to GPOs. Hospitals, group practices and other clinics that are members of a GPO purchase products directly from the Company under the terms negotiated by the GPO. Negotiated pricing and discounts are recognized as a reduction of the selling price of products at the time of the sale. Revenue from sales to members of GPOs is otherwise consistent with general revenue recognition policies as previously described.
Cash and Cash Equivalents
All highly liquid debt instruments purchased with an original maturity of three months or less are classified as cash equivalents.
Allowance for Doubtful Accounts
Judgment must be exercised when assessing the sufficiency of the allowance for estimated uncollectible accounts receivable. Estimates are based on historical collection experience within the markets in which the Company operates as well as assessment of average accounts receivable aging days and other customer-specific
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
information, such as bankruptcy filings or liquidity problems of customers. When it is determined that an account receivable is uncollectible, it is written off and relieved from the reserve. Any future determination that the allowance for estimated uncollectible accounts receivable is not properly stated could result in changes in operating expense and results of operations.
Fair Value of Financial Instruments
Financial instruments include cash and cash equivalents, accounts receivable, and accounts payable. Cash and cash equivalents are reported at their respective fair values on the balance sheet dates. The recorded carrying amount of accounts receivable and accounts payable approximates their fair value due to their short-term maturities.
Inventories
Inventories are stated at the lower of standard cost, which approximates actual cost on a first-in, first-out basis, or market. The Company may be exposed to a number of factors that could result in portions of its inventory becoming either obsolete or in excess of anticipated usage. These factors include, but are not limited to, technological changes in its markets, competitive pressures in products and prices, and the introduction of new product lines. The Company regularly evaluates its ability to realize the value of inventory based on a combination of factors, including historical usage rates, forecasted sales, product life cycles, and market acceptance of new products. When inventory that is obsolete or in excess of anticipated usage is identified, it is written down to realizable salvage value or an inventory valuation reserve is established.
Property and Equipment
Property and equipment are stated at cost less accumulated depreciation. Depreciation expense is computed using the straight-line method over estimated useful lives of the respective assets, which are three to five years office furniture and equipment, three to four years for computer software and hardware, three to six years for demonstration and loaned equipment, and 30 years for buildings. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful life. Land is not depreciated. Costs associated with acquiring and installing software to be used for internal purposes are capitalized.
Long-Lived Assets and Goodwill
The value of long-lived assets is reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of that asset may not be recoverable. When the sum of the undiscounted future net cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount, an impairment loss would be measured based on the discounted cash flows compared to the carrying amount. No impairment charge has been recorded in any of the years presented.
Goodwill is tested for impairment on October 1st of each year; however, this assessment may take place at any time in the event of changes in circumstances that indicate the carrying value may be impaired. The determination of whether any potential impairment of goodwill exists is based upon a comparison of the fair value of the reporting unit to the basis of the underlying net assets of such reporting unit. To determine the fair value of the reporting unit, the Company utilizes subjective valuations for the reporting unit based on a discounted cash flow analysis. Any excess of the carrying value of the reporting unit’s goodwill over the implied fair value of the reporting unit’s goodwill will be recorded as an impairment loss. No impairment was recorded in any of the years presented.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
Acquired intangible assets with definite lives are being amortizing using the straight-line and graded methods over periods ranging from seven to 20 years.
Research & Development and Capitalized Software Development Costs
Costs incurred in research and development are charged to operations as incurred. Some of the Company’s products include imbedded software which is essential to the product’s functionality. In accordance with SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed, costs incurred in the research and development of new software components and enhancements to existing software components are expensed as incurred until technological feasibility has been established. The Company capitalizes software development costs when the project reaches technological feasibility and ceases capitalization when the project is ready for release. Software development costs are amortized on a straight-line basis over the estimated useful life of the product. Amortization begins when the product is available for general release to the customer.
Share-Based Compensation
Prior to January 1, 2006, the Company accounted for employee share-based compensation using the intrinsic value method supplemented by pro forma disclosures in accordance with Accounting Principles Board No. (“APB”) 25 and SFAS 123, Accounting for Stock-Based Compensation, as amended by SFAS 148, Accounting for Stock-Based Compensation-Transition and Disclosures. Since the Company granted options with exercise prices equal to the fair value of the Company’s stock on the date of grant, no intrinsic value and therefore no expense was recorded for these options under APB 25.
Effective January 1, 2006, the Company adopted SFAS 123R, Share-Based Payment, using the modified prospective approach and, accordingly, prior periods have not been restated to reflect the impact of SFAS 123R. Under SFAS 123R, share-based awards granted prior to its adoption will be expensed over the remaining portion of their vesting period. These awards are being expensed under the single-option straight line method using the same fair value measurements that were used in calculating pro forma share-based compensation expense under SFAS 123. However, in adopting SFAS 123R, the Company reviewed the inputs for volatility under the Black-Scholes valuation methodology and determined that the volatility inputs originally used for grants of options in 2004 and 2005 were overstated, which resulted in the reported pro forma expense being overstated by an immaterial amount The Company has not adjusted the previously reported pro forma expense. For share-based awards granted on or after January 1, 2006, the Company is amortizing share-based compensation expense under the single-option straight line method over the requisite service period, which is generally a four-year vesting period. See Note 11.
Under SFAS 123R, the value of each option is estimated on the date of grant using an option pricing model, such as Black-Scholes, which was developed for use in estimating the value of freely traded options. The Company’s employee stock options have characteristics significantly different from those of traded options. Similar to other option pricing models, it requires the input of highly subjective assumptions, including stock price volatility. Changes in the subjective input assumptions can materially affect the estimated fair value of the Company’s stock options.
SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from initial estimates. Share-based compensation expense was recorded net of estimated forfeitures for the year ended December 31, 2007, such that expense was recorded only for those
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
share-based awards that are expected to vest. Under APB 25, to the extent awards were forfeited prior to vesting, the previously recognized expense was reversed in the period of forfeiture. Upon adoption of SFAS 123R and for the year ended December 31, 2007, the Company did not record a cumulative adjustment to account for the expected forfeitures of share-based awards granted to non-employees prior to January 1, 2006 (primarily consultants to the Company), for which the Company previously recorded an expense, as the adjustment was not material.
Prior to the adoption of SFAS 123R, the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the consolidated statement of cash flows. SFAS 123R requires the cash flow resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as a cash inflow from financing activities and a cash outflow from operating activities. The Company treats tax deductions from certain stock option exercises as being realized when they reduce taxes payable in accordance with relevant tax law.
Uncertain Tax Positions
The Company adopted FASB Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement 109 on January 1, 2007. This interpretation clarifies what criteria must be met prior to recognition of the financial statement benefit, in accordance with SFAS 109, Accounting for Income Taxes, of a position in a tax return. Prior to adopting FIN 48, the Company’s policy was to establish reserves that reflected the probable outcome of known tax contingencies. Favorable resolution was recognized as a reduction to the effective income tax rate in the period of resolution. As compared to a contingency approach, FIN 48 is based on a benefit recognition model. Provided that the tax position is deemed more likely than not of being sustained, FIN 48 permits a company to recognize the largest amount of tax benefit that is greater than 50 percent likely of being ultimately realized upon settlement. The tax position must be derecognized when it is no longer more likely than not of being sustained.
Foreign Currency
The functional currency of our foreign subsidiaries is the local currency of the country where the subsidiary is located. Accordingly, unrealized exchange adjustments for foreign subsidiaries of $1.1 million, $(451,000) and $(156,000) for the years ended December 31, 2007, 2006 and 2005, respectively are included as a component of accumulated other comprehensive income (loss).
Gains and losses from transactions denominated in currencies other than the functional currencies of the Company and its subsidiaries are included in other income and expense. In 2007 and 2006, net foreign currency transactions losses were $661,000 and $22,000, respectively. In 2005, net foreign currency transaction gains and losses netted to an immaterial amount. Foreign currency gains and losses result primarily from fluctuations in the exchange rate between the US Dollar, Canadian Dollar, and Euro.
Comprehensive Income
In accordance with SFAS 130, Reporting Comprehensive Income, the Company reports by major components and as a single total the change in its net assets during the period from non-owner sources. The consolidated statement of comprehensive income (loss) has been included with the consolidated statement of stockholders’ equity. Accumulated other comprehensive income consists of net unrealized gains and losses on available for sale securities and realized exchange gains and losses on foreign operations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
Basic and Diluted Net Income (Loss) per Share
Net income (loss) per share is computed in accordance with SFAS 128, Earnings per Share. Basic net income (loss) per share is based upon the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is based upon the weighted average number of common shares outstanding and dilutive common stock equivalents outstanding during the period. Common stock equivalents are options granted and shares of restricted stock issued under the Company’s stock awards plans and are calculated under the treasury stock method. Common equivalent shares from unexercised stock options and restricted stock are excluded from the computation when there is a loss as their effect is anti-dilutive, or if the exercise price of such options is greater than the average market price of the stock for the period.
For the year ended December 31, 2007, common stock equivalents of 1,215,944 were included in the weighted average shares outstanding used to calculate diluted income per share, while 345,182 shares were excluded from the calculation because of their anti-dilutive effect. For the year ended December 31, 2006, common stock equivalents of 1,347,531 were included in the weighted average shares outstanding to calculate diluted income per share, while 1,348,000 shares were excluded from the calculation of diluted net loss per share because of their anti-dilutive effect. For the year ended December 31, 2005, common stock equivalents of 1,263,000 shares were included in the weighted average shares outstanding used to calculate diluted income per share, while 38,000 shares were excluded from the calculation.
Certain Significant Risks and Uncertainties
Financial instruments that potentially subject the Company to credit risk consist principally of cash and cash equivalents, short-term investments, and accounts receivable. Cash and cash equivalents, and short-term investments consist of cash in bank accounts and investments in money market funds. To minimize its exposure to credit risk, the Company invests in highly liquid, high investment-grade financial instruments.
The Company sells its products primarily to hospitals and medical institutions. Customers are generally not required to provide collateral or other security to support accounts receivable. Allowances for estimated potential bad debt losses are maintained. No single customer or distributor accounted for more than 10% of accounts receivable at December 31, 2007, 2006 or 2005.
Recent Accounting Pronouncements
In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No (“SFAS”) 141 (revised 2007), Business Combinations, which replaces SFAS 141. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed and the goodwill acquired. SFAS 141R also establishes disclosure requirements that will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective as of the beginning of an entity’s fiscal year that begins after December 15, 2008 and will be adopted by the Company in the first quarter of fiscal 2009. While the Company expects that SFAS 141R will have an impact on accounting for business combinations once adopted, the effect is dependent upon acquisitions at that time.
In September 2006, the FASB issued SFAS 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective January 1, 2008. The Company does not believe the adoption of SFAS 157 will have a material impact on the consolidated financial statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS 159 was issued to allow entities to voluntarily choose to measure certain financial assets and liabilities at fair value (“fair value option”). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, SFAS 159 specifies that unrealized gains and losses for that instrument shall be reported in earnings at each subsequent reporting date. SFAS 159 is effective January 1, 2008. The Company does not believe the adoption of SFAS 159 will have a material impact on the consolidated financial statements.
2-BUSINESS COMBINATIONS
Xltek
On November 29, 2007, the Company completed the acquisition of Excel-Tech Ltd. (“Xltek”), based in Oakville, Ontario, Canada pursuant to an Arrangement Agreement dated as of October 9, 2007. Under the terms of the Arrangement Agreement, Natus acquired Xltek by means of a court-approved plan of arrangement in Canada. Xltek develops and markets computer-based electrodiagnostic systems and disposable supplies used by medical practitioners to aid in the detection, diagnosis, and monitoring of neurologic and sleep disorders. The acquisition adds to the Company’s growth opportunities by broadening its product offerings in neurology, including Xltek’s products for the diagnosis of peripheral nervous system dysfunction.
