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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read together with our condensed consolidated financial statements and related notes included elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. You should review the cautionary statements under the heading "Part II: Item 1A. Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q and in our other Securities and Exchange Commission filings. Our actual results could differ materially from those contained in or implied by the forward-looking statements. See "Special Note Regarding Forward-Looking Statements" following the Table of Contents for further information regarding forward-looking statements. Certain amounts and percentages in this discussion and analysis have been rounded for convenience of presentation. Unless otherwise noted, the figures in the following discussions are unaudited. Overview We are a global medical device company focused on designing, developing and commercializing innovative and proprietary complex spine technologies and techniques. Our complex spine products are used by spine surgeons to treat some of the most difficult and challenging spinal pathologies, such as deformity (primarily scoliosis), trauma and tumor. We believe these procedures typically receive a higher rate of positive insurance coverage and often generate more revenue per procedure as compared to other spine surgery procedures. We have applied our product development expertise in innovating complex spine technologies and techniques to the design, development and commercialization of an expanding number of proprietary MIS products. These proprietary MIS products are designed to allow for less invasive access to the spine and faster patient recovery times compared to traditional open access surgical approaches. We have also leveraged these core competencies in the design, development and commercialization of an increasing number of products for patients suffering from degenerative spinal conditions. We categorize our revenue in the United States amongst revenue generated from the treatment of complex spine pathologies, treatment using MIS approaches and the treatment of degenerative spinal conditions. We define our complex spine procedures as those that involve the treatment of the most difficult and challenging spinal pathologies, such as deformity (primarily scoliosis), trauma and tumor. We consider MIS procedures as degenerative procedures done through minimally invasive approaches designed to allow for less invasive access to the spine and faster patient recovery times as compared to traditional open access surgical approaches. We categorize degenerative procedures as those involving products treating degenerative spinal conditions such as traditional spinal fusions. We report revenue related to the sale of biomaterials as part of our complex spine, MIS and degenerative spine revenue categories. We expect our revenue to continue to be driven by aggregate sales growth in all categories. Our revenue classifications may evolve as we grow our business, continue to commercialize new products, adapt to surgeon preferences and surgical techniques and expand our sales globally. The primary market for our products has been the United States, where we sell our products through a hybrid sales organization consisting of direct sales employees and independent sales agencies. As of September 30, 2014, our U.S. sales force consisted of 121 direct sales employees and 66 independent sales agencies, who distribute our products and are compensated through a combination of base salaries, individual and company-based performance bonuses, commissions and stock options. We do not sell our products through or participate in physician-owned distributors (PODs). We also market and sell our products internationally in 29 countries. We sell our products directly in certain markets such as the United Kingdom and Germany and use independent distributors in other markets such as Australia, Japan and Spain. For the three and nine months ended September 30, 2014, international sales accounted for approximately 27.8% and 29.1%, respectively, of our revenue. As of September 30, 2014, our international sales force consisted of 37 direct sales employees, eight independent agencies and 19 independent distributors. Our independent distributors manage the billing relationship with each hospital in their respective territories and are responsible for servicing the product needs of their surgeon customers. We believe there are significant opportunities for us to increase our presence through the expansion of our sales force and the commercialization of additional products. Components of our Results of Operations We manage our business globally within one reportable segment, which is consistent with how our management reviews our business, prioritizes investment and resource allocation decisions and assesses operating performance. 