Orthofix International N.V.
ORTHOFIX INTERNATIONAL N V (Form: 10-Q, Received: 11/07/2007 17:07:25)


 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q
 
(Mark one)

T
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2007
 
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from____________ to ____________.

Commission File Number:  0-19961

ORTHOFIX INTERNATIONAL N.V.
 
(Exact name of registrant as specified in its charter)

Netherlands Antilles
 
N/A
(State or other jurisdiction ofincorporation or organization)
 
(I.R.S. Employer Identification No.)
     
7 Abraham de Veerstraat
Curaçao
Netherlands Antilles
 
N/A
(Address of principal executive offices)
 
(Zip Code)
 
 
 599-9-4658525
 
 
 (Registrant’s telephone number, including area code)
 
     
 
Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x   No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):  
Large Accelerated filer  o         Accelerated filer  x          Non-Accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). 
Yes o   No T

As of November 5, 2007, 16,935,239 shares of common stock were issued and outstanding.



Table of Contents

3
Item 1.
3
Item 2.
20
Item 3.
31
Item 4.
32
33
Item 1.
33
Item 1A.    
34
Item 6.
35
38
 
Forward-Looking Statements
 
This Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, which relate to our business and financial outlook and which are based on our current beliefs, assumptions, expectations, estimates, forecasts and projections.  In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “intends,” “predicts,” “potential” or “continue” or other comparable terminology.  These forward-looking statements are not guarantees of our future performance and involve risks, uncertainties, estimates and assumptions that are difficult to predict.  Therefore, our actual outcomes and results may differ materially from those expressed in these forward-looking statements.  You should not place undue reliance on any of these forward-looking statements.  Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any such statement to reflect new information, the occurrence of future events or circumstances or otherwise.
 
Factors that could cause actual results to differ materially from those indicated by the forward-looking statements or that could contribute to such differences include, but are not limited to, unanticipated expenditures, changing relationships with customers, suppliers and strategic partners, unfavorable results in litigation matters, risks relating to the protection of intellectual property, changes to the reimbursement policies of third parties, changes to governmental regulation of medical devices, the impact of competitive products, changes to the competitive environment, the acceptance of new products in the market, conditions of the orthopedic industry and the economy, currency or interest rate fluctuations and the other risks described under Item 1A – “Business – Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 and Part II, Item 1A – “Risk Factors” in this Form 10-Q.


PAR T I                 FINANCIAL INFORMATION
 
Ite m 1.   Condensed Financial Statements
 
CONDENSED CONSOLIDATED BALANCE SHEETS

(U.S. Dollars, in thousands except share data)
 
September 30,
   
December 31,
 
   
2007
   
2006
 
Assets
 
(Unaudited)
   
(Note 2)
 
Current assets:
           
Cash and cash equivalents
  $
23,562
    $
25,881
 
Restricted cash
   
11,570
     
7,300
 
Trade accounts receivable, net
   
118,793
     
104,662
 
Inventories, net
   
89,810
     
70,395
 
Deferred income taxes
   
9,020
     
6,971
 
Prepaid expenses and other current assets
   
25,109
     
18,759
 
Total current assets
   
277,864
     
233,968
 
Securities and other investments
   
4,082
     
4,082
 
Property, plant and equipment, net
   
31,532
     
25,311
 
Patents and other intangible assets, net
   
255,609
     
261,159
 
Goodwill
   
319,243
     
313,070
 
Deferred taxes and other long-term assets
   
31,120
     
24,695
 
Total assets
  $
919,450
    $
862,285
 
Liabilities and shareholders’ equity
               
Current liabilities:
               
Bank borrowings
  $
8,381
    $
78
 
Current portion of long-term debt
   
3,300
     
3,334
 
Trade accounts payable
   
22,341
     
23,544
 
Other current liabilities
   
49,258
     
34,084
 
Total current liabilities
   
83,280
     
61,040
 
Long-term debt
   
305,584
     
312,055
 
Deferred income taxes
   
93,558
     
95,019
 
Other long-term liabilities
   
6,017
     
1,536
 
Total liabilities
   
488,439
     
469,650
 
                 
Contingencies (Note 17)
               
Shareholders’ equity:
               
Common shares (16,676,753 and 16,445,859 shares issued at September 30, 2007 and December 31, 2006, respectively)
   
1,668
     
1,645
 
Additional paid-in capital
   
144,243
     
128,297
 
Retained earnings
   
268,716
     
248,433
 
Accumulated other comprehensive income
   
16,384
     
14,260
 
Total shareholders’ equity
   
431,011
     
392,635
 
Total liabilities and shareholders’ equity
  $
919,450
    $
862,285
 

The accompanying notes form an integral part of these condensed consolidated financial statements.


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

(Unaudited, U.S. Dollars, in thousands except share and per share data)
 
Three Months Ended
   
Nine Months Ended
 
   
2007
   
2006
   
2007
   
2006
 
                         
Net sales
  $
121,120
    $
83,368
    $
361,488
    $
249,219
 
Cost of sales
   
30,742
     
21,007
     
94,546
     
63,665
 
Gross profit
   
90,378
     
62,361
     
266,942
     
185,554
 
Operating expenses (income)
                               
Sales and marketing
   
47,055
     
36,277
     
138,949
     
98,985
 
General and administrative
   
16,908
     
11,747
     
49,619
     
36,337
 
Research and development
   
5,953
     
42,865
     
18,313
     
48,550
 
Amortization of intangible assets
   
4,671
     
1,929
     
13,710
     
5,408
 
KCI settlement, net of litigation costs
   
-
     
-
     
-
      (1,093 )
     
74,587
     
92,818
     
220,591
     
188,187
 
Operating income (loss)
   
15,791
      (30,457 )    
46,351
      (2,633 )
                                 
Interest (expense) income, net
    (5,666 )     (482 )     (17,200 )    
164
 
Other income (expense), net
   
529
      (508 )    
287
      (753 )
Income (loss) before minority interests and income taxes
   
10,654
      (31,447 )    
29,438
      (3,222 )
Minority interests
    (10 )    
-
      (53 )    
-
 
Income (loss) before income taxes
   
10,644
      (31,447 )    
29,385
      (3,222 )
Income tax expense
    (2,616 )     (3,970 )     (7,902 )     (11,221 )
                                 
Net income (loss)
  $
8,028
    $ (35,417 )   $
21,483
    $ (14,443 )
                                 
Net income (loss) per common share - basic
  $
0.48
    $ (2.19 )   $
1.30
    $ (0.90 )
                                 
Net income (loss) per common share - diluted
  $
0.48
    $ (2.19 )   $
1.27
    $ (0.90 )
                                 
Weighted average number of common shares -  basic
   
16,639,019
     
16,193,086
     
16,546,385
     
16,084,388
 
                                 
Weighted average number of common shares - diluted
   
16,889,303
     
16,193,086
     
16,925,084
     
16,084,388
 

The accompanying notes form an integral part of these condensed consolidated financial statements.
 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

(Unaudited, U.S. Dollars, in thousands)
 
2007
   
2006
 
             
Cash flows from operating activities:
           
Net income (loss)
  $
21,483
    $ (14,443 )
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
               
Depreciation and amortization
   
21,334
     
10,937
 
Amortization of debt costs
   
523
     
316
 
In process research & development
   
-
     
40,000
 
Provision for doubtful accounts
   
3,532
     
4,330
 
Deferred taxes
    (3,919 )     (8,808 )
Stock-based compensation
   
8,006
     
5,416
 
Amortization of step up of fair value in inventory acquired from Blackstone
   
2,718
     
-
 
Other
    (1,328 )    
1,261
 
Change in operating assets and liabilities:
               
Restricted cash
    (4,270 )     (5,762 )
Accounts receivable
    (14,829 )     (7,397 )
Inventories
    (19,086 )     (7,621 )
Prepaid expenses and other current assets
    (5,976 )     (4,994 )
Accounts payable
    (2,707 )    
7,551
 
Current liabilities
   
8,277
      (29,745 )
Net cash provided by (used in) operating activities
   
13,758
      (8,959 )
                 
Cash flows from investing activities:
               
Investments in affiliates and subsidiaries
    (2,117 )     (336,808 )
Capital expenditures
    (23,752 )     (6,769 )
Net cash used in investing activities
    (25,869 )     (343,577 )
                 
Cash flows from financing activities:
               
Net proceeds from issuance of common stock
   
6,799
     
10,742
 
Tax benefit on non-qualified stock options
   
1,164
     
2,048
 
Repayment of long-term debt
    (6,524 )    
(15,044
Payment of debt issuance cost
   
-
      (5,708 )
Proceeds from long-term debt
    19       330,000  
Proceeds from bank borrowings
   
7,870
     
3,047
 
Net cash provided by financing activities
   
9,328
     
325,085
 
Effect of exchange rate changes on cash
   
464
     
779
 
Net decrease in cash and cash equivalents
    (2,319 )     (26,672 )
Cash and cash equivalents at the beginning of the year
   
25,881
     
63,786
 
Cash and cash equivalents at the end of the period
  $
23,562
    $
37,114
 

The accompanying notes form an integral part of these condensed consolidated financial statements.


NOTES TO THE CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1:
BUSINESS
 
Orthofix International N.V. (the “Company”) is a multinational corporation principally involved in the design, development, manufacture, marketing and distribution of medical equipment, principally for the orthopedic products market.
 
NOTE 2:
BASIS OF PRESENTATION
 
The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Pursuant to these rules and regulations, certain information and note disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States, have been condensed or omitted.  In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for a fair presentation have been included.  Operating results for the three and nine months ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007.  The balance sheet at December 31, 2006 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.  For further information, refer to the Consolidated Financial Statements and Notes thereto of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006.
 

NOTE 3:
RECENTLY ISSUED ACCOUNTING STANDARDS
 
On January 1, 2007, the Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which clarifies the accounting for uncertainty in income taxes. As a result of the implementation of FIN 48, the Company recognized $1.2 million in additional liability for unrecognized tax benefits (including interest and penalties), which was accounted for as a reduction to the January 1, 2007 balance of retained earnings.  As of September 30, 2007, the Company’s unrecognized tax benefits totaled $1.5 million including interest of $0.2 million.  All of the unrecognized tax benefits recorded would affect the Company’s effective tax rate if recognized.
 
