EXAC Exactech, Inc. (delisted)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2016 AND 2015

(Unaudited)

The accompanying unaudited condensed consolidated financial statements of Exactech, Inc. and its subsidiaries (the “Company”, “Exactech”, “we”, “us” or “our”), which are for interim periods, have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission relating to interim financial statements. These unaudited condensed consolidated financial statements do not include all disclosures provided in the Company's audited annual financial statements. The condensed financial statements should be read in conjunction with the audited financial statements and notes contained in Exactech's Annual Report on Form 10-K for the year ended December 31, 2015, as filed with the Securities and Exchange Commission.

In the opinion of management, all adjustments considered necessary for a fair presentation have been included, consisting of normal recurring adjustments. Our subsidiaries, Exactech Asia, Exactech UK, Exactech Japan, Exactech France, Exactech Taiwan, Exactech Deutschland, Exactech Ibérica, Exactech International Operations, Blue Ortho, Exactech Australia and Exactech U.S., are consolidated for financial reporting purposes, and all intercompany balances and transactions have been eliminated. Results of operations for the nine month period ended September 30, 2016 are not necessarily indicative of the results to be expected for the full year.

Certain amounts reported for prior periods have been reclassified to be consistent with the current period presentation.

During the first quarter of 2016, we changed the classification of surgical instrumentation not yet placed in service from non-current inventory in the other assets category to surgical instrumentation in the property, plant and equipment category. In order to present comparable financial statements, we reclassified $14.4 million of non-current inventory in the December 31, 2015 balance sheet to property, plant and equipment. We also reclassified the effect of the classification change on the cash flow statement for the nine months ended September 30, 2015 by reducing cash used for inventory by $4.8 million in cash flow from operations and increasing the cash used for property, plant and equipment in cash flow from investing. The prior period reclassification had no impact on our condensed consolidated statements of income or equity in the condensed consolidated balance sheets.

During the third quarter of 2016, we reclassified the inventory allowance reconciling items for the nine months ended September 30, 2015 reported on the cash flow statement and in Note 6 to the condensed consolidated financial statements.  The prior period change resulted in no impact on our operating cash flows in our condensed consolidated statements of cash flows, our condensed consolidated statements of income or equity in the condensed consolidated balance sheets.  

In October 2016, the Financial Accounting Standards Board (“FASB”) issued new guidance which allows recognition of the income tax consequences upon intra-entity transfers of assets other than inventory when the transfer occurs. The guidance should be applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. The new guidance is effective for annual and interim periods beginning after December 15, 2017, and early adoption is permitted. We are currently assessing the impact of adopting this guidance on our financial statements.

In August 2016, the FASB issued new guidance to clarify how certain transactions are presented and classified in the statement of cash flows. The guidance is aimed at reducing the existing diversity in practice. The guidance will be effective for annual and interim periods beginning after December 15, 2017, with early adoption permitted. We are currently assessing the impact of adopting this guidance on our financial statements.

In March 2016, the FASB issued updated guidance related to accounting for employee share-based payments. The guidance simplifies the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. The guidance is effective for annual and interim periods beginning after December

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15, 2016, an d early adoption is permitted. We are currently assessing the impact of adopting this guidance on our financial statements.

In February 2016, the FASB issued updated guidance on leases. The new standard requires all lessees to recognize a lease liability and a right-of-use asset, measured at the present value of the future minimum lease payments, at the lease commencement date. Lessor accounting remains largely unchanged under the new guidance.  A modified retrospective approach should be applied for leases existing at the beginning of the earliest comparative period presented in the financial statements. The guidance is effective for annual and interim periods beginning after December 15, 2018, and early adoption is permitted. We are currently assessing the impact of adopting this guidance on our financial statements.