21 --------------------------------------------------------------------------------Revenue We market and sell spinal implants, disposables and instruments, primarily to hospitals, for use by surgeons to treat patients with spinal pathologies. In the United States and international markets where we have direct employee sales locations, which include the United Kingdom, Ireland, Germany, Austria and Switzerland, we manage and maintain the sales relationships with our hospital customers. In those international markets where we utilize independent distributorships, we do not manage or maintain the sales relationships with the hospital customers. We do, however, support our distributor partners by providing product training, medical education and engineering expertise to surgeons practicing in these markets. In markets where we have a direct presence, we generally assign our surgical sets to our direct sales employees. A surgical set typically contains the instruments, including any disposables, and spinal implants necessary to complete a successful surgery. With our support, the direct sales employee maintains the surgical sets and places them with our hospital customers for use by surgeons. We recognize revenue upon receipt of a delivered order confirming that our products have been used in a surgical procedure. In our international markets where we utilize independent distributorships, we generally sell our surgical sets and the related spinal implant replenishments to our distributors on pre-agreed business terms. We recognize revenue when the title to the goods and the risk of loss related to those goods are transferred. All such sales to distributors are not subject to contingencies and are, therefore, final. International revenue was 30.9% and 27.8% of total revenue for the three months ended September 30, 2013 and 2014, respectively, and 27.7% and 29.1% during the nine months ended September 30, 2013 and 2014, respectively. We anticipate that sales in international markets will grow faster than sales in the United States in the near term. In addition, we generated 59.2% and 57.7% of our U.S. revenue for the three months ended September 30, 2013 and 2014, respectively, from the sale of our complex spine and MIS products and 59.0% and 57.0% for the nine months ended September 30, 2013 and 2014, respectively. We expect that these core product categories will continue to be a significant contributor to our revenue growth in the future. While we believe the proportion of our international revenue from complex spine and MIS is even higher than in the United States, a significant portion of our international revenue is derived from our distributor partners who do not report their product usage at the surgeon or hospital level, which prevents us from providing a specific breakdown for our international revenue among our three product categories. Cost of Revenue Except for certain specialty products that we manufacture in-house, our instruments, spinal implants and related offerings are manufactured to our specifications by third-party suppliers who meet our manufacturer qualification standards. Our third-party manufacturers meet FDA, International Organization for Standardization (ISO) and other country-specific quality standards supported by our internal specifications and procedures. Substantially all of our suppliers manufacture our products in the United States. Our cost of revenue consists primarily of costs of products purchased from our third-party suppliers, amortization of surgical instruments, inventory reserves, royalties, inbound shipping, inspection and related costs incurred in making our products available for sale or use. Cost of revenue also includes related personnel and consultants' compensation and stock-based compensation expense. Beginning in 2013, our cost of revenue included the effect of a 2.3% excise tax on the sale of medical devices sold in the United States. We expect our cost of revenue to increase in absolute terms due primarily to increased sales volume and changes in the geographic mix of our sales as our international operations tend to have a higher cost of revenue as a percentage of sales. Research, Development and Engineering Our research, development and engineering expenses primarily consist of research and development, engineering, product development, clinical expenses, regulatory expenses, related consulting services, third-party prototyping services, outside research activities, materials production and other costs associated with the design and development of our products. Research, development and engineering expenses also include related personnel and consultants' compensation and stock-based compensation expense. We expense research, development and engineering costs as they are incurred. We expect to incur additional research, development and engineering costs as we continue to design and commercialize new products. While our research, development and engineering expenses fluctuate from period to period based on the timing of specific research, development and testing initiatives, we generally expect these costs will increase in absolute terms over time as we continue to expand our product portfolio and add related personnel. 22 -------------------------------------------------------------------------------- Sales and Marketing Sales and marketing expenses primarily consist of commissions to our independent distributors, as well as compensation, commissions, benefits and other related costs, including stock-based compensation, for personnel employed in our sales, marketing and clinical sales support departments. Sales and marketing also includes the costs of medical education, training, sales related shipping and corporate communications activities. We expect our sales and marketing expenses will increase in absolute terms due to increased sales volume, the continued expansion of our sales force and the continued design and commercialization of new products. General and Administrative General and administrative expenses include compensation, benefits and other related costs, including stock-based compensation for personnel employed in our executive management, finance, regulatory, information technology and human resource departments, as well as facility costs and costs associated with consulting and other finance, legal, information technology and human resource services provided by third-parties. We include legal and litigation expenses as well as costs related to the development and protection of our intellectual property (IP) portfolio in general and administrative expenses. We expect our general and administrative expenses to continue to increase in absolute