The Company files a consolidated income tax return in the U.S. federal jurisdiction and numerous consolidated and separate income tax returns in many state and foreign jurisdictions.  The following table summarizes these open tax years by major jurisdiction:

   
Open Tax Year
   
Examination in
 
Examination not yet
Jurisdiction
 
Progress
 
Initiated
United States
 
N/A
 
2005-2006
Various States
 
1996-2005
 
1996-2005
Brazil
 
2004-2005
 
2005-2006
Cyprus
 
N/A
 
2005-2006
France
 
N/A
 
2002-2006
Germany
 
2003-2005
 
2006
Italy
 
N/A
 
2002-2006
Mexico
 
N/A
 
2000-2006
Netherlands
 
N/A
 
2004-2006
Puerto Rico
 
N/A
 
N/A
Seychelles
 
N/A
 
N/A
Switzerland
 
N/A
 
2004-2006
United Kingdom
 
N/A
 
2003-2006
 
The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits within its global operations in income tax expense. To the extent interest and penalties are not assessed with respect to uncertain tax positions, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision.
 

NOTE 4:
STOCK-BASED COMPENSATION
 
The Company accounts for its stock-based compensation plans in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment”, using the modified prospective transition method.  Under SFAS No. 123(R), all stock-based compensation costs are measured at the grant date, based on the estimated fair value of the award, and are recognized as expense in the income statement over the requisite service period.  Commencing in June 2007, the Company offered restricted shares in addition to stock options as a form of stock-based compensation.
 
The following table shows the detail of stock-based compensation by line item in the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2007 and 2006:
 
(In US$ thousands)
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2007
   
2006
   
2007
   
2006
 
                         
Cost of sales
  $
113
    $
83
    $
293
    $
151
 
                                 
Sales and marketing
   
800
     
472
     
1,993
     
882
 
                                 
General and administrative (1)
   
1,846
     
822
     
4,978
     
3,916
 
                                 
Research and development
   
126
     
136
     
742
     
467
 
                                 
Total
  $
2,885
    $
1,513
    $
8,006
    $
5,416
 
 

(1)
The nine months ended September 30, 2006 amount includes $656 of stock-based compensation from the accelerated vesting of options associated with the transition of senior management in the first quarter of 2006.

NOTE 5:
RECLASSIFICATIONS
 
Certain prior year amounts have been reclassified to conform to the 2007 presentation.  The reclassifications have no effect on previously reported net income (loss) or shareholders’ equity.

 
NOTE 6:
INVENTORY
 
Inventories are valued at the lower of cost or estimated net realizable value, after provision for excess or obsolete items.  Cost is determined on a weighted-average basis, which approximates the FIFO method.  The valuation of work-in-process, finished goods, field inventory and consignment inventory includes the cost of materials, labor and production.  Field inventory represents immediately saleable finished goods inventory that is in the possession of the Company’s direct sales representatives.
 
Inventories were as follows:
 
   
September 30,
   
December 31,
 
( In US$ thousands)
 
2007
   
2006
 
             
Raw materials
  $
10,275
    $
8,384
 
Work-in-process
   
8,698
     
6,665
 
Finished goods
   
39,719
     
34,901
 
Field inventory (as described above)
   
9,749
     
7,485
 
Consignment inventory
   
28,054
     
20,173
 
     
96,495
     
77,608
 
Less reserve for obsolescence
    (6,685 )     (7,213 )
    $
89,810
    $
70,395
 
 
NOTE 7:
BLACKSTONE ACQUISITION
 
The following acquisition was recorded using the purchase method of accounting:
 
Blackstone Acquisition
 
On September 22, 2006, the Company purchased 100% of the stock of Blackstone Medical, Inc. (“Blackstone”) for a purchase price of $333.0 million plus acquisition costs. The acquisition and related costs were financed with approximately $330.0 million of senior secured bank debt, as described in Note 10, and cash on hand.  Blackstone, a company based in Springfield, Massachusetts, which was privately held when acquired by the Company, specializes in the design, development and marketing of spinal implant and related biologic products.  Blackstone's product lines include spinal fixating devices including hooks, rods, screws, plates, various spacers and cages and related biologics products.
 
The Company considered this acquisition as a way to fortify and further advance its business strategy to expand its spinal sector. The acquisition broadened the Company's product lines, reduced reliance on the success of any single product and enlarged channel opportunities for products from Blackstone’s and the Company’s existing operations.

Factors that contributed to the valuation of Blackstone included the recognition that Blackstone had established itself to the Company’s belief as one of the largest private spine companies with a broad portfolio of spinal product offerings. Further, Blackstone has a strong brand name and product identity in the spinal industry. Blackstone has a history of sales and earnings growth that compares favorably to the fast growing spinal market that its product lines serve. The Company valued Blackstone after reviewing a range of valuation methodologies for the transaction, including comparable publicly-traded companies, comparable precedent transactions, discounted cash flow analysis and comparison to the Company’s trading multiples.

The acquisition has been accounted for using the purchase method in accordance with SFAS No. 141, “Business Combinations.” The purchase price has been allocated to the assets acquired and liabilities assumed based on their estimated fair market value at the date of acquisition.

 
The final allocation of the purchase price reflects the following:
 
Current assets, other than cash
  $
40,101
 
Fixed assets acquired
   
2,872
 
Intangible assets not subject to amortization – registered     trademarks
   
77,000
 
Intangible assets subject to amortization (12-16 year weighted average useful life):
       
Distribution networks (12 – 16 year weighted average useful life)
   
55,000
 
Patents (13 year weighted average useful life)
   
70,000
 
     
244,973
 
Goodwill (indefinite lived intangible asset)
   
136,603
 
In-process research and development
   
40,000
 
Deferred tax asset
   
14,985
 
Total assets acquired
   
436,561
 
         
Current liabilities
    (13,037 )
Deferred tax liability
    (78,442 )
Total liabilities assumed
    (91,479 )
Net assets acquired
  $
345,082
 

The results of Blackstone’s operations have been included in the Company’s consolidated results of operations from the date of acquisition.

The purchase price has been allocated to assets acquired, purchased in-process research and development and liabilities assumed based on their estimated fair market value at the acquisition date.  The amount of the purchase price allocated to purchased in-process research and development was written off at the date of acquisition and resulted in a charge of $40.0 million.  This charge was included in the research and development expense line item on the Consolidated Statements of Operations for the year ended December 31, 2006 and was not deductible for income tax purposes in the United States.  Purchased in-process research and development was principally comprised of the value of the Dynamic Stabilization and Cervical Disk which together accounted for 93% of the fair value. The fair value of the in-process research and development was estimated using the discounted earnings method.  The Company expects material net cash inflows from the Dynamic Stabilization to commence in 2008 and material net cash inflows from the Cervical Disk to commence in 2012.  The nature of the costs expected to complete the Dynamic Stabilization and Cervical Disk include research and development expense and research and development maintenance expense to make modifications and enhancements to the products.  The Company expects to incur costs of approximately $0.7 million for the Dynamic Stabilization in 2007 and approximately $10.0 million for the Cervical Disk during the period 2007 through 2010.  As of September 30, 2007, the Company does not believe there have been any material changes in the assumptions made at the time of acquisition relating to in-process research and development. Of the total Blackstone purchase price, $50.0 million was placed into an escrow account.  As described in the Agreement and Plan of Merger, the Company can make claims for reimbursement from the escrow account for certain defined items relating to the acquisition for which Orthofix is indemnified.  As described in Note 17, the Company has certain contingencies arising from the acquisition that management expects will be reimburseable from the escrow account should the Company have to make a payment to a third party.  Management believes that the amount that it will be required to pay relating to the contingencies will not exceed the amount of the escrow account, however there can be no assurance that the contingencies will not exceed the amount of the escrow account.

There are no residual values for any of the intangible assets subject to amortization acquired during the Blackstone acquisition. Definite lived intangible assets acquired in the Blackstone acquisition consist of:

 
(In US$ thousands)
 
Fair value at
Acquisition
 
Remaining
Useful Life
         
Distribution networks
  $
55,000
 
12 to 16 Years
Patents
   
70,000
 
13 Years
Total definite lived intangible assets
  $
125,000
   

The Company determined that trademarks acquired during the Blackstone acquisition, valued at $77.0 million, are indefinite lived intangible assets. The Company considered the criteria prescribed by paragraphs 11 (a), (c), (e) and (f) of SFAS No. 142, “Goodwill and Other Intangible Assets”, in making this determination. The Company is not aware of any legal, regulatory, or contractual provisions that limit the useful lives of these registered trademarks and does not believe the effects of obsolescence, demand, competition, or other economic factors will cause the useful lives of these registered trademarks to be limited. The Company concluded that no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of the registered trademarks to the Company, and therefore the useful lives of the registered trademarks are considered to be indefinite.
 
NOTE 8:       
GOODWILL
 
The change in the net carrying value of goodwill for the period ended September 30, 2007 is as follows:
 
(In US$ thousands)
 
Domestic
   
Blackstone
   
 Breg
   
International
   
Total
 
At December 31, 2006
  $
31,793
    $
132,784
    $
101,322
    $
47,171
    $
313,070
 
Purchase price adjustment (1)
   
-
     
3,819
     
-
     
-
     
3,819
 
Purchase of minority interest
   
-
     
-
     
-
     
128
     
128
 
Foreign currency
   
-
     
-
     
-
     
2,226
     
2,226
 
At September 30, 2007
  $
31,793
    $
136,603
    $
101,322
    $
49,525
    $
319,243
 
 

(1)  Principally relates to legal fees incurred in connection with the acquisition of Blackstone and related contingencies.
 
NOTE 9:
BANK BORROWINGS
 
(In US$ thousands)
 
September 30,
2007
   
December 31,
2006
 
Borrowings under line of credit
  $
8,381
    $
78
 
 
The weighted average interest rate on borrowings under lines of credit as of September 30, 2007 and December 31, 2006 was 4.80% and 3.00%, respectively.
 
Borrowings under lines of credit consist of borrowings in Euros.  The amount available to borrow under the line of credit was 6.2 million Euros at September 30, 2007 and December 31, 2006.   As of September 30, 2007, the Company had utilized 5.9 million Euro of its Italian line of credit.  The Italian line of credit gives the Company the option to borrow amounts in Italy at rates which are determined at the time of borrowing.  This line of credit is unsecured.