In November 2015, the FASB issued amended guidance on income taxes, which simplifies the classification of deferred income tax liabilities and assets in a classified statement of financial position. The amendment requires entities that present a classified balance sheet to classify all deferred tax liabilities and assets as a noncurrent amount. The amendment is effective for fiscal years and interim periods within those years beginning after December 15, 2016, and may be early adopted on a prospective basis or on a retrospective basis to all periods presented. In the first quarter of 2016 we adopted the amended guidance on a retrospective basis, and reclassified $1.7 million of current deferred tax assets to non-current deferred tax liabilities as of December 31, 2015.

In September 2015, the FASB issued guidance on business combination provisional adjustments during the measurement period. The new standard requires that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The guidance is effective for annual and interim periods beginning on or after December 15, 2017, and early application is permitted. We are currently assessing the impact of adopting this guidance on our financial statements; however, we do not expect the adoption of this guidance to have a material impact on our financial position or results of operations.

In May 2014, the FASB issued new revenue recognition guidance that supersedes the existing revenue recognition guidance and most industry-specific guidance applicable to revenue recognition. The new guidance is based on the principle that revenue is recognized upon the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance will also result in enhanced disclosures about revenue, provide guidance for transactions that were not previously addressed comprehensively, and clarify guidance for multiple-element arrangements. In July 2015, the FASB delayed the effective date of this guidance by one year. The guidance is effective for the first fiscal quarter of 2018, and early application is not permitted earlier than January 1, 2015.  We are currently assessing the impact of adopting this guidance on our financial statements.

Our financial instruments include cash and cash equivalents, trade receivables, debt, and foreign currency hedges. The carrying amounts of cash and cash equivalents, and trade receivables approximate fair value due to their short maturities. The carrying amount of debt approximates fair value due to the variable interest rate associated with the debt. The fair values of foreign currency hedges are based on dealer quotes.

The table below provides information on our liabilities that are measured at fair value on a recurring basis:

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The fair value of our contingent consideration liability is management's best estimate based on the present value of estimated payment scenarios, which is determined based on inputs not observable in the market. We use assumptions we believe would be made by a market participant. We evaluate our estimates on a quarterly basis, as additional data impacting the assumptions is obtained, and recognize any changes in the unaudited condensed consolidated statements of income. See Note 12, Business Acquisition, for further discussion on the contingent consideration.

We test goodwill for impairment annually as of the 1 ^st of October. Our impairment analysis as of October 1, 2016 has not been completed.

Other Intangible Assets – The following table summarizes the carrying values of our other intangible assets at September 30, 2016 and December 31, 2015:

Foreign Currency Transactions – Gains and losses resulting from our transactions and our subsidiaries’ transactions that are made in currencies different from our and their own are included in income as they occur and as other income (expense) in the condensed consolidated statements of income.

Foreign Currency Options – During 2016, we entered into foreign currency forward contracts as economic hedges against the exchange rate fluctuations of the U.S. Dollar (USD) against the Euro (EUR), the British Pound (GBP) and the Japanese Yen (JPY). During the nine months ended September 30, 2016, we recognized losses of $0.4 million related to these instruments.  The recognized losses were recorded in other income

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(expense) in the unaudited condensed consolidated statements of income related to the fair value of these currency options based upon dealers’ quotes.

During 2015, we entered into foreign currency forward contracts as economic hedges against the strengthening of the USD against the EUR and the JPY. During the nine months ended September 30, 2015, we recognized a loss of $0.4 million in the condensed consolidated statements of income related to the fair value of these currency options based upon dealers’ quotes.

Foreign Currency Translation

We are exposed to market risk related to changes in foreign currency exchange rates. The functional currency of substantially all of our international subsidiaries is their local currency. Transactions are translated into USD, and translation gains and losses are recognized in “Other comprehensive income (loss)”. Fluctuations in exchange rates affect our financial position and results of operations. The majority of our foreign currency exposure is to the EUR, GBP, Australian Dollar (AUD) and JPY. During the nine months ended September 30, 2016, translation gains were $2.4 million, which were primarily due to the weakening of the GBP and offset partially by the strengthening of the JPY and the AUD in each case against the USD. During the nine months ended September 30, 2015, translation losses were $2.7 million, which were primarily due to the weakening of the JPY against the USD, offset partially by the strengthening of the EUR and GBP against the USD. We do not expect that translation gains and losses for the balance of the year ending December 31, 2016 will have a material adverse effect on our financial position, results of operations or cash flows.