dollars as we hire additional personnel to support the growth of our business. In addition, we expect to incur increased expenses as a result of being a public company. General and administrative expenses also include amortization expense of certain of our intangible assets. However, the amortization of such assets is expected to decline over the next several years as such assets subject to amortization become fully amortized based on their estimated useful lives. Income Tax Provision We are taxed at the rates applicable within each jurisdiction in which we operate and/or generate revenue. The effective income tax rate, tax provisions, deferred tax assets and deferred tax liabilities will vary according to the jurisdiction in which profits arise. Tax laws are complex and subject to different interpretations by management and the respective governmental taxing authorities, and require us to exercise judgment in determining our income tax provision, our deferred tax assets and liabilities and the valuation allowance recorded against our net deferred tax assets. Deferred tax assets and liabilities are determined using the enacted tax rates in effect for the years in which those tax assets are expected to be realized. A valuation allowance is established when it is more likely than not that the future realization of all or some of the deferred tax assets will not be achieved. Material Trends and Uncertainties The global spinal surgery industry has been growing as a result of: • the increased accessibility of healthcare to more people worldwide; • advances in technologies for treating conditions of the spine, which have increased the addressable market of patients; and • overall population growth, aging patient demographics and an increase in life expectancies around the world. Nonetheless, we face a number of challenges and uncertainties, including: • ongoing requirements from our hospital partners related to pricing and operating procedures; • continued market acceptance of our new product innovations; • the unpredictability of government regulation over healthcare in the worldwide markets; • competitive threats in the future displacing current surgical treatment protocols; and • the impact of industry consolidation on the overall market. Results of Operations The following table sets forth, for the periods indicated, our results of operations expressed as dollar amounts: 23 -------------------------------------------------------------------------------- Three Months Ended September 30, Nine Months Ended September 30, 2013 2014 2013 2014 (In thousands) Revenue $ 39,776 $ 47,624 $ 114,975 $ 137,363 Cost of revenue 11,782 16,135 34,892 46,583 Gross profit 27,994 31,489 80,083 90,780 Operating expenses: Research, development and engineering 3,048 4,872 9,327 11,854 Sales and marketing 19,566 25,016 58,840 71,185 General and administrative 14,939 14,507 44,170 47,158 Total operating expenses 37,553 44,395 112,337 130,197 Loss from operations (9,559 ) (12,906 ) (32,254 ) (39,417 ) Other income (expense): Foreign currency transaction (loss) gain 2,134 (3,081 ) 724 (2,131 ) Discount on prepayment of stockholder notes - - - (4,825 ) Interest expense (721 ) (116 ) (1,878 ) (2,115 ) Total other expense, net 1,413 (3,197 ) (1,154 ) (9,071 ) Loss before income tax (benefit) expense (8,146 ) (16,103 ) (33,408 ) (48,488 ) Income tax (benefit) expense (1,968 ) 37 (7,467 ) 82 Net loss (6,178 ) (16,140 ) (25,941 ) (48,570 ) Accretion and adjustment of preferred stock to fair value (129 ) - (13,814 ) 6,879 Net loss attributable to common stockholders $ (6,307 ) $ (16,140 ) $ (39,755 ) $ (41,691 ) Three Months Ended September 30, 2014 Compared to the Three Months Ended September 30, 2013 The following table sets forth, for the periods indicated, our revenue by geography expressed as dollar amounts and the changes in such revenue between the specified periods expressed in dollar amounts and as percentages: Three Months Ended September 30, 2013 2014 $ Increase % Change (In thousands) United States $ 27,491 $ 34,385 $ 6,894 25.1 % International 12,285 13,239 954 7.8 % Total revenue $ 39,776 $ 47,624 $ 7,848 19.7 % Total revenue increased $7.8 million, or 19.7%, from $39.8 million for the three months ended September 30, 2013 to $47.6 million for the three months ended September 30, 2014. The increase in revenue was primarily driven by $7.0 million in greater sales volume in the United States due to continued expansion of our customer base and $0.6 million in growth in our international distributor markets, primarily Australia and the Netherlands. The increases in the United States were offset in part by a decrease in revenue from our existing customer base and changes in the mix of products sold. U.S. Revenue The following table sets forth, for the periods indicated, our U.S. revenue by product category expressed as dollar amounts and the changes in such revenue between the specified periods expressed in dollar amounts and percentages. To further align its procedure categorizations, beginning in the second quarter of 2014, the Company began to report MIS sales attributable to complex spine procedures, which were historically reported in the minimally invasive product category, within the complex spine category. Accordingly, the complex spine category presented below includes MIS sales attributable to complex spine procedures which were historically reported in the minimally invasive procedure category of $1.4 million for the three months ended September 30, 2013. The financial information for the three months ended September 30, 2014 do not reflect a change to the complex spine category because we now include MIS sales attributable to complex spine procedures within the complex spine category. 