 
NOTE 10:
LONG-TERM DEBT
 
(In US$ thousands)
 
September 30,
2007
   
December 31,
2006
 
             
Long-term obligations
  $
308,700
    $
315,175
 
Other loans
   
184
     
214
 
     
308,884
     
315,389
 
 Less current portion
    (3,300 )     (3,334 )
    $
305,584
    $
312,055
 
 
On September 22, 2006 the Company’s wholly-owned U.S. holding company subsidiary, Orthofix Holdings, Inc. (“Orthofix Holdings”), entered into a senior secured credit facility with a syndicate of financial institutions to finance the acquisition of Blackstone.  The senior secured credit facility provides for (1) a seven-year amortizing term loan facility of $330.0 million, the proceeds of which, together with cash balances were used for payment of the purchase price of Blackstone; and (2) a six-year revolving credit facility of $45.0 million.  As of September 30, 2007, the Company had no amounts outstanding under the revolving credit facility and $308.7 million outstanding under the term loan facility.  Obligations under the senior secured credit facility have a floating interest rate of London Inter-Bank Offered Rate (“LIBOR”) plus a margin or prime rate plus a margin.  Currently, the term loan is a LIBOR loan, and the margin is 1.75%, which margin is adjusted quarterly based upon the leverage ratio of the Company and its subsidiaries.  The effective interest rate as of September 30, 2007 on the senior secured debt is 6.95%, compared to 7.12% as of December 31, 2006.
 
Each of the domestic subsidiaries of the Company (which includes Orthofix Inc., Breg Inc., and Blackstone) and Colgate Medical Limited and Victory Medical Limited (wholly-owned financing subsidiaries of the Company) have guaranteed the obligations of Orthofix Holdings under the senior secured credit facility.  The obligations of the subsidiaries under their guarantees are secured by the pledges of their respective assets.
 
In conjunction with obtaining the senior secured credit facility and the amendment thereto, the Company incurred debt issuance costs of $6.2 million.  As of September 30, 2007, $5.2 million of capitalized debt issuance costs is included in other long-term assets compared to $5.8 million at December 31, 2006.
 
Certain subsidiaries of the Company have restrictions on their ability to pay dividends or make intercompany loan advances pursuant to the Company’s senior secured credit facility.  The net assets of Orthofix Holdings and its subsidiaries are restricted for distributions to the parent company.  All other subsidiaries of the Company have access to these net assets for operational purposes.  The amount of restricted net assets of Orthofix Holdings and its subsidiaries as of September 30, 2007 is $288.3 million compared to $247.2 million at December 31, 2006.
 
NOTE 11:
COMMON SHARES
 
For the nine months ended September 30, 2007, the Company issued 230,894 shares of common stock upon the exercise of outstanding stock options and shares issued pursuant to our employee stock purchase plan for net proceeds of $6.8 million.
 

NOTE 12:
COMPREHENSIVE INCOME (LOSS)
 
Accumulated other comprehensive income is comprised of foreign currency translation adjustments and the effective portion of the gain (loss) for derivatives designated and accounted for as a cash flow hedge.  The components of and changes in other comprehensive income (loss) are as follows:
 
(In US$ thousands)
 
Foreign Currency Translation Adjustments
   
Fair Value of
Derivatives
   
Accumulated Other Comprehensive Income
 
Balance at December 31, 2006
  $
14,315
    $ (55 )   $
14,260
 
Unrealized loss on derivative instrument, net of tax of $161
   
-
      (575 )     (575 )
Foreign currency translation adjustment
   
2,699
     
-
     
2,699
 
Balance at September 30, 2007
  $
17,014
    $ (630 )   $
16,384
 

 
(In US$ thousands)
 
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2007
   
2006
   
2007
   
2006
 
Net income (loss)
  $
8,028
    $ (35,417 )   $
21,483
    $ (14,443 )
                                 
Other comprehensive income (loss):
                               
Unrealized loss on derivative instrument, net of tax
    (367 )    
-
      (575 )    
-
 
Foreign currency translation adjustment
   
1,227
     
397
     
2,699
     
6,838
 
Total comprehensive income (loss)
  $
8,888
    $ (35,020 )   $
23,607
    $ (7,605 )
 
NOTE 13:
BUSINESS SEGMENT INFORMATION
 
The Company’s segment information is prepared on the same basis that the Company’s management reviews the financial information for operational decision making purposes. Concurrent with the acquisition of Blackstone, the Company redefined its business segments and market sectors.  All prior period information presented has been restated to conform to the new segments and market sectors.  The Company is comprised of the following segments:
 
Orthofix Domestic
Orthofix Domestic (“Domestic”) consists of operations in the United States of Orthofix Inc., which manufactures and distributes stimulation and orthopedic products.  Domestic uses both direct and distributor sales representatives to sell Spine and Orthopedic products to hospitals, doctors and other healthcare providers in the United States market.

Blackstone
Blackstone (“Blackstone”) consists of Blackstone Medical, Inc., based in Springfield, Massachusetts, and its two subsidiaries, Blackstone GmbH and Goldstone GmbH. Blackstone specializes in the design, development and marketing of spinal implant and related biologic products. Blackstone's operating loss includes amortization of acquired intangible assets and inventory which has been stepped-up in value for the Blackstone acquisition. Blackstone distributes its products through a network of domestic and international distributors, sales representatives and affiliates.

 
Breg
Breg (“Breg”) consists of Breg, Inc. Breg, based in Vista, California, designs, manufactures, and distributes orthopedic products for post-operative reconstruction and rehabilitative patient use and sells its Sports Medicine products through a network of domestic and international distributors, sales representatives and affiliates.

Orthofix International
Orthofix International (“International”) consists of international operations located in Europe, Mexico, Brazil and Puerto Rico, as well as independent distributors located outside the United States.  International uses both direct and distributor sales representatives to sell Spine, Orthopedics, Sports Medicine, Vascular and Other products to hospitals, doctors, and other healthcare providers.

Group Activities
Group Activities are comprised of Orthofix International N.V., the ultimate parent corporation and Orthofix Holdings, the U.S. holding company.
 
The following tables present external and intersegment sales by segment for the three and nine month periods ended September 30:
 
For the three month period ended September 30:
 
   
External Sales
   
Intersegment Sales
 
(In US$ thousands)
 
2007
   
2006
   
2007
   
2006
 
Domestic
  $
41,971
    $
37,952
    $
858
    $
818
 
Blackstone
   
29,448
     
-
     
1,012
     
-
 
Breg
   
21,206
     
18,667
     
1,337
     
406
 
International
   
28,495
     
26,749
     
5,958
     
10,072
 
Total
  $
121,120
    $
83,368
    $
9,165
    $
11,296
 

For the nine month period ended September 30:
 
   
External Sales
   
Intersegment Sales
 
(In US$ thousands)
 
2007
   
2006
   
2007
   
2006
 
Domestic
  $
122,718
    $
113,185
    $
3,137
    $
2,476
 
Blackstone
   
85,859
     
-
     
2,449
     
-
 
Breg
   
61,522
     
55,901
     
2,561
     
1,027
 
International
   
91,389
     
80,133
     
22,108
     
44,218
 
Total
  $
361,488
    $
249,219
    $
30,255
    $
47,721
 
 
 
The following table presents operating income (loss) by segment for the three and nine month periods ended September 30:
 
Operating Income (Loss)
 
Three Months Ended 
September 30,
   
Nine Months Ended 
September 30,
 
(In US$ thousands)
 
2007
   
2006
   
2007
   
2006
 
Domestic
  $
14,050
    $
7,391
    $
42,124
    $
26,430
 
Blackstone
    (816 )     (40,271 )     (2,164 )     (40,271 )
Breg
   
2,686
     
1,392
     
6,013
     
4,926
 
International
   
4,230
     
4,594
     
14,824
     
16,509
 
Group Activities
    (3,735 )     (3,258 )     (11,644 )     (8,546 )
Eliminations
    (624 )     (305 )     (2,802 )     (1,681 )
Total
  $
15,791
    $ (30,457 )   $
46,351
    $ (2,633 )

 The following tables present sales by market sector for the three and nine month periods ended September 30, 2007 and 2006:
 
   
Sales by Market Sector
for the three month period ended September 30, 2007
 
 (In US$ thousands)
 
Orthofix
Domestic
   
Blackstone
   
Breg
   
Orthofix
International
   
Total
 
                               
Spine
  $
31,693
    $
29,448
    $
-
    $
168
    $
61,309
 
Orthopedics
   
10,278
     
-
     
-
     
16,026
     
26,304
 
Sports Medicine
   
-
     
-
     
21,206
     
869
     
22,075
 
Vascular
   
-
     
-
     
-
     
4,718
     
4,718
 
Other
   
-
     
-
     
-
     
6,714
     
6,714
 
                                         
Total
  $
41,971
    $
29,448
    $
21,206
    $
28,495
    $
121,120
 
 
 
   
Sales by Market Sector
for the three month period ended September 30, 2006
 
 (In US$ thousands)
 
Orthofix
Domestic
   
Blackstone
   
Breg
   
Orthofix
International
   
Total
 
                               
Spine
  $
29,216
    $
-
    $
-
    $
66
    $
29,282
 
Orthopedics
   
8,736
     
-
     
-
     
14,749
     
23,485
 
Sports Medicine
   
-
     
-
     
18,667
     
739
     
19,406
 
Vascular
   
-
     
-
     
-
     
5,084
     
5,084
 
Other
   
-
     
-
     
-
     
6,111
     
6,111
 
                                         
Total
  $
37,952
    $
-
    $
18,667
    $
26,749
    $
83,368
 
 
 
   
Sales by Market Sector
for the nine month period ended September 30, 2007
 
 (In US$ thousands)
 
Orthofix
Domestic
   
Blackstone
   
Breg
   
Orthofix
International
   
Total
 
                               
Spine
  $
92,650
    $
85,859
    $
-
    $
421
    $
178,930
 
Orthopedics
   
30,068
     
-
     
-
     
51,865
     
81,933
 
Sports Medicine
   
-
     
-
     
61,522
     
3,033
     
64,555
 
Vascular
   
-
     
-
     
-
     
15,217
     
15,217
 
Other
   
-
     
-
     
-
     
20,853
     
20,853
 
                                         
Total
  $
122,718
    $
85,859
    $
61,522
    $
91,389
    $
361,488
 
 
 
   
Sales by Market Sector
for the nine month period ended September 30, 2006
 
 (In US$ thousands)
 
Orthofix
Domestic
   
Blackstone
   
Breg
   
Orthofix
International
   
Total
 
                               
Spine
  $
86,595
    $
-
    $
-
    $
186
    $
86,781
 
Orthopedics
   
26,590
     
-
     
-
     
44,552
     
71,142
 
Sports Medicine
   
-
     
-
     
55,901
     
2,018
     
57,919
 
Vascular
   
-
     
-
     
-
     
15,417
     
15,417
 
Other
   
-
     
-
     
-
     
17,960
     
17,960
 
                                         
Total
  $
113,185
    $
-
    $
55,901
    $
80,133
    $
249,219
 
 
NOTE 14:
INCOME TAXES
 
The difference between the reported provision for income taxes and a provision computed by applying the statutory rates applicable to each subsidiary of the Company is primarily attributable to a discrete tax benefit resulting from tax credits associated with research and development expense.  Further, the effective tax rate has been positively affected by the Company’s European restructuring in 2006 and a similar transaction in 2002, whereby certain intangible assets were sold between subsidiaries in order to optimize the Company’s supply chain.  Such assets were sold at estimates of fair value based upon valuations which remain subject to review by the local taxing authorities.  Further the effective tax rate has been affected by non-deductible foreign losses, the generation of unutilizable net operating losses in various jurisdictions, tax planning associated with the acquisition of Breg and the Section 199 deduction related to income attributable to production activities occurring in the United States. 
 