The Company acquired all of the outstanding common shares of Xltek for a price of $3.25 Canadian (“CAD”) per share. All options and deferred share unit awards (whether vested or unvested) outstanding on the effective date of the acquisition were acquired by the Company in return for a cash payment of CAD $3.25 less the consideration deemed to have been paid by holder of the respective awards. The acquisition is valued at $64 million including direct costs and was funded with the Company’s available cash, $14 million of Xltek cash, and $35 million of borrowing on the Company’s credit facility with Wells Fargo Bank.
In accordance with SFAS 141, Business Combinations, the acquisition has been accounted for as a purchase business combination. Under the purchase method of accounting, the assets acquired and liabilities assumed from Xltek at the date of acquisition are recorded in the consolidated financial statements at their respective fair values as of the acquisition date. The excess of the purchase price over the fair value of the acquired net assets has been recorded as goodwill in the amount of $26.3 million. This goodwill is expected to be non-deductible for tax purposes. Xltek’s results of operations are included in the consolidated financial statements from the date of the acquisition.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
The determination of estimated fair value requires management to make significant estimates and assumptions. The Company determined the fair value by applying established valuation techniques, based on information that management believed to be relevant to this determination. The following table summarizes the preliminary purchase price allocation of the fair value of the assets acquired and liabilities assumed at the date of acquisition, as adjusted (in thousands):
Valuing certain components of the acquisition, including primarily inventory, building, deferred tax assets and liabilities, and accrued expenses required the Company to make estimates that may be adjusted in the future; consequently the purchase price allocation is considered preliminary. Final determination of these estimates could result in an adjustment to the preliminary purchase price allocation, with an offsetting adjustment to goodwill.
Identifiable intangible assets. Intangible assets included in the purchase price allocation consist of: (a) core technology of $3.1 million assigned an average economic life of 20 years being amortized on the straight line method, (b) developed technology of $9.1 million assigned an economic life of 20 years being amortized on the straight line method, (c) customer-related intangible assets of $1.4 million assigned an economic life of seven years being amortized on the straight line method, and (d) tradenames of $5.3 million that have an indefinite life and are not being amortized.
Goodwill. Approximately $26.3 million has been allocated to goodwill. Goodwill represents the excess of the purchase price over the fair value of the underlying net tangible and intangible assets. In accordance with SFAS 142, Goodwill and Other Intangible Assets, goodwill will not be amortized but instead will be tested for impairment at least annually (more frequently if certain indicators are present). In the event that management determines that the value of goodwill has become impaired, the Company will incur an accounting charge for the amount of impairment during the fiscal quarter in which the determination is made.
Deferred tax assets (liabilities)/valuation allowance. A preliminary estimate of $6.1 million has been allocated to current deferred tax assets, $8.8 million has been allocated to non-current deferred tax assets, and
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
$6.3 million has been allocated to non-current deferred tax liabilities, which primarily results from amortizable intangible assets. The net deferred tax asset of $8.6 million has been offset by a valuation allowance of $8.6 million. The net deferred tax asset after valuation allowance is zero. The future release of the valuation allowance will result in a reduction in goodwill.
In-process research and development. A preliminary estimate of $300,000 has been allocated to in-process research and development and has been charged to operating expense as of the date of the acquisition. Due to its non-recurring nature, the in-process research and development expense has been excluded from the unaudited pro forma condensed combined statements of operations below.
Xltek is currently developing new products in several product areas that qualify as in-process research and development. Projects that qualify as in-process research and development represent those that have not yet reached technological feasibility. Technological feasibility is defined as being equivalent to completion of a beta-phase working prototype in which there is no remaining risk relating to the development. The Company believes there is a risk that these development efforts and enhancements will not achieve technology feasibility, or if they do, will not be competitive with other products using alternative technologies that offer comparable functionality.
The value assigned to in-process research and development was determined by considering the importance of each project to the overall development plan, estimating costs to develop the purchased in-process research and development into commercially viable products, estimating the resulting net cash flows from the projects when completed, and discounting the net cash flows to their present value. The revenue estimates used to value the purchased in-process research and development were based on estimates of relevant market sizes and growth factors, expected trends in technology, and the nature and expected timing of new product introductions by Xltek and its competitors.
The estimates used in valuing in-process research and development are based upon assumptions believed to be reasonable but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur. Accordingly, actual results may vary from the projected results.
The following unaudited pro forma combined results of operations of Natus for the years ended December 31, 2007 and 2006 are presented as if the acquisition of Xltek had occurred on the first day of the periods presented.
Unaudited Pro Forma Financial Information
(in thousands, except per share data)
For purposes of the pro forma condensed combined financial information, interest expense was calculated on the debt outstanding based on the current prime rate as quoted by Wells Fargo Bank.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
The unaudited pro forma financial information are provided for comparative purposes only and are not necessarily indicative of what actual results would have been had the Company acquired Xltek on such dates, nor do they give effect to synergies, cost savings, and other changes expected to result from the acquisition. Accordingly, the pro forma financial results do not purport to be indicative of results of operations as of the date hereof, for any period ended on the date hereof, or for any other future date or period.
Olympic
The Company acquired privately held Olympic Medical Corp. (“Olympic”) in October 2006 for $16.9 million cash, including direct costs of the acquisition. In addition the Company assumed and immediately paid $2.7 million of Olympic obligations associated with the acquisition. Olympic, based in Seattle, Washington develops and markets medical products used in the neonatal intensive care unit and pediatric department of the hospital, including devices for the detection of neurologic function of newborns. The acquisition enhances the Company’s growth opportunities by broadening its product offerings, which the Company is leveraging through its direct sales force in the U.S. and international distribution organization. The Company plans to retain Olympic Medical’s operations, as well as their established brands and existing products.