24 -------------------------------------------------------------------------------- Three Months Ended September 30, 2013 2014 $ Increase % Change (In thousands) Complex spine $ 11,330 $ 14,585 $ 3,255 28.7 % Minimally invasive 4,946 5,258 312 6.3 % Degenerative 11,215 14,542 3,327 29.7 % Total U.S. revenue $ 27,491 $ 34,385 $ 6,894 25.1 % U.S. revenue increased $6.9 million, or 25.1%, from $27.5 million for the three months ended September 30, 2013 to $34.4 million for the three months ended September 30, 2014. Sales in our complex spine, MIS and degenerative categories represented 41.2%, 18.0% and 40.8% of U.S. revenue, respectively, for the three months ended September 30, 2013, compared to 42.4%, 15.3% and 42.3% of U.S. revenue, respectively, for the three months ended September 30, 2014. The overall U.S. revenue growth was driven by new surgeon users representing $7.0 million of revenue, offset in part, by unfavorable changes in price, a decrease in existing customer usage and mix of products sold. The complex spine category growth of $3.3 million reflects increased surgeon usage of our MESA and EVEREST systems of $2.3 million, an initial stocking order of implants of $0.5 million, which has been categorized based on experienced surgical implant usage patterns to date of such order, and increased usage of our biomaterials offering of $0.2 million. The MIS category growth of $0.3 million primarily reflects increased surgeon usage of our EVEREST(R) minimally invasive products. The degenerative category growth of $3.3 million primarily reflects increased surgeon usage of our EVEREST(R) product line of $0.9 million and increased usage of our biomaterials offering of $0.7 million. International Revenue International revenue increased $0.9 million, or 7.8%, from $12.3 million for the three months ended September 30, 2013 to $13.2 million for the three months ended September 30, 2014. International revenue increased as a result of expanded customer usage of $0.4 million in our Italian, United Kingdom and German markets. The revenue growth from these markets includes a $0.2 million increase in revenue resulting from favorable foreign currency fluctuations, due to a strengthening of the Pound Sterling and the Euro as compared to the U.S. Dollar. International revenue also reflects growth of $0.6 million from our international distributor partners, primarily in Australia and the Netherlands, as our partners continue to invest in new surgical sets and their market penetration continues to grow. Cost of Revenue Cost of revenue increased $4.3 million, or 36.9%, from $11.8 million for the three months ended September 30, 2013 to $16.1 million for the three months ended September 30, 2014. The increase was primarily due to increased sales volume, increasing utilization of our custom designed instruments, and increased inventory reserve expense. Amortization expense, increased $0.9 million, or 63.7%, from $1.4 million in the three months ended September 30, 2013 to $2.3 million for the three months ended September 30, 2014. The increase in amortization expense is primarily a result of increased investment in surgical instruments and the absence of the one-time benefit realized in 2013 from the change in useful life of our surgical instruments from three years to five years. In addition, the cost of revenue associated with the medical device excise tax in the United States was approximately $0.5 million for each of the three months ended September 30, 2013 and 2014. Gross Profit Gross profit decreased as a percentage of revenue from 70.4% for the three months ended September 30, 2013 to 66.1% for the three months ended September 30, 2014. The decrease in gross profit as a percentage of revenue is primarily due to changes in the mix of products sold in the United States, pricing declines in the United States. and select international markets, higher instrument amortization expense, and increased inventory reserve expense. Research, Development and Engineering Research, development and engineering expenses increased $1.9 million, or 59.8%, from $3.0 million for the three months ended September 30, 2013 to $4.9 million for the three months ended September 30, 2014. The increase was primarily due to higher payroll expenses, including stock based compensation, and increased development activities of products in our pipeline. Sales and Marketing 25 -------------------------------------------------------------------------------- Sales and marketing expenses increased $5.4 million, or 27.9%, from $19.6 million for the three months ended September 30, 2013 to $25.0 million for the three months ended September 30, 2014. The increase was primarily due to an increase in sales commissions as a result of increased sales volume and employee compensation costs including stock based compensation resulting from our continued hiring of direct sales employees since September 30, 2013. The increase was also due in part to increased costs associated with travel, marketing, advertising, and shipping expense. General and Administrative General and administrative expenses decreased $0.4 million, or 2.9%, from $14.9 million for the three months ended September 30, 2013 to $14.5 million for the three months ended September 30, 2014. The decrease was primarily due to lower amortization expense on intangible assets, partially offset by increased employee compensation and benefit costs associated with the increase in personnel to support the expansion of our business, amortization of the compensation cost of restricted stock units issuances, and increased third-party legal and other consulting expenses. General and administrative expenses includes amortization of intangible assets of $7.5 million and $5.0 million for the three months ended September 30, 2013 and September 30, 2014, respectively. Other Income (Expense) Other Income (Expense), decreased $4.6 