NOTE 15:
EARNINGS PER SHARE
 
For the three and nine month periods ended September 30, 2007 and 2006, there were no adjustments to net income (loss) (the numerators) for purposes of calculating basic and diluted net income (loss) per common share.  The following table sets forth a reconciliation of the share numbers (the denominators) in computing earnings per share in accordance with SFAS No. 128, “Earnings Per Share”:
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2007
   
2006
   
2007
   
2006
 
                         
Weighted average common shares - basic
   
16,639,019
     
16,193,086
     
16,546,385
     
16,084,388
 
Effect of dilutive securities
   
250,284
     
-
     
378,699
     
-
 
Weighted average common shares – diluted
   
16,889,303
     
16,193,086
     
16,925,084
     
16,084,388
 
 

The Company did not include 172,218 and 145,218 options in the diluted shares outstanding calculation for the three and nine month periods ended September 30, 2007, because their inclusion would have been antidilutive or because their exercise price exceeded the average market price of the Company’s common stock during the period.  For both the three and nine month periods ended September 30, 2006, the Company did not include 680,300 options in the diluted shares outstanding calculation because their inclusion would have been antidilutive or because their exercise price exceeded the average market price of the Company’s common stock during the period.

NOTE 16:
DERIVATIVE INSTRUMENT

In 2006, the Company entered into a cross-currency swap agreement to manage its foreign currency exposure related to a portion of the Company’s intercompany receivable of a U.S. dollar functional currency subsidiary that is denominated in Euro.  The derivative instrument, a ten-year fully amortizable agreement with a notional amount of $63.0 million, is scheduled to expire on December 30, 2016.  The instrument is designated as a cash flow hedge.  The amount outstanding under the agreement as of September 30, 2007 is $63.0 million.  Under the agreement, the Company pays Euro and receives U.S. dollars based on scheduled cash flows in the agreement.  The Company recognized the unrealized loss on the change in fair value of this swap arrangement of $0.4 million and $0.6 million, net of tax, within other comprehensive income for the three and nine month periods ended September 30, 2007.

NOTE 17:
CONTINGENCIES
 
Litigation
 
Effective October 29, 2007, the Company’s subsidiary, Blackstone, entered into a settlement agreement with respect to a patent infringement lawsuit captioned Medtronic Sofamor Danek USA Inc., Warsaw Orthopedic, Inc., Medtronic Puerto Rico Operations Co., and Medtronic Sofamor Danek Deggendorf, GmbH v. Blackstone Medical, Inc., Civil Action No. 06-30165-MAP, filed on September 22, 2006 in the United States District Court for the District of Massachusetts. In that lawsuit, the plaintiffs had alleged that (i) they were the exclusive licensees of United States Patent Nos. 6,926,718 B1, 6,936,050 B2, 6,936,051 B2, 6,398,783 B1 and 7,066,961 B2 (the “Patents”), and (ii) Blackstone's making, selling, offering for sale, and using within the United States of its Blackstone Anterior Cervical Plate, 3º Anterior Cervical Plate, Hallmark Anterior Cervical Plate and Construx Mini PEEK VBR System products infringed the Patents, and that such infringement was willful.  The Complaint requested both damages and an injunction against further alleged infringement of the Patents. The Complaint did not specifically state an amount of damages.  Blackstone denied infringement and asserted that the Patents were invalid.  On July 20, 2007, the Company submitted a claim for indemnification from the escrow fund established in connection with the agreement and plan of merger between the Company, New Era Medical Corp. and Blackstone, dated as of August 4, 2006 (the “Merger Agreement”), for any losses to the Company or Blackstone resulting from this matter.  The Company was subsequently notified by legal counsel for the former shareholders that the representative of the former shareholders of Blackstone has objected to the indemnification claim and intends to contest it in accordance with the terms of the Merger Agreement.  The Company is unable to predict the outcome of the escrow claim or to estimate the amount, if any, that may ultimately be returned to the Company from the escrow fund.  The settlement agreement is not expected to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

On or about July 23, 2007, Blackstone received a subpoena issued by the Department of Health and Human Services, Office of Inspector General, under the authority of the federal healthcare anti-kickback and false claims statutes.  The subpoena seeks documents for the period January 1, 2000 through July 31, 2006 which is prior to Blackstone’s acquisition by the Company.  The Company believes that the subpoena concerns the compensation of physician consultants and related matters.  Blackstone is cooperating with the government’s request and is in the process of responding to the subpoena.  The Company is unable to predict what action, if any, might be taken in the future by the Department of Health and Human Services, Office of Inspector General or other governmental authorities as a result of this investigation or what impact, if any, the outcome of this matter might have on its consolidated financial position, results of operations, or cash flows.  On September 17, 2007, the Company submitted a claim for indemnification from the escrow fund established in connection with the Merger Agreement for any losses to the Company or Blackstone resulting from this matter.  The Company was subsequently notified by legal counsel for the former shareholders that the representative of the former shareholders of Blackstone has objected to the indemnification claim and intends to contest it in accordance with the terms of the Merger Agreement.  The Company is unable to predict the outcome of the escrow claim or to estimate the amount, if any, that may ultimately be returned to the Company from the escrow fund.

On or about September 27, 2007, Blackstone received a federal grand jury subpoena issued by the United States’ Attorney’s Office for the District of Nevada (“USAO-Nevada”). The subpoena seeks documents for the period from January 1999 to the present. The Company believes that the subpoena concerns payments or gifts made by Blackstone to certain physicians. Blackstone is cooperating with the government’s request and is in the process of responding to the subpoena.  The Company is unable to predict what action, if any, might be taken in the future by the USAO-Nevada or other governmental authorities as a result of this investigation or what impact, if any, the outcome of this matter might have on its consolidated financial position, results of operations, or cash flows.  It is the Company’s intention to submit a claim for indemnification from the escrow fund established in connection with the Merger Agreement for any losses to the Company or Blackstone resulting from this matter.


By order entered on January 4, 2007, the United States District Court for the Eastern District of Arkansas unsealed a qui tam complaint captioned Thomas v. Chan, et al., 4:06-cv-00465-JLH, filed against Dr. Chan, Blackstone and other defendants including another device manufacturer.  A qui tam action is a civil lawsuit brought by an individual for an alleged violation of a federal statute, in which the U.S. Department of Justice has the right to intervene and take over the prosecution of the lawsuit at its option.  The complaint alleges causes of action under the False Claims Act for alleged inappropriate payments and other items of value conferred on Dr. Chan.  On December 29, 2006, the U.S. Department of Justice filed a notice of non-intervention in the case.  Plaintiff subsequently amended the complaint to add the Company as a defendant.  The Company believes Blackstone and the Company have meritorious defenses to the claims alleged and the Company intends to defend vigorously against this lawsuit.  On September 17, 2007, the Company submitted a claim for indemnification from the escrow fund established in connection with the Merger Agreement for any losses to the Company or Blackstone resulting from this matter.  The Company was subsequently notified by legal counsel for the former shareholders that the representative of the former shareholders of Blackstone has objected to the indemnification claim and intends to contest it in accordance with the terms of the Merger Agreement.  The Company is unable to predict the outcome of the escrow claim or to estimate the amount, if any, that may ultimately be returned to the Company from the escrow fund.

Between January 2007 and May 2007, Orthofix, Inc. and/or Blackstone were named defendants, along with other medical device manufacturers, in three civil lawsuits alleging that Dr. Chan had performed unnecessary surgeries in three different instances.  All three civil lawsuits have recently been served and are pending in the Circuit Court of White County, Arkansas.  The Company believes Blackstone and Orthofix, Inc. have meritorious defenses to the claims alleged and we intend to defend vigorously against these lawsuits.  On September 17, 2007, the Company submitted a claim for indemnification from the escrow fund established in connection with the Merger Agreement for any losses to the Company or Blackstone resulting from one of these three civil lawsuits.  The Company was subsequently notified by legal counsel for the former shareholders that the representative of the former shareholders of Blackstone has objected to the indemnification claim and intends to contest it in accordance with the terms of the Merger Agreement.  The Company is unable to predict the outcome of the escrow claim or to estimate the amount, if any, that may ultimately be returned to the Company from the escrow fund.
 
In addition to the foregoing, the Company has submitted claims for indemnification from the escrow fund established in connection with the Merger Agreement for losses that have or may result from certain claims against Blackstone alleging that plaintiffs and/or claimants were entitled to payments for Blackstone stock options not reflected in Blackstone's corporate ledger at the time of Blackstone's acquisition by the Company.  To date, the representative of the former shareholders of Blackstone and the Company has not objected to approximately $1.5  million in claims from the escrow fund, with certain claims remaining pending. 

The Company cannot predict the outcome of any proceedings or claims made against the Company or its subsidiaries and there can be no assurance that the ultimate resolution of any claim will not have a material adverse impact on its consolidated financial position, results of operations, or cash flows.