The Company is obligated to make future payments pursuant to an earnout provision in the purchase agreement of up to $3.1 million over a three-year period based primarily on the achievement of certain revenue targets for the Olympic Cool-Cap system. The Company recorded $599,000 of additional purchase consideration during the year ended December 31, 2007 pursuant to this earnout provision that was recorded as an increase of goodwill.
The Company made adjustments to the preliminary purchase price allocation of $204,000 during the year ended December 31, 2007 associated primarily with royalty arrangements and employee compensation, with offsetting increases in goodwill.
Deltamed
The Company purchased all the common stock of privately held Deltamed S.A., headquartered in Paris, France, and its wholly owned subsidiaries, Raciar-Alvar, located in Bordeaux, France, and IT-Med, located near Frankfurt, Germany (collectively “Deltamed”) in September 2006 for approximately $4.1 million cash including direct costs of the acquisition. Deltamed is a European manufacturer of medical devices used in the detection of neurological dysfunction, epilepsy, and sleep disorders through the use of electroencephalograph (“EEG”) and polysomnography (“PSG”) technologies. The acquisition adds to the Company’s international growth opportunities by broadening its product offerings and leveraging its distribution organization.
The Company made an adjustment to the preliminary purchase price allocation of $328,000 during the year ended December 31, 2007 associated with an increase in accrued liabilities related to employee severance costs with an offsetting increase in goodwill. The severance plan was formulated at the time of the acquisition and was finalized during the three months ended September 30, 2007.
Nascor
The Company completed the purchase of certain product rights, manufacturing and distribution contracts, inventory, and intangible assets from Nascor Pty. Ltd. in September 2006 for $953,000 in cash, including direct costs of the acquisition. The Company previously distributed certain Nascor products in the United States and certain other countries. This acquisition provides the Company with worldwide distribution rights and improved margins on these products.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
The Company is obligated to make future payments pursuant to an earnout provision of the purchase agreement of up to $675,000 over a three-year period based on the achievement of certain revenue targets. The Company made earnout adjustments to the purchase price allocation of $307,000 during the year ended December 31, 2007 with offsetting increases in goodwill.
Bio-logic
The Company acquired Bio-logic Systems Corp. (“Bio-logic”) in January 2006 for $69.3 million in cash, including direct costs of the acquisition. The Company made this acquisition to supplement its hearing screening business with the addition of Bio-logic’s diagnostic hearing products as well as to open up new market opportunities in the areas of EEG diagnosis and monitoring of neurological dysfunction and sleep disorders.
The Company made an adjustment to the preliminary purchase price allocation of $503,000 during the three months ended March 31, 2007 associated with a reduction in deferred tax assets as of the acquisition date related to the Company’s research and development tax credit carryforwards, as more fully described in Note 14-Income Taxes, with an offsetting increase in goodwill.
Fischer-Zoth
The Company purchased all the common stock of privately held Fischer-Zoth Diagnosesysteme GmbH and affiliated entities (“Fischer-Zoth”), as well as intangible assets held individually by the owners of Fischer-Zoth, in September 2004 for $5.7 million in cash, including direct costs of the acquisition. Fischer-Zoth is a manufacturer of otoacoustic emissions (“OAE”) products used to detect hearing impairment in newborns through adults. The acquisition added to the Company’s growth opportunities by broadening its product offerings in hearing screening and supporting expansion into new markets.
The Company made adjustments to the preliminary purchase price allocation of $717,000 and $12,000 during 2007 and 2006, respectively, pursuant to earnout provisions of the purchase agreement associated with the sales of Fischer-Zoth products with offsetting increases in goodwill. No further purchase consideration is payable under the terms of the purchase agreement.
3-INVENTORIES
Inventories consist of (in thousands):
Work in process represents an immaterial amount in all periods presented.
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
4-PROPERTY AND EQUIPMENT
Property and equipment consist of (in thousands):
Depreciation and amortization expense of property and equipment was $2.1 million, $1.6 million, and $1.3 million in the years ending December 31, 2007, 2006, and 2005, respectively.
5-GOODWILL
The carrying amount of goodwill and the changes in those balances are as follows (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
6-INTANGIBLE ASSETS
The following table summarizes the components of gross and net intangible asset balances (in thousands):
Definite lived intangible assets are amortized over their weighted average lives of 12 years for patents, 17 years for technology, and seven years for customer-related intangibles. Intangible assets with indefinite lives are not subject to amortization.
Amortization expense related to intangible assets with definite lives was as follows (in thousands):
Expected annual amortization expense related to amortizable intangible assets is as follows (in thousands):
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
7-ACCRUED LIABILITIES
Accrued liabilities consist of (in thousands):
8-OTHER LIABILITIES
Other liabilities consist of (in thousands):
9-RESERVE FOR PRODUCT WARRANTIES
The Company provides a warranty on all medical device products that is generally one year in length. The Company also sells extended service agreements on its medical device products. Service for domestic customers is provided by Company-owned service centers that perform all service, repair and calibration services. Service for international customers is provided by a combination of Company-owned facilities and third-party vendors on a contract basis.
The Company has accrued a warranty reserve, included in accrued liabilities on the accompanying balance sheets, for the expected future costs of servicing products during the initial warranty period. Amounts are added to the reserve on a per-unit basis by reference to historical experience in honoring warranty obligations. On new products, where the Company does not have historical experience of the cost to honor warranties, additions to the reserve are based on a combination of factors including the standard cost of the product and other judgments, such as the degree to which the product incorporates new technology. As warranty costs are incurred, the reserve is reduced.