million, from $1.4 million in income for the three months ended September 30, 2013 to $(3.2) million of expense for the three months ended September 30, 2014. The decrease in other income (expense) was primarily attributable to an increase in loss on foreign currency transactions of $5.2 million with our subsidiaries, partially offset by a reduction in interest expense of $0.6 million. Income Tax (Benefit) Expense Benefit from income taxes decreased $2.0 million, to an expense of $37,000 for the three months ended September 30, 2014. Our effective tax rate calculated as a percentage of loss before income tax benefit was 24.2% for the three months ended September 30, 2013 and (0.2)% for the three months ended September 30, 2014. The change in the effective tax rate was due to the effect of an increase in the valuation allowance on our deferred tax assets as of September 30, 2014. Nine Months Ended September 30, 2014 Compared to the Nine Months Ended September 30, 2013 The following table sets forth, for the periods indicated, our revenue by geography expressed as dollar amounts and the changes in such revenue between the specified periods expressed in dollar amounts and as percentages: Nine Months Ended September 30, 2013 2014 $ Increase % Change (In thousands) United States $ 83,091 $ 97,371 $ 14,280 17.2 % International 31,884 39,992 8,108 25.4 % Total revenue $ 114,975 $ 137,363 $ 22,388 19.5 % Total revenue increased $22.4 million, or 19.5%, from $115.0 million for the nine months ended September 30, 2013 to $137.4 million for the nine months ended September 30, 2014. The increase in revenue was primarily driven by $21.6 million in greater sales volume in the United States due to continued expansion of our customer base and changes in our mix of products sold, $1.4 million in growth in our direct international markets, primarily Germany and the United Kingdom including $0.8 million of favorable foreign currency exchange and $5.3 million in growth in our international distributor markets, primarily Australia, Spain and Denmark. The increases in the United States were offset in part by a decrease in revenue from our existing customer base. U.S. Revenue The following table sets forth, for the periods indicated, our U.S. revenue by product category expressed as dollar amounts and the changes in such revenue between the specified periods expressed in dollar amounts and percentages. To further align its procedure categorizations, beginning in the second quarter of 2014, the Company began to report MIS sales attributable to complex spine procedures, which were historically reported in the minimally invasive product category, within the complex 26 -------------------------------------------------------------------------------- spine category. Accordingly, the complex spine category presented below includes MIS sales attributable to complex spine procedures which were historically reported in the minimally invasive procedure category of $4.1 million and $3.9 million for the nine months ended September 30, 2013 and 2014, respectively. Nine Months Ended September 30, 2013 2014 $ Increase % Change (In thousands) Complex spine $ 35,111 $ 40,375 $ 5,264 15.0 % Minimally invasive 13,945 15,138 1,193 8.6 % Degenerative 34,035 41,858 7,823 23.0 % Total U.S. revenue $ 83,091 $ 97,371 $ 14,280 17.2 % U.S. revenue increased $14.3 million, or 17.2%, from $83.1 million for the nine months ended September 30, 2013 to $97.4 million for the nine months ended September 30, 2014. Sales in our complex spine, MIS and degenerative categories represented 42.3%, 16.8% and 40.9% of U.S. revenue, respectively, for the nine months ended September 30, 2013, compared to 41.5%, 15.5% and 43.0% of U.S. revenue, respectively, for the nine months ended September 30, 2014. The overall U.S. revenue growth was driven by new surgeon users representing $13.0 million of revenue and from the mix of products sold, offset, in part, by unfavorable changes in price and a decrease in existing customer usage. The complex spine category growth of $5.3 million reflects increased surgeon usage of our EVEREST(R) system of $2.3 million, an initial stocking order of implants of $0.5 million, which has been categorized based on experienced surgical implant usage patterns to date of such order, and increased usage of our biomaterials offering of $1.0 million. The MIS category growth of $1.2 million primarily reflects increased surgeon usage of our minimally invasive products in the evaluation phase for adult complex spine patients. The degenerative category growth of $7.8 million primarily reflects increased surgeon usage of our EVEREST(R) product line of $2.2 million, and increased usage of our biomaterials offering of $2.0 million. International Revenue International revenue increased $8.1 million, or 25.4%, from $31.9 million for the nine months ended September 30, 2013 to $40.0 million for the nine months ended September 30, 2014. International revenue increased significantly as a result of expanded customer usage of $2.3 million in our Italian, United Kingdom and German markets. The revenue growth from these markets includes a $0.8 million increase in revenue resulting from foreign currency fluctuations, due to a strengthening of the Pound Sterling and the Euro as compared to the U.S. Dollar. International revenue also reflects growth of $5.3 million from our international distributor partners, primarily in Australia, Spain and Denmark, as our partners continue to invest in new surgical sets and their market penetration continues to grow. Cost of Revenue Cost of revenue increased $11.7 million, or 33.5%, from $34.9 million for the nine months ended September 30, 2013 to $46.6 million for the nine months ended September 30, 2014. The increase was primarily due to increased sales volume, increasing utilization