Hedging Activities

We do not enter into or hold derivative instruments for trading or speculative purposes. During December 2015, we terminated our interest rate swap, which we had entered into to eliminate variability in future cash flows by converting LIBOR-based variable-rate interest payments into fixed-rate interest payments. The fair value of our interest rate swap agreement was based on dealer quotes. The change in fair value during the nine months ended September 30, 2015 of $6,000 was recorded as accumulated other comprehensive loss in the consolidated balance sheets.

Inventories are valued at the lower of cost or net realizable value using a FIFO inventory method. Inventory is comprised of implants and instruments held for sale, including implants consigned or loaned to customers and agents. The consigned or loaned inventory remains our inventory until we are notified of the implantation. We are required to maintain substantial levels of inventory because it is necessary to maintain all sizes of each component to fill customer orders. The size of the component to be used for a specific patient is typically not known with certainty until the time of surgery, and certain sizes are typically used less frequently than the “standard” sizes. Due to this uncertainty, a minimum of one of each size of each component in the system to be used must be available to each sales representative at the time of surgery, including unusual sizes that will be sold less frequently than “standard” sizes. Although we may conclude that it is more likely than not that all quantities on hand of certain sizes will eventually not be sold, we do not consider such items “excess inventory,” as our business model requires that we maintain such quantities in order to sell the “standard” sizes. As a result of the need to maintain substantial levels of all sizes and components of inventory, we are subject to the risk of inventory obsolescence. In the event that a substantial portion of our inventory becomes obsolete, it would have a material adverse effect on the Company.

An allowance charge for slow moving inventories is recorded based upon an analysis of slow moving inventory items within a product group level. The slow moving inventory allowance is analyzed and calculated based on comparing the current quantity of inventory to historical sales and provides an allowance for any slow moving inventory on a systematic basis, which recognizes the cost of anticipated future obsolescence over the average fifteen year expected life of product groups. We believe this method is appropriate as it recognizes the lack of utility of these items (as a charge to cost of goods sold) over the related product group revenue life cycle. The key inputs to our slow moving allowance are trailing twelve months usage and the expected product life. Due to the nature of slow moving inventory changes in sales patterns from historical trends and future product release schedules, this could impact our allowance analysis. For items that we identify as obsolete, we record a charge to reduce their carrying value to net realizable value. We also maintain an allowance for discrepant inventory to allow for items that are lost or damaged.  Allowance charges for the three and nine months ended September 30, 2016 were $1.1 million and $3.4 million, respectively. Allowance charges for the three and nine months ended September 30, 2015 were $1.4 million and $3.5 million, respectively.

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We also test our inventory levels for the amount of inventory that we expect to sell within one year. Due to the scope of products required to support surgeries and the fact that we stock new subsidiaries, add consignment locations, and launch new products, the level of inventory often exceeds the forecasted level of cost of goods sold for the next twelve months. We classify our estimate of such inventory as non-current.

The following table summarizes our classifications of inventory as of September 30, 2016 and December 31, 2015: 

At September 30, 2016, net operating loss carry forwards of our foreign and domestic subsidiaries totaled $29 million, some of which begin to expire in 2020. For accounting purposes, the estimated tax effect of these net operating loss carry forwards results in a deferred tax asset.  The deferred tax asset associated with these losses was $8.7 million with a valuation allowance of $4.8 million charged against this deferred tax asset assuming these losses will not be fully realized. At December 31, 2015, these net operating loss carry forwards totaled $27.3 million, and the deferred tax asset was $8.5 million with a valuation allowance of $4.3 million charged against this deferred tax asset assuming these losses will not be fully realized.