Activity in the warranty reserve for the years ended December 31, 2007, 2006 and 2005 is presented in Item 15 - Exhibits and Financial Statement Schedules, Schedule II: Valuation and Qualifying Accounts.
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
10-STOCKHOLDERS’ EQUITY (DEFICIT)
Common Stock
The Company has 120,000,000 shares of common stock authorized at a par value or $0.001 per share. On July 19, 2001, the Company completed an initial public offering of its shares pursuant to which it issued 5,750,000 common shares for proceeds of $56,451,000, net of issuance costs. In August 2006, the Company issued 2,645,000 shares of its common stock in a registered offering. The offering was priced at $11.66 per share, which was the closing price of its stock on the day prior to the offering, raising $29.3 million, net of underwriting fees and other costs of the offering.
Preferred Stock
The Company has 10,000,000 shares of preferred stock authorized at a par value of $0.001 per share. In accordance with the terms of the amended and restated certificate of incorporation, the Board of Directors is authorized to provide for the issuance of one or more series of preferred stock, including increases or decreases to the series. The Board of Directors has the authority to set the rights, preferences, and terms of such shares. As of December 31, 2007, no shares of preferred stock were issued and outstanding.
Stockholder Rights Plan
The Company adopted a Stockholder Rights Plan in September 2002 (the “Rights Plan”), as amended in October 2002, February 2003, March 2005, and September 2006. Pursuant to the Rights Plan, the Company declared a dividend of one Preferred Stock Purchase Right per share of common stock (the “Rights”) and each such Right has an exercise price of $23.00. The Rights become exercisable, unless redeemed by the Company, upon the occurrence of certain events, including the announcement of a tender offer or exchange offer for the Company’s common stock or the acquisition of a specified percentage of the Company’s common stock by a third party.
11-SHARE-BASED COMPENSATION
Share-Based Compensation Expense
The Company adopted SFAS 123R on January 1, 2006. Share-based compensation was recognized as follows in the consolidated statement of operations, (in thousands, except per share):
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
As of December 31, 2007, unrecognized compensation related to the unvested portion of the Company’s stock options and other stock awards was approximately $6.5 million, which is expected to be recognized over a weighted average period of 5.8 years.
SFAS 123R requires the Company to present proforma information for the comparative periods prior to the adoption of SFAS 123R as if the Company had accounted for all share-based compensation under the fair value method of the original SFAS 123. Had compensation expense for the Company’s employee stock option awards been determined based on the fair value method at the grant dates using the Black-Scholes option pricing model consistent with the fair value method of SFAS 123, the Company would have recorded additional compensation expense and its net income and earnings per share would have been equal to the pro forma amounts presented in the following table (in thousands, except per share):
Stock Awards Plans
The Company’s 2000 Stock Option Plan provided for the granting of incentive stock options to employees and non-statutory stock options to employees, directors and consultants. In March 2005 and June 2005, respectively, the Board of Directors and the stockholders of the Company approved the Amended and Restated 2000 Stock Awards Plan (the “Restated Plan”). The Restated Plan was amended to also allow for the grant of restricted stock awards, stock bonuses, stock appreciation rights and restricted stock units. As of December 31, 2007, there were 4,996,564 shares available for awards under the Restated Plan.
Under the Restated Plan, incentive stock options may be issued at not less than the fair market value of the common stock on the date of grant, as determined by the Board of Directors. Options issued under the Restated Plan become exercisable as determined by the Board of Directors and expire no more than 10 years after the date of grant. Most options vest ratably over four years. The Company has not issued incentive stock options since 2005.
The Company also has adopted the 1991 Stock Option Plan (the “1991 Plan”) and the 2000 Supplemental Stock Option Plan (the “Supplemental Plan”), which provided for the granting of incentive stock options to employees and nonqualified stock options to employees and consultants. Options outstanding under the 1991 Plan and the Supplemental Plan generally were governed by the same terms as those under the 2000 Plan. Effective July 20, 2001, additional option grants under the 1991 Plan and the Supplemental Plan were discontinued and remaining authorized shares under such plans that were not subject to outstanding option grants were canceled. Options outstanding on July 20, 2001 remain outstanding pursuant to their original terms.
The Company’s 2000 Director Stock Option Plan (the “Director Plan”) provides for an initial grant to new nonemployee directors of options to purchase 22,500 shares of common stock. Subsequent to the initial grants,
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
each nonemployee director was granted options to purchase 7,500 shares of common stock at the next meeting of the Board of Directors following the annual meeting of stockholders, if on the date of the annual meeting the Director has served on the Board of Directors for six months. In June 2007, the Board of Directors amended the Director Plan to reduce the annual option grants awarded under the Director Plan from 7,500 shares to 5,000 shares. The amendment did not require stockholder approval. As of December 31, 2007, there were 586,142 shares reserved for issuance under the Director Plan.
Stock Option Activity
Stock option activity under the Company’s stock awards plans for the year ended December 31, 2007 is summarized as follows:
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
The following table summarizes information concerning outstanding and exercisable options outstanding at December 31, 2007:
The intrinsic value of options exercised, representing the difference between the closing stock price of Company’s common stock on the date of the exercise and the exercise price, in the years ended December 31, 2007, 2006, and 2005, was $3.2 million, $3.5 million, and $7.0 million, respectively.
As of December 31, 2007, there were: (a) 2,558,282 options vested and expected to vest with a weighted average exercise price of $7.67, an intrinsic value of $28.5 million, and a weighted average remaining contractual term of 5.77 years; and (b) 2,039,847 options exercisable with a weighted average exercise price of $6.53, an intrinsic value of $25.0 million, and a weighted average remaining contractual term of 5.75 years.
Cash received from option exercises for the years ended December 31, 2007 and 2006 was $1.5 million and $1.3 million, respectively.