In addition to the foregoing, in the normal course of our business, the Company is involved in various lawsuits from time to time and may be subject to certain other contingencies.

Concentrations of credit risk
 
There have been no material changes from the information provided in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006.
 

Ite m 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis addresses our liquidity, financial condition, and the results of our operations for the three and nine months ended September 30, 2007 compared to our results of operations for the three and nine months ended September 30, 2006.  These discussions should be read in conjunction with our historical consolidated financial statements and related notes thereto and the other financial information included in this Form 10-Q and in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.
 
General
 
We are a diversified orthopedic products company offering a broad line of surgical and non-surgical products for the Spine, Orthopedics, Sports Medicine and Vascular market sectors.  Our products are designed to address the lifelong bone-and-joint health needs of patients of all ages, helping them achieve a more active and mobile lifestyle.  We design, develop, manufacture, market and distribute medical equipment used principally by musculoskeletal medical specialists for orthopedic applications.  Our main products are invasive and minimally invasive spinal implant products and related biologics; non-invasive bone growth stimulation products used to enhance the success rate of spinal fusions and to treat non-union fractures; external and internal fixation devices used in fracture treatment, limb lengthening and bone reconstruction; and bracing products used for ligament injury prevention, pain management and protection of surgical repair to promote faster healing.  Our products also include a device for enhancing venous circulation, cold therapy, other pain management products, bone cement and devices for removal of bone cement used to fix artificial implants and airway management products used in anesthesia applications.
 
We have administrative and training facilities in the United States and Italy and manufacturing facilities in the United States, the United Kingdom, Italy and Mexico.  We directly distribute our products in the United States, the United Kingdom, Italy, Germany, Switzerland, Austria, France, Belgium, Mexico, Brazil, and Puerto Rico.  In several of these and other markets, we also distribute our products through independent distributors.
 
Our consolidated financial statements include the financial results of the Company and its wholly-owned and majority-owned subsidiaries and entities over which we have control.  All intercompany accounts and transactions are eliminated in consolidation.
 
Our reporting currency is the United States Dollar.  All balance sheet accounts, except shareholders’ equity, are translated at period-end exchange rates, and revenue and expense items are translated at weighted average rates of exchange prevailing during the period.  Gains and losses resulting from foreign currency transactions are included in other income (expense).  Gains and losses resulting from the translation of foreign currency financial statements are recorded in the accumulated other comprehensive income component of shareholders’ equity.
 
Our financial condition, results of operations and cash flows are not significantly impacted by seasonal trends.  In addition, we do not believe our operations will be significantly affected by inflation.  However, in the ordinary course of business, we are exposed to the impact of changes in interest rates and foreign currency fluctuations.  Our objective is to limit the impact of such movements on earnings and cash flows.  In order to achieve this objective, we seek to balance non-dollar income and expenditures.  During the first nine months of 2007, we have used derivative instruments to hedge  certain foreign currency fluctuation exposures.  See Item 3 – “Quantitative and Qualitative Disclosures About Market Risk.”
 
On September 22, 2006, we completed the acquisition of Blackstone Medical, Inc. (“Blackstone”), a privately held company specializing in the design, development and marketing of spinal implant and related biologics products. The purchase price for the acquisition was $333.0 million, subject to certain closing adjustments, plus transaction costs and other accruals totaling approximately $12.1 million as of September 30, 2007. The acquisition and related costs were financed with $330.0 million of senior secured term debt and cash on hand.  Debt issuance costs were approximately $6.2 million.
 
Effective with the acquisition of Blackstone, we manage our operations as four business segments: Domestic, Blackstone, Breg, and International.  Orthofix Domestic (“Domestic”) consists of operations of our subsidiary Orthofix Inc.  Blackstone consists of Blackstone’s domestic and international operations.  Breg consists of Breg Inc.’s (“Breg”) domestic operations and international distributors.   Orthofix International (“International”) consists of operations which are located in the rest of the world (excluding Blackstone’s international operations), as well as independent export distribution operations.  Group Activities are comprised of the operating expenses and identifiable assets of Orthofix International N.V. and its U.S. holding company, Orthofix Holdings, Inc.
 
 
Segment and Market Sector Revenues
 
The following tables display net sales by business segment and net sales by market sector.  We provide net sales by market sector for information purposes only.  We keep our books and records and account for net sales, costs of sales and expenses by business segment.  In 2006, concurrent with the acquisition of Blackstone, we redefined our business segments and market sectors.  All prior period information has been restated to conform to the new business segments and market sectors.
 
Business Segment:
 
   
Three Months Ended September 30,
 
(In US$ thousands)
 
2007
   
2006
 
   
Net Sales
   
Percent of Total Net Sales
   
Net Sales
   
Percent of Total Net Sales
 
Domestic
  $
41,971
      35 %   $
37,952
      46 %
Blackstone
   
29,448
      24 %    
-
      - %
Breg
   
21,206
      17 %    
18,667
      22 %
International
   
28,495
      24 %    
26,749
      32 %
Total
  $
121,120
      100 %   $
83,368
      100 %
 
 
   
Nine Months Ended September 30,
 
(In US$ thousands)
 
2007
   
2006
 
   
Net Sales
 
 
Percent of Total Net Sales
   
Net Sales
   
Percent of Total Net Sales
 
Domestic
  $
122,718
      34 %   $
113,185
      46 %
Blackstone
   
85,859
      24 %    
-
      - %
Breg
   
61,522
      17 %    
55,901
      22 %
International
   
91,389
      25 %    
80,133
      32 %
Total
  $
361,488
      100 %   $
249,219
      100 %


Market Sector:
 
   
Three Months Ended September 30,
 
(In US$ thousands)
 
2007
   
2006
 
   
Net Sales
   
Percent of Total Net Sales
   
Net Sales
   
Percent of Total Net Sales
 
                         
Spine
  $
61,309
      51 %   $
29,282
      35 %
Orthopedics
   
26,304
      22 %    
23,485
      29 %
Sports Medicine
   
22,075
      18 %    
19,406
      23 %
Vascular
   
4,718
      4 %    
5,084
      6 %
Other
   
6,714
      5 %    
6,111
      7 %
                                 
Total
  $
121,120
      100 %   $
83,368
      100 %
 

   
Nine Months Ended September 30,
 
(In US$ thousands)
 
2007
   
2006
 
   
Net Sales
   
Percent of Total Net Sales
   
Net Sales
   
Percent of Total Net Sales
 
                         
Spine
  $
178,930
      49 %   $
86,781
      35 %
Orthopedics
   
81,933
      23 %    
71,142
      29 %
Sports Medicine
   
64,555
      18 %    
57,919
      23 %
Vascular
   
15,217
      4 %    
15,417
      6 %
Other
   
20,853
      6 %    
17,960
      7 %
                                 
Total
  $
361,488
      100 %   $
249,219
      100 %

 
The following table presents certain items from our Condensed Consolidated Statements of Operations as a percentage of net sales for the periods indicated:
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2007
   
2006
   
2007
   
2006
 
   
(%)
   
(%)
   
(%)
   
(%)
 
                         
Net sales
   
100
     
100
     
100
     
100
 
Cost of sales
   
25
     
25
     
26
     
26
 
Gross profit
   
75
     
75
     
74
     
74
 
Operating expenses (income)
                               
Sales and marketing
   
39
     
44
     
38
     
40
 
General and administrative
   
14
     
15
     
14
     
15
 
Research and development
   
5
      51 *    
5
      20 *
Amortization of intangible assets
   
4
     
2
     
4
     
2
 
KCI settlement, net of litigation costs
   
-
     
-
     
-
      (1 )
Total operating income (loss)
   
13
      (37 )    
13
      (1 )
Net income (loss)
   
7
      (43 )    
6
      (6 )
                                 
 
 
* - Includes $40.0 million related to the write-off of acquired in-process research and development of Blackstone.
 
Three Months Ended September 30, 2007 Compared to Three Months Ended September 30, 2006
 
Net sales increased 45% to $121.1 million for the third quarter of 2007 compared to $83.4 million for the third quarter of 2006.  The impact of foreign currency increased sales by $1.5 million during the third quarter of 2007 as compared to the third quarter of 2006.
 
Sales by Business Segment:
 
Net sales in Domestic increased to $42.0 million in the third quarter of 2007 compared to $38.0 million in the third quarter of 2006, an increase of 11%.  Domestic represented 35% of total net sales during the third quarter of 2007 and 46% of total net sales for the third quarter of 2006. The increase in Domestic sales was partially the result of a 8% increase in sales in the Spine market sector.  This increase continues to be driven by our Spinal-Stim® and Cervical-Stim® products. The Cervical-Stim® continues to be the only FDA-approved stimulation device for the enhancement of fusion in the cervical spine. The Orthopedic market sector sales increased 18% due to increased sales of internal fixation products and a 26% increase in sales of the Physio-Stim® compared to the third quarter of 2006.  These increases were partially offset by a 15% decrease in sales of external fixation products when compared to the third quarter of 2006.
 
 Domestic Sales by Market Sector:
 
   
Net Sales for the
Three Months Ended September 30,
       
(In US$ thousands)
 
2007
   
2006
   
Growth
 
                   
Spine
  $
31,693
    $
29,216
     
8%
 
Orthopedics
   
10,278
     
8,736
     
18%
 
                     
 
 
Total
  $
41,971
    $
37,952
     
11%
 
 
 
Net sales in Blackstone were $29.4 million in the third quarter of 2007, which represented 24% of total net sales for the third quarter of 2007.  There are no sales for Blackstone for the comparable period of the prior year.  All of Blackstone’s sales are recorded in our Spine market sector.  On a pro forma basis Blackstone sales increased 41% when compared to the third quarter of 2006 and would have represented 20% of pro forma total net sales in third quarter 2006.
 
Net sales in Breg increased $2.5 million to $21.2 million for the third quarter of 2007 compared to $18.7 million for the third quarter of 2006, an increase of 14%.  The increase in sales was primarily due to sales of Breg bracing products which increased 18% from the third quarter of 2006.  Our Fusion XT™ products contributed to this increase.  Sales of cold therapy products increased 15% compared to third quarter of 2006. These increases were partially offset by a 5% decrease in sales for pain therapy products.  All of Breg’s sales are recorded in our Sports Medicine market sector.
 