Our income tax returns are subject to examination in numerous state, federal and foreign jurisdictions due to the multiple income tax jurisdictions in which we operate. We are not currently aware of any material open examinations in any such jurisdiction. As of September 30, 2016, we had no liability recorded as an uncertain tax benefit.

The following is a schedule of future debt maturities as of September 30, 2016, for the years ending December 31 (in thousands):

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Litigation

There are various claims, lawsuits, and disputes with third parties and pending actions involving various allegations against us incident to the operation of our business, principally product liability cases. While we believe that the various claims are without merit, we are unable to predict the ultimate outcome of such litigation. We therefore maintain insurance, subject to self-insured retention limits, for all such claims, and establish accruals for product liability and other claims based upon our experience with similar past claims, advice of counsel and the best information reasonably available. At September 30, 2016 and December 31, 2015, we had $120,000 and $100,000 accrued, respectively, for product liability claims. These product liability claims are subject to various uncertainties, and it is possible that they may be resolved unfavorably to us. While it is not possible to predict with certainty the outcome of the various cases, it is the opinion of management that, upon ultimate resolution, the cases will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.

Our insurance policies covering product liability claims must be renewed annually. Although we have been able to obtain insurance coverage for product liability claims at a cost and on other terms and conditions that have been acceptable to us, we may not be able to procure acceptable policies in the future.

Purchase Commitments

At September 30, 2016, we had outstanding commitments for the purchase of inventory, raw materials and supplies of $13.5 million and outstanding commitments for the purchase of capital equipment of $5.4 million. Purchases under our distribution agreements were $2.5 million during the nine months ended September 30, 2016.

In June 2016 we entered into an agreement to pay a total of $5.9 million for the naming of the Exactech Arena at the newly remodeled Stephen C. O’Connell Center, a sports and entertainment complex on the University of Florida’s campus. Payments will be made annually over the term of the agreement. The sponsorship gives us presence at the venue, use of University of Florida facilities and television coverage and commercial spots on Fox Sports Sun and Fox Sports Florida during arena events. The 10-year agreement will become effective December 1, 2016, and contains an option to extend for an additional five years.

Our Taiwanese subsidiary, Exactech Taiwan, entered into a license agreement with the Industrial Technology Research Institute (ITRI) and the National Taiwan University Hospital (NTUH) for the rights to technology and patents related to the repair of cartilage lesions. As of September 30, 2016, we have paid approximately $2.1 million for the licenses, patents, and equipment related to this license agreement, and we will make royalty payments when the technology becomes marketable. Using the technology, we plan to launch a cartilage repair program that will include a device and method for the treatment and repair of cartilage in the knee joint. It is expected that the project will require us to complete human clinical trials under the guidance of the Food & Drug Administration in order to obtain pre-market approval for the device in the United States. The agreement terms include a license fee based on the achievement of specific, regulatory milestones and a royalty arrangement based on sales once regulatory clearances are established.

We evaluate our operating segments by our major product lines: extremity implants, knee implants, hip implants, biologics and spine, and other products. The “other products” segment includes miscellaneous sales categories, such as surgical instruments held for sale, bone cement, instrument rental fees, shipping charges, and other implant product lines. Evaluation of the performance of operating segments is based on their respective incomes from operations before taxes, interest income and expense, and nonrecurring items. Intersegment sales and transfers are not significant. The accounting policies of the reportable segments are the same as those described in Note 2 of the notes to our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2015.

Total assets not identified with a specific segment are listed as “corporate” and include cash and cash equivalents, accounts receivable, income taxes receivable, deposits and prepaid expenses, deferred tax assets, land, facilities, office furniture and computer equipment, notes receivable, and other investments. Depreciation and amortization on corporate assets is allocated to the product segments for purposes of evaluating the income (loss) from operations, and capitalized surgical instruments are allocated to the appropriate product line supported by those assets.

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Summarized information concerning our reportable segments is shown in the following table (in thousands):

Geographic distribution of our long-lived assets and inventory is shown in the following table (in thousands):

Geographic distribution of our sales is summarized in the following table (in thousands):