Black-Scholes Inputs
The fair value of option grants was estimated using the Black-Scholes option pricing model with the following weighted average assumptions:
The Company has no history or expectation of paying dividends on its common stock. The risk-free interest rate is based on the U.S. Treasury yield for a term consistent with the expected life of the awards in effect at the time of grant. Expected volatility is based exclusively on historical volatility data of the Company’s common stock. The expected term of stock options granted is based exclusively on historical data and represents the
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
period of time that stock options granted are expected to be outstanding. The expected term is calculated for and applied to one group of stock options, as the Company does not currently expect substantially different exercise or post-vesting termination behavior among its employee population. The Company uses the simplified method for calculating expected term allowed by SEC Staff Accounting Bulletin No. (“SAB”) 107.
Share-based compensation expense associated with options is based on awards ultimately expected to vest. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company used a pre-vesting forfeiture rate of 20% in the calculation of share-based compensation expense for the 12 months ended December 31, 2007, based on weighted average historical forfeiture rates. Under the provisions of SFAS 123R, the Company will record additional expense if the actual forfeiture rate is lower than estimated, and will record a recovery of prior expense if the actual forfeiture is higher than estimated. In the Company’s pro forma information required under SFAS 123 for the periods prior to the adoption of SFAS 123R, the Company accounted for forfeitures as they occurred.
Prior to June 2006 the Board of Directors of the Company approved grants of options that had a term of 10 years. In June 2006 the Board of Directors determined that future grants of options, including options granted to employees and directors on or after June 15, 2006, will have a term of six years. As of December 31, 2007, this change in policy has had an immaterial impact upon the Black-Scholes input for expected term; however, the Company expects that over time this new policy will have the effect of reducing the input for expected term, which will reduce the fair value of future options calculated under the Black-Scholes method.
Restricted Stock Activity
The following table summarizes the activity for restricted stock awards during the year ended December 31, 2007.
The fair market value of vested restricted stock awards at December 31, 2007 was $120,900. The weighted average remaining contractual life for unvested restricted stock awards and restricted stock units at December 31, 2007 was 3.2 years and 2.6 years, respectively.
Employee Stock Purchase Plan
The 2000 Employee Stock Purchase Plan (the “ESPP”) was adopted effective upon the closing of the Company’s initial public offering. Under the ESPP, eligible employees can elect to have salary withholdings of up to 15% of the sum of their W-2 cash compensation and 401(k) contributions withheld during the offering period, to purchase shares of common stock on April 30 and October 31 of each year. The purchase price for shares acquired under the ESPP is 85% of the fair market value on the last day of the offering period. As of December 31, 2007, there were 4,401,613 shares reserved for future issuance under the ESPP.
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
Because the ESPP does not have a “look back” feature, the compensation expense associated with the Plan is not measured by the use of the Black-Scholes pricing model, but rather by measuring the difference between the fair market value of the Company’s stock on the last day of the offering period and the purchase price for the offering period, which is 85% of the fair market value. The Company reported $18,000 and $77,000 of compensation expense associated with the ESPP during the three and 12 months ended December 31, 2007, respectively.
Cash received from purchases under the ESPP for the years ended December 31, 2007, 2006, and 2005, respectively, was approximately $505,000, $382,000, and $474,000.
12-RESTRUCTURING RESERVE
Bio-logic Integration
On January 9, 2006, the Company initiated an integration plan related to the acquisition of Bio-logic (the “Bio-logic Plan”). Under the Bio-logic Plan, the Company reduced the size of its combined workforce by approximately 23 employees, representing 10% of the workforce of the Company. The Plan resulted in the elimination of redundant costs resulting from the acquisition of Bio-logic and improved efficiencies in operations. Substantially all of the staff reductions were completed by December 31, 2006.
The Bio-logic Plan has been accounted for in accordance with FASB, Emerging Issues Task Force Issue (“EITF”) 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination. All costs associated with the Bio-logic Plan were recognized as a liability assumed as of the consummation date of the merger. Substantially all of the costs associated with the Bio-logic Plan will result in the outlay of cash.
Following is a reconciliation of the beginning and ending restructuring reserve balances related to the Bio-logic Plan (in thousands):
The Company does not expect to incur any additional costs under this plan and expects to complete all restructuring activities during 2008.
Xltek Integration
In December 2007, the Company initiated an integration plan related to the acquisition of Xltek (the “Xltek Plan”). The Xltek Plan resulted in an immediate reduction of 16 Xltek employees. Total employee severance costs related to these staff reductions were approximately $2.0 million, including costs related to change of control provisions in the employment contracts of four executive officers of Xltek totaling $1.9 million.
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
Severance payments to the four executive officers will be paid out over a weighed average period of 13 months from the date of the acquisition. The Company expects further staff reductions to occur during the second half of 2008 and expects to incur an estimated additional $400,000 in severance costs, which has been included in the table below.
The Xltek Plan has been accounted for in accordance with EITF 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination. All costs associated with the Xltek Plan were recognized as a liability assumed as of the effective date of the acquisition. Substantially all of the costs associated with the Xltek Plan will result in the outlay of cash.
Following is a reconciliation of the beginning and ending restructuring reserve balances related to the Xltek Plan (in thousands):
The Company does not expect to incur any additional costs under the Xltek Plan and expects to complete all restructuring activities during 2008.
13-OTHER INCOME (EXPENSE), NET
Other income (expense), net consisted of, (in thousands).
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
14-INCOME TAXES
The components of the Company’s income tax expense for the years ended December 31, 2007, 2006, and 2005 consisted of the following (in thousands):
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2007 and 2006 are as follows (in thousands):
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
The Company’s amount of income tax recorded differs from the amount using the federal statutory rate of 39%, 35% and 34%, for 2007, 2006 and 2005, respectively, are as follows (in thousands):
At December 31, 2007 the Company had total U.S. federal net operating loss carryforwards of approximately $4.2 million, available to reduce future taxable income. The federal net operating loss carryforwards, if not utilized to offset taxable income in future periods, will expire in various amounts beginning in 2024. At December 31, 2007 the Company had research and development credit carryforwards of approximately $110,000 for federal tax purposes that expire through 2026. Moreover, the Company has federal alternative minimum tax credits of $45,000. At December 31, 2007, the Company had foreign net operating losses of $20.7 million and $1.8 million from Xltek and Deltamed, respectively.