of our custom designed instruments, higher instrument amortization expense, and increased inventory reserve expense. Amortization expense increased $2.5 million, or 69.6%, from $3.5 million in the nine months ended September 30, 2013 to $6.0 million for the nine months ended September 30, 2014. The increase in amortization expense is primarily a result of increased investment in surgical instruments and the absence of the one-time benefit realized in 2013 from the change in useful life of our surgical instruments from three years to five years. In addition, the cost of revenue associated with the medical device excise tax in the United States was approximately $1.5 million and $1.6 million for the nine months ended September 30, 2013 and 2014, respectively. Gross Profit Gross profit decreased as a percentage of revenue from 69.7% for the nine months ended September 30, 2013 to 66.1% for the nine months ended September 30, 2014. The decrease in gross profit as a percentage of revenue is primarily due to changes in the mix of sales between the United States and international markets, pricing declines in the United States and select international markets, and increased inventory reserve expenses. International revenue reimbursements from insurers vary widely in each international region and are typically lower than revenue reimbursements from insurers in the United States. Additional contributors to the decreased gross profit as a percentage of revenue include a higher instrument amortization expense and the gross profit impact of $3.8 million of increased biomaterials sales which have a lower selling price relative to their cost than our existing implant products. 27 -------------------------------------------------------------------------------- Research, Development and Engineering Research, development and engineering expenses increased $2.6 million, or 27.1%, from $9.3 million for the nine months ended September 30, 2013 to $11.9 million for the nine months ended September 30, 2014. The increase was primarily due to higher payroll expenses, including stock based compensation, and increased development activities of products in our pipeline. Sales and Marketing Sales and marketing expenses increased $12.4 million, or 21.0%, from $58.8 million for the nine months ended September 30, 2013 to $71.2 million for the nine months ended September 30, 2014. The increase was primarily due to increased sales commissions as a result of the increased sales volume and increased employee compensation costs resulting from our continued hiring of direct sales employees since September 30, 2013. The increase is also due in part to increased spending on travel and higher shipping costs. General and Administrative General and administrative expenses increased $3.0 million, or 6.8%, from $44.2 million for the nine months ended September 30, 2013 to $47.2 million for the nine months ended September 30, 2014. The increase was primarily due to increased employee compensation and benefit costs associated with the increase in personnel to support the expansion of our business, amortization of the compensation cost of RSUs issued in 2013 and increased third-party legal and other consulting expenses. General and administrative expenses includes amortization of intangible assets of $22.6 million and $20.1 million in the nine months ended September 30, 2013 and the nine months ended September 30, 2014, respectively. Other Income (Expense) Other Income (Expense), increased $7.9 million from $(1.2) million for the nine months ended September 30, 2013 to $(9.1) million for the nine months ended September 30, 2014. The increase in other income (expense) was attributable to the acceleration of discount expense on notes to stockholders of $4.8 million as a result of their prepayment and higher interest expense of $0.2 million attributable to higher average debt balances during the period and a $2.9 million increase in loss from foreign currency transactions. Income Tax (Benefit) Expense Benefit from income taxes decreased $7.5 million, to an expense of $82,000 for the nine months ended September 30, 2014. Our effective tax rate calculated as a percentage of loss before income tax benefit was 22.4% for the nine months ended September 30, 2013 and (0.2)% for the nine months ended September 30, 2014. The change in the effective tax rate was due to the effect of an increase in the valuation allowance on our deferred tax assets as of September 30, 2014. Liquidity and Capital Resources Since our inception in 2004, we have incurred significant operating losses and anticipate that our losses will continue in the near term. We expect our operating expenses will continue to grow as we expand our product portfolio and penetrate further into existing markets and enter new markets. We will need to generate significant revenue to achieve profitability as we grow our business. Prior to our IPO in May 2014, we had funded our operations primarily with proceeds from the sales of preferred and common stock, notes to stockholders, a revolving credit facility and cash flow from operations. On May 13, 2014, we completed our IPO of 8,825,000 shares of our common stock for $15 per share for gross proceeds of $132.4 million, or approximately $118.8 million of net proceeds after consideration of underwriting commissions and offering expenses. With the proceeds, we retired all amounts outstanding under our revolving credit facility and notes to stockholders and satisfied our commitment to pay cumulative dividends outstanding on our preferred stock upon its conversion to common stock in connection with the IPO. As of September 30, 2014, we had cash and cash equivalents of $23.2 million as compared to $7.4 million of cash and cash equivalents as of December 31, 2013. As of September 30, 2014, we had no