Net sales in International increased 7% to $28.5 million in the third quarter of 2007 compared to $26.7 million in the third quarter of 2006.  International net sales represented 24% and 32% of our total net sales in the third quarter of 2007 and the third quarter of 2006, respectively. The impact of foreign currency increased International sales by 6% or $1.5 million, during the third quarter of 2007 as compared to the third quarter of 2006.  International sales in the third quarter of 2007 were also positively impacted by a 9% increase in Orthopedic products due to increased sales of our internal fixation products, including the eight-Plate Guided Growth System®, as well as increased sales of Physio-Stim® and other products used in orthopedic applications.  Sales of Breg products within International, included in the Sports Medicine market sector, increased $0.1 million or 18% when compared to third quarter 2006.  International sales in the Vascular market sector, which consist of the A-V Impulse product, decreased $0.4 million or 7%.  Sales of our Other products increased $0.6 million or 10% when compared to third quarter 2006.  These increases were slightly offset by sales of external fixation products which decreased 14% compared to the prior period.
 
International Sales by Market Sector:
 
   
Net Sales for the
Three Months Ended September 30,
       
(In US$ thousands)
 
2007
   
2006
   
Growth
 
                   
Spine
  $
168
    $
66
     
155%
 
Orthopedics
   
16,026
     
14,749
     
9%
 
Sports Medicine
   
869
     
739
     
18%
 
Vascular
   
4,718
     
5,084
     
(7)%
 
Other
   
6,714
     
6,111
     
10%
 
                     
 
 
Total
  $
28,495
    $
26,749
     
7%
 
 
Sales by Market Sector:
 
Sales of Spine products increased 109% to $61.3 million in the third quarter of 2007 compared to $29.3 million in the third quarter of 2006.  The increase is primarily due to the addition of Blackstone product sales and sales growth of spinal stimulation products in the United States.  The Cervical-Stim® continues to be the only FDA-approved device for the enhancement of fusion in the cervical spine.
 
Sales of our Orthopedic products increased 12% to $26.3 million in the third quarter of 2007 compared to $23.5 million in the third quarter of 2006.  The increase of $2.8 million was attributable to sales of internal fixation devices including the eight-Plate Guided Growth System ® which increased 74%, Physio-Stim® which increased 28% and sales of other products used in orthopedic applications which increased 142%. These increases were partially offset by sales of external fixation products which decreased 14% compared to the prior period.
 
 
Sales of our Sports Medicine products increased 14% to $22.1 million in the third quarter of 2007 compared to $19.4 million in the third quarter of 2006.  As discussed above, the increase in sales is primarily due to sales of our Breg bracing products and cold therapy, particularly the Fusion™ XT knee brace as well as increased sales of Breg products in International.
 
Sales of our Vascular products decreased 7% to $4.7 million in the third quarter of 2007 compared to $5.1 million in the third quarter of 2006.  The $0.4 million decrease in A-V Impulse sales was due to weaker sales in the US market.
 
Sales of Other products grew 10% to $6.7 million in the third quarter of 2007 compared to $6.1 million in the third quarter of 2006.  The increase was primarily due to an increase in sales of distributed products and airway management products.
 
Gross Profit - Our gross profit increased 45% to $90.4 million in the third quarter of 2007, from $62.4 million in the third quarter of 2006.  The increase was primarily due to the increase of 45% in net sales.  Gross profit as a percent of net sales in the third quarter 2007 was 74.6% compared to 74.8% in the third quarter of 2006. During the third quarter, we experienced negative impacts from the amortization of the step-up in inventory associated with the Blackstone acquisition and from negative foreign currency impacts which were slightly offset by a reversal of a previously recorded accrual made in connection with one of our distributors.  Excluding the favorable benefit to gross margins in the third quarter of 2007, gross margins would have been 73.9%. The step-up in the Blackstone inventory from purchase accounting is now fully amortized .

Sales and Marketing Expenses - Sales and marketing expenses, which includes commissions, royalties and bad debt provision, generally increase and decrease in relation to sales.  Sales and marketing expense increased $10.8 million to $47.1 million in the third quarter of 2007 compared to $36.3 million in the third quarter of 2006.  As a percent of sales, sales and marketing expenses were 38.8% in the third quarter of 2007 compared to 43.5% for the prior year. Sales and marketing expense in the third quarter of 2006 included the impact of approximately $4.7 million of monthly fees associated with the termination of the Medtronic Sofamor Danek (“Danek”) marketing agreement. Excluding these fees, the sales and marketing as a percent of sales in the third quarter of 2006 was 37.9%. The year-over-year increase in sales and marketing as a percent of sales, excluding the impact of the termination of the Danek agreement is primarily attributable to the inclusion of Blackstone sales and marketing expense.

General and Administrative Expense – General and administrative expense increased $5.2 million in the third quarter of 2007 to $16.9 million compared to $11.7 million in the third quarter of 2006.  The increase was primarily attributable to the inclusion of Blackstone general and administrative expense of $4.1 million for which there was no comparable cost in the third quarter of 2006. General and administrative expense as a percent of sales slightly decreased to 14.0% for the third quarter 2007 compared to 14.1% in the prior year.

Research and Development Expense - Research and development expense decreased $36.9 million in the third quarter of 2007 to $6.0 million compared to $42.9 million in the third quarter of 2006.  Research and development expense in the third quarter of 2006 included a charge of $40.0 million related to the write-off of in-process research and development resulting from the Blackstone acquisition.  Approximately $3.2 million is related to Blackstone, for which there was no comparable cost in the prior year.

Amortization of Intangible Assets – Amortization of intangible assets increased $2.8 million in the third quarter of 2007 to $4.7 million compared to $1.9 million in the third quarter of 2006.  Amortization expense included $2.8 million related to amortization of intangible assets acquired in the Blackstone acquisition.

Interest Income (Expense), net – Interest expense, net was $5.7 million in the third quarter of 2007 compared to $0.5 million in the third quarter of 2006.  Interest expense for the third quarter of 2007 included interest expense of $5.6 million related to the senior secured term loan used to finance the Blackstone acquisition.
 
Other Income (Expense), net – Other income, net was $0.5 million for the third quarter of 2007 compared to other expense of $0.5 million in the third quarter 2006. The other income in the third quarter of 2007 was due to foreign exchange gains resulting from the weakening during the quarter of the U.S. Dollar as contrasted to the opposite effect in the third quarter 2006.
 
 
Income Tax Expense Our estimated worldwide effective tax rate was 24.6% and 12.6% during the third quarter of 2007 and 2006, respectively.  The effective tax rates for the third quarter of 2007 included a tax credit for research and development expense relating to 2003.  Without this discrete item our estimated worldwide effective tax rate for the third quarter of 2007 was 26.7% due to the positive effects of our European restructuring, research and development tax credits, tax planning associated with the acquisition of Breg, and an increase in the domestic production deduction, which were partially offset by non-deductible foreign losses and the generation of unutilizable net operating losses in various jurisdictions which negatively affected our tax rate.  The effective tax rate for the third quarter 2006 reflects the non-deductibility, for tax purposes, of the $40.0 million purchased in-process research and development charge associated with the Blackstone acquisition. Excluding the charge for in-process research and development, our effective tax rate was 46% due to negative effects of our European restructuring, tax adjustments in foreign jurisdictions and a higher percentage of income being earned in the United States, a higher tax jurisdiction.
 
Net Income (Loss) Net income for the third quarter of 2007 was $8.0 million, or $0.48 per basic share and $0.48 per diluted share, compared to net loss of $35.4 million, or $2.19 per basic share and $2.19 per diluted share, for the third quarter of 2006.  The weighted average number of basic common shares outstanding was 16,639,019 and 16,193,086 during the third quarter of 2007 and 2006, respectively.  The weighted average number of diluted common shares outstanding was 16,889,303 and 16,193,086 during the third quarter of 2007 and 2006, respectively.


Nine Months Ended September 30, 2007 Compared to Nine Months Ended September 30, 2006
 
Net sales increased 45% to $361.5 million for the first nine months of 2007 compared to $249.2 million for the first nine months of 2006.  The impact of foreign currency increased sales by $5.5 million during the first nine months of 2007 as compared to the first nine months of 2006.
 
Sales by Business Segment:
 
Net sales in Domestic increased to $122.7 million in the first nine months of 2007 compared to $113.2 million in the first nine months of 2006, an increase of 8%.  Domestic represented 34% of total net sales during the first nine months of 2007 and 46% of total net sales for the first nine months of 2006. The increase in Domestic sales was partially the result of a 7% increase in sales in the Spine market sector.  This increase continues to be driven by the only FDA-approved stimulator for the cervical spine, the Cervical-Stim®. The Orthopedic market sector sales increased 13% due to sales of internal fixation products and a 17% increase in sales of the Physio-Stim® compared to the first nine months of 2006.  These increases were partially offset by a 9% decrease in sales of external fixation products when compared to the first nine months of 2006.
 
 Domestic Sales by Market Sector:
 
   
Net Sales for the
Nine Months Ended September 30,
       
(In US$ thousands)
 
2007
   
2006
   
Growth
 
                   
Spine
  $
92,650
    $
86,595
     
7%
 
Orthopedics
   
30,068
     
26,590
     
13%
 
                         
Total
  $
122,718
    $
113,185
     
8%
 
 
Net sales in Blackstone were $85.9 million in the first nine months of 2007, which represented 24% of total net sales for the first nine months of 2007.  There are no sales for Blackstone for the comparable period of the prior year.  All of Blackstone’s sales are recorded in our Spine market sector.  On a pro forma basis Blackstone sales increased 40% when compared to the first nine months of 2006 and would have represented 20% of pro forma total net sales in first nine months 2006.
 
 
Net sales in Breg increased $5.6 million to $61.5 million for the first nine months of 2007 compared to $55.9 million for the first nine months of 2006, an increase of 10%.  The increase in sales was primarily due to sales of Breg bracing products which increased 12% from the first nine months of 2006.  Our Fusion XT™ products contributed to this increase.  Sales of cold therapy products increased 13% compared to the first nine months of 2006. These increases were partially offset by a 11% decrease in sales for pain therapy products.  All of Breg’s sales are recorded in our Sports Medicine market sector.
 