In the table above, the tax effect of a non-deductible charge for acquired in-process research and development for the year ended December 31, 2006 of $2.1 million is reported as a discrete item. In the Company’s consolidated financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2006, the tax effect of this item was reported as a component of Federal statutory tax expense.
The extent to which the federal operating loss and tax credit carryforwards can be used to offset future taxable income may be limited, depending on the extent of ownership changes within any three-year period, as provided in the Tax Reform Act of 1986. Such a limitation could result in the expiration of carryforwards before they are utilized.
A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Accordingly, valuation allowances of $9.3 million and $119,000 were recorded during the years ended December 31, 2007 and 2006, respectively, including $8.6 million in 2007 that was generated through the acquisition of Xltek. Any future release of the valuation allowance associated with the acquisition of Xltek will be recognized as a reduction in goodwill.
The Company receives tax deductions from the gains realized by employees on the exercise of certain non-qualified stock options for which the benefit is recognized as a component of stockholders’ equity. In 2007 the Company recorded approximately $598,000 of additional paid in capital related to exercises of non-qualified stock options by employees.
The Company has not provided for U.S. federal income and foreign withholding taxes on undistributed earnings from non-U.S. operations as of December 31, 2007 because such earnings are intended to be reinvested indefinitely.
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
Uncertain Tax Positions
The Company adopted FASB Interpretation (“FIN”) 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement 109 on January 1, 2007. This interpretation clarifies what criteria must be met prior to recognition of the financial statement benefit, in accordance with SFAS 109, Accounting for Income Taxes, of a position taken in a tax return. Prior to adopting FIN 48, the Company’s policy was to establish reserves that reflected the probable outcome of known tax contingencies. Favorable resolution was recognized as a reduction to the effective income tax rate in the period of resolution. As compared to a contingency approach, FIN 48 is based on a benefit-recognition model. Provided that the tax position is deemed more likely than not of being sustained, FIN 48 permits a company to recognize the largest amount of tax benefit that is greater than 50 percent likely of being ultimately realized upon settlement. The tax position must be derecognized when it is no longer more likely than not of being sustained.
The initial application of FIN 48 resulted in a reversal of existing reserves accrued under SFAS 5, Accounting for Contingencies, of $523,000. The total amount of uncertain tax positions recorded on January 1, 2007 was $1.4 million, exclusive of interest and penalties. If all of our uncertain tax positions were sustained in our favor, the Company would recognize an aggregate tax benefit of $1.4 million in the future periods in which the positions were sustained.
A reconciliation of the beginning and ending amount of unrecognized tax benefits (excluding interest and penalties) is as follows (in thousands):
The unrecognized tax benefits of $1.4 million include $1.3 million of uncertain tax positions that would impact the Company’s effective tax rate if recognized.
At December 31, 2007, the Company had cumulatively accrued approximately $200,000 for estimated interest and penalties related to uncertain tax positions. The Company records interest and penalties related to unrecognized tax positions as a component of income tax expense, which totaled approximately $30,000 for the 12 months ended December 31, 2007.
The Company is currently unaware of any uncertain tax positions that could result in significant additional payments, accruals, or other material deviation in this estimate over the next 12 months.
The Company’s tax returns remain open to examination as follows: U.S. federal, 2004 through 2007; U.S. states, generally 2003 through 2007; significant foreign jurisdictions, generally 2005 through 2007.
15-EMPLOYEE BENEFIT PLAN
The Company has a 401(k) tax-deferred savings plan under which eligible employees may elect to have a portion of their salary deferred and contributed to the plan. Employer matching contributions are determined by the Board of Directors and are discretionary. Employer matching contributions were $429,700 and $161,000, respectively, in the years ended December 31, 2007 and 2006. There were no employer matching contributions in 2005. Employer contributions vest ratably over two years from the date of employment.
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
16-SEGMENT, CUSTOMER, AND GEOGRAPHIC INFORMATION
The Company operates in one reportable segment in which it provides healthcare products used for the screening, detection, treatment, monitoring and tracking of common medical ailments such as hearing impairment, neurological dysfunction, epilepsy, sleep disorders, and certain newborn conditions, including jaundice, brain injury, and metabolic testing. Natus develops, manufactures, and markets advanced neurodiagnostic and newborn care products to healthcare professionals in over 80 countries. Product offerings include computerized neurodiagnostic systems for audiology, neurology, polysomnography, and neonatology, as well as newborn care products such as hearing screening systems, phototherapy devices for the treatment of newborn jaundice, head-cooling products for the treatment of brain injury in newborns, and software systems for managing and tracking disorders and diseases for public health laboratories.
Our end-user customer base includes hospitals, clinics, laboratories, physicians, nurses, audiologists, and governmental agencies. Most of our international sales are to distributors, who in turn, resell our products to end users or sub-distributors.
The following is revenue and long-lived asset information by geographic region (in thousands):
Long-lived assets include property and equipment (net), intangible assets and goodwill. During the years ended December 31, 2007, 2006 and 2005, no single customer or foreign country contributed to more than 10% of revenue, and revenue from services was less than 10% of revenue. During the year ended December 31, 2007, revenue from the Neometrics product line contributed to less than 3% of revenue.
During the years ended December 31, 2007, 2006 and 2005, respectively, revenue from devices and systems was $73.2 million, $51.6 million and $19.4 million, while revenue from supplies and services was $43.5 million, $36.9 million and $23.2 million.