outstanding indebtedness and we had working capital of $82.0 million, compared to $32.5 million as of December 31, 2013. Our principal long-term liquidity need is working capital to support the continued growth of our business through the hiring of direct sales employees and independent sales agencies to expand our global sales force, purchases of additional inventory to support future sales activities and development and commercialization of new products through our research and development efforts. We are currently in negotiations to relocate our corporate headquarters and enter into a new lease to occupy such location when our existing lease expires in 2016. The new lease is expected to result in an increase in annual rent expense of 28 -------------------------------------------------------------------------------- approximately $2.0 million to $2.5 million. We expect to fund our long-term capital needs with the IPO proceeds, availability under our revolving credit facility (which may vary due to changes in our borrowing base) and cash flow from operations. To the extent additional funds are necessary to meet our long-term liquidity needs as we continue to execute our business strategy, we anticipate that they will be obtained through the incurrence of additional indebtedness, additional equity financings or a combination of these potential sources of funds. Although we believe that these sources will provide sufficient liquidity for us to meet our long-term capital needs, our liquidity and our ability to fund these needs will depend to a significant extent on our future financial performance, which will be subject in part to general economic, competitive, financial, regulatory and other factors that are beyond our control. In addition to these general economic and industry factors, the principal factors determining whether our cash flows will be sufficient to meet our long-term liquidity requirements will be our ability to provide attractive products to our customers, changes in our customers' ability to obtain third-party coverage and reimbursement for procedures that use our products, increased pricing pressures resulting from intensifying competition, cost increases and slower product development cycles resulting from a changing regulatory environment. If those factors change significantly or other unexpected factors adversely affect us, our business may not generate sufficient cash flow from operations and future financings may not be available on terms acceptable to us or at all to meet our liquidity needs. In assessing our liquidity, management reviews and analyzes our current cash-on-hand, the average number of days our accounts receivable are outstanding, payment terms that we have established with our vendors, inventory turns, foreign exchange rates, capital expenditure commitments and income tax rates. Cash Flows The following table shows our cash flows from operating, investing and financing activities for the nine months ended September 30, 2013 and 2014: Nine Months Ended September 30, 2013 2014 (In thousands)Net cash used in operating activities $ (11,986 ) $ (28,524 ) Net cash used in investing activities (8,808 ) (10,638 ) Net cash provided by financing activities 23,700 54,994 Effect of exchange rate on cash 11 (66 ) Net change in cash and cash equivalents $ 2,917 $ 15,766 Cash Used in Operating Activities Net cash used in operating activities increased $16.5 million from $12.0 million for the nine months ended September 30, 2013 to $28.5 million for the nine months ended September 30, 2014. The increase in net cash used in operations was due primarily due to increases in inventory purchases to support future sales activities and a decrease of accounts payable and accrued expenses from the nine months ended September 30, 2013 to the nine months ended September 30, 2014. Cash Used in Investing Activities Net cash used in investing activities increased $1.8 million from $8.8 million for the nine months ended September 30, 2013 to $10.6 million for the nine months ended September 30, 2014. The increase in net cash used in investing activities was primarily attributable to increased purchases of surgical instruments for use within our global distribution network and greater software development activities to support our internal systems. Cash Provided by Financing Activities Net cash provided by financing activities increased $31.3 million from $23.7 million for the nine months ended September 30, 2013 to $55.0 million for the nine months ended September 30, 2014. For the nine months ended September 30, 2014 cash provided by financing activities included approximately $121.9 million received from issuances of common stock, net of expenses, and $14.6 million of proceeds from notes to stockholders. In 2013, we received $13.0 million from issuances of our preferred and common stock in private placements and $9.9 million of proceeds from the issuance of notes to stockholders. Cash used in financing activities during the nine months ended September 30, 2014, included prepayments of notes to stockholders of $39.2 million, payments on the bank line of credit of $23.5 million and dividends paid on preferred stock of 29 --------------------------------------------------------------------------------$18.5 million from use of the proceeds of our IPO. In 2013, such activities used in financing activities totaled approximately $1.5 million. Capital Expenditures Our capital expenditures increased $2.0 million from $8.6 million for the nine months ended September 30, 2013 to $10.6 million for the nine months ended September 30, 2014. Of the increase, $1.2 million was the result of an increase in purchases of instrumentation to support surgical sales and $0.8 million was due to an increase in property and equipment mainly as a result of greater software