Net sales in International increased 14% to $91.4 million in the first nine months of 2007 compared to $80.1 million in the first nine months of 2006.  International net sales represented 25% and 32% of our total net sales in the first nine months of 2007 and the first nine months of 2006, respectively.  The impact of foreign currency increased International sales by 6%, or $5.3 million, during the first nine months of 2007 as compared to the first nine months of 2006.  Sales in the first nine months of 2007 were also positively affected by a $1.9 million sale to a distributor in Latin America.  International sales in the first nine months of 2007 were also positively impacted by a 16% increase in sales of Orthopedic products due to increased sales of our internal fixation products, including the eight-Plate Guided Growth System ® , as well as increased sales of Physio-Stim® and other products used in orthopedic applications.  Sales of Breg products internationally which are included in the Sports Medicine market sector, increased $1.0 million or 50% when compared to the first nine months of 2006.  International sales in the Vascular market sector, which consist of the A-V Impulse product, decreased $0.2 million.  Sales of our Other products increased $2.9 million when compared to the first nine months of 2006.
 
International Sales by Market Sector:
 
   
Net Sales for the
Nine Months Ended September 30,
       
(In US$ thousands)
 
2007
   
2006
   
Growth
 
                   
Spine
  $
421
    $
186
     
126%
 
Orthopedics
   
51,865
     
44,552
     
16%
 
Sports Medicine
   
3,033
     
2,018
     
50%
 
Vascular
   
15,217
     
15,417
     
(1)%
 
Other
   
20,853
     
17,960
     
16%
 
                     
 
 
Total
  $
91,389
    $
80,133
     
14%
 
 
Sales by Market Sector:
 
Sales of Spine products increased 106% to $179.0 million in the first nine months of 2007 compared to $86.8 million in the first nine months of 2006.  The increase is primarily due to the addition of Blackstone product sales and sales growth of spine stimulation products in the United States.  Spine stimulation sales increased 7% compared to the first nine months of 2006. The Cervical-Stim® continues to be the only FDA-approved stimulation device for the enhancement of fusion in the cervical spine.
 
Sales of our Orthopedic products increased 15% to $81.9 million in the first nine months of 2007 compared to $71.1 million in the first nine months of 2006.  The increase of $10.8 million was attributable to sales of internal fixation devices including the eight-Plate Guided Growth System ® which increased 95% and sales of other products used in orthopedic applications which increased 108%. These increases were partially offset by sales of external fixation products which decreased 6% compared to the prior period.
 
 
Sales of our Sports Medicine products increased 11% to $64.6 million in the first nine months of 2007 compared to $57.9 million in the first nine months of 2006.  As discussed above, the increase in sales is primarily due to sales of our Breg bracing products and cold therapy, particularly the Fusion™ XT knee brace as well as increased sales of Breg products in International.
 
Sales of our Vascular products decreased 1% to $15.2 million in the first nine months of 2007 compared to $15.4 million in the first nine months of 2006.  This decrease was due to a $0.2 million decrease in A-V Impulse sales due to weaker sales in the US market.
 
Sales of Other products grew 16% to $20.9 million in the first nine months of 2007 compared to $18.0 million in the first nine months of 2006.  The increase was primarily due to an increase in sales of distributed products and airway management products.
 
Gross Profit - Our gross profit increased 44% to $266.9 million in the first nine months of 2007, from $185.6 million in the first nine months of 2006.  The increase was primarily due to the increase of 45% in net sales.  Gross profit as a percent of net sales in the first nine months of 2007 was 73.8% compared to 74.5% in the first nine months of 2006. During the first nine months of 2007, we experienced negative impacts from the amortization of the step-up in inventory associated with the Blackstone acquisition and from negative foreign currency impacts which were slightly offset by a reversal of a previously recorded accrual made in connection with one of our distributors.  Excluding the favorable benefit to, gross margins in the first nine months of 2007, gross margins would have been 73.6%. The step-up in the Blackstone inventory from purchase accounting is now fully amortized .

Sales and Marketing Expenses - Sales and marketing expenses, which include commissions, royalties and bad debt provision, generally increase and decrease in relation to sales.  Sales and marketing expense increased $39.9 million to $138.9 million in the first nine months of 2007 compared to $99.0 million in the first nine months of 2006.  As a percent of sales, sales and marketing expenses were 38.4% in the first nine months of 2007 compared to 39.7% for the prior year. Sales and marketing expense in the first nine months of 2006 included the impact of approximately $4.7 million of monthly fees associated with the termination of a marketing services agreement formerly in place between the Company’s subsidiary Orthofix Inc. and Medtronic Sofamor Danek. Excluding these fees, sales and marketing as a percent of sales for the first nine months of 2006 was 37.8%. The year-over-year increase in sales and marketing as a percent of sales, excluding the impact of the termination of the Danek agreement is primarily attributable to the inclusion of Blackstone sales and marketing expense.

General and Administrative Expense – General and administrative expense increased $13.3 million in the first nine months of 2007 to $49.6 million compared to $36.3 million in the first nine months of 2006.  The increase is primarily attributable to the inclusion of Blackstone general and administrative expense of $11.5 million for which there was no comparable cost in the first nine months of 2006. General and administrative expense as a percent of sales decreased to 13.7% for the third quarter 2007 compared to 14.6% in the prior year reflecting leverage obtained from spreading general and administrative costs over a larger revenue base after the Blackstone acquisition.

Research and Development Expense - Research and development expense decreased $30.3 million in the first nine months of 2007 to $18.3 million compared to $48.6 million in the first nine months of 2006.  Research and development expense in the first nine months of 2006 included a charge of $40.0 million related to the write-off of in-process research and development resulting from the Blackstone acquisition.  Approximately $9.4 million is related to Blackstone, for which there was no comparable cost in the prior year.

Amortization of Intangible Assets – Amortization of intangible assets increased $8.3 million in the first nine months of 2007 to $13.7 million compared to $5.4 million in the first nine months of 2006.  Amortization expense included $8.3 million related to amortization of intangible assets acquired in the Blackstone acquisition.

KCI Settlement, Net of Litigation Costs – The gain, net of litigation costs, on the settlement of the KCI litigation in the first nine months of 2006 was $1.1 million for which there was no comparable gain in the first nine months of 2007.

Interest Income (Expense), net – Interest expense, net was $17.2 million in the first nine months of 2007 compared to $0.2 million of interest income in the first nine months of 2006.  Interest expense for the first nine months of 2007 included interest expense of $16.8 million related to the senior secured term loan used to finance the Blackstone acquisition.
 
 
Other Income (Expense), net – Other income, net was $0.3 million for the first nine months of 2007 compared to other expense of $0.8 million in the first nine months of 2006. The other income in the first nine months of 2007 was due to foreign exchange gains resulting from the weakening during the first nine months of the U.S. Dollar as contrasted to the opposite effect in the first nine months of 2006.
 
Income Tax Expense Our estimated worldwide effective tax rate was 26.9% and (348.3)% during the first nine months of 2007 and 2006, respectively.  The effective tax rate for the nine months of 2007 included a tax credit for research and development expense relating to 2003.  Without this discrete item our estimated worldwide effective tax rate for the nine months of 2007 was 27.5% due to the positive effects of our European restructuring, research and development tax credits, tax planning associated with the acquisition of Breg, non-deductible foreign losses, and an increase in the domestic production deduction which were partially offset by the generation of unutilizable net operating losses in various jurisdictions. The effective tax rate for the first nine months of 2006 reflects the non-deductibility, for tax purposes, of the $40.0 million purchased in-process research and development charged associated with the Blackstone acquisition. Excluding the charge for in-process research and development, our effective tax rate was 31%. Our effective tax rate in the first nine months of 2006 benefited from a one-time tax benefit of $2.9 million resulting from our election to adopt a new tax provision in Italy.  Without this discrete item, our estimated worldwide effective tax rate for the first nine months of 2006 was 38% as result of higher production of pre-tax income being earned in the United States, a higher tax jurisdiction.
 
Net Income (Loss) – Net income for the first nine months of 2007 was $21.5 million, or $1.30 per basic share and $1.27 per diluted share, compared to net loss of $14.4 million, or $0.90 per basic share and $0.90 per diluted share, for the first nine months of 2006.  The weighted average number of basic common shares outstanding was 16,546,385 and 16,084,388 during the first nine months of 2007 and 2006, respectively.  The weighted average number of diluted common shares outstanding was 16,925,084 and 16,084,388 during the first nine months of 2007 and 2006, respectively.

Liquidity and Capital Resources
 
Cash and cash equivalents at September 30, 2007 were $23.6 million. This compares to $25.9 million at December 31, 2006.  In addition, we had $11.6 million of restricted cash at September 30, 2007 available for use in our U.S. operations as compared to $7.3 million at December 31, 2006.

Net cash provided by operating activities was $13.8 million for the first nine months of 2007 compared to net cash used in operating activities of $9.0 million in the first nine months of 2006.  Net cash provided by (used in) operating activities is comprised of net income (loss), non-cash items (including stock-based compensation) and changes in working capital.  Net income increased $35.9 million to $21.5 million in the first nine months of 2007 from a net loss of $14.4 million in the comparable 2006 period.  Non-cash items decreased $22.6 million in the first nine months of 2007 compared to the same period in 2006 primarily as a result of the non-cash effect of increased depreciation and amortization related to the Blackstone acquisition and lower deferred tax assets which were offset by decreased in-process research and development costs due the write off of in-process research and development costs associated with the Blackstone acquisition.  Working capital accounts consumed $38.6 million of cash in the first nine months of 2007 compared to $48.0 million in the same period in 2006.  The principal uses of cash for working capital were attributable to increases in accounts receivable and inventory to support additional sales and certain operational initiatives which were partially offset by an increase in other current liabilities.  Overall performance indicators for our two primary working capital accounts, accounts receivable and inventory, reflect days sales in receivables of 90 days at September 30, 2007 compared to 95 days at September 30, 2006 and inventory turns of 1.4 times at September 30, 2007 compared to 2.0 times at September 30, 2006. The lower inventory turns and resultant higher inventory reflect inventory investment to support Blackstone sales, to open an international distribution center and support for new internal fixation products.