17-PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT EXPENSES
During 2007 the Company recorded $300,000 of purchased in-process research and development expenses in connection with its acquisition of Xltek. The in-process research and development expenses were accounted for pursuant to SFAS 141, Business Combinations, and FIN 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method.
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
Xltek
The Company recorded $300,000 of acquired in-process research and development in connection with the acquisition of Xltek. The portion of the Xltek purchase price allocated to in-process research and development represents the estimated fair value of the research and development project in-process at the time of acquisition. The project had not yet reached technological feasibility, was deemed to have no alternative use and accordingly was immediately charged to operating expense at the acquisition date. This charge is included in the Company’s Consolidated Statements of Operations for the year ended December 31, 2007 as a separate component of operating expense.
During 2006 the Company recorded $9.8 million of purchased in-process research and development expenses in connection with two separate business combinations. The in-process research and development expenses were accounted for pursuant to SFAS 141, Business Combinations and FIN 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method.
Bio-logic
The Company recorded $5.9 million of acquired in-process research and development expenses in connection with the acquisition of Bio-logic. The portion of the Bio-logic purchase price allocated to in-process research and development represents the estimated fair value of the research and development project in-process at the time of acquisition. The project had not yet reached technological feasibility, was deemed to have no alternative use and, accordingly, was immediately charged to operating expense at the acquisition date. This charge is included in the Company’s Consolidated Statements of Operations for the year ended December 31, 2006 as a separate component of operating expense.
The acquired in-process research and development represents a development project for an ambulatory recorder/amplifier for the Bio-logic Ceegraph and Sleepscan systems. At the date of the acquisition there was a significant risk associated with the technological viability of the device, however, the project was completed during 2007 and the Company is now selling the Netlink Traveler device.
Olympic
The Company recorded $3.9 million of acquired in-process research and development expenses in connection with the acquisition of Olympic Medical. The portion of the Olympic purchase price allocated to in-process research and development represents the estimated fair value of the research and development project in-process at the time of acquisition. The product in question required approval by the FDA through the premarket approval process, and there was significant risk that the device would not be approved. Accordingly, the value of the product was immediately charged to operating expense at the acquisition date in accordance with FIN 4. This charge is included in the Company’s Consolidated Statements of Operations for the year ended December 31, 2006 as a separate component of operating expense.
The purchased in-process research and development represents a development project that had been ongoing for seven years at the time of the acquisition. Olympic developed a medical device that can used to treat infants born with moderate to severe hypoxic ischemic encephalopathy (“HIE”). The device uses selective head cooling to reduce the core temperature of the newborn’s brain by approximately four degrees centigrade in a controlled manner for 72 hours. Results of the clinical trial for the Cool-Cap validated the benefit of direct brain cooling in reducing the severity of brain injury resulting from newborn HIE.
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
The FDA approved the Cool-Cap device in December 2006. The Olympic Cool-Cap is now the only FDA approved device for administering brain cooling as a treatment for HIE.
18-Debt and Credit Arrangements
Our total long-term borrowings as of December 31, 2007 were composed of the following (in thousands):
The Company had no outstanding long-term debt at December 31, 2006.
19-COMMITMENTS AND CONTINGENCIES
Leases
The Company has entered into noncancelable operating leases for some of its facilities located in the U.S. and Europe through December 2016. Minimum lease payments under noncancelable operating leases as of December 31, 2007 are as follows (in thousands):
NATUS MEDICAL INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Years Ended December 31, 2007, 2006 and 2005
Rent expense, which is recorded on the straight-line method from commencement over the period of the lease, totaled $1,230,000, $634,000, and $844,000 in 2007, 2006 and 2005, respectively.
Purchase Commitments
The Company had various firm purchase commitments for inventory totaling $12.6 million at December 31, 2007.
Indemnifications
In November 2002, the FASB issued FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantee of Indebtedness of Others. The Company has determined that certain agreements, described below, fall within the scope of FIN 45.
Under its bylaws, the Company has agreed to indemnify its officers and directors for certain events or occurrences arising as a result of the officer or director’s serving in such capacity. The Company has a directors and officers liability insurance policy that limits the Company’s exposure and enables it to recover a portion of any future amounts paid resulting from the indemnification of its officers and directors. In addition, the Company enters into indemnification agreements with other parties in the ordinary course of business. In some cases the Company has obtained liability insurance providing coverage that limits its exposure for these other indemnified matters. The Company has not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements. The Company believes the estimated fair value of these indemnification agreements is minimal and has not recorded a liability for these agreements as of December 31, 2007.
20-SUBSEQUENT EVENTS
Restructuring Plan
On February 11, 2008, the Company adopted an integration and restructuring plan that is designed to eliminate redundant costs resulting from prior acquisitions and to improve efficiencies in operations. Under the plan, the Company will centralize the research and development activities supporting each of the Company’s three main product families, as follows: (a) activities associated with North American diagnostic neurology product lines will be consolidated at the Xltek facility in Oakville, Ontario, Canada, (b) activities associated with newborn hearing screening and diagnostic hearing product lines will be consolidated at the Bio-logic facility in Mundelein, Illinois, and (c) activities associated with other newborn care products will be consolidated at the Olympic Medical facility in Seattle, Washington.
In addition, the Company will eliminate redundancies in North American field sales and service personnel resulting from the acquisition of Xltek. Finally, the Company will eliminate certain production resources as it continues to outsource assemblies to contract manufacturers.
These actions will be phased in during the first nine months of 2008. The Company expects these actions to be essentially cost neutral in 2008, as savings during the year will be largely offset by severance costs, which the Company expects to total approximately $800,000.
Substantially all employees involved in the workforce reduction will be required to render additional services to the Company after notification that their position will be eliminated in order to receive certain severance benefits in excess of those required by law. In accordance with SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities, severance costs will be accrued ratably during the period of time from notification until separation from employment.
EXHIBIT INDEX