development activities undertaken to support our internal systems. For the remainder of 2014, we expect capital expenditures to increase from 2013 levels as we continue to expand our global distribution network and purchase of additional inventory to support that expansion. We intend to use a portion of the IPO proceeds and cash flows from our operations to fund our additional future capital expenditures through the end of 2014. Indebtedness Revolving Credit Facility On October 21, 2014, we amended our senior secured asset-backed revolving credit facility with Silicon Valley Bank and Comerica Bank (the lenders). The amended credit facility consists of a revolving credit facility of $40.0 million with a sub-facility for letters of credit in the aggregate availability amount of $10.0 million and a swingline sub-facility in the aggregate availability amount of $5.0 million. The amendment removed the sub-facility provided by the Export-Import Bank of the United States, which had been party to prior agreements. The credit facility is secured by a first priority lien on all of our personal property assets, including intellectual property, and matures in October 2015. ABR loans under the revolving credit facility bear interest at a rate per annum equal to ABR, plus 0.75%. LIBOR loans under the revolving credit facility bear interest at a rate per annum equal to the greater of (i) LIBOR, plus 2.50% or (ii) 3.75%. The total obligations under the amended credit facility cannot exceed (i) the lesser of the total revolving commitment of $40 million or (ii) the borrowing base, which is calculated as (x) 85% of accounts receivable so long as certain of those accounts receivable do not exceed, in the aggregate, 50% of the borrowing base plus (y) 35% of the value of the eligible inventory provided that the contribution of the value of the eligible inventory not exceed the less of 40% of the borrowing base or $10 million. Borrowings under the revolving credit facility remain secured by a first priority lien on all of the Borrower's personal property assets, including intellectual property. The revolving credit facility contains various financial covenants and negative covenants with which the Company must maintain compliance, including a consolidated adjusted quick ratio for K2M, Inc., K2M UK Limited and select subsidiaries not less than 1.20:1.00 as of the last day of any month, as well as the provision of certain financial reporting and company information as required, Notes to Stockholders In January and March 2014, we executed securities purchase agreements and note agreements with certain existing stockholders. Pursuant to such securities purchase agreements, such existing stockholders agreed to purchase 121,111 shares of our common stock from us at $19.05 per share, resulting in cash proceeds of $2.3 million. Pursuant to the note agreements, we issued notes to such stockholders in an aggregate principal amount of $16.9 million at a discount for cash consideration of $14.6 million. Following these note issuances, the outstanding aggregate principal amount of notes to stockholders was $39.2 million. On May 13, 2014, we prepaid the principal balance of notes to stockholders, along with accrued interest with proceeds from our IPO. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in conformity with U.S. GAAP, which requires the use of estimates, judgments and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. The Company's critical accounting estimates are described in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical 30-------------------------------------------------------------------------------- Accounting Policies and Estimates" in our Prospectus dated May 7, 2014. An accounting estimate is considered critical if the estimate requires management to make an assumption about matters that were highly uncertain at the time the estimate was made, different estimates reasonably could have been used, or if changes in the estimate that would have a material impact on the Company's financial condition or results of operations are reasonably likely to occur from period to period. Management believes that the accounting estimates employed are appropriate and resulting balances are reasonable; however, actual results could differ from the original estimates, requiring adjustments to these balances in future periods. The Company has reviewed these policies and determined that those policies remain the Company's critical accounting policies as of and for the three and nine months ended September 30, 2014. Recently Issued Accounting Pronouncements The Company qualifies as an "emerging growth company" (EGC) pursuant to the provisions of the JOBS Act and has elected to take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act which permits EGCs to defer compliance with new or revised accounting standards (the EGC extension) until non-issuers are required to comply with such standards. Accordingly, so long as the Company continues to qualify as an EGC, it will not have to adopt or comply with new accounting standards until non-issuers are required to comply with such standards. Deformity Business Seasonality and Other Quarterly Fluctuations in Revenue Although our revenue in the third quarter of 2014 was higher than the revenue in the second quarter of 2014, our revenue is typically higher in the second and fourth quarters of our fiscal year, driven by higher sales of our complex spine products, which is influenced by the higher incidence of adolescent surgeries during these periods to coincide with the beginning of summer vacation and holiday periods. In addition, our international revenue fluctuates quarterly based on the timing of product registrations, expansion to new markets and product orders from our exclusive international distribution partners. |