Net cash used in investing activities was $25.9 million during the first nine months of 2007 compared to $343.6 million during the first nine months of 2006.  During the first nine months of 2007, we invested $23.8 million in capital expenditures of which $6.2 million were related to the investment in instrumentation and the acquisition of InSWing™ interspinous process spacer patents at Blackstone.  In the first nine months of 2007, we also invested $2.1 million in investment in subsidiaries and affiliates which was a result of adjustments in purchase accounting related to Blackstone and a purchase of a minority interest in our subsidiary in Brazil.  On September 22, 2006, we purchased Blackstone for $333.0 million plus various transaction costs.  In addition, during the first nine months of 2006, we invested $6.8 million in capital expenditures and we paid $1.1 million to purchase 52% of International Medical Supplies Distribution GmbH, a distributor of Breg products in Germany.


Net cash provided by financing activities was $9.3 million in the first nine months of 2007 compared to $325.1 million in the first nine months of 2006.  In the first nine months of 2007, we repaid approximately $6.5 million of principal of the senior secured term loan and borrowed $7.9 million to support working capital in our Italian subsidiary.  In addition, we received net proceeds of $6.8 million from the issuance of 230,894 shares of our common stock upon the exercise of stock options and shares issued pursuant to our employee stock purchase plan. Commencing in June 2007, we offered restricted shares in addition to stock options as a form of stock-based compensation. In the first nine months of 2006, we prepaid the remaining $14.8 million of the principal of the senior secured term loan, which was obtained to help finance the Breg acquisition.  On September 22, 2006, we borrowed $330.0 million in the form of a new senior secured credit agreement, which along with cash balances were used to finance the acquisition of Blackstone and pay debt issuance and other costs.  In addition, we received net proceeds of $10.7 million from the issuance of 376,376 shares of our common stock upon the exercise of stock options and shares issued pursuant to our employee stock purchase plan and $2.0 million of related tax benefit in the first nine months of 2006.

On September 22, 2006 our wholly-owned U.S. holding company subsidiary, Orthofix Holdings, Inc. (“Orthofix Holdings”), entered into a senior secured credit facility with a syndicate of financial institutions to finance the acquisition of Blackstone.  The senior secured credit facility provides for (1) a seven-year amortizing term loan facility of $330.0 million, the proceeds of which, together with cash balances were used for payment of the purchase price of Blackstone; and (2) a six-year revolving credit facility of $45.0 million.  As of September 30, 2007 we had no amounts outstanding under the revolving credit facility and $308.7 million outstanding under the term loan facility.  Obligations under the senior secured credit facility have a floating interest rate of London Inter-Bank Offered Rate (“LIBOR”), or prime rate plus a margin, currently LIBOR plus 1.75%, which is adjusted quarterly based upon the leverage ratio of the Company and its subsidiaries.  Our effective interest rate as of September 30, 2007 on our senior secured debt is 6.95%.  The Company, certain foreign subsidiaries of the Company, including Colgate Medical Limited (Orthofix Holdings’s immediate parent) and certain of Orthofix Holdings’s direct and indirect subsidiaries, including Orthofix Inc., Breg and Blackstone, have guaranteed the obligations of Orthofix Holdings under the senior secured credit facility.  The obligations of Orthofix Holdings under the senior secured credit facility and the guarantors under their guarantees are secured by the pledge of their respective assets located in the United States.

At September 30, 2007, we had outstanding borrowings of $8.4 million and unused available lines of credit of approximately 0.3 million Euro ($0.2 million) under a line of credit established in Italy to finance the working capital of our Italian operations. The terms of the line of credit give us the option to borrow amounts in Italy at rates determined at the time of borrowing.

We will continue to search for viable acquisition candidates that would expand our global presence as well as add additional products appropriate for current distribution channels.  An acquisition of another company or product line by us could result in our incurrence of additional debt and contingent liabilities.

We believe that current cash balances together with projected cash flows from operating activities, the available revolving credit facility, the exercise of stock options, and our debt capacity are sufficient to cover anticipated working capital and capital expenditure needs including research and development costs over the near term.
 

Ite m 3.   Quantitative and Qualitative Disclosures About Market Risk
 
We are exposed to certain market risks as part of our ongoing business operations.  Primary exposures include changes in interest rates and foreign currency fluctuations. These exposures can vary sales, cost of sales, costs of operations, and the cost of financing and yields on cash and short-term investments.  We use derivative financial instruments, where appropriate, to manage these risks.   However, our risk management policy does not allow us to hedge positions we do not hold nor do we enter into derivative or other financial investments for trading or speculative purposes.  As of September 30, 2007, we had a currency swap in place to minimize foreign currency exchange risk related to a 46.2 million Euro intercompany note foreign currency exposure.
 
We are exposed to interest rate risk in connection with our senior secured term loan and borrowings under our revolving credit facility, which bear interest at floating rates based on LIBOR or the prime rate plus an applicable borrowing margin. Therefore, interest rate changes generally do not affect the fair market value of the debt, but do impact future earnings and cash flows, assuming other factors are held constant. 
 
As of September 30, 2007, Orthofix Holdings had $308.7 million of variable rate term debt represented by borrowings under its senior secured term loan at a floating interest rate of LIBOR or prime rate plus a margin, currently LIBOR plus 1.75%, which is adjusted quarterly based upon the leverage ratio of the Company and its subsidiaries.  The effective interest rate as of September 30, 2007 on the senior secured debt is 6.95%.  Based on the balance outstanding under the credit facility as of December 31, 2006 an immediate change of one percentage point in the applicable interest rate on the variable rate debt would cause an increase or decrease in interest expense of approximately $3.1 million on an annual basis. 
 
Our foreign currency exposure results from fluctuating currency exchange rates, primarily the U.S. Dollar against the Euro, Great Britain Pound, Mexican Peso and Brazilian Real.  We face cost of goods currency exposure when we produce products in foreign currencies such as the Euro or Great Britain Pound and sell those products in U.S. Dollars.  We face transactional currency exposures when foreign subsidiaries (or the Company itself) enter into transactions, generally on an intercompany basis, denominated in currencies other than their functional currency.  As of September 30, 2007, we had an uncovered intercompany receivable denominated in Euro for approximately 6.4 million.  We are currently evaluating our options to limit the foreign currency exposure on this receivable.


Item 4.  Controls and Procedures
 
Disclosure Controls and Procedures
 
Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we performed an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a - 15(e) or 15d – 15 (e)) as of the end of the period covered by this report.  Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective.
 
Changes in Internal Control over Financial Reporting
 
In July 2007, we implemented an Enterprise Resource Planning (“ERP”) system at Blackstone, a wholly-owned subsidiary which we acquired on September 22, 2006. The ERP system, developed by Epicor, is expected to improve and enhance internal controls over financial reporting. This ERP system materially changes how transactions are processed at Blackstone.

As a result of the recent acquisition of Blackstone, we are continuing to integrate the processes, systems and controls relating to the acquired subsidiary into our existing system of internal control over financial reporting.
 
We identified certain business process and control issues at our Brazilian subsidiary which has September 2007 year to date revenues of approximately $6.5 million and net income of approximately $0.9 million.  We have commenced implementing certain internal controls to address the business process and control issues.  We expect these certain internal controls to be in place by December 31, 2007.  We have implemented certain additional corporate oversight controls during the third quarter to help minimize the risk of the noted control issues.
 
Except for the processes, systems, and controls relating to the integration of Blackstone and conversion to the ERP system and certain business process and control issues at our Brazilian subsidiary, there have not been any changes in our internal control over financial reporting during the fiscal quarter ended September 30, 2007 that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting.
 

PAR T II          OTHER INFORMATION
 
I tem 1.  Legal Proceedings
 
Effective October 29, 2007, our subsidiary, Blackstone, entered into a settlement agreement with respect to a patent infringement lawsuit captioned Medtronic Sofamor Danek USA Inc., Warsaw Orthopedic, Inc., Medtronic Puerto Rico Operations Co., and Medtronic Sofamor Danek Deggendorf, GmbH v. Blackstone Medical, Inc., Civil Action No. 06-30165-MAP, filed on September 22, 2006 in the United States District Court for the District of Massachusetts. In that lawsuit, the  plaintiffs had alleged that (i) they were the exclusive licensees of United States Patent Nos. 6,926,718 B1, 6,936,050 B2, 6,936,051 B2, 6,398,783 B1 and 7,066,961 B2 (the “Patents”), and (ii) Blackstone's making, selling, offering for sale, and using within the United States of its Blackstone Anterior Cervical Plate, 3º Anterior Cervical Plate, Hallmark Anterior Cervical Plate and Construx Mini PEEK VBR System products infringed the Patents, and that such infringement was willful.  The Complaint requested both damages and an injunction against further alleged infringement of the Patents. The Complaint did not specifically state an amount of damages.  Blackstone denied infringement and asserted that the Patents were invalid.  On July 20, 2007, we submitted a claim for indemnification from the escrow fund established in connection with the agreement and plan of merger between us, New Era Medical Corp. and Blackstone, dated as of August 4, 2006 (the “Merger Agreement”), for any losses to us or Blackstone resulting from this matter.  We were subsequently notified by legal counsel for the former shareholders that the representative of the former shareholders of Blackstone has objected to the indemnification claim and intends to contest it in accordance with the terms of the Merger Agreement.  We are unable to predict the outcome of the escrow claim or to estimate the amount, if any, that may ultimately be returned to us from the escrow fund.  The settlement agreement is not expected to have a material impact on our consolidated financial position, results of operations or cash flows. 

On or about July 23, 2007, Blackstone received a subpoena issued by the Department of Health and Human Services, Office of Inspector General, under the authority of the federal healthcare anti-kickback and false claims statutes.  The subpoena seeks documents for the period January 1, 2000 through July 31, 2006 which is prior to Blackstone’s acquisition by us.  We believe that the subpoena concerns the compensation of physician consultants and related matters.  Blackstone is cooperating with the government’s request and is in the process of responding to the subpoena.  We are unable to predict what action, if any, might be taken in the future by the Department of Health and Human Services, Office of Inspector General or other governmental authorities as a result of this investigation or what impact, if any, the outcome of this matter might have on its consolidated financial position, results of operations, or cash flows.  On September 17, 2007, we submitted a claim for indemnification from the escrow fund established in connection with the Merger Agreement for any losses to us or Blackstone resulting from this matter.  We were subsequently notified by legal counsel for the former shareholders that the representative of the former shareholders of Blackstone has objected to the indemnification claim and intends to contest it in accordance with the terms of the Merger Agreement.  We are unable to predict the outcome of the escrow claim or to estimate the amount, if any, that may ultimately be returned to